ALDRIDGE STATE HIGH SCHOOL

ES6 - INTERNAL CONTROLS

Internal control of a business enterprise involves those internal methods and measures that ensure
efficient management of the enterprise and achievement of planned objectives. In todays
business, internal controls in all areas can be strengthened by the use of computers where
transactions, once recorded, cannot be adjusted.
The general aims of internal control are to:
safeguard the assets of the business
check the accuracy and reliability of the businesss accounting data
promote operational efficiency
encourage aderence to prescribed managerial !"licies.
Accounting controls are the methods and procedures designed to safeguard the assets of the
business and to check the accuracy and reliability of its accounting data.
Administrative controls are the methods and procedures designed to promote operational
efficiency and to encourage adherence to prescribed managerial policies.
Internal controls built into an accounting system aim to:
!re#ent err"rs from being made in the first instance
detect err"rs if they are made
!re#ent teft and fraud from occurring
increase efficiency through budgeting procedures.
Internal acc"unting c"ntr"ls are built around the following se#en !rinci!les:
reliable, competent personnel
verification
authorisation
responsibility
separation of dutiesrotation of duties
ade!uate and accurate documents and records
physical controls and security.
CASH
I$%ORTANCE O& CASH
"ash is such an important asset for the following reasons:
#ost business transactions eventually lead to the business receiving cash $cash receipts% or
paying cash $cash payments%.
&ecause cash is easily stolen, ade!uate controls must be implemented to ensure that people
with dishonest intentions are detected.
GENERAL INTERNAL CONTROLS O'ER CASH
A good system of internal control over cash should have the following features:
All money received should be evidenced by a document or other proof. This makes it more
difficult for employees to steal money. A document or other proof allows the
business to check that the actual cash on hand corresponds to the amount that
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should be on hand.
All cash received should be banked intact at the end of each business day. 'Intact( means that
payments should not be made out of the days receipts. &anking daily ensures that large
amounts of money will therefore not be left on the premises overnight.
All cash payments should be made by che!ue or electronic funds transfer $)*T% e+cept when
amounts are small enough to be paid through a petty cash fund.
All cash should be kept in a safe !lace. "hange kept on hand for the ne+t
working day should be under lock and key, preferably in a safe.
At regular intervals, the businesss records must be checked against, or reconciled with, an
inde!endent rec"rd called a bank statement. This is particularly important where there are
many )*Ts of cash. If this occurs, the receipt of daily bank statements or Internet access to
bank statements is very important. &ank statements are vital, not only to ensure the
reconciliation of the final balance, but also to record the many transactions that are now
occurring electronically.
)mployees who receive or handle cash should not be involved with the recording of these
transactions in the accounting records. This se!arati"n "f duties is designed to prevent a
person from taking money and disguising the theft by adjusting the businesss records.
)mployees are less likely to commit fraud if they know that they can be moved
without prior notice. This r"tati"n "f duties may allow the ne+t person doing
the job to discover any unusual entries. )mployees should also be made to
take annual holidays so that other people do their job in their absence. Again,
errors or unusual entries can be discovered in this way.
CREDIT
I$%ORTANCE O& CREDIT
"ontrol over credit is becoming more important because of the tendency to rely less on cash and
to use credit cards and credit facilities provided. #any business transactions are carried out on a
credit basis, such as the purchasing and selling of inventories. These credit transactions create
accounts receivable and payable and ade!uate controls must be implemented over them.
INTERNAL CONTROL O'ER ACCO(NTS RECEI'A)LE
Credit a!!r"#al:
All customers who apply for credit must be thoroughly investigated for their credit *"rtiness+
,uch things as permanent employment or length of time in business, amount of incomeprofit,
permanent residence, ability to pay debts, past credit history and credit ratings from other firms
must be looked at before credit is given. This investigation is essential, because if credit is given to
the wrong people, there is an increased risk of bad debts occurring.
The business must have a credit !"licy and must decide the following:
what the minimum re!uirements will be before credit is granted
the number of days given for accounts receivable to pay
whether or not discounts will be given
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the amount of interest $if any% that will be charged on overdue accounts
In larger businesses, these functions are generally carried out by a credit department. "redit
approval must always be the responsibility of the finance section and not the responsibility of the
sales section. In this way, salespeople are not tempted to adjust a persons credit rating simply to
get a sale. -hen a credit sale is made, it is important that salespeople check the credit status of
the potential customer.
