Unit-2

RISK ASESSMENT AND INTERNAL CONTROL

AUDIT RISK

Whenever auditor fails to express a correct opinion in an auditing situation he should be borne by
the audit risk. Risk is considered at both overall and individual levels.

Kinds of Audit Risk: There are three kinds of audit risks

(a) Inherent risk: "The risk which is the susceptibility of an account balance of a class of transaction
to mis-statement which could be material either individually or aggregate of mis-statements". It is
the result of business environment and the type of transactions.

(b) Control risk: The risk which arises due to defects in the internal control system that fails to detect
material errors. The control risk varies inversely with the internal control system of the organisation.
The effect of control risk depends on the internal control system. If more the effective internal
control system less is the control risk and vice-versa.

(c) Detection risk: The risk which arises due to non-detection of mis statements by the auditor with
substantive procedures or tests. The detection risks arising from selection of inappropriate quality
control measures can be minimised by using appropriate quality measures

Internal control
Internal control is a broad term and has a wide coverage. It covers the control of the whole
management system. The control may be financial or non- financial involving a number of checks
exercised in a business to ensure its efficient and economic working. It includes internal check,
internal audit and all other types of checks. The following statement is very significant in this regard.

“Internal control means not only internal check and internal audit but the whole system of controls,
financial and otherwise established by the management in order to carry on the business of the
company in an orderly manner, safeguard its assets and secure as for as possible the accuracy and
reliability of its records"

Definitions and Meaning of Internal control

Main definitions of internal control are:

1. "In every well-organised concern there exist a large number of ways and means whereby check is
imposed on the accuracy of the executive work. These ways and means are called the system of
internal control."

2. According to W.W.Big. "Internal control is best regarded as indicating the whole system of
controls, financial and otherwise, established by the management in the conduct of a business,
including internal check, internal audit and other forms of control."

Features of Internal Control

Internal control has the following features:

1. It is not only internal check and internal audit but also competes accounting and administrative
controls

2. It comprises both financial and administrative controls

3. It is a system established by the management of the business to run the business activities
effectively and efficiently

Objectives of Internal Control

The main objectives of internal control aner

1.To achieve accuracy and reliability in the maintenance of accounting records.

2. To saleguard the assets and records of the business

3 . To promote operational efficiency by avoiding wastage of news

4. To ensure strict implementation of management policies and procedures.

5. To assist the management in its planning activities.

6.To ensure that all transactions are carried out only with proper authorization of the management

Basic principles of Internal Control

1. There should be well-developed plan of organization with proper delegation of authority and
responsibility to various operational hierarchy.

2. There should be competent and trustworthy personnel for the successful working of internal
control system

3. There should be a scientifically developed wood and filing system in the organization.

4. Every transaction should be carried out with proper authority from the concerned authority.

5. There should not be any deviation from the established p without formal sanction by the
management
INTERNAL CHECK

It is an arrangement of duties of members of staff in such a manner than the work performed by
one person is automatically and independently checked by the others.

According to F.R.M. De PAULA, “Internal check means practically a continuous internal audit carried
on by the staff itself, by means of which the work of each individual is independently checked by
other members of the staff.”

According to D.R. DAVAR, “Internal check is a system or method introduced with defined instructions
given to staff as to their sphere of work with a view to control and verification of their work and also
maintenance of accurate records as the ultimate aim.”

Objectives of Internal Check

1. To exercise moral pressure over staff.

2. To ensure that the accounting system produces reliable and adequate information.

3. To provide protection to the resources of the business against fraud, carelessness and inefficiency.
4. To distribute the work in such a business transaction is left unrecorded.

5. To allocate duties and responsibilities of each clerk in such a way that he may be held responsible
for particular fraud or error.

6. To minimize the chances of errors, frauds or irregularities in the business based on the principle of
division of labor.

7. To detect errors and frauds easily if it is committed, because in an efficient internal check system,
there is based on the principle of division of labor.

8. To detect errors and frauds easily if it is committed, because in an efficient internal check system,
there is a provision for independent checking.

