Chapter 2 INTERNAL CONTROL

Learning Objectives

• To understand the meaning, definition and objectives of internal control.

• To understand the advantages and disadvantages of internal control.
• To understand the principles of good internal control system.
• To analyse the methods of evaluating internal control system.
• To identify the differences between internal check and internal control.

POINTS TO RECALL

In the previous chapter, we have studied meaning and importance of internal

check system and application of internal check system with respect to cash and
trading transactions.

2.1 Introduction internal control system is weak auditor has

to verify the transactions in detail.
Internal control is the overall control
environment established by management of an
2.2 Meaning
enterprise for effective and efficient monitoring
and control of its operations. It aims at adherence Internal Control refers to the process of control
to management policies, safeguarding of assets exercised by the management either financial
of the enterprise, proper accounting and record or non-financial to ensure proper accounting
of the business transactions. Internal check of business transaction and reliability of
and internal control are vital components of records. Internal Control has a wide coverage
the control system. which includes checks and controls exercised
The auditor should properly understand to ensure efficient and effective functioning of
and assess the Internal Control System to the business organisation. In other words, it
determine the degree of reliance to be placed is a process implemented by the management
on it and accordingly to plan the nature, to provide the following:
timing and extent of audit procedures to be i. Proper accounting and reliability of
performed by him. If the Internal Control is records,
found to be effective, the auditor may resort ii. Effectiveness and efficiency of business
to selective verification. However, when operations, and
14 Internal Control
iii. Compliance with laws and regulations. in the conduct of a business including
The scope of internal control system is vast. internal check, internal audit and other
It comprises both administrative control as forms of control.”
well as accounting control. From various definitions, the following
points emerge:
2.3 Definition • Internal control is a system of control or
• Auditing Practices (SAP-6) of Institute practice put in place by management.
of Chartered Accountants of India: • Controls are established over financial
“Internal Control System refers to the and non-financial areas of business.
whole system of controls, financial or • Controls take the forms like internal audit
otherwise, established by the management and internal check.

2.4 Objectives of Internal Control

Each organization must have a system of anti-theft devices are used for providing
internal control in place for achieving the protection.
preset goals. Other than accomplishing
3. Increased Efficiency: To assist human
the desired goals and objectives of the
resource and performance management,
organization, this system plays a very
and to keep proper control over business
important role in any organization. The main
activities to achieve maximum levels of
objectives of internal control are as follows:
efficiency.
1. Compliance: To have compliance with
law and accounting practices that is 4. Review and Correction: To review
generally accepted and followed in the the working of the business, locate
country. The accounting process also weak points in operations and to take
needs to be in compliance with these. corrective measures for proper working.
2. Security: To provide security to 5. Resource Utilization: To ensure that all
customers, employees and property the resources, i.e., men, material, money
of the organization, physical security and machines of the organization are
systems like security guards, locks and optimally used.

Internal Control 15
2.5 Advantages of Internal 4. Operational Efficiency:
Control It facilitates fixation of accountability,
error – free work performance, accuracy
reliability and authenticity of entries
and eradicate inefficiency, fraud, theft,
etc. Moreover, this system enables the
management to assess the performance
of employees. All these collectively
contribute to enhance the operational
efficiency of organization as a whole.

2.6 Disadvantages of
Internal Control

Organizational
Structure

An audit control system can give the 2

following advantages: 4
Human Error
Disadvantages Size of the
of Internal Organization
1. Detection of Errors and Frauds: Internal controls

control systems are structured in such a

way that work done by one employee in
Costly
a process is checked by another without 3

