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Lesson#17
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DOCUMENTING THE INTERNAL CONTROL SYSTEM
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DOCUMENTING THE INTERNAL CONTROL SYSTEM
Benefits of Internal Control to the entity
Based on our previous studies we can now identify the following
principal benefits that may arise for an
entity from a sound system of internal control:
a) Assurance that all transactions are completely and accurately
processed.
b) Confidence that only authorized transactions takes place.
c) Assurance that adequate documentation supporting transactions
is created and retained.
d) Assurance that the company’s assets and liabilities are
correctly stated, in order for them to
make informed decisions on the operations of the business.
e) Minimization of the risk of fraud and misappropriation of
assets.
Benefits of Internal Control to the auditor
Of course, if the audit client benefits from a sound system of
internal control, it is likely that the auditor will
also be benefited. All of the above stated benefits help to
promote a situation where the financial statements
present a true and fair view. In simple terms, a good system of
internal control will make life easier for the
auditor.
Auditor’s work on the Internal Control
International standards on auditing emphasize the importance of
internal control to the auditor by stating
that auditor should:
a) Obtain an understanding of the accounting and internal
control system sufficient to plan the
audit and develop an effective audit approach, and
b) Use professional judgment to assess the components of audit
risk and to design audit
procedures to ensure it is reduced to an acceptably low level.
At an early stage in their work auditors will have to decide the
extent to which they wish to place reliance on
the internal controls of the enterprise. As the audit proceeds,
that decision will be kept under review and,
depending on the results of their examination, they may decide
to place more or less reliance on these
controls.
Categories of Internal Control
These are often summarized by using the mnemonic SOAP MAPS as
follows:
a) Supervision
b) Organization
c) Arithmetic and Accounting
d) Physical
e) Management and Monitoring
f) Authorization
g) Personnel
h) Segregation of duties
a) Supervision
There should be adequate supervision of work to ensure that
controls are being complied with.
Possible application: a supervisor or manager reviews and checks
the work of a subordinate.
b) Organization
Enterprises should have a formal, documented organization
structure with clear lines of
responsibility.
Possible application: lines of authority within an organization
make it clear which individuals are responsible
for decisions and transactions
c) Arithmetic and Accounting
The company should ensure that there are adequate controls to
ensure the completeness and
accuracy of its financial records.
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59
Possible application: standard accounting procedures such as the
use of control accounts, reconciliation
procedures and the performance of arithmetic checks on
accounting records.
d) Physical
There should be adequate physical control to ensure the security
and safekeeping of its assets such
as plant and machinery, valuable inventory items and cash.
Possible application: banking cash immediately, controlling
access to inventory areas; electronic tagging of
inventory and portable non-current assets.
e) Management and Monitoring
There should be sufficient controls in existence to ensure
management can effectively control the
business operations.
Possible application: the use of budgeting and standard costing
systems; the establishment of an internal
audit department
f) Authorization
All transactions should be authorized.
Possible application: authorization of purchases, cash and bank
payments, sale of non-current assets, sales
to customers on credit, bad debt write offs.
g) Personnel
Employees should be appropriately qualified and of suitable
caliber to perform the required tasks.
Possible application: recruiting the right people for the job;
training them effectively, motivating and
rewarding employees in an appropriate way.
h) Segregation of duties
There should be an appropriate division of responsibilities to
reduce the opportunity for fraud and
manipulation.
This is a fundamental control procedure designed to ensure that
one person does not have sole
charge of a transaction from beginning till end. Perfect
segregation of duties exists where each of
the main stages in a transaction are under the control of a
different person.
Possible application:
Consider an inventory purchasing system in a manufacturing
company:
Stage Documentation Responsibility
Initiation Stores requisition Stores keeper
Authorization Purchase order Purchasing officer
Custody Goods received note Receiving officer
Recording Invoice Account department
Documenting the system
Documenting the system is an extremely important stage in the
audit;
Auditing standards state that in planning the audit, auditors
should obtain and document
an understanding
of the accounting system and control environment
sufficient to determine their audit
approach.
The various methods of ascertaining and recording the system may
be summarized as follows:
1. Organization chart
2. Narrative notes
3 Flowcharts
4 Internal control questionnaires (ICQs)
5 Internal control evaluation checklists (ICEC)
page
60
Organization Chart
Managing Director
Production
Director
Sales
Director
Finance
Director
Production
Planning
Factory
Manager
Purchases
Controller
Distribution
Manager
Advertising
Manger
Manager
Accounts
Chief
Accountant
Narrative Notes
This is a simple and apparently convenient way of describing
systems. Having ascertained the system, the
auditor draws up a narrative description of it for the audit
files. An example might be:
Sales invoices are prepared by Mr._____ They are checked by Mr.
_____ and then passed to Mr. _____ for
recording in the customer’s account in the sales ledger etc.
Shortcomings of the method:
1. Notes can take up a disproportionate amount of space
2. Notes may be difficult to interpret
3. What happens it personnel change?
Flowcharts
This is becoming an increasingly widely used technique for
recording accounting systems in audit files.
A flowchart is a diagrammatical representation of an accounting
system.
A good flowchart will be supplemented with narrative.
Flowcharts have the following advantages:
(i) They portray the flow of documents through the system and
enable the auditor to relate those
movements with procedures and checks carried out as part of that
system.
(ii) They show the movement of documents in such a way that,
when properly prepared, the
sources and destinations of all documents will be clear.
(iii) They help to highlight weaknesses in the control of the
business.
(iv) They enable audit tests to be clearly related to weaknesses
in the accounting system.
Standard symbols are used to represent documents, operations and
checks carried out.
Flow lines are used to join up the symbols and represent the
movement of documents.
Dotted lines are used to represent the flow of information
between documents.
Essentials of flowchart
Internal control evaluation flowcharts
must
highlight the following:
(a) the sequence
of operations happening to each
document (e.g. authorization, checking, matching, filing)
(b) the
segregation of staff duties and who is
responsible for each operation.
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61
Symbols used in manual systems flowcharts
• A document
• A multi-part set of
documents
• Pre-numbered document
• A book of account
• An operation performed
on a document
• A check performed on a
document
• Filing a book or
document
• Document flow
• Information flow
• Connector with another
page/flow-line
N
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62
Flowchart of purchases
Narratives:
1 Requisition note raised when goods
are at a pre-set re-order level. Order
quantity is pre-determined by use of a
copy of the previous purchase order.
2 Signed by store manager.
3 Buyer checks authorization.
4 Purchase order set prepared.
8 P02 filed temporarily to act as a check
on overdue deliveries.
10 P04 and P05 are filed until goods are
received.
11 Weekly check on overdue deliveries.
12 Goods checked to PO to ensure they
are in agreement.
13 If not damaged, goods are accepted
and a goods received note set is raised.
Where quantity received is below order a
shortage memo set is also raised and a
note made on the purchase order.
14 P05 is sent back to the warehouse to
act as the next requisition note.
Commentary on the above flowchart
(a) All operations and checks are positioned on vertical lines
within a particular department.
(b) Horizontal lines show the movement of a document between
departments.
(c) In practice the flowchart would continue, dealing with the
processing of the purchase invoice/credit
note/day books/payables ledger/cash book etc. The
flow-lines at the bottom of the
page would continue to
page 2 of
the flowchart.
(d) Note that the narrative to the flowchart does not deal with
all of the operation numbers since some
should be self-explanatory e.g. operation 9 represents the
numerical filing of P03 in the buying department.
page
63
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