Rec"rding
The use of c"ntr"l acc"unts and subsidiary ledgers is desirable where the number of accounts
warrant their use. This control occurs through comparison of the schedule of accounts receivable
with the control account in the general ledger.
)illing
A ta, in#"ice is the main document that certifies a credit sale has taken place. An
ad-ust.ent/credit n"te certifies that a sales return or allowance has occurred. As well,
state.ents "f acc"unt should be sent at regular intervals to accounts receivable so that cash
from these credit sales is collected as soon as possible. A statement of account is simply a list of
the transactions $goods sold on credit, cash received and so on% that have occurred and is in the
same form as a three.column ledger.
,tatements of account also help to ensure that the businesss records are correct,
as most people receiving an incorrect statement will contact the firm. This, in
conjunction with spot checks made by the accountant or internal auditor to see that
statements of account agree with actual accounts receivable balance, help ensure
that the businesss accounting records are accurate.
If there is a large number of accounts receivable, a techni!ue called cycle billing may be used.
Instead of sending out all accounts receivable at the end of each month and have a very heavy
workload at that time, cycle billing spreads this workload over the whole month. "ustomers are
grouped alphabetically and statements are sent out in a cycle during the month. *or e+ample,
statements for accounts receivable whose names start with A.* will be sent out on the first day of
every month, /.0 on the 1
th
, #., on the 23
th
and T.4 on the 55
nd
.
Re!"rting
)ach accounts receivable must be monitored to ensure that debts are paid on time. The most
common techni!ue used is called 'ageing the accounts receivable(. A report is prepared setting
out the age of each account as current, up to 67 days past the due date, 87 days past the due date
and so on.
This report identifies slow.paying customers so that appropriate
action can be taken. The older the debt, the less likely it is that the
account will be paid. Accounts receivable must therefore be
constantly reminded of the debt. /enerally, accounts receivable
are contacted by telephone andor reminder notices $varying in
degrees of tact% are sent with overdue accounts. *or e+ample, the
first reminder may say, '9erhaps you have overlooked this account, please pay promptly(. The
final letter may say, 'If payments are not received within 52 days, court action will be taken(.
If all procedures fail to collect the money owing, the account may have to be written off as a bad
debt.
Se!arati"n "f duties
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This is a very important principle of internal control. :o person who handles the physical assets of
cash or inventories should also have access to the accounts receivable records. This is to ensure
that assets are not removed illegally and the records adjusted to cover up the fraud.
INTERNAL CONTROL O'ER ACCO(NTS %A0A)LE
%r"!er aut"risati"n
This should be obtained before goods are ordered. ,uppliers should be approved on the basis of
price, !uality and the ability to fill orders on time. 9roper authorisation must also be obtained
before che!ues are drawn to pay accounts. This ensures that each accounts payable is paid the
correct amount.
Rec"rding
The use of c"ntr"l acc"unts and subsidiary ledgers $if suited to the style of the business% allows
greater control through comparison of the control account in the general edger with the schedule of
accounts payable.
%r".!t !ay.ent
9rocedures should be implemented to ensure that payments are made
promptly, especially within any discount periods. This means that the business
takes advantage of any discounts and maintains its reputation for prompt payments.
Se!arati"n "f duties
9eople who handle the accounts payable records should not handle the payment of cash or the
receipt of inventories.
IN'ENTORIES
I$%ORTANCE O& IN'ENTORIES
Inventories are important for several reasons. They are an integral part of profit determination.
They are used in calculating any inventory adjustment to be included in cost of goods sold and
therefore have a great bearing on the profit figure.
/ross profit ; ,ales < "ost of goods sold
A figure for closing inventories must be obtained so that the &alance ,heet can be accurately
prepared. "losing inventories are one of the items of value owned on balance day.
Inventories should be turned over as !uickly as possible. The faster the turnover $sales%, the
greater the opportunity to make profits.
