MODULE -2 RISK ASSESSMENT AND INTERNAL CONTROL

AUDIT RISK
Audit risk is the risk that auditors face, when they issue an incorrect opinion on the financial
statements, leading to the possibility that the statements are materially misstated.
In other words, Audit risk is the overall risk that the auditor is willing to accept for issuing an
audit opinion.
Components of Audit Risk:
1. Inherent Risk
Inherent risk is the susceptibility of an assertion in the financial statements to material
misstatement, even in the absence of controls. It is influenced by factors such as complexity.
industry characteristics, and inherent weaknesses in the accounting processes.
2. Control Risk
Control risk is the risk that internal controls will fail to prevent or detect material misstatements
in the financial statements. It depends on the effectiveness of an organization's internal controls.
3. Detection Risk
Detection risk is the risk that audit procedures will fail to detect material misstatements that
exist in the financial statements. It is controlled by the nature, timing, and extent of audit
procedures performed by the auditor.
ASSESSMENT OF RISK
The assessment of risk involves identifying, evaluating, and addressing risks that could affect
the accuracy and reliability of an organization's financial statements. Effective risk assessment
allows auditors to tailor their audit procedures to focus on areas with higher risks of material
misstatement.
Assessment Process:
1. Understanding the Entity and Environment
a) Gain an understanding of the client's business, industry, and operations.
b) Consider external factors that could impact the financial statements.
2. Identifying Risks
a) Identify potential risks that could lead to material misstatements.
3. Assessing Inherent Risk
a) Evaluate the inherent risk for various accounts and assertions.
b) Assess factors such as complexity, subjectivity, and susceptibility to fraud.
4. Assessing Control Risk
a) Evaluate the effectiveness of internal controls.
b) Consider the design and operation of control
5 Determining Detection Risk
a) Determine the level of detection risk needed to achieve the desired level of audit risk.
b) Adjust detection risk based on the assessed inherent risk and control risk.
BENEFITS OF RISK ASSESSMENT IN AUDITING
1.Efficient Resource Allocation: Focus audit efforts on areas with higher risks, optimizing the
allocation of audit resources.
2.Effective Audit Planning: Develop a well-structured audit plan that addresses identified
risks.
3.Enhanced Audit Quality: Tailor audit procedures to areas of greatest risk, leading to a more
thorough and effective audit.
4.Informed Decision-Making: Provide reliable and relevant information to assist in decision-
making by management and stakeholders.
5.Increased Credibility: Strengthen the credibility and reliability of the audit process and
resulting audit opinion.
MEANING OF INTERNAL CONTROL
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, to safeguard its assets and to secure as far as
possible the accuracy and reliability of its records.
OBJECTIVES OF INTERNAL CONTROL
1. To evaluate the efficiency of performance in the various activities of the business.
2. To ensure orderly, efficient and economic conduct of the business.
3. To see that access to and use of assets are made only with proper authorization.
4. To safe guard the assets of the organization by preventing frauds, wastes and
inefficiency.
5. To ensure that transactions are recorded in the proper books of accounts regularly,
correctly and systematically, according to policies and procedures and the accounts
are accurate and reliable.
INTERNAL CHECK
It is the arrangement of the accounting duties under which the work of one person comes
under the scrutiny of another person, so that it is not possible to commit fraud without
collusion between two or more persons.
DEFINITIONS OF INTERNAL CHECK
According to L. R. Dicksee, "Internal check is an arrangement of the accounting routine that
errors and frauds are automatically prevented or discovered by the very operation of the book
keeping itself."
OBJECTIVE OF INTERNAL CHECK
1.To prevent the commission of any error or fraud by a clerk.
2. To prevent the misappropriation of cash or goods by any clerk.
3. To throw responsibility on a particular clerk, when the fraud or mistake is detected.
4. To detect a fraud or an error quickly and easily.
5. To have an accurate record of all business transactions.
IMPORTANCE OF INTERNAL CHECK
1. Assigning Responsibility: To allocate the duties and responsibilities of every employee
in such a manner that they may be identified and held responsible for a particular error
or fraud.
2. Minimizing Error or Fraud: To minimize the possibility of any error or fraud done
by any staff member.
3. Detecting Errors or Frauds: To detect errors or frauds easily due to independent
checking of work done by one employee by another employee.
4. Reducing Clerical Mistakes: To minimize the possibility of omission of any
