TOPIC 8 INTERNAL CONTROL: A VITAL TOOL IN MANAGING RISKS

1.      Define internal control.

It is the process designed and effected by those charged with governance,

management and other personnel to provide reasonable assurance about the
achievement of the entity’s objectives with regard to reliability of financial reporting,
effectiveness and efficiency of operations and compliance with applicable laws and
regulations.

2.      What are the objectives of internal control?

 Reliability of the entity’s financial reporting

 Effectiveness and efficiency of operations

 Compliance with applicable laws and regulation

3.      What is internal control system?

It means that all internal controls adopted by the management of an entity to

assist in achieving objective of ensuring the orderly and efficient conduct of its business,
including adherence to management policies, the safeguarding of assets, the prevention
and detection of fraud and error, the accuracy and completeness of the accounting
records, and the timely preparation of reliable financial information.

4.      What are the elements of internal control?  Summarize each component and
its factors and components.

A. Control Environment

Factors reflected in the control environment:

 The function of the board of directors and its committees

 Management’s philosophy and operating style

 The entity’s organizational structure and methods of assigning

authority and responsibility

 Management’s control system including the internal audit function

personnel policies and procedures and segregation of duties

Factors comprising the control environment:

1. Communication and Enforcement of Integrity and Ethical Values

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 2. Commitment to Competence

3. Participation by those Charged with Governance

4. Management’s Philosophy and Operating Style

5. Organizational Structure

6. Assignment of Authority and Responsibility

7. Human Resources Policies and Procedures

B. Entity’s Risk Assessment Process

Risk can arise or change due to following circumstance:

 Changes in operating environment

 New personnel

 New or revamped information systems

 Rapid growth

 New technology

 New business models, products, or activities

 Corporate restructurings

 Expanded foreign operations

 New accounting pronouncements

Considerations Specific to Smaller Entities

It is the engagement partner who would be responsible for

considering the susceptibility of entity’s financial statements to material
misstatements due to fraud and error.

C. Information System, Including the Business Process, Relevant to

Financial Reporting and Communication

This consists of procedures and records designed and established to:

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  Initiate, record, process, and report entity transactions and to
maintain accountability for the related assets, liabilities, and equity.

 Resolve incorrect processing of transactions, for example,

automated suspense files and procedures followed to clear
suspense items out on a timely basis

 Process and account for system overrides or bypasses to controls

 Transfer information from transaction processing systems to the

general ledger

 Capture information relevant to financial reporting for events and

conditions other than transaction, such as the depreciation and
amortization of assets and changes in the recoverability of
accounts receivables

 Ensure information required to be disclosed by the applicable

financial reporting framework is accumulated, recorded, processed,
summarized and appropriately reported in the financial statements

Journal Entries

These are required on recurring basis to record transactions. It also

includes the use of non-standard journal entries to record non-recurring,
unusual transactions or adjustments.

Related Business Processes

 Develop, purchase, produce, sell and distribute an entity’s products

and services

 Ensure compliance with laws and regulations

 Record information, including accounting and financial reporting

information

Information system encompasses methods and records that:

 Identify and record all valid transactions.

 Describe on a timely basis the transactions in sufficient detail to

permit proper classification of transactions for financial reporting.

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  Measure the value of transactions in a manner that permits
recording their proper monetary value in financial statements.

 Determine the time period in which transactions occurred to permit

recording of transactions in the proper accounting period.

 Present properly the transactions and related disclosures in the

financial statements.

Application to Small Entities

Information systems in small business are likely to be less formal

but their role is just as significant.

D. Control Activities

Major categories of control procedures:

A. Performance Review

B. Information Processing Controls

1. Proper authorization of transactions and activities

2. Segregation of duties

3. Adequate documents and records

4. Safeguard over access to assets

5. Independent checks on performance

C. Physical Controls

E. Monitoring of Controls

It involves the assessing of design and operation of controls on a timely

basis and taking corrective action as necessary. Some monitoring
activities may include communications from external parties.

Application to Small Business

They are more likely to be informal and are typically performed as a part of
the overall management of the entity’s operations.

5.      What is the relationship among the 5 components of internal control?

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 The five components relate to each other, because all of them must be present to
have a satisfactory system of control in almost any large scale organization. They also
relate to the functions of the accounting system.

6.      Define fraud.

It is an intentional act involving the use of deception that results in a material

misstatement of the financial statements.

7.      Fraud vs. Error

Intent to deceive is what distinguishes fraud from errors. Errors are not
intentional.