knowledge of the former. In such an

environment, any fraud committed is
brought to light unless there is collusion
among fraudsters. An audit control system can give the
2. Time Saving: Auditor can test check or following limitations or disadvantages:
sample check the transactions to ensure 1. Organizational Structure: Deficiencies
reliability, and accuracy of entries in the in organizational structure make internal
books. Hence, he can complete his audit control ineffective.
work and prepare financial statements 2. Size of the Organization: Small
within the prescribed time. organizations have very low levels of
3. Minimum Scope for Errors and Frauds: internal control, which are almost
Each employee does only a limited work negligible due to more interference by
assigned to him, moreover, consciousness owners and management.
of his work being independently checked 3. Costly: The implementation of internal
by another keeps him to be always alert control procedures and processes involves
at work. In such a context, chances for incurring costs in terms of time, effort
commission of error or fraud are lesser. and resources.
16 Internal Control
4. Human Error: Internal control fails as among the employees of the organization.
there are posibility of human errors. Each and every work of the organization
should be divided in different stages and
should be allocated to the employees in
2.7 Principles of Good accordance with their skill and expertise.
Internal Control System 4. Separation of Operational responsibility
from Record Keeping: If each department
of an organization is being assigned to
prepare its own records and reports, there
may be a tendency to manipulate results
for showing better performance. In order
to ensure reliable records and information,
record-keeping function is separated
from the operational responsibility of the
concerned department.
5. Separation of the custody of assets from
accounting: To protect against misuse
of assets and their misappropriation,
it is required that the custody of assets
An effective or good system of internal control and their accounting should be done
should have the following principles: - by separate persons. When a particular
1. Well-designed Accounting System: person performs both the functions, there
Internal Control should provide for a is a chance of utilizing the organisation’s
well designed accounting system. The assets for his personal interest and
financial and accounting activities must adjusting the records to relieve himself
be separated. For example, person who from the responsibility of the assets.
is responsible in handling cash (cashier) 6. Supervision: Directors should review
and the person who accounts cash the company’s financial operations and
(accountant) should be done by two position at regular and frequent intervals.
different persons. Comparison with results for previous
2. Competent Personnel: In any internal periods indicates discrepancies that call
control system, personnel are the for further examination. Where budgetary
most important element. When the control is in use, attention will be drawn
employees are competent and efficient to material variances and explanations
in their assigned work, the Internal required. From time to time, special
Control System can be worked and reviews of particular items such as stocks,
operated efficiently and effectively or the operation of the wages department,
even if some of the other elements should be undertaken.
of the Internal Control System are absent. 7. Sound Practice: Sound practices of
3. Division of Work: This refers to the administration require that established
procedure of division of work properly procedures, policies and delegation
Internal Control 17
 of responsibility should be open to all internal check and in no circumstances;
employees of the organisation. This it should divert any one of responsibilities
helps in avoiding doubts, attempts to placed on him. It is the examination of
shift responsibility for unsatisfactory accounts of a business concern by its
employees specially appointed for the
performance etc.
purpose. It is an independent appraisal
8. Internal Audit: Internal audit is a part of activity within an organization for the
of the whole system of Internal Control. review of accounting, financial and other
It should operate independently of the business practices.

2.8 Kinds of Internal Control

The type of internal control system to be 1. Preventive Controls: Preventive controls

employed in an organization depends upon are designed to discourage errors or
the requirements and nature of the business. irregularities from occurring. They are
Generally, there are three types of Internal proactive controls that help to ensure
Control in an organisation preventive departmental objectives are being met.
control, detective control and corrective Examples of preventive controls are:
control. These types of controls are essential • Segregation of Duties: Duties are
for an effective internal control system. From segregated among different people to
a quality standpoint, preventive controls reduce the risk of error or inappropriate
are essential because they are proactive action. Normally, responsibilities for
and emphasize quality. However, detective authorizing transactions (approval),
controls play a critical role by providing recording transactions (accounting)
evidence that the preventive controls are and handling the related asset
functioning as intended. (custody) are divided.
18 Internal Control
 • Approvals, Authorizations, and occurred. Examples of detective controls
Verifications: Management authorizes are:
employees to perform certain activities • Reviews of Performance: Management
and to execute certain transactions compares information about current
within limited parameters. In addition, performance to budgets, forecasts,
management specifies those activities prior periods, or other benchmarks to
or transactions that need supervisory measure the extent to which goals and
approval before they are performed or objectives are being achieved and to
executed by employees. A supervisor’s identify unexpected results or unusual
approval (manual or electronic) implies conditions that require follow-up.
that he or she has verified and validated
• Reconciliations: An employee relates
that the activity or transaction conforms
different sets of data to one another,
to established policies and procedures.
identifies and investigates differences,
• Security of Assets (Preventive and
and takes corrective action, when
Detective): Access to equipment,
necessary.
inventories, securities, cash and other
assets is restricted; assets are periodically • Physical Inventories
counted and compared to amounts • Audits
shown on control records. 3. Corrective Controls: Corrective controls
2. Detective Controls: They are designed to target at the correction of errors and
find errors or irregularities after they have irregularities as soon as they are detected.

