Internal Control and Internal Check | Organisation | Auditing

Some of the most frequently asked exam questions on internal check and internal control auditing functions are follows:

Q.1. Discuss the importance of internal control and internal auditing func­tions in an organisation.

Ans. The Statutory Auditor (cost auditor or financial auditor) in forming his opinion on cost and finan­cial information needs reasonable assurance that the accounting system is adequate, that the trans­actions are properly recorded in the Accounting Records and that significant transactions have not been omitted.

Such assurance is usually drawn by him from a combination of reliance on certain in­ternal controls and performance of substantive au­dit procedures. Internal controls coupled with In­ternal Auditing, even if fairly simple and unsophis­ticated, may contribute to the reasonable assurance the Auditor seeks, thus assisting him to reduce the extent of application of substantive tests of audit.

Therefore, it should be obvious that unless an organisation has the machinery or a system to check the accuracy of the records, accounts and primary documents, the Auditor cannot have sufficient and appropriate evidence to certify the correctness of the data, which, in all probability, have to be ac­complished through a vast volume of detailed work.

The special aspects of Internal Control or Internal Audit would, in relation to the accounting records, include checking the arithmetical accuracy of the records (e.g., stocks or raw materials ledger, wages and salaries under different accounting heads etc. control accounts and trial balances, and comparing the results of inventory counts with accounting records.

Further, the Auditor has to give an opinion on the credibility of the company’s Cost and Financial Statements as required by law. It could be possible for him to collect and assess the audit evidence within a reasonable time and at a reasonable cost provided that the organisation has an existence of Internal Control and Internal Auditing systems com­mensurate to its size and complexity.

The existence of such control systems would also assist him to evaluate, judge and become aware of the nature and extent of weakness in them, and to draw the atten­tion of the management, on a timely basis, to the material weaknesses for improvement.

Q.2. Identify the auditor’s approach to the study and evaluation of internal con­trol system operation in an organisa­tion.

Ans. Although specific techniques for study­ing and evaluating internal control system differ among auditors, a general model illustrated below shows the review and evaluation process.

The review of a system of internal controls involves six steps:

1. Obtaining information about the system and the environment in which it operates.

2. Testing the validity of information obtained in Step I.

3. Documenting the auditor’s understanding of the system.

4. Performing a preliminary evaluation of the sys­tem.

5. Undertaking ‘compliance tests’ if controls are reliable.

6. Undertaking ‘substantive tests’ if controls are unreliable.

For obtaining information about the system, the auditor should be alert to the general controls that ensure the functioning of the control system. He should gather information through inquiry and ob­servation of appropriate personnel and reference to procedures manuals, flowcharts, job descriptions, or other information prepared by the client. The general controls here refer to the control environ­ment.

Q.3. The extent and efficacy of internal control largely determines the scope of statutory auditor’s work. Elu­cidate the statement.

Ans. The above definition suggests two types of internal control, viz., administrative controls (i.e., the orderly and efficient conduct of business, and adherence to management policies) and account­ing controls (i.e., the accuracy and completeness of the accounting records, timely preparation of reliable information, the prevention and detection of fraud and error, including the proper accounting for safeguarding of assets).

The ultimate aim and scope of auditor’s work is the examination of fi­nancial statements, viz., Profit & Loss Account and the Balance Sheet, and to certify that the statements present ‘true and fair view’ of the state of affairs of a business enterprise. In order to discharge this res­ponsibility and liability, the auditor should have a firm basis for reliance on the accounting records. This is possible only when he finds that the inter­nal control measures are appropriate to provide him a reasonable assurance about the reliability of ac­counting records and information.

Again, unless an organisation has a system to check the accuracy of the records, accounts, and primary documents, the auditor cannot have sufficient and appropriate evidence to certify the correctness of the data which, in all probability, have to be ac­complished by him through a vast volume of de­tailed work.

The existence of adequate internal control system, commensurate to the size and com­plexity of an organisation, would assist him to evalu­ate, judge and become aware of the nature and ex­tent of weaknesses in them, and to draw the atten­tion of the management, on a timely basis, to the material weaknesses for improvement.

With the above perspective, the Institute of Chartered Accountants of India (in its ‘Guide to Company Audit’) recommends that the auditor should study and evaluate the systems of internal control and internal audit and their effectiveness while determining the scope and extent of an au­diting exercise.

The Companies Auditors’ Report Order, 2003 makes a provision that the auditor has to report specifically on the system of internal control in regard to the purchase of materials, stores, etc., and also to state whether there is an internal audit system commensurate with the nature and size of the company.

Q.4. List the important aspects that an auditor should consider in evaluating the effectiveness of the internal con­trols operating in a computerised ac­counting function in a large organisation.

Ans. The important internal control aspects that are normally built into a computerised (EDP-based) accounts function may be listed as follows:

1. Administrative Controls:

These include:

(a) Division of responsibilities,

(b) Control over computer operators,

(c) File control,

(d) File identification procedures,

(e) File reconstruc­tion procedures and

(f) Fire precaution and stand-by arrangement.

