Internal Controls Affecting Assets

Internal Control over Cash Transactions

Most of the processes relating to cash handling are the responsibility of the finance department, under the direction of the
treasurer. These processes include handling and depositing cash receipts; signing checks; investing idle cash; and
maintaining custody of cash, marketable securities, and other negotiable assets. In addition, the finance department must
forecast cash requirements and make both short-term and long-term financing arrangements.

Ideally, the functions of the finance department and the accounting department should be integrated in a manner that
provides assurance that:

1. All cash that should have been received was in fact received, recorded accurately and deposited promptly.
2. Cash disbursements have been made for authorized purposes only and have been properly recorded.
3. Cash balances are maintained at adequate, but not excessive, levels by forecasting expected cash receipts and
payments related to normal operations. The need to obtain loans for investing excess cash is thus made known on
a timely basis.

A detailed study of the business processes of the company is necessary in developing the most efficient control
procedures, but there are some general guidelines to good cash handling practices in all types of business. These
guidelines for achieving internal control over cash may be summarized as follows:

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 and observe cash register totals.
6. Deposit cash receipts daily.
7. Make all disbursements by check or electronic funds transfer, with the exception of small expenditures from petty
cash.
8. Have monthly bank reconciliation prepared by employees not responsible for the issuance of checks or custody of
cash. The completed reconciliation should be reviewed promptly by an appropriate official.
9. Monitor cash receipts and disbursements by comparing recorded amounts to forecasted amounts and investigating
variances from forecasted amounts.

Potential Misstatements - Cash Receipts

Description of Internal Control Weakness or Factors that

Examples
Misstatement Increase the Risk of Misstatement

Fraud:
 Overstating cash receipts on the books  Lack of segregation of duties of the
Recording fictitious by transferring cash between bank accounts functions of access to cash and
cash receipts without appropriate recording of the record keeping; no effective review of
transfer to cover up an embezzlement of bank reconciliations.
cash.
Fraud:
 A cashier fails to ring up and record cash  Inadequate supervision of cashiers; failure
sales and embezzles the cash. to encourage customers to obtain cash
Failure to record receipts.
receipts from Error:  Inadequate controls for reconciling cash
cash sales  A bookkeeper accidentally omits the register tapes and accounting records;
recording of the receipts from one cash inadequate controls for reconciling bank
register for the day. accounts.
 Fraud:
 A cashier embezzles cash payments by  Lack of segregation of duties between
customers on receivables, without personnel who have access to cash receipts
recording the receipts in the customers' and those who make entries into the
accounts. accounts receivable records.
Failure to record cash  A bookkeeper accidentally who has access  Lack of segregation of duties between
from to cash receipts embezzles cash collected personnel who have access to cash receipts
collection of accounts from customers and writes off the related and those who make entries into the
receivable receivables. accounts receivable records.
 Inadequate reconciliations of subsidiary
Error: records of accounts receivable with the
 A bookkeeper accidentally fails to record general ledger control account.
payment on a receivable

Fraud:
 Holding the cash receipts journal open to  Ineffective board of directors, audit
record next year's cash receipts as having committee, or internal audit function; "tone
Early (late) recognition occurred in this year. at the top" not conductive to ethical
of cash conduct; undue pressure to show improved
receipts — "cutoff Error: financial position.
problems"  Recording cash receipts based on bad  Failure to list and deposit cash receipts on a
information about date of receipt. timely basis.