&ecause large amounts of money are invested in inventories, ade!uate controls
must be implemented so that theft and other losses are kept to a minimum. ,tore
cameras, store detectives, inspection of shopping bags and mirrors are methods
used to prevent theft by customers.
The !uantity of inventories must be continually monitored. :either too
many nor too few inventories should be kept on hand. If the level of
inventories held by the business is too high and goods are not selling,
then money is being tied up and not being used to generate profit. This is
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why many businesses have a clearance sale < to reduce the price and convert slow.moving
inventories to cash so that faster.moving inventories can be purchased. If the level of
inventories held by the business is too low, sales will be lost to competitors and goodwill will
diminish.
The !uality and type of inventories are very important. The business should try to have
available for sale the right goods, at the right place, at the right time. A constant check must be
made to ensure that inventories are not out of date, the wrong colour or si=e, or of poor !uality,
otherwise sales will suffer.
Also, the procedures for controlling inventories depends on the size of the business:
If the business is large, these functions are shared between different departments and internal
controls must be built into the system.

If the business is small, each of the functions could be performed and supervised by the owner
so that control measures are more easily implemented.
St"c1ta1ing 2!ysical st"c1ta1e "r !ysical in#ent"ry3
If a business keeps inventories as part of its normal operation, an annual
physical st"c1ta1e is a necessity.
St"c1ta1ing is te !r"cess "f listing4 c"unting and #aluing uns"ld in#ent"ries "n and+
A stocktake is necessary for two main reasons:
It is needed to determine the value of the inventories on hand at a particular date. This value is
used in the &alance ,heet.
It is the only way of determining actual inventories on hand. If the perpetual inventory system
is used, the figure arrived at can also be compared with what should have been on hand. It
can them be seen whether goods have been lost through theft or spoilage.
INTERNAL CONTROL O'ER THE %(RCHASE O& IN'ENTORIES
The ordering of goods is dependent upon three factors:
te re"rder !"int, which is a predetermined minimum amount of an item that a business
would like to maintain
te re"rder 5uantity, which is the !uantity to be ordered when the reorder point is reached
te lead ti.e4 which is the amount of time it takes from when a business places an order to
when the product actually arrives.
/enerally, the longer the lead time $if, for e+ample, the goods have to come from overseas%, the
higher the reorder point and the higher the reorder !uantity. The shorter the lead time $if, for
e+ample, the supplier is in the same city%, the lower the reorder point and the lower the reorder
!uantity.
-hen the goods are ordered, a !urcase "rder or an "rder f"r. is despatched to the
supplier.
-hen the goods are received, a deli#ery d"c1et or des!atc d"c1et will accompany the
goods. "are must be taken to ensure that the goods received are in fact the goods ordered.
An original ta, in#"ice may be received at the time of delivery or at a later date.
If goods are returned by us $purchases returns%, an original ad-ust.ent/credit n"te will be
received.
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INTERNAL CONTROL O'ER THE SALE O& IN'ENTORIES
>rders may be received over the counter, by post, by telephone, from travelling salespeople or
electronically by electronic data interchange $)?I% or from a website.
If orders are not received electronically, they are generally entered onto a standardised sales
"rder to be processed by the organisation.
-hen the order is filled, details of the transaction are recorded on an original ta, in#"ice and
an original des!atc d"c1et+ The original despatch docket will accompany the goods and the
original ta+ invoice can accompany the goods or be sent later. "opies are kept by our
business.
If goods are returned to us $sales returns%, an original ad-ust.ent/credit n"te will be sent and
a copy kept by us.
If goods are sold for cash, a cash register summary is generally used.
INTERNAL CONTROL O'ER STORED IN'ENTORIES
&ecause inventories represent such a large investment by the business, loss through theft,
damage, deterioration or obsolescence lead to lower sales and therefore lower profit. Ade!uate
controls must therefore be implemented. These controls are generally e+ercised over location,
security and turnover.
L"cati"n
Inventories should be warehoused where they are readily accessible by those people
authorised to handle them. At each location, inventories of a similar nature should be stored
together.
In a retail situation, the goods should be displayed in the most appropriate way in order to
ma+imise e+posure, but minimise the risk of loss through theft.
Security
The warehouse must be locked and only authorised personnel should have access to the keys.
&urglar alarms and ade!uate security staff should be employed.