8.      What are the types of misstatements?  Summarize each type and its
components

A. Misstatements arising from front misappropriation of assets

It occurs when a perpetrator stelas or misuses an organization’s assets. It

commonly occurs when employees:

 Gain access to cash and manipulate accounts to cover up cash thefts

 Manipulate cash disbursements through fake companies

 Steal inventory or other assets and manipulate the financial records to

cover up the fraud

B. Misstatements arising from fraudulent financial reporting

Three common ways in which this can take place include:

 Manipulation, falsification, or alteration of accounting records or supporting

documents

 Misrepresentation or omission of events, transactions, or other significant

information.

 Intentional misapplication of accounting principles

9.      What is the fraud triangle?  Summarize each element and its components

It characterizes incentives, opportunities and rationalizations that enable fraud to

exist.

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 Three elements of the fraud triangle:

 Incentives or Pressures to Commit Fraud

Incentives relating to asset misappropriation:

o Personal factors

o Pressure from family, friends, or culture

o Addictions

Incentives for fraudulent financial reporting

o Management compensation schemes

o Improved earnings or balance sheet

o Debt covenants

o Pending retirement or stock option expirations

o Personal wealth

o Greed

 Opportunities to Commit Fraud

The management should consider:

o Significant related-party transactions

o Company’s industry position

o Management’s inconsistency

o Simple transactions made complex

o Complex transactions

o Ineffective monitoring of management by the board

o Complex organizational structure

o Weak internal controls

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  Rationalizing the Fraud

For asset misappropriation, it often revolves around mistreatment by the

company or a sense of entitlement by the individual perpetrating the fraud.

For fraudulent financial reporting, the rationalization can range from

“saving the company” to personal greed.

10.  What are the risk factors contributory to misappropriation of assets? 

Summarize the components of the fraud involved vis-à-vis incentive/pressures,
opportunities and attitudes/rationalization

 Embezzling receipts

 Stealing physical assets or intellectual property

 Causing an entity to pay for goods and services not received

 Using an entity’s assets for personal use

A. Incentives/Pressure

1. Personal financial obligations may create pressure to misappropriate

assets

2. Adverse relationship between the entity and employees with access to

cash or other assets may motivate to misappropriate those assets.

B. Opportunities

1. Certain characteristics or circumstances may cause asset

misappropriation such as:

a. Large amount of cash on hand or processed

b. Inventory items that are small in size, of high value, or in high

demand

c. Fixed assets which are small in size, marketable, or lacking

observable ownership

2. Inadequate internal control over assets in terms of:

a. Segregation of duties

b. Oversight of senior management expenditures

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 c. Management oversight of employees responsible for assets

d. Job applicant screening

e. Record keeping with respect to assets

f. System of authorization

g. Physical safeguards over cash

h. Complete and timely reconciliation of assets

i. Appropriate documentation

j. Mandatory vacations for employees

k. Management understanding of information technology

l. Access controls over automated records

C. Attitudes/Rationalizations

1. Disregard for the need for monitoring assets

2. Disregard for internal control

3. Behavior indicating displeasure with the entity

4. Changes in behavior or lifestyle

5. Tolerance of petty theft

11.  What are the risk factors contributory to fraudulent financial reporting?

Summarize the components of the fraud involved vis-à-vis incentive/pressures,
opportunities and attitudes/rationalization

 Manipulation, falsification, or alteration of accounting records

 Misrepresentation or omission in the financial statements

 Intentional misapplication of accounting principles

A. Incentive/Pressure

This may exist when management is under pressure, from outside or inside
the entity, to achieve an expected earnings target or financial outcome.

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 B. Opportunities

This exist when an individual believes internal control can be overridden,

because an individual is in a position of trust or has knowledge of specific
weaknesses in internal control.

C. Rationalizations

Some individuals possess an attitude, character or set of ethical values that

allow them knowingly and intentionally to commit a dishonest act.

12.  Who is responsible for the prevention and detention of fraud?

It rests with both those charged with governance of the entity and management.

13.  What are the 3 basic business transaction cycles?

1. Sales and Collections Cycle

2. Acquisitions and Payment Cycle

3. Payroll and Personnel Cycle

14.  Discuss the errors and fraudulent activities that could result if there is poor
internal control pertaining to each cycle.