transaction from being recorded in the books of accounts.
5. Enhancing Work Efficiency: To enhance the efficiency of the staff, as the
management of duties is based on the principle of division of labour.
ADVANTAGES OF INTERNAL CHECK
1. Proper Allocation of Work
It facilitates a proper and rational distribution of work among the members of the staff based
on the principles of division of labour.
2. Early detection and minimization of errors and frauds
In an internal check system no individual is allowed-to handle a job completely from beginning
to the end the work of each individual is automatically checked by the other.
3. Increased Efficiency
In an internal check system, there is a proper and rational distribution of work among the
employees according to their qualification, experience and specialization. It leads to increased
efficiency of work and overall economy.
4. Quick Preparation of Final Accounts
In an intermal check system all accounts are checked side by side, no errors remain in book
keeping, hence, final accounts can be prepared easily and without any loss of time.
5. Convenience to the Auditor
In an organization where, internal check system is prevalent, routine checking is not required.
Possibilities of errors and frauds are minimum. The statutory auditor can easily avoid detailed
checking and can adopt only test checking. His work, thus, becomes very easy.
6. Increase in profits and development of the business
Internal check system leads to overall efficiency and economy in operations, which in tum
results in more profits to the shareholders and development of the business.
7. Reliable Accounting System
If there 1S a good system of internal check, the owner of the concern may rely upon the
geniuses and accuracy of the accounts.
LIMITATIONS OF INTERNAL CHECK
1. Expensive for small business
Internal check system requires a large number of employees so it is quite expensive especially
for small business.
2. Collusion among employees
In an internal check system there are possibilities of collusion among employees. As a result,
frauds may happen.
3. Disorder in the working of the business
In the absence of a well organized internal check system, mutual rivalries among employees
begin. As result chaos and disorder in the working of the business prevails and the work suffers.
4. Quality Sacrificed
Every employee of the business wants to complete the work quickly without taking it seriously.
As a result, possibility of error remains and quality suffers.
5. Carelessness on the part of the owner and top level officials
The owner and other high level officials believe that nothing can go wrong under a sound
internal check system.
6. Carelessness on the part of the auditor
The auditor comes to rely on the correctness of accounts. He may not apply tests and procedures
of his own. So his work suffers. Some of the irregularities may remain undetected.
7. Risky for an auditor
If the auditor does not apply tests and procedures of his own and if he relies on the output of
the system his work cannot be free from irregularities.
FUNDAMENTAL PRINCIPLES OF INTERNAL CHECK
1. The system of internal check should be reviewed from time to time to ascertain the
loopholes and to introduce improvements.
2. Works relating to purchase returns, sales returns, allowances, discounts, bad debts etc.,
should be performed by responsible officials under strict control.
3. There should be effective control over all purchases, receipts and issue of goods.
4. The cash and bank balances should be verified frequently by a responsible official.
5. All payments should be made by crossed cheque as far as possible.
 6. All remittances received should be deposited into the bank either on the same day or on
the next day.
7. The cashier should not have access to the ledgers.
8. The receipts and payments of cash should be entrusted to different persons.
9. The debtors and creditors of the business should be requested to send statements of
accounts at certain intervals to a responsible official.
10. The system of internal check should be simple, easily workable and effective
INTERNAL CHECK AS REGARDS TO PAYMENT OF WAGES
To minimize the fraudulent manipulations of wage records, cash and the other risks, the
following internal check system can be adopted:
Maintenance of wage records
1. Time recording clock should be maintained for recording the time of workers entering and
leaving the place of work.
2. If the workers are paid on the basis of piece-wages system, proper books for recording the
actual work done by workers should be maintained.
3. If workers are allowed to work overtime, overtime slip must be issued to such workers by
the property authorized official.
4. If any worker wants to go out of the factory, he should take written permission from the
authorized person.
5. If casual workers are also employed in the organization, a list of such workers must be
prepared by the foreman of each department. The list so prepared must be certified by the
officer, who is authorized to appoint casual workers.