2.9 Methods of Evaluating Internal Control System

Internal Control 19
The following are the methods of Internal Control System and involves
evaluating Internal Control System: asking questions to various people at
1. Narrative Record or Memorandum different levels in the organization. The
Approach: It is a complete and exhaustive questionnaire is in a pre-designed format
descriptive record of the system. It is to ensure collection of complete and
appropriate in circumstances where a all relevant information. The questions
formal control system is lacking, like are designed in a manner that would
in case of small businesses. Gaps in the facilitate obtaining full information
control system are difficult to identify through answers “Yes” or “No’’.
using a narrative record.
2. Check List: It is a series of instructions
2.10 Auditor’s Duty in
that a member of the audit staff is
Evaluating the System
required to follow. They have to
of Internal Control
be signed or initialled by the audit
assistant as proof for having followed 1. Understand the System: The auditor
the instructions given. A specific should understand the control system
statement is required for every by discussing with personnel at various
weakness area. levels in the organisation. He should
3. Flow Chart: It is a pictorial also refer to organisation charts and
representation of the Internal Control manuals for this purpose.
System depicting its various elements
2. Determining the Reliability: The
such as operations, processes and
management installs and maintains
controls, which help in giving a
an adequate Internal Control System
concise and comprehensive view of the
taking into account the nature and
organization’s working to the auditor. A
size of the business. It is the duty of an
complete flow chart would depict the
process of raising documents, personnel auditor to establish a basis or degree of
involved in doing so, the flow of reliance on the system of control.
documents through various departments, 3. Determining the Adequacy: The auditor
maintenance of records, flow of goods and should apply various compliance tests
consideration, and dealing with results. in order to determine the adequacy of
The internal control evaluation process internal control system.
becomes easier through a flow chart as a 4. Review and Evaluation: Auditor
broad picture of all the controls involved should critically review and evaluate the
can be gauged in a glimpse. internal control system to determine
4. Internal Control Questionnaire: This the efficiency of its operations. If there
is the most widely used method for is a good system of internal control the
collecting information regarding the work of an auditor becomes easy.

20 Internal Control
2.11 Differences between Internal Check
and Internal Control

S.No Basis Internal Check Internal Control

1. Meaning A system of allocation of It consists of all the methods

responsibility, division of work, and procedures adopted to assist
and methods of recording in achieving the objective of
transactions, whereby the work efficient conduct of business.
of an employee is checked It includes Internal Check and
continuously by another. Internal Audit.

2. Scope It operates in routine to double In Internal Control Systems,

check every part of a transaction work of one person is
at the time of occurrence and automatically checked by
recording of the same. another.

3. Objective Its objective is to ensure that no Its object is to ensure

employee has exclusive control adherence to management
over any transaction or group of policies, safeguarding of assets,
transactions and their recording prevention and detection of
in the books. frauds and errors, accuracy and
completeness of accounting
records.

4. Point of Time Methods of recording In Internal Control System,

transactions are devised where checking is done simultaneously
work of an employee is checked with the conduct of work. Every
continuously by correlating it transaction is checked as soon
with the work of others. as it is entered.

5. Thrust of The thrust of internal check The thrust of internal control

System system is to prevent errors. lies in fixing of responsibility
and division of work to avoid
duplication.

6. Cost Involved It is a part of internal control The system proves to be costly

and a method of division of in case of small businesses
work, therefore does not add to because more number of
the cost. employees are engaged.

7. Report The summary of day to day Internal control provides for

transactions work as report to built in MIS reports.
the senior.

Internal Control 21
 STUDENTS ACTIVITY

1. Discuss the Internal Control System for cash

deposits and withdrawals in a bank.
2. Visit a company and discuss with Stores
manager regarding Internal Control System
followed for Material Management.
3. MOCK Bank: Set up a model bank in your
classroom and discuss the procedure for
deposits, withdrawal and sanctioning of loans.
4. If you are residing in a gated community,
discuss about the security system followed in
your campus.