I. Sales and Collections Cycle

1. Errors in Recording Sales and Collections Transactions include

mechanical errors, recording sales in wrong period, bookkeeper’s failure
to understand proper accounting for a transaction

2. Fraud in Sales and Collections generally relate to fraudulent financial

reporting. Frauds in cash collection is typically accomplished by clerk or
management-level employees.

a) Fraudulent Financial Reporting involving sales typically results in

overstated sales or understated sales returns and allowances.

b) Misappropriation of Assets: Withholding Cash Receipts

1. Skimming – refers to the act of withholding cash receipts without

recording them

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 2. Lapping – used to conceal the fact that cash has been
abstracted; the shortage in one customer’s account is covered
with a subsequent payment made by another customer.

3. Kiting – counting the cash twice by using the float in the banking
system.

II. Acquisition and Payments Cycle

1. Errors in the Acquisition and Payments Cycle

 Failing to record a purchase in the proper period

 Recording goods accepted on consignment as a purchase

 Misclassifying purchases of assets and expenses

 Failing to record a cash payment

 Recording a payment twice

 Failing to record prepaid expenses as assets

2. Fraud in the Acquisitions of Payment Cycle

a) Paying for Fictitious Purchases involves creating fictitious invoice

and processing the invoice for payment.

b) Receiving Kickbacks is when purchasing agent may agree with a

vendor to receive a kickback (refund payable to the purchasing
person on goods or services acquired from the vendor).

c) Purchasing Goods for Personal Use may be done by executive or

purchasing agents and charged to the company’s account.

III. Payroll and Personnel Cycle

1. Errors

a) Paying employees at the wrong rate

b) Paying employees for more hours than they worked

c) Charging payroll expense to the wrong accounts

d) Keeping terminated employees on the payroll

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 2. Frauds involving payroll

a) Fictitious employees

b) Excess payments to employees

c) Failure to record payroll

d) Inappropriate assignment of labor costs to inventory

15.  Which department or who is responsible in handling cash of the company?

It is the responsibility of the finance department, under the direction of the

treasurer.

16.  What is necessary in developing the most efficient control procedure of cash

handling?

There should be a detailed study of the business processes of the company.

17.  Summarize the guidelines for achieving internal control over cash.

1. Do not permit any one employee to handle a transaction from beginning to

end

2. Separate cash handling from record keeping

3. Centralize receiving of cash to the extent practical

4. Record cash receipts on a timely basis

5. Encourage customers to obtain receipts

6. Deposit cash receipts daily

7. Make all disbursements by check or electronic fund transfer

8. Have monthly bank reconciliation by employees not in custody of cash.

9. Monitor cash receipts and disbursements

Study and familiarize yourself with the potential misstatements for cash receipts;
cash disbursements, the examples and internal control weakness or factors that
increase the risk of misstatement.

18.  What are the most important group of financial investments?  Why?

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 It consists of marketable stocks and bonds, because they are found more
frequently and usually are of greater peso value than the other kinds of investment
holdings.

19.  What are the elements of adequate internal control over financial

investments?

1. Formal investment policies that limit the nature if investments in securities and
other financial instruments.

2. An investment committee of the board of directors that authorizes and reviews

financial investment activities for compliance with investment policies.

3. Separation of duties between the executive authorizing purchases and sales of

securities and derivative instruments, the custodian of the securities, and the person
maintaining the records of investments.

4. Complete detailed records of all securities and derivative instruments owned

and the related provisions and terms

5. Registration of securities in the name of the company.

6. Periodic physical inspection of securities on hand by an internal auditor or an

official having no responsibility for the authorization, custody, or record keeping of
investments.

7. Determination of appropriate accounting for complex financial instruments by

competent personnel.

Study and familiarize yourself with the potential misstatements for financial
investments, the examples and internal control weakness or factors that increase
the risk of misstatement.

20.  What is included in accounts receivables?

These include not only claims against customers arising from the sales of goods
or services, but also a variety of miscellaneous claims such as loans to officers or
employees, loans to subsidiaries, claims against various other films, claims for tax
refunds and advantages to suppliers.

21.  Define notes receivable and its use in business.

Notes receivable are written promises to pay certain amounts at future dates. It is
used for handling transactions of substantial amount.

22.  Summarize the control environment concerning revenues.

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 Because of the risk of intentional misstatement of revenues, the control
environment is very important. Of particular importance is an independent audit
committee of the board of directors that monitors management’s judgements about
revenue recognition principles and estimates. Management should establish a tone at
the top of the organization that encourages integrity and ethical financial reporting.
These ethical standards should be communicated and observed throughout the
organization.

23.  Study and familiarize yourself with the potential misstatements for

revenues/receivables, the examples and internal control weakness or factors that
increase the risk of misstatement.

24.  What is the basic characteristic of effective control over notes receivables? 

What will this principle require?

