INTERNAL CONTROL

Internal controls are systems, rules, and procedures used by a company to maintain
integrity of accounting information, foster accountability, and thwart fraud. These are
implemented and monitored by the company's senior management and board of
directors, which aid in increasing operational effectiveness by increasing the level of
accuracy as well as timeliness of financial reporting. Other purposes include protecting
assets, ensuring compliance to laws and regulations, and accomplishing operational
objectives.

Three Fundamental Categories of Internal Control

1. Detective internal control - is a type of control that is commonly used for fraud
prevention, quality control, and legal compliance. It protects the company's assets
by identifying any issues, anomalies, or mistakes in its accounting process.
Examples include inventory count, reconciliation, internal audits, and surprise
cash counts.

2. Preventive Internal Control - from the name itself, this is designed to prevent
accounting errors and irregularities from taking place. It is used to improve clerical
accuracy and preventing employee fraud and accounting problems, resulting in
efficient business operations. Examples are separation of duties, controlled
access to the accounting and financial reporting system, double-entry accounting,
limiting management involvement in financial statement preparation, etc.

3. Corrective Internal Control - this type of internal control is used to correct errors
that were discovered by the detective and preventive internal controls to avert
them from causing even more problems. Examples include physical audits of
assets and inventory, adjustments or rectification entries in the accounting
system, ledger verification, and updating policy or procedures.

INTERNAL CONTROL OVER CASH TRANSACTIONS

Most of the cash handling processes are the finance department's responsibility, 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.

Ideally, the functions of the department 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 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.

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. Centralized receiving of cash to the extent of 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 disbursement by check or electronic funds transfer, with the exception
of small expenditures from petty cash
8. Have a monthly bank reconciliation prepared by employees not responsible
for the issuance of checks or custody of cash
9. Monitor cash receipts and disbursement by comparing recorded amounts to
forecasted amounts and investigating variances from forecasted amounts.

INTERNAL CONTROL OVER FINANCIAL INVESTMENTS

The most important group of financing investments consists of marketable stocks
and bonds because they are found more frequently and usually are of greater
peso value than other kinds of investment handling.
Other types of investments often encountered include:

 Commercial paper- issued by corporations

 Mortgages and trust deeds
 The cash surrender value of life insurance policies
Derivatives - are financial instruments that "derive" their value from other financial
instruments, underlying assets, or indexes.
Major elements of adequate internal control over financial investments include:
1. Formal investment policies that limit the nature of 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.

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 for Tax Refunds
 Advantages to Suppliers

Sources and Nature of Notes Receivable:

 are written promises to pay certain amounts at future dates.

 used for handling transactions of substantial amounts

In banks and other financial institutions:

 Notes Receivable usually constitute the single most important asset.

Internal Control of Accounts Receivable and Revenue

  Components to be considered:
 Risk Assessment
 Monitoring the Accounting Information
 Communication System
 Control Activities

Control Environment:

 Independent Audit Committee – monitors the managements judgments

 Effective Internal Audit
 ‘Tone at the Top’ – encourages integrity and ethical financial reporting
 Ethical Standards – should be communicated and observed
 Incentives for Dishonest Reporting – eliminate unrealistic sales or earnings
Targets

Internal Control of Over Notes Receivable

 The custodian of notes receivable does not have access to cash or to

general accounting records
 The acceptance and renewal of notes be authorized in writing by a responsible
official who does not have custody of the notes.
 The write-off of defaulted notes is approved in writing by responsible officials and
effective procedures are adopted for subsequent follow-up of such
defaulted notes.

INTERNAL CONTROL OVER INVENTORIES AND COST OF GOODS SOLD

The interrelationship of inventories and the 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.

The importance of adequate internal control over inventories and the 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.
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 facilitates the auditor’s work in
analyzing additions and retirements, verifying the depreciation provision and
maintenance expenses, and 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
are
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 are 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
order (bottom), stating reasons for retirement and bearing appropriate approvals.
INTERNAL CONTROL: AFFECTING LIABILITIES AND EQUITY
LIABILITY
Accounts payable:

 Referred to voucher payable for a voucher system

 Are amounts due to vendors and suppliers for goods or services received that
not yet been paid.
-Invoices and statements from supplies usually evidence accounts payable arising from
the purchase of goods or services and most other liabilities. However, accrued liabilities
(sometimes called accrued expenses) generally accumulate over time, and
management must make accounting estimates of the year-end liability. Such estimates
are often necessary for salaries, pensions, interest, rent, taxes and similar items.
-The client's creditors will generally maintain complete records of their receivables and
will inform the client if payment is not received. This feature aids auditors in the
discovery of fraud, since the perpetrator must be able to obtain and respond to the
demands for payment.
- The self-interest of creditors constitutes an effective control in accounting for payable.