Essential Characteristics/Principles of a Good System of Internal Check

1. Responsibility: Responsibility of each individual must be properly defined and fixed. The work of
the business should be allocated amongst various clerks in such a manner that their duties and
responsibilities are clearly and judiciously divided

2. Completion: The work should be divided in such a way that no single person is allowed to
complete the work solely by himself from the beginning to the end. However, there should be no
duplication of work.

3. Rotation of employees: A good system of internal check should not allow person having custody of
assets to have access to the books of account. A system of transfer or 2 rotation of employees from
one seat of work to another must be followed by the business.

4. Automatic check: A good system of internal check must provide for an automatic checking of the
work of one clerk by the other.
5. Reliance: No clerk of the business should be relied upon too much.

6. Safeguards: Safeguards should be prescribed to keep un-used cheque books, files and securities
etc.

7. Supervision: A strict supervision should be exercised to ensure that the prescribed internal checks
and procedures are fully operative.

8. Formal sanction: No deviation should be allowed from the established procedures till it is formally
sanctioned by the top official.

9. Periodical review: The system of internal check is reviewed from time to time to introduce
improvements.

Advantages of Internal Check

Some of the widely accepted advantages of an efficient system of internal check are as follows:

1. For the Business

a) Proper division of work: Internal check entails a proper and rational distribution of work among
the members of staff of the enterprises keeping in view their individual qualifications, experience
and area of specialization.

b) Detection of errors and frauds: since no individual worker is allowed to handle a job completely
from the beginning to the end, and the work of each clerk is automatically checked by the other, this
heaps in the early detection and discovery of errors and frauds and the possibilities of the
commission of errors and frauds can be minimized.

c) Increased efficiency coupled with economy: A good system of internal check increase the
efficiency of work among the staff and leads to overall economy.

d) Moral check: knowledge of subsequent checking of each employees work by others, acts as a
great check to commission of errors and frauds.

2. For the Auditor

a) Quick preparation of final accounts: The Profit & Loss Account and the Balance Sheet are prepared
without any loss of time.

b) Convenience to Auditor: Where an organization is operating system internal check, the statutory
auditor may conveniently avoid detailed checking of the transactions. He may apply a few tests here
and there and can relieve himself from detailed checking.

3. For the Owner

a) Accuracy of the accounts can be relied upon: if there is a system of internal check the owner of
the concern may rely upon genuineness and accuracy of the accounts.

b) Increase in profits: Overall efficiency and economy in operations result in more profits, thus
ensuring larger dividends for the owners or shareholders.
Disadvantages of Internal Check

Depending on each other proves fatal in the quick disposal of the work. If one person is absent, the
day-to-day work will be seriously disrupted. Following are some of the disadvantages of a system of
internal check.

1. Costly for small business: A system of internal check system quite expensive especially for small
business houses.

2. Quality is sacrificed for Promptness: In an internal check system quality of work declines because
the clerks of the business attach greater importance to become quick and do not care if in the
process their work gets sub-standardised.

3. Carelessness among high officials: The possibility of some of the responsible and high officials
being complacent increases as they believe, though not always rightly, that under a sound system of
internal check nothing can go wrong.

4. Disorder in the working of a business: In the absence of a proper organized system of internal
check there will be chaos and disorder in the working of business.

5. Risky for an auditor: If the auditor does not apply tests and procedure his own and if he relies on
the output of the system his work cannot be free from irregularities if the system itself proves to be
defective.

Internal Check with regard to Cash:

The risk of misappropriation of cash needs no emphasis. The chances of fraud are numerous in cash
transactions. For example, receipts may not be entered in the cash-book: records of cash received
may be understated by preparing duplicate receipt for amounts less than the original. Cash sales
may be treated as credit sales charging the amount to fictitious debtors, etc. The following are the
points that should be taken into consideration while devising a good and proper system of internal
checks for cash transactions:

Cash Sales: Cash Sales are of three types: a. Sales at Counter / Counter Sales b. Sales by travelling
Salesmen. c. Postal sales.

