Auditing – Internal Control

In this chapter, we will discuss how Internal Control works in Auditing. Internal Control system is one of the basic and essential factors for efficient and effective management. It covers the whole management system of an organization, both financial or non-financial. Internal control system is helpful for the management and also the Auditor in achieving goals and targets effectively. Therefore, internal control system covers a number of checks and control to ensure efficient and economic working.

There are two types of controls — Financial Control and Administrative Control. Reliability of financial records and safeguarding of assets is a part of financial control. We will now understand in detail what Internal Control System.

What is Internal Control

Internal Control comprises of the plan of the organization and all the co-ordinate methods and measures adopted within a business to safeguard its assets, check the accuracy and reliability of its accounting data to promote operational efficiency and to encourage adherence to prescribed managerial policies.

Purpose of Internal Control

Let us now understand the purpose of Internal Control from different points of view.

From Auditor’s Point of View

It is very important from the Auditor’s point of view to study and evaluate the system of internal control. To obtain an adequate understanding of the internal control system, that must be tested. The Auditor has to determine whether audit is possible, if yes, then he should determine the scope of audit.

From Client’s Point of View

  • Internal control system provides reliable and accurate data that is necessary for decision making and to run business activity efficiently.
  • Adequate internal control system safeguard business assets, in absence of it, assets of the company may be stolen, misused or accidentally destroyed.
  • Internal control system within organization is necessary to discourage and stop non performing business activities and to protect business from wastage is all aspects of the business.
  • Internal control system insures that rules and procedures are to be followed by business personnel.

Characteristics of Internal Control

Following are the main characteristics of Internal Control usually abbreviated as CROSSASIA −

  • Competent and trustworthy personnel
  • Records, Financial and other Organization plan
  • Organizational plans
  • Segregation of duties
  • Supervision
  • Authorization
  • Sound practice
  • Internal Audit
  • Arithmetic and accounting controls

Limitations of Internal Control

Following are the inherent limitations of Internal Control −

  • Management decision to choose cost effective control system may reduce the effectiveness of internal control system.
  • There are chances of misuse by a person of authority who is operating on internal control system.
  • Objectives of internal control systems may be defeated by manipulation of management.
  • Since internal control system is involved in routine transactions, irregular transactions may be overlooked.
  • Changes in conditions may affect the effectiveness of internal control system.

Scope of Internal Control

Following are the main areas which are generally covered by a good internal control system −

  • Cash − Here, internal control is applied over payments and receipts of an organization. This is to safeguard from misappropriation of cash.
  • Control over Sale and Purchase − With proper and efficient control system for transactions regarding purchase and sale of material, handling of material and accounting for the same is must.
  • Financial Control − It deals with the efficient system of accounting, recording and supervision.
  • Employee’s Remuneration − Internal control system is applied to preparation and maintenance of records of employees and the payment methods also. It is also necessary to safeguard against misappropriation of cash.
  • Capital Expenditure − Internal control system ensures the proper sanction of capital expenditure and also the use of it for the purpose intended.
  • Inventory Control − It covers the proper handling of inventory, minimization of slow moving items or dead stock, proper valuation of stock, recording of it, etc.
  • Control over Investments − internal control system is applied to the proper recording of transactions be it purchases, additions, sale or redemption, income on investments, profit or loss on investment.

Internal Control and Auditor

An Auditor should ensure that certain rules and procedures are followed by the business unit he is working on, in spite of the fact that a sound system of internal control is as sole responsibility of the management. The Auditor can simply guide or help the management if he is asked to do so, because he has no authority to prescribe such rules and procedures. The degree of reliance on the system depends upon the effectiveness of internal control system; therefore, the Auditor should review and evaluate the internal control system of an organization to prepare his audit Program.

Review of Internal Control System

Internal control system should be reviewed by the Auditor before star audit as described below −

  • Reviewing the system of accounting entries, whether recorded as per accounting standard or not.
  • To frame audit program according to present circumstances.
  • Frauds, errors and mistakes are likely to be located or not.
  • To review existence of internal audit program and to check the efficiency of internal control system.
  • To review the reliability of reports, records and certificates as presented by the management.
  • To check if there is any possibility of improvement in existing internal control system.