The basic characteristic consists of subdivision of duties. This principle requires

that:

1. The custodian of notes receivable not have access to cash or to

general accounting records

2. The acceptance and renewal of notes be authorized in writing by a

responsible official who does not have custody of the notes.

3. The write-off of defaulted notes be approved in writing by responsible

officials and effective procedures adopted for subsequent follow-up of
such defaulted notes.

25.  What internal control system should be implemented or designed over cost

of goods sold?

These controls include procedures for selecting vendors, ordering merchandise

or materials, inspecting goods received, recording liability to the vendor, and authorizing
and making cash disbursements.

26.  What are the sources and nature of inventories and cost of goods sold?

1. Goods on hand ready for sale, whether the merchandise of a trading

concern or the finished goods of a manufacturer.

2. Goods in the process of production

3. Goods to be consumed directly or indirectly in production, such as raw

materials, purchased parts, and supplies.

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Study and familiarize yourself with the potential misstatements for inventory/cost
of goods sold, the examples and internal control weakness or factors that
increase the risk of misstatement.

27.  What is included in the term property, plant and equipment?

It includes all tangible assets with a service life of more than one year that are
used in the operation of the business and are not acquired for the purpose of resale.

28.  What are the 3 major subgroups?

1. Land

2. Buildings, machinery, equipment and land improvements

3. Natural resources

29.  Summarize the internal control over plant and equipment.

1. A subsidiary ledger consisting of a separate record for each unit of

property.

2. A system of authorization requiring advance executive approval of all

plant and equipment acquisitions, whether by purchase, lease or
construction.

3. A reporting procedure assuring prompt disclosure and analysis of

variances between authorized expenditures and actual costs.

4. An authoritative written statement of company policy distinguishing

between capital expenditures and revenue expenditures.

5. A policy requiring all purchases of plant and equipment to be handled

through the purchasing department and subjected to a standard
routine for receiving, inspection and payment.

6. Periodic physical inventories designed to verify the existence, location

and condition of all property listed in the accounts and to disclose the
existence of any unrecorded units.

7. A system of retirement procedures, including serially numbered

retirement work orders, stating reasons for retirement and bearing
appropriate approvals.

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Study and familiarize yourself with the potential misstatements for investments in
property, plant and equipment, the examples and internal control weakness or
factors that increase the risk of misstatement.

30.  Define accounts payable.

It is used to describe short-term obligations arising from the purchase of goods

and services in the ordinary course of business.

31.  What are the typical transactions creating accounts payable?

These include the acquisition on credit of merchandise, raw materials, plant

assets and office supplies.

32.  What are the sources of accounts payable?

Other sources include the receipt of services, such as legal and accounting
services, advertising, repairs and utilities.

33.  Summarize the internal control measures over accounts payable.

It is important to recognize that the account payable of one company are the
accounts receivable of other companies. Thus, there is a little danger off errors, since
the client’s creditors will generally maintain complete records of their receivables and
will inform the client if payment is not received. Some companies may choose to
minimize their record keeping of liabilities and to rely on creditors to call attention to any
delay in making payment.

Study and familiarize yourself with the potential misstatements for accounts
payable, the examples and internal control weakness or factors that increase the
risk of misstatement.

34.  Summarize the internal control over debts.

Authorization by the Board of Directors

The bylaws of a corporation usually require that the board of directors

approve borrowing. This will include review and approval of such matters as the choice
of the bank or trustee, type of security, registration with SEC, agreements with
investment bankers, compliance with requirements of the state of incorporation, and
listing of bonds on a securities exchange.

Use of an Independent Trustee

The trustee is charged with the protection of the creditors’ interests and
with monitoring the issuing company’s compliance with the provisions of the indenture.

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 Interest Payments on Bonds and Notes Payable

Many corporations assign the entire task of paying interest to the trustee
for either bearer bonds or registered bond. This makes effective control be highly
achieved.

35.  Summarize the internal control over owner’s equity and its components.

Three principal elements of strong internal control:

1. Proper authorization of transactions by the board of directors and corporate

office

2. The segregation of duties in handling these transactions

3. The maintenance of adequate records

Internal control on equity

Control of Share Capital and Transactions by the Board of Directors

All changes in share capital accounts should receive formal advance

approval by board of directors. The board must determine the number of shares
to be issued.

Independent Registrar and Stock Transfer Agent

Internal control is stronger when the services of an independent share

registrar and a stock transfer agent are utilized because the bank trust
companies acting in these capacities will have the experience, specialized
facilities, and trained personnel.

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