 Potential Misstatements - Cash Disbursements

Description of Internal Control Weakness or Factors that

Examples
Misstatement Increase the Risk of Misstatement

Fraud:
 A bookkeeper prepares a check to himself  Inadequate segregation of duties of record
and records it as having been issued to a keeping and preparing cash disbursements,
major supplier or check signer does not review and cancel
supporting documents
Inaccurate recording of
Error:  Ineffective control for matching invoices
a purchase or
 A disbursement is made to pay an invoice with receiving documents before
disbursement
for goods that have not been received disbursements are authorized
 Disbursements for travel and entertainment  Ineffective accounting coding procedures
are improperly included with merchandise may result from incompetent accounting
purchases personnel, inadequate chart of accounts, or
no controls over posting process
Error:
Duplicate recording  A purchase is recorded when an invoice is  Ineffective controls for review and
and payment of received from a vendor and recorded again cancellation of supporting documents by
purchases when a duplicate invoice is sent by the the check signer
vendor
Fraud:
 In conjunction with recorded (but  Ineffective control over record keeping for
Unrecorded
deposited) cash receipts, an employee and access to cash
disbursements
writes and chases an unrecorded check for
the identical amount
Internal Control over Financial Investments
The most important group of financial investments 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. Other types of investments
often encountered include commercial paper issued by corporations, mortgages and trust deeds, and the cash surrender
value of life insurance policies. The internal auditors also must be concerned with derivatives that are used to hedge
various financial and operational risks or for speculation. Derivatives are financial instruments that "derive” their value
from other financial instruments, underlying assets, or indexes. For example, a simple derivative would involve a
commitment by a company to purchase a commodity at a certain price at some point in the future. Other derivatives are
much more complex, involving, for example, relationships between fluctuations in European interest rates and the price of
copper.
The major elements of adequate internal control over financial investments include the following:
 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.
In many concerns, segregation of the functions of custody and record keeping is achieved by the use of an independent
safekeeping agent, such as a stockholder, bank or trust company. Since the independent agent has no direct contact with
the employee responsible for maintaining accounting records of the investments in securities, the possibilities of
concealing fraud through falsification of the accounts are greatly reduced. If securities are not placed in the custody of an
independent agent, they should be kept in a bank safe-deposit box under the joint control of two or more of the company's
officials. Joint control means that neither of the two custodians may have access to the securities except in the presence of
the other. A list of securities in the box should be maintained in the box, and the deposit or withdrawal of securities should
be recorded on this list along with the date and signatures of all persons present. The safe-deposit box rental should be in
the name of the company, not in the name of an officer having custody of securities.
Complete detailed records of all securities and derivative instruments owned are essential to satisfactory control. These
records frequently consist of a subsidiary' record for each security and derivative instrument, with such identifying data as
the exact name, face amount or par value, certificate number, number of shares, date of acquisition, name of broker, cost,
terms and any interest or dividend payments received. Actual interest and dividends should be compared to budgeted
amounts, and significant variances should be investigated. The purchase and sale of investments often is entrusted to a
responsible financial executive, subject to frequent review by an investment committee of the board of directors.
Potential Misstatements - Financial Investments

Description of Internal Control Weakness or Factors that

Examples
Misstatement Increase the Risk of Misstatement
Error:  Inadequate accounting manual;
 Failure to record changes in market values incompetent accounting personnel
Misstatement of of investments  Ineffective board of directors, audit
recorded value of committee, or internal audit function; not
investments Fraud: conducive to ethical conduct; undue
 Misstatement of the value of closely held pressure to meet earnings targets
investment
Fraud:  Inadequate segregation of duties of record
Unauthorized  An employee with access to securities keeping for and custody of securities
investment transactions coverts them for personal use

Error:  Inadequate accounting manual;

Incomplete recording
 Failure to record derivative agreements incompetent accounting personnel
of investments
which are embedded in other agreements  Inadequate monitoring by internal auditors

Internal Control over Receivables

Accounts receivable include not only claims against customers arising from the sale 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.
Sources and Nature of Notes Receivable
Notes receivable are written promises to pay certain amounts at future dates. Typically, notes receivable is used for
handling transactions of substantial amounts; these negotiable documents are widely used. In banks and other financial
institutions, notes receivable usually constitutes the single most important asset.
Internal Control of Accounts Receivable and Revenue
To understand internal control over accounts receivable and revenue, one must consider the various components,
including the control environment, risk assessment, monitoring, the (accounting) information and communication system,
and control activities.
Control Environment
Because of the risk of intentional misstatement of revenues, the control environment is very important to effective internal
control over revenue and receivables. Of particular importance is an independent audit committee of the board of directors
that monitors management’s judgments about revenue recognition principles and estimates, as well as an effective internal
audit function. 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. Also,
incentives for dishonest reporting, such as undue emphasis on meeting unrealistic sales or earnings targets, should be
eliminated.
 Potential Misstatements - Revenue/Receivables