Appropriate documentation must be completed when inventories enter and leave the
warehouse.
In a retail store, various measures can be adopted to stop pilfering by staff and shoplifting by
customers. These include bag inspections, video cameras, dye markers and store detectives.
Inventories must be ade!uately insured.
Turn"#er
Inventories should be turned over as !uickly as possible. The faster the turnover $sales%, the
greater the opportunity to make profits.
It is most important that measures be taken to ensure that items that are purchased first are
sold first. In this way, inventories will be rolled over and old stock will not be left standing on
shelves or lying at the bottom of bins.
A minimum of one stocktake must be taken each year. ,tocktakes determine the amount and
condition of inventories on hand. They help to detect slow.moving inventories and those out of
date or damaged. ,teps may have to be taken to dispose of unsuitable inventories.
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NON C(RRENT ASSETS
:on.current assets are assets, other than current assets, that are purchased by the
business and are not intended for resale but are used within the operation of the
business to earn revenue, and will normally be kept and used for longer than one
accounting period. "urrent assets are those assets which are in the form of cash or
will be converted into cash within the financial year, such as inventories and accounts receivable.
-hen non.current assets are classified in the &alance ,heet, they are grouped under the following
headings 9roperty, 9lant and )!uipment, Intangible Assets and Investments.
These assets are specifically ac!uired because they will help the business grow, it is therefore
necessary to ensure appropriate controls are implemented over these long.term assets.
INTERNAL CONTROLS O'ER %RO%ERT04 %LANT AND E6(I%$ENT
The most important control over 9roperty, 9lant and )!uipment is the 9roperty, 9lant and
)!uipment register. -hen a business has more than one item of 9roperty, 9lant and )!uipment, it
is desirable that a register be kept to record details of each asset. A register enables:
9roper control over such assets through the use of the control accountsubsidiary ledger
techni!ue.
Accurate accounting for property, plant and e!uipment.
INTERNAL CONTROLS O'ER THE %(RCHASE O& %RO%ERT04 %LANT 7 E6(I%$ENT
Aut"risati"n 8 The purchase of an item of 9roperty, 9lant and )!uipment is a major decision,
therefore re!uires higher level management to authorise such purchases.
Selecti"n < As the purchase of an item of 9roperty, 9lant and )!uipment will commit the business
to large payments of money, it is important all facts are known before purchase. )g. 9erformance,
reliability, anticipated repair costs, cost of delivery, etc.
%r""f "f "*nersi! < The purchase of 9roperty, 9lant and )!uipment is usually accompanied by
proof of ownership, such as title deeds to property. These need to be kept in a safe or a bank
safety deposit bo+.
%ay.ent "f cas < >nce the purchase is authorised, it becomes a normal cash payment and
details are recorded in the 9roperty, 9lant and )!uipment register.
INTERNAL CONTROL O'ER THE STORAGE O& %RO%ERT04 %LANT 7 E6(I%$ENT
L"cati"n < All assets should be identified by some means, usually by a number. The 9roperty,
9lant and )!uipment register identifies assets owned and their location.
$aintenance < It is essential that all assets are kept in good working order.
%r"tecti"n < The assets need to be protected against theft and damage. Ade!uate insurance
should also be maintained against any unforeseen circumstances.
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INTERNAL CONTROL O'ER THE DIS%OSAL O& %RO%ERT04 %LANT 7 E6(I%$ENT
Aut"risati"n < To prevent an unauthorised employee selling valuable assets, proper
authorisation must occur when disposing of assets.
%ysical dis!"sal < This can take place in the form of outright sale, tender, trade.in or scrapping.
-hichever method is adopted, the best possible price should be obtained, and this, too, should be
authorised.
Recei!t "f cas < *or all money received from the disposal of an asset, a receipt must be issued
and the money put through the cash receipts journal. ?isposal of the asset is then recorded in the
9roperty, 9lant and )!uipment register.
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Internal C"ntr"ls Re#isi"n 6uesti"n
Terri #aker owns #erry #usic #akers, a music store, and employs an
accountant, an accounts clerk, two cash register operators, and a part.time
sales assistant. After analysis of the cash, credit and inventories procedures
undertaken in her business, she e+plained the current practices:
The cash register operators totalled the cash they received for the day and passed
the cash and the receipts to the accountant. The accountant recorded the receipts
in the cash receipts journal.