2. System Development Controls:

These include:

(a) Standard procedure and documentation,

(b) System and programme test,

(c) File con­version,

(d) Acceptance and authorisation pro­cedure, and

(e) System and programme amendments.

3. Procedural Controls:

These include:

(a) Input controls establishment of control, verification of conversion, and authorisation of input;

(b) Processing controls;

(c) Output con­trols general, directly related to input, indi­rectly related to input, exception reports, and distribution of output;

(d) Master File Controls amendment to standing data, maintenance of standing data and maintenance of transac­tion data.

Q.5. Stores and spares constitute nearly half the total expenditure of a manu­facturing company. The Managing Director has apprehensions that cer­tain malpractices are going on in the receipt, storage, issue and accounting of stores. He requests you, as an in­ternal auditor of the company, to ex­amine the procedures followed and to suggest an effective internal control system for the receipt, storage and is­sue of stores.

Make a suitable report outlining the various control procedures you would suggest.

Ans. Ref. No. : TA/4/IC Dated 25.4.2004.

To

The Managing Director, X Y Z Mfg. Co. Limited.,

Dear Sir,

Sub: Report on Inventory Control Procedures

Kindly refer to your letter no. XYZ/MC/5 Dated 2.4.2004,1 express my sincerest gratitude to you for the confidence reposed in me, and for request­ing me to examine the procedures followed and to suggest effective internal control system for the re­ceipt, storage, issue and accounting of stores in your works.

My observations vis-a-vis recommendation to bring about the improvements in the system are reported as under:

Observations based on present practices Recommendations:

1. Purchase & Receipts

(i) No Purchase Of­ficer.

(ii) Stores Officer ini­tiates the purchases.

(iii) System of tenders or quotations except for capital goods is absent.

(iv) Incoming materi­als, on many occasions, are received from the sup­plier’s end based on the verbal orders of the stores. Purchase Orders to regularize them are pre­pared based on the sup­pliers’ invoices.

(v) The purchase records kept are neither systematic nor compre­hensive.

(vi) Receipts of stores are not recorded daily.

(vii) No system of pre­paring Goods Received Note.

(viii) No intimation in advance to the accounts dept.. of the stores re­ceived.

The purchasing func­tion should be divorced from the stores. It should be centralised.

Whole time Purchase officer should be en­gaged and authorised to carry out the follow­ing:

(a) Scrutinizing the purchase requisitions;

(b) Maintaining and updating the list of suppliers and their per­formance;

(c) Obtaining quo­tations or tenders from the right suppliers;

(d) Presenting a comparative statement of quotations as to price, quality, quantity, delivery terms, pay­ment terms, special clauses, etc., and ob­taining approval from the Finance dept.; and

(e) Issuing Pur­chase Orders to the Suppliers with copies to receiving/stores/ac­counts/indenting de­partments.

The Receiving function should be in­dependent of Stores. It should prepare G. R. Note for each stores received and send cop­ies to stores/accounts/indenting departments.

2. Storage & Issues:

(i) Predetermination of Stores stock levels is not done.

(ii) Stocks are not veri­fied at regular intervals but at random only at the year end.

(iii) Year-end stocks sub­mitted by the Stores Of­ficer are taken for granted.

(iv) No system of Bin tags.

(v) Issues to the con­suming departments are not always based on au­thorised documents.

(vi) Store-keeping ar­rangements are not sys­tematic.

The function of storekeeping and stores is­suing should be streamlined on the fol­lowing lines:

(a) Verifying in­coming materials with the information con­tained in G. R. Note;

(b) Storing/stack­ing/placing materials at the right bins/contain­ers/spaces-;

(c) Maintaining Bin Cards for each item as a perpetual inventory measure;

(d) Issuing the ma­terials only against Stores Requisitions au­thorised by a Compe­tent Official;

(e) The entries for each receipt and issues, including transfers and returns of stores should be made in Bin Cards promptly;

(f) Material Con­trol dept. should Ad­vise about the stock levels to the Stores Of­ficer; and

(g) Stock checks should be on continu­ous basis by the Offi­cials independent of this dept..

3. Accounting & Control:

(i) List of stores dis­crepancies is not made out.

(ii) No Stores Ledger at the accounts dept..

(iii) Classification of stores based on values is not done as a measure of inventory control

(a) Stores Ledger should be maintained both in quantity and value.

(b) Stores discrepancies should be inves­tigated before book adjustments.

(c) Periodic recon­ciliation between the Stores Ledgers and the Bin Cards should be introduced to locate the differences for further investigation as to the causes.

I would be glad to have further discussions on any of the points indicated above, should you re quire any clarifications.

With kindest regards.

Yours faithfully,

Internal Auditor.

Q.6. What do you understand by the term ‘Internal check’? Or, State the principles of internal check.

Ans. An arrangement of staff duties whereby no one person is allowed to carry through and to record every aspect of a trans­action so that, without collusion between two or more persons, fraud is being prevented and at the same time the possibilities of error are reduced to a minimum. It is, thus, a system whereby the work methods are so laid out that the accounts and procedures are not under the absolute control of anybody. The work of one employee is complementary to that of an­other. A continuous audit is made by employees.