SUMMARY

• Internal Control is the overall control environment established by management

of an enterprise for effective and efficient monitoring and control of its
operations. It aims at adherence to management policies, safeguarding of assets
of the enterprise, proper accounting and record of the business transactions.
The type of Internal Control System to be employed in an organization
depends upon the requirements and nature of the business. Generally, there are
three types of Internal Control in an organization namely; preventive, detective
and corrective controls.

KEY TERMS

• Internal Control –A system refers to the whole system of controls, financial or

otherwise, established by the management in the conduct of a business including
Internal Check, Internal Audit and other forms of control.
• Preventive Controls– It is designed to discourage errors or irregularities from
occurring.
• Detective Controls- It is designed to find errors or irregularities after they have
occurred.
• Narrative Record - It is a complete and exhaustive description of the system. It
is appropriate in circumstances where a formal control system is lacking, like in
the case of small businesses.

22 Internal Control
 • Flow Chart - It is a pictorial representation of the Internal Control System depicting its
various elements such as operations, processes and controls, which help in giving a concise
and comprehensive view of the organization’s working to the auditor.
• Internal Control Questionnaire: It is the most widely used method for
collecting information regarding the Internal Control System and involves
asking questions to various people at different levels in the organization. The
questionnaire is in a pre-designed format to ensure collection of complete and
all relevant information.
• SAP-6: Standing Auditing Practices framed by Chartered Accountants of India.

EVALUATION

I. Multiple Choice Questions:

1. Internal Control is 4. Under which of the following methods,

a. Part of Internal Check the auditor evaluates control by
b. A part of Internal Audit observation and writes down?
a. Oral approach
c. Whole system of control
employed by management b. Narrative approach
d. Examination of reliability of c. Flow chart
transaction d. Questionnaire method
5. Check list contains the instruction to
2. Which of the following is used for
be followed by the
evaluation of Internal Control?
a. Internal Auditor
a. Internal questionnaire approach
b. External Auditor
b. Flow Chart Method
c. Audit Assistants
c. Narrative Approach
d. Employee of the Organisation
d. All of the above
6. An auditor should study and evaluate
3. Representation of the entire control Internal Controls to
system in diagram under evaluation a Determine whether assets are
system. safeguarded
a Flow Chart Method b Suggest improvements in internal
b Narrative Approach control
c Internal Questionnaire Approach c Plan Audit procedures
d All of the above d Express and opinion

Internal Control 23
7. A flow chart, made by the auditor, of 9. The effectiveness of Internal Control
an entity’s Internal Control System is a System determines the extent of
graphic representation that depicts the checking done by the
auditor’s. a. Management
a Understanding of the system b. Auditor
b Understanding of fraud risk c. Accountant
factors d. None of the above
c Documentation of assessment of
control risk 10. Proper segregation of duties reduces
the opportunities in which a person
d The auditor and his audit
would both
assistants
a. establish controls and executes them
8. Internal Control Questionnaire b. records cash receipts and cash
contains the questions need to be payments
followed by the .
c. perpetuate errors and frauds and
a Employer conceals them
b Employee d. record the transaction in Journal
c Auditor and Ledger.
d Banker

Answers 1.(c), 2.(d), 3.(a), 4.(c), 5.(c), 6.(c), 7.(b), 8.(b), 9.(b), 10.(c)

II. Very Short Answer Questions

1. What is Internal Control? 4. What is Flow chart method of evaluation?

2. Define Internal Control 5. What is Internal control
3. What is meant by Narrative questionnaire?
approach? 6. What is Check list?

III. Short Answer Questions

1. State the objectives of internal control. 2. What are the kinds of internal control?

IV. Essay Type Questions

1. What are the advantages and 3. Discuss the methods of evaluating
disadvantages of internal control system? Internal Control System.
2. Explain the principles of good Internal 4. Differentiate Internal control from
Control System. Internal check.

24 Internal Control
References
1. Auditing Practical - B. N. Tandon & Others, S. Chand Publications.
2. Auditing Practical – L. Natarajan, Margham Publications.
3. Auditing Practical – S. Vengadamani, Margham Publications.
4. Auditing – T. R. Sharma, Sahitya Bhawan Publications
5. Auditing Theory & Practice – Pardeep & Others, Kalyani Publishers.
6. Auditing Practical – Dr. Radha, Prasanna Publishers & Distributors.
7. Principles and Practice of Auditing – DinkarPagare, Sultan Chand & Sons.

Internal Control 25