Description of Internal Control Weakness or Factors that

Examples
Misstatement Increase the Risk of Misstatements
Fraud:  Ineffective board of directors, audit
 Recording fictitious sales without receiving committee, or internal audit function;
a customer order or shipping the goods undue pressure to meet earnings targets.
 Intentional over shipment of goods "Top management action" not conducive to
ethical conduct.
Error:  Ineffective billing process in which billing
Recording unearned
 Recording sales based on the receipt of is not tied to shipping information.
revenue
orders from customers rather than the  Ineffective controls for testing invoices, or
shipment of goods ineffective input validation checks and
 Inaccurate billing and recording of sales computer reconciliations to ensure the
 Recording cash that represents a liability as accuracy of databases.
revenue  Inadequate accounting manual;
incompetent accounting personnel
Fraud:  Ineffective board of directors, audit
 Holding the sales journal open to record committee, or internal audit function;
next year's sales as having occurred in the undue pressure to meet earnings targets.
Early (late) recognition
current year "Top management action" not conducive to
of revenue - "cutoff
ethical conduct.
error"
Error:  Ineffective cutoff procedures in the
 Recording sales in the wrong period based shipping department
on incorrect shipping information
Fraud:  Ineffective board of directors, audit
 Recording sales when the customer committee, or internal audit function;
is likely to return the goods undue pressure to meet earnings targets.
"Top management action" is not conducive
Recording revenue Error: to ethical conduct.
when significant  Recording sales when the  Aggressive attitude of management toward
uncertainties exist customer's payment is contingent financial reporting; incompetent chief
upon the customer receiving accounting officer
financing or selling the goods to
another party (e.g., consignment
sales)
Fraud:  Ineffective board of directors, audit
 Recording the franchise revenue committee, or internal audit function;
when the franchises are sold even undue pressure to meet earnings targets.
Recording revenue
though an obligation to perform "Top management action" is not conducive
when significant
significant services still exists to ethical conduct.
services still must be
 Aggressive attitude of management toward
performed by seller
Error: financial reporting; incompetent chief
 Amount of revenue earned on franchises is accounting officer
miscalculated
Fraud:  Ineffective board of directors, audit
 Misstating the percentage of completion of committee, or internal audit function;
several projects by a construction company undue pressure to meet earnings targets.
Overestimation of the using the percentage-of-completion method "Top management action" is not conducive
amount of revenue revenue recognition to ethical conduct.
earned  Overestimating the percentage of  Aggressive attitude of management toward
completion on projects by a construction financial reporting; incompetent chief
company using the percentage of accounting officer
completion method of revenue recognition

Internal Control over Notes Receivable

As previously stated, a basic characteristic of effective control consists of the subdivision of duties. As applied to notes
receivable, this principle requires that:
1. The custodian of notes receivable does 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.
Internal Control over Inventories and Cost of Goods Sold
The interrelationship of inventories and cost of goods sold makes it logical for the two topics to be considered together.
The controls that assure the fair valuation of inventories are found in the purchases (or acquisition) cycle. These controls
include procedures for selecting vendors, ordering merchandise or materials, inspecting goods received, recording the
liability to the vendor, and authorizing and making cash disbursements. In a manufacturing business, the valuation of
inventories also is affected by the production (or conversion) cycle, in which various manufacturing costs are assigned to
inventories, and the cost of inventories is then transferred to the cost of goods sold.
Sources and Nature of Inventories and Cost of Goods Sold
The term inventories are used in this chapter to include:
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; and
3. good to be consumed directly or indirectly in production, such as raw materials, purchased parts, and supplies.

Internal Control over Inventories and Cost of Goods Sold

The importance of adequate internal control over inventories and cost of goods sold from the viewpoint of both
management and the auditors can scarcely be overemphasized. In some companies, management stresses control over
cash and securities but pays little attention to control over inventories. Since many types of inventories are composed of
items not particularly susceptible to theft, management may consider controls to be unnecessary in this area. Such
thinking ignores the fact that controls for inventories affect nearly all the functions involved in producing and disposing of
the company's products.
Potential Misstatements - Inventory/Cost of Goods Sold