1. Sales at Counter / Counter Sales: The following procedure may be of great use in regard to cash
sales:

a) A specific number, name or work may be allotted to every salesman.

b) Every salesman is supplied with a separate book containing blank copies of cash memo.

c) Cash memos should be printed in numerical sequence.

d) Cash memos are printed in different colours for salesman at different counters.

e) When the sales man sells goods to a customer he prepares four copies of the Cash Memo. These
copies are checked by the senior clerk.
 f) Three copies of the cash memo are handed over to the customer and the fourth is retained by the
salesman.

g) The customer should hand over three copies of the cash memos to the cashier, who alters
collecting the amounts and recording it in his cash register, returns two copies to the customer duly
stamp marked “cash paid”.

h) So the cashier collects the amount and records it in his cash register.

i) The customer should present two copies of the cash memos at the counter where the goods
purchased by him are to be delivered.

j) Here the customer will get the goods purchased by him are to be delivered to him.

k) The Clerk, at the delivery counter, checks the sales and delivers the goods to the customer and
also keeps one copy of the cash memos.

l) In big business houses, the customer’s copy of the cash memo may be checked by the security
staff before the customer is allowed to check out of the place.

m) At the end of the day, each counter salesman, cashier and the delivery counter clerk should
prepare summaries of Cash Sales.

n) The cash sales summary prepared by the cashier should be verified with the cash sales summary
of each salesman and the delivery counter clerk.

o) The differences if any should be immediately enquired into.

p) If the summaries tally, accounts are certified as correct. Then it is sent to the General Manager
and another copy is sent to accounts department.

q) Daily cash receipts should be deposited into the bank on the same day.

r) Where cash recording machines are used, the total cash received as shown by the machine should
be checked with the amount actually banked.

2. Sales by Travelling Salesmen: In big business houses, generally Travelling salesmen are employed
to push sales and to collect debts. These Salesmen collect debts from old customers and accept
advances for new ones. Ordinarily debtors will be asked to send the remittances by post and not to
hand over the cash to any representative of the enterprise. But in exceptional circumstances
travelling Salesmen may be permitted to collect cash from the debtors. For example, where it is
necessary for enforcement of the terms of credit or where refusal by travelling salesman to collect
cash from a debtor may be regarded as a bad policy. Whatever the case may be, a good system of
check over these salesmen is vitally essential. So the following precautions must be taken:

a) Travelling salesmen should be issued with pre-numbered, rough receipt books.

b) Final receipt against receipt of cash by travelling salesman should be issued either from the
branch or head office to which the salesman is attached.
c) Customers should be asked to contact the head office or branch office if the final receipt is not
mailed to them within a stipulated period.

d) Travelling salesmen should be instructed to remit the entire cash collected by them to the head
office or branch office to which they are attached, without making any deduction towards salary or
commission payable to them.

e) Head office or branch office should regularly send the statement of accounts to keep them
informed of the latest position as to their liability.

f) Special attention should be paid to customer’s accounts that have become overdue. g) There
should be surprise transfers of travelling Salesmen from one area to another. This will increase the
efficiency of the agents and will also reduce the chances of fraud.

3. Postal Sales or Value Payable Post (V.P.P) sales: The following points should be noted in this
regard.

a) There should be a separate register to record sales by post of VALUE PAYABLE POST.

b) When cash is received against V.P.P sales, it should be entered in the V.P.P register and then it
should be posted to the cash book.

c) Separate bank pay-in-slips should be used to deposit cash received against post sales.

d) An offer should be deputed to check carefully this register an special attention should be given to
those goods that have been returned and those against which payments has not been received .

e) Cash book and orders received should be checked and order received should bed properly filed
too.

Internal Check with regard to Cash Purchases

1. Requisition: The procedure for issuing purchase requisitions should be specified. The head of the
department, who is in the need of goods, should fill in a requisition slip duly signed and then should
send it to the purchases department. The details about the quantity, is quality and the time by which
the goods must be supplied be clearly mentioned in the requisition slip.

2. Enquiry: Purchase department makes an enquiry about the terms and conditions of purchases
from different suppliers. For this purpose tender are generally invited. But, who shall open and
accept the tenders, should be clearly specified. At a rule, the lowest tender should be accepted and
accordingly a decision be taken.