Q.7. How far does internal check affect the work of an auditor?

Ans. The auditor may be relieved of undertaking detailed checking if there is an efficient system of internal check. He can plan to utilise the time saved thereby in auditing the other important areas. But he himself has to decide as to the extent of reliance he can place on the internal checks depending on the particular circumstances. He should test the systems of internal check for his satisfaction.

In the event of his dissatisfaction or suspicion, he must probe the matter to the bottom. In the absence of any suspicious circumstances, he may rely upon the internal checks in force but is not totally relieved of his responsibility. He runs the risk of being held liable for negligence if errors and frauds are de­tected afterwards.

The internal check system is in­troduced not by the auditor but by the client or­ganisation. So, the auditor should appraise the sys­tem for reliability with reasonable skill and care. In short, the existence of an efficient internal check system may reduce the auditor’s work vol­ume but does not reduce his liability.

Q.8. What are the objects, ad­vantages and disadvantages of inter­nal check?

Ans. The objects of internal control are :

(1) To prevent errors or frauds or irregularities;

(2) To pinpoint responsibility on the person(s) and to locate vulnerable stages where frauds and errors occur or are likely to occur;

(3) To increase the efficiency of the staff;

(4) To protect the integrity of the business and to facilitate business control by achieving the reliability of accounting records and data; and

(5) To provide rational allocation of work among the staff.

Advantages of Internal Control:

(1) It prevents errors or frauds or irregularities;

(2) It pinpoints responsibility on the person(s) and locates vulnerable stages where frauds and errors occur or are likely to occur;

(3) It increases the efficiency of the staff;

(4) It protects the integrity of the business and facilitates business control by achieving the reliability of accounting records and data; and

(5) It provides rational allocation of work among the staff.

Disadvantages of Internal Control:

(1)The internal check system is suitable in a big organisation. A small organisation cannot af­ford to it.

(2) Collusion in disguise among the staff is sure to defeat the very purpose of the system.

(3) An auditor, in all probability, relies on the sys­tem and is therefore tempted to apply test-checks rather than thorough checks.

Q.9. (a) What do you understand by ‘Test Checks’?

(b) Indicate the factors to be considered by an auditor when deciding upon the extent of test checks to be made, and

(c) State the advantages and disadvantages of test checks.

Ans. (a) Test Check:

A check on a selection of entries generally made at random or by scien­tific sampling to prove the reliability of accounting procedures and internal control.

It, thus, involves checking a few transactions out of a large number of transactions keeping in view the time at the disposal of the auditor.

(b) When deciding upon the extent of test checks to be applied, the auditor should consider the fol­lowing factors.

(1) Circumstantial factors:

(i) The volume of transactions involved is fairly large;

(ii) The vouching of each and every trans­action is rendered difficult;

(iii) The detailed checking is cumbersome and a costly exer­cise;

(iv) Time available for audit is a con­straint; and

(v) The verification of a large number of similar items does not provide extra reliance on the audit results.

(2) Precautionary factors:

(i) Selection of entries, even if at random, must be repre­sentative;

(ii) Selection of periods and of entries for checking must be different every year;

(iii) System of internal checks in force must be efficient, as otherwise the auditor may be liable for negligence.

(c) Advantages:

(i) It minimizes the work of the auditor;

(ii) It affords economy of time and cost of audit;

(iii) It facilitates audit planning and pro­gramming; and

(iv) It allows more time to be spent in the audit areas where test checks are not suit­able.

Disadvantages:

(i) The errors and frauds may remain undetected;

(ii) The auditor needs to be very careful and must have a keen sense of judgment to apply the system; and

(iii) The auditor runs the risk of being held responsible for negligence for non-detection of errors and frauds.

Q.10. ‘The Auditor Faces two Risks when Performing an Audit”. — Indicate the two risks in clear and precise terms.

Ans. (1) The risks that the client will make an error or perpetrate an irregularity in the processes of ac­counting that will result in misstatements in the cost and/or financial statements. This risk is assessed by the auditor by means of study, test, and evalua­tion of the internal control system operated by the client. It is generally assumed by the auditor that the stronger the system of internal control, the lower the risk that the client will prepare misstated cost and/or financial statements.

(2) The risk that the auditor will not be able to detect errors or irregularities that result in misstated cost and/or financial statements. This risk can, how­ever, be controlled by varying the nature, extent, and timing of the substantive tests (tests of finan­cial statement balances and disclosures, transactions that affect these balances and disclosures, and ana­lytical reviews).

Thus, it may be stated that an inverse relation­ship exists between an effective system of internal controls and the effort of an auditor in testing the balances and disclosures in the cost and/or finan­cial statements.

Q.11. What do you understand by the fol­lowing expression “Assessment of Audit Risk”?

Ans. It is at the final phase of planning and audit. The auditor should obtain knowledge of the busi­ness and of economic and industry conditions to assess his risk. By estimating the areas of risk, he will be in a better position to determine the alloca­tion of time and resources for completion of audit. The assessment of audit risk is usually made by seeking answers to a questionnaire suitably de­signed by the auditor.