Description of Internal Control Weakness or Factors that

Examples
Misstatements Increase the Risk of Material Misstatement

Fraud:  Ineffective board of directors, audit

 Intentional misstatement of production committee, or internal audit function;
costs assigned to inventory undue pressure to meet earnings targets.
 Intentional misstatement of inventory "Top management action" not conducive to
prices ethical conduct.
Misstatement of  Undue pressure to meet earnings targets
inventory costs Errors:  Ineffective cost accounting system; failure
 The assignment of direct labor costs, direct to update standard costs on a timely basis
material costs, or factory overhead to  Ineffective input validation controls on the
inventory items is inaccurate database of inventory costs; ineffective
 Erroneous pricing of inventory supervision of the personnel that enter the
costs on the final inventory schedule
Fraud:  Ineffective physical controls over
 Items are stolen with no journal entry inventories
reflecting the theft  Ineffective board of directors, audit
 Inventory quantities in locations not visited committee, or internal audit function;
Misstatement of
by auditors are systematically overstated undue pressure to meet earnings targets.
inventory quantity
"Top management action" not conducive to
Errors: ethical conduct.
 Miscounting of inventory by personnel  Ineffective controls or supervision of
involved in physical inventory physical inventory
Fraud:  Ineffective board of directors, audit
 Intentional recording of purchases in the committee, or internal audit function;
Early (late) recognition subsequent period undue pressure to meet earnings targets.
of purchases - "cutoff "Top management action" not conducive to
problems" Error: ethical conduct.
 Recording purchases of the current period  Ineffective accounting procedures that do
in the subsequent period not tie recorded purchases to receiving data
Internal Control over Property, Plant and Equipment
The term properly, plant and equipment 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. Three major subgroups of such assets are
generally recognized:
Land, such as properly used in the operation of the business, has the significant characteristic of not being subject to
depreciation.
Buildings, machinery, equipment and land improvements, such as fences and parking lots, have limited service lives and
are subject to depreciation.
Natural resources (wasting assets), such as oil wells, coal mines, and tracts of timber, are subject to depletion as the
natural resources are extracted or removed.
Acquisitions and disposals of property, plant and equipment are usually large in dollar amount, but concentrated in only a
few transactions. Individual items of plant and equipment may remain unchanged in the accounts for many years.
Internal Control over Plant and Equipment
The amounts invested in plant and equipment represents a large portion of the total assets of many industrial concerns.
Maintenance, rearrangement and depreciation of these assets are major expenses in the income statement. The total
expenditures for the assets and related expenses make strong internal control essential to the preparation of reliable
financial statements. Errors in measurement of income may be material if assets are scrapped without their cost being
removed from the accounts, or if the distinction between capital and revenue expenditures is not maintained consistently.
The losses that inevitably arise from uncontrolled methods of acquiring, maintaining, and retiring plant and equipment are
often greater than the losses from fraud in cash handling.
In large enterprises, the auditors may expect to find an annual plant budget used to forecast and control acquisitions and
retirements of plant and equipment. Many small companies also forecast expenditures for plant assets. Successful
utilization of a plant budget presupposes the existence of reliable and detailed accounting records for plant and equipment.
A detailed knowledge of the kinds, quantities and condition of existing equipment is an essential basis for intelligent
forecasting of the need for replacements and additions to the plant.
Other key controls applicable to plant and equipment are as follows:
1. A subsidiary ledger consisting of a separate record for each unit of property. An adequate plant and equipment
ledger facilitate the auditor’s work in analyzing additions and retirements, in verifying the depreciation provision
and maintenance expenses, and in comparing authorizations with actual expenditures.
2. A system of authorization requiring advance executive approval of all plant and equipment acquisitions, whether
by purchase, lease or construction. Serially numbered capital work orders are a convenient means of recording
authorizations.
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. A dollar minimum ordinarily will be established for capitalization; any expenditures of a lesser
amount automatically classified as charges against current revenue.
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 (bottom), stating reasons
for retirement and bearing appropriate approvals.
Potential Misstatements - Investments in Property, Plant and Equipment

Description of Internal Control Weakness or Factors that

Examples
Misstatements Increase the Risk of the Misstatement
Fraud:  Undue pressure to meet earnings targets
 Expenditures for repairs and maintenance  Inadequate accounting manual;
expenses recorded as property, plant and incompetent accounting personnel
Misstatement of equipment acquisitions to overstate income
acquisition of property,
plant and equipment Error:
 Purchases of equipment erroneously
reported in maintenance and repairs
expense account
Error:  Inadequate accounting policies, e.g., failure
Failure to record
 An asset that has been replaced is to use retirement work orders
retirements of property,
discarded due to its lack of value, without
plant and equipment
an accounting entry
Error:  Inadequate accounting manual;
Improper reporting of  A "gain" recorded on an exchange of incompetent accounting personnel
unusual transactions nonmonetary assets that lacks commercial
substance