Any cash received by mail was recorded and receipted by the accountant in a cash
remittance book.
The accounts clerk was given the money at the end of the day with a deposit slip
already completed by the accountant. If the accounts clerk was too busy, he would
lock the cash in the safe for the night and go to the bank whenever he could the
ne+t day.
>n *riday, the part.time sales assistant would be paid in cash from the cash
register.
>ther employees would be paid by che!ue or direct deposit.
As soon as any invoices were received, the accountant would place them in a
folder. At the end of the month, the accountant had the authority and proceeded to
prepare and sign the che!ues.
The accounts clerk kept a petty cash system for small payments. >n the rare
occasion that the fund did not balance, money was transferred from the cash
register to the petty cash fund.
)ach month a bank statement was received and the accountant was responsible for
the reconciliation process. The accountant then informed #s #aker of the cash
position of the business.
All staff are trustworthy and are permitted to purchase stock by completing a
purchase order form. Any staff member unloads all stock received and stack it on
the shelves.
The business does not have any way of knowing what stock should
be on hand.
>verdue account notices are sent out once an account is 87 days
overdue.
As #s #akers auditor, analyse control, or procedural, weaknesses that you have found
and which could be improved.
Rec"..end major processes which need to be addressed.
A full e+planation is re!uired.
9repare your answer in re!"rt format, appro+imately 877 words, and provide any
additional information.
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INTERNAL CONTROLS E9TRA RE'ISION 6(ESTION
@ou work as a junior accountant for -illiams and ,ons, "hartered Accountants. @our
employers have presented the following case study to you.
Aead the case study and apply your knowledge of accounting internal controls in the areas
of cash, inventories, credit transactions and non.current assets to deter.ine whether
appropriate procedures have been followed. /ive your rec"..endati"ns to improve the
situation.
The case study is as follows:
&rutons ,hoe ,tore, 277 /oondoon ,treet, /ladstone specialises in
selling shoes. #s Tracy &ruton owns and manages the business which
has two full.time employees and two part.time employees. #s &ruton has
asked you to investigate the controls in place in the areas of cash, credit, inventories and
non.current assets and make recommendations to improve internal control in these areas.
#s &ruton ensures that all staff fre!uently try different tasks so they become skilled in
most areas. ,he also allows any of the staff to order stock for the store, by completing an
order form when they believe that levels are low. -hen inventories are received from the
supplier, any of the staff available help to unload and store the goods in the storeroom. #s
&ruton bases inventory levels on past e+perience and the advice of her staff. -hen the
monthly statements are prepared, she makes an estimate at the end of the month for
closing inventories, e+cept at the end of the financial year when a complete physical
stocktake is undertaken.
The Accounts #anager, #ichael ?ickson, keeps control of all accounts in the business and
operates a general ledger only. #ichael collects all the money, records all financial
transactions, and completes the banking twice a week. The Accounts "lerk, Bohn "harles,
is not permitted to enter any accounting data and basically does general office duties, so
#ichael has more time to do the books. The business has appro+imately 577 accounts
receivable and 277 accounts payable, which are both maintained manually.
Accounts payable usually operate on the terms 327, n67 and accounts receivable
generally settle accounts within C7 days. #ichael gives Bohn a list of overdue accounts so
that reminders can be sent out once an account is 87 days overdue.
?uring the month, Bohn places any unpaid invoices into a folder and gives these to
#ichael on the 67
th
of each month, in order for him to pay them. #ichael has authority to
sign che!ues to pay for these invoices if #s &ruton is not available.
The full.time staff are paid on a weekly basis through a direct deposit from the businesss
bank account to their own bank accounts. The part.time staff, however, are paid from the
cash in the till. This saves #ichael having to write out a che!ue.
The business has a number of laptops for staff to work on. As there was a lack of space
the laptops were stored in a cupboard with the cleaning products. #s &ruton re!uired a
laptop, however, when he went to the cupboard there were none left, no one knew where
they all were.
9repare a report to #s &ruton highlighting areas of control in which you
would implement changes and state why these changes are necessary.
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