INTERNAL CONTROL OVER OTHER DEBTS

Internal Control Over debt:

 Authorization by the Board of Directors

 Use of independent trustee
 Interest payments on bond and Notes payable

Authorization by the Board of Directors

1. The treasurer of the company will prepare reports on the proposed financing
2. The Board of Directors will review the report subject for approval
3. The BOD will issue an authorization that will include approval of such matters as
the choice of a bank or trustee, the type of security registration with the SEC,
agreements with investment bankers, compliance with requirements of the state
of incorporation. and listing of bonds on a securities exchange.
 4. After the issuance of long-term debt, the board of directors should receive a
report stating the net amount received and its disposition as, for example,
acquisition of plant assets, addition to working capital, or other purposes.

Use of an Independent Trustee

1. Any company large enough to issue bonds and able to find a ready market for
the securities will almost always utilize the services of a large bank as an
independent trustee.
2. Internal control is strengthened by the fact that the trustee does not have access
to the issuing company's assets or accounting records and the fact that the
trustee is a large financial institution with legal responsibility for its actions.

Obligation of Independent Trustees

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. The trustee also
maintains detailed records of the names and addresses of the registered owners of the
bonds, cancels old bond certificates and issues new ones when bonds change
ownership, follows procedures to prevent over issuance of bond certificates, distribute
interest payments, and distributes principal payments when then bonds mature.

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 bonds. Highly effective control is then achieved, since the
company will issue a single check for the full amount of the semiannual interest
payment on the entire bond issue.

INTERNAL CONTROL OVER OWNERS' EQUITY

The three principal elements of strong internal control over share capital and dividends:
1. The proper authorization of transactions by the board of directors and corporate
office,
2. The segregation of duties in handling these transactions (preferably the use
payments), and
3. The maintenance of adequate records.
Control of Share Capital Transactions by the Board of Directors
All changes in share capital accounts should receive formal advance approval by the
board of directors. Authority for all dividend actions rests with the directors. The
declaration of a dividend must Specify not only the amount per share but also the date
of record and the date of payment.
Independent Registrar and Stock Transfer Agent
In appraising internal control over share capital, the first question that the auditors
consider is whether the corporation employs the services of an independent share
registrar and a share transfer agent or handles its own capital share transactions.
Internal control is far stronger when the services of an independent share registrar and
a stock transfer agent are utilized because the banks or trust companies acting in these
capacities will have more expertise.

Internal Control over Dividends

1. The company performs the function of dividend payment by itself
Typically, only the small corporations or the corporations that have no/minimal
complex equity structure pays the dividends itself without relying on the outside
services of an independent dividend-paying agent.
In a small corporation that does not use the services of a dividend-paying agent
the responsibility for payment of dividends is usually lodged with the treasurer
and the secretary

How a company performs the function of dividend payment by itself.

1. After declaration of a dividend by the board of directors, the secretary
prepares a list of shareholders as of the date of record, the number of shares
held by each, and the amount of the dividend each is to receive. Dividend
checks controlled by serial numbers are drawn payable to individual
stockholders in the amount shown on the list.
2. The stockholder list and dividend checks are submitted to the treasurer for
approval and signature.
3. The checks should be reconciled by the treasurer with the total of shares
outstanding and mailed without again coming under control of the officer who
prepared them. (Segregation of duties)
4. Cash in the amount of the total dividend is then transferred from the general
bank account to a separate dividend bank account.
 5. Records of the dividend payment in the dividend check register should match
records in the dividend bank account.

2. Utilizes the services of an independent dividend-paying agent

The bank or trust company serving as stock transfer i s usually appointed to
distribute the dividend since it maintains the detailed records of shareholders.
The use of an independent fiscal agent is to be recommended from the stand-
point of internal control, for it materially reduces the possibility of fraud or error
arising in connection with the distribution of dividends.

Utilizes the services of an independent dividend-paying agent

1. The corporation will provide the agent with a certified copy of the dividend
declaration and a check for the full amount of the dividend.
2. The agent issues dividend checks to the individual shareholders and sends
the corporation a list of the payments made.