Preparation of wage sheets

The work of preparation of wage sheets should be done by a separate department. This work
should be done at least by four clerks, so that irregularities may be minimized. For instance,
two clerks should examine the time records, piece wage records, overtime records etc.
Payment of wages
a) The cashier should with draw the net amount as shown in the wage sheets.
b) The payment of wages must be made by a person, who is in no way concerned with the
preparation of wage sheets.
c) Each worker, who is to receive the wages should be present at the time of disbursement.
d) The foreman of each department should be present at the time of payment to identify the
workers of his section.
e) The signatures of the workers must be obtained, when they receive the amount of wages.
f) Special arrangements should be made to pay to the absentee workers.
g) A list of unpaid workers should be prepared by the cashier and foreman of each department.
h) The officer employing casual workers should not be connected with the payment of wages.
INTERNAL CHECK AS REGARDS TO CASH SALES

Sales over the counter

a) For each counter, a separate salesmen should be appointed to look after his counter
b) Each salesman should be given a separate sales memo book. Such books should be of
different colours for different counters
c) The salesmen, when he sells the goods to the customers, he should prepare three copies of
cash memo.
d) The cashier, after having received the price of the goods from the customer, should give one
copy duly stamped as cash paid to the customer and other copy must be retained by him.
e) At the end of the day, the cashier should prepare statement showing total cash received and
salesmen should prepare sales summary to know the total sales. Then both these statements
should be sent to the officer in charge for verification.

Postal sales
a) A separate register should be maintained for recording sales made by VPP (value payable by
post).
b) The goods returned should also be recorded in the VPP register.
c) The total receipts on this account should be entered in the VPP register.
d) Any advance received should be entered in the VPP register.

Sales by traveling agents

1. The traveling agents should be allowed to issue rough receipts to the customers for cash
received on the sale of the articles. Final receipts should be issued only by the head office.
2. Agents should remit the entire proceeds to the head office or they should deposit the cash
daily in a bank.
3. Agents should not be allowed to deduct their commission out of sale proceeds collected by
them
INTERNAL CHECK AS REGARDS TO PURCHASES
Requisition
Requisition book must be kept by each department in the organization. The department
requiring goods must prepare a requisition slip in duplicate, by clearly mentioning the details
about quantity, quality and the time by which the goods must be supplied and send it to the
purchase department.
Purchase order
After the receipt of requisition slip, the purchase department should invite quotations from the
vendors and select the vendor, who supplies quality goods at reasonable price. Then the
purchase department should prepare four copies of purchase orders. One copy should be sent
to the vendor, second to the stores and third to the accounting department.
Receipt of goods
On receipt of goods, the purchase department should carefully inspect the goods so received
with the help of purchase order and invoice. Then the purchase department must enter the goods
received in the goods inwards book and send the goods to the stores and should also inform the
concerned department about the receipt of the goods.
Invoice
The accounting department should compare the invoice with the purchase order and it should
also verify the calculations. If goods received are in order and the calculations are found to be
correct, proper arrangements should be made for making payment to the vendors.
MEANING OF INTERNAL AUDIT
Internal audit is an independent, objective assurance and consulting activity designed to add
value and improve an organization's operations. The role of internal audit is to provide
independent assurance that an organization's risk management, governance and internal control
processes are operating effectively.
OBJECTIVES OF INTERNAL AUDIT
1.To verify the correctness, accuracy and authenticity of the financial accounting and statistical
records presented to the management.
2.To confirm that the liabilities have been incurred by the organization in respect of its valid
and legitimate activities.
3.To comment on the effectiveness of the internal control system and the internal check system
in force and to suggest ways and means to improve these systems.
4.To facilitate the early detection and prevention of frauds.
5.To examine the protection afforded to company's assets and use of them for business purpose.
6.To identify the authorities responsible for purchasing assets and other items as well as
disposal of assets.
7.To ensure that the standard accounting practices which have to be followed by the
organization are strictly followed.
8. To undertake special investigation for the management.
ADVANTAGES OF INTERNAL AUDIT
1. To ascertain whether the internal check and accounting system are adequate and effective.
2. To ascertain whether the predetermined policies, plans and procedures have been complied
with.
3. To evaluate the performance of the personnel, who are entrusted with certain responsibilities.
4. To ascertain whether the properties of the concern are safeguarded.
5. To suggest to the management the improvements desired in the internal check system,
accounting system.
DISADVANTAGES OF INTERNAL AUDIT
1. Introduction of an internal audit system is quite expensive, as it involves additional costs.
Therefore, it is suitable only for big concerns but not for small concerns.
2.If the internal audit system is not properly organized, it may create chaos and disorder in the
working of the business.