3. Purchase Order: The Purchase Department places orders which should be recorded in the
Purchase Order book. Four copies of purchase order should be prepared. One copy will be sent to
the vendor, second to the store department, third copy to the Accounts department and fourth one
will be retained by the purchase department itself. A responsible officer should review the purchase
order, before signing by the authorized person or director.
4. Receipt of Goods: On receipt of goods, the purchase department should be properly inspect them,
and there after an entry in the goods inward (Receipt) book, the same should be sent to the stores.
Concerned department should be informed about the receipt of the goods.

5. Making the Payments: The Purchase Department should thoroughly check the invoices and send
the same to accounting department for payment. The accounting department should compare the
invoice with the purchase order and Incoming Inspection Report and should also verify the
calculation. The Accounts Department should enter the invoice in the Purchase Book. Only
responsible official should draw cheque for the payment of invoice. At the time of signing, a signing
authority must verify that correct payment is made. If some portion of the goods is returned to the
supplier, a proper entry must be made in the Purchase Return Book. A Credit Note to that effect
must be obtained from the supplier and accounts section must adjust the payment accordingly. A
good system of internal check with regard to purchase will prevent the following types of
irregularities, errors and frauds.

a) Fictitious Payment: Fictitious Purchase may be recorded in the purchase book and the payments
withdrawn may be misappropriated.

b) Double Payment: Some invoices may be recorded twice and double payment made may be
misappropriated.

c) Artificial inflation in profits: Goods purchased may not be entered in the period so as to inflate
profits.

d) Artificial reduction in profits: Goods not received in one period may be entered as purchases so as
to show profits less than the actual.

Internal Check with regard to Wages

The system of internal check for wages should be devised in a careful and planned way, especially in
manufacturing concerns, employing large number of workers, possibilities of frauds are always
there. Thus efforts should be made to prevent such frauds with the help of some suitable
arrangements of internal check which should be revised from time to time in the light of experience
gained. System should be actively enforced and supervised by some responsible official. The
Objectives are as follows:

a) To avoid inclusions of dummy workers in the list of workers.

b) To avoid incorrect time or piece work records.

c) To avoid fraudulent manipulation of wage-sheet and misappropriation of money etc.

d) To minimize such frauds, the following system of internal check for wages is suggested.

Maintenance of Wage Records

1. Time Records: Workers are paid their wages normally on the basis of time. Thus the time spent by
each worker should be correctly recorded in the time record book and for this purpose the following
methods are in practice.
a) The time recording clock: The time recording clock is placed at the gate under the charge of a
timekeeper. As soon as worker enters the gate, the time keeper inserts his time into the clock which
records the time. It is recorded when the worker leaves the factory.

b) Brass token: The workers are given brass token bearing their numbers. At the gate, a time board
is maintained on which each worker hangs his token as soon as he enters in the factory. The time
keeper is thus able to record the time of workers entering the factory. He should be vigilant enough
to see that no workers hang the token of others who are late or absent.

c) Attendance cards/punching machine: Each worker is provided with a time card with his name,
number, department and wages rate mentioned on it. He should punch card at the time of his arrival
and departure. The punching or card must be supervised by the time-keeper. Foreman of each
department should also be asked to keep the time records of his workers. The time keeper and
foreman should separately prepare the time records and the name of absentees at the end of the
day.

d) Computers: This method is the most popular method now especially with the multinationals. An
identity card is issued to each worker and when the employee enters the factory and leaves the
factory, he puts his identity card in the slot of the time recording machine. This machine is controlled
by the computer. So the computer records the time the employee spends in the office. Another
advantage of this method is that only with a proper identity card, the employee can enter the office.
That is only if the identity card is the authorized one, then only the door will open for the employee.

2. Piece-work records: Where the workers are paid on the basis of the wages system, proper hooks
for actual work done by workers should /may be maintained. Each worker should be provided with a
job card or piece work return form bearing his name, hob number, nature of worker should be
recorded on this card which should be countersigned by the foreman of the department. Store-
keeper to whom the goods manufactured are handed over, should sign this card. It should be finally
checked by piece work reviewer along with quality of goods.

3. Overtime records: Ordinarily overtime work should not be encouraged. No worker should be
allowed to work overtime unless he is authorized to do so by the authorized official of the
organization. Strict check must be kept on loiterers at the place of work. Overtime slips should be
sanctioned in advance. Such slips should bear the name and number of worker, overtime put in the
job or the department in which he is engaged. At the weekend such slips should be sent to the
department in and the job or the department in which he is engaged. At the weekend such slips
should be sent to the time-keeper who will forward them to the wage office.

4. Pass-out records: The workers should not be allowed to leave the factory before the scheduled
time. But if sometimes, a worker wants to go out of the factory on his personal work during working
hours he should not be allowed to go out of the factory premises without obtaining permission from
authorized official who should issue passout slips. Such slips are handed over to gatekeeper wage
office should also be given copy of such slips. In case a worker leaves the factory before time on his
own account, it should be properly accounted.

5. Preparation of wage sheets: The preparation of wage sheets should be done by a separate
department. This work should be done by five clerks to minimize the irregularities. Information
regarding attendance can be had from the attendance register, job cards, piece work register,
overtime slips, pass out slips etc,. For time workers and piece rage workers, separate wage sheet
should be used. In big factories loose wage sheet should be used so that the work may be
distributed amongst various clerks easily. All the essential particulars should be entered in the wage
slips which should have columns for:
a) Name
b) Number/code number allotted to him and his address
c) Total time worked d) Details of word
e) Rate
f) Total amount of wages
g) Bonus
h) Overtime, if any
i) Deductions
j) Net amount payable

The whole work is to be divided in various parts to be done by separate clerks in the wage
department.

i. Two clerks should examine the time and piece wage records, over time records and other
statements received from the foreman.

ii. The third clerk is to prepare individual employee statement i.e., name of the worker, code number
allotted to him and his address, total time worked and rate of wages.

iii. The fourth clerk is to check the calculations and deduct the permissible amount i.e. rent,
provident fund, income tax, installment of loans and other permissible deductions under the
PAYMENT OF WAGES ACT, 1936. From the gross wages to arrive at the net amount to be paid to the
workers.

iv. The fifth clerk is to check the whole work thoroughly.

v. All these clerks should initial the wage slips before these are signed by some responsible officer,
such as director or works manager.

Internal check with regard to Stores (Stock)

The Stores Department has the charge of preserving and issuing stores to different departments.
Proper control of stores is very much essential to prevent pilferage (small theft) and misuse.
Therefore, the internal check system in relation to stores must be given careful attention. The
following general rules may be followed to ensure effective check on the stores.

1. Location of stores: Store should be located at a convenient place. It should have proper stores
facilities so that goods may not be misplaced, misused or wasted.

2. Receipts of stores: On receiving stores, the Stores Department will prepare a “Goods Received
Note’ in triplicate. One copy will be sent to the Purchase Department. Second copy will be sent to
Accounts Department. The third will be retained by the Stores Department itself. All the details
about stores should be noted on the note. Stores should be properly checked after their receipt.
 3. Preservation of stores: Goods received should be stored at their allotted racks. The system of Bin
Cards should be used to show the receipts, issues and balance of stores. Such Bin Cards may be kept
hanging on the places where stores are preserved. Stores inventory software may be used on
computer for item stored.

4. Issue of stores: No item from the stores should be issued to any person without formal requisition
or demand note from some authority. Only authorized person should be allowed to remove articles
from the stores according to the requisition. The Stores Officer should be seated near the gate so
that all issues may be made under his supervision. For the materials or stores returned from the job
or the department. Material return note should be written and properly accounted for. Likewise,
Material Transfer Notes should be used for the materials transferred form one department or job to
another. The gate keeper should be instructed not to allow any material out of the factory without
necessary permit from the Store-Keeper or Invoice of Sales Department.

5. Recording: After the issue of materials from the stores, the Store Issue Requisition should be sent
to the Stores Accounts Section for proper records there. The Bin Cards should be checked out
compared from time to time with stores records.