ALDRIDGE STATE HIGH SCHOOL
ES6 - INTERNAL CONTROLS
Internal control of a business enterprise involves those internal methods and measures that ensure
efficient management of the enterprise and achievement of planned objectives. In today’s
business, internal controls in all areas can be strengthened by the use of computers where
transactions, once recorded, cannot be adjusted.
The general aims of internal control are to:
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safeguard the assets of the business
check the accuracy and reliability of the business’s accounting data
promote operational efficiency
encourage adherence to prescribed managerial policies.
Accounting controls are the methods and procedures designed to safeguard the assets of the
business and to check the accuracy and reliability of its accounting data.
Administrative controls are the methods and procedures designed to promote operational
efficiency and to encourage adherence to prescribed managerial policies.
Internal controls built into an accounting system aim to:
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prevent errors from being made in the first instance
detect errors if they are made
prevent theft and fraud from occurring
increase efficiency through budgeting procedures.
Internal accounting controls are built around the following seven principles:
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reliable, competent personnel
verification
authorisation
responsibility
separation of duties/rotation of duties
adequate and accurate documents and records
physical controls and security.
CASH
IMPORTANCE OF CASH
Cash is such an important asset for the following reasons:
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Most business transactions eventually lead to the business receiving cash (cash receipts) or
paying cash (cash payments).
Because cash is easily stolen, adequate controls must be implemented to ensure that people
with dishonest intentions are detected.
GENERAL INTERNAL CONTROLS OVER CASH
A good system of internal control over cash should have the following features:
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All money received should be evidenced by a document or other proof. This makes it more
difficult for employees to steal money. A document or other proof allows the
business to check that the actual cash on hand corresponds to the amount that
should be on hand.
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All cash received should be banked intact at the end of each business day. “Intact” means that
payments should not be made out of the day’s receipts. Banking daily ensures that large
amounts of money will therefore not be left on the premises overnight.
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All cash payments should be made by cheque or electronic funds transfer (EFT) except when
amounts are small enough to be paid through a petty cash fund.
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All cash should be kept in a safe place. Change kept on hand for the next
working day should be under lock and key, preferably in a safe.
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At regular intervals, the business’s records must be checked against, or
reconciled with, an independent record called a bank statement. This is particularly important
where there are many EFTs of cash. If this occurs, the receipt of daily bank statements or
Internet access to bank statements is very important. Bank statements are vital, not only to
ensure the reconciliation of the final balance, but also to record the many transactions that are
now occurring electronically.
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Employees who receive or handle cash should not be involved with the recording of these
transactions in the accounting records. This separation of duties is designed to prevent a
person from taking money and disguising the theft by adjusting the business’s records.
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Employees are less likely to commit fraud if they know that they can be moved
without prior notice. This rotation of duties may allow the next person doing
the job to discover any unusual entries. Employees should also be made to
take annual holidays so that other people do their job in their absence. Again,
errors or unusual entries can be discovered in this way.
CREDIT
IMPORTANCE OF CREDIT
Control over credit is becoming more important because of the tendency to rely less on cash and
to use credit cards and credit facilities provided. Many business transactions are carried out on a
credit basis, such as the purchasing and selling of inventories. These credit transactions create
accounts receivable and payable and adequate controls must be implemented over them.
INTERNAL CONTROL OVER ACCOUNTS RECEIVABLE
Credit approval:
All customers who apply for credit must be thoroughly investigated for their credit worthiness.
Such things as permanent employment or length of time in business, amount of income/profit,
permanent residence, ability to pay debts, past credit history and credit ratings from other firms
must be looked at before credit is given. This investigation is essential, because if credit is given to
the wrong people, there is an increased risk of bad debts occurring.
The business must have a credit policy and must decide the following:
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what the minimum requirements will be before credit is granted
the number of days given for accounts receivable to pay
whether or not discounts will be given
the amount of interest (if any) that will be charged on overdue accounts
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In larger businesses, these functions are generally carried out by a credit department. Credit
approval must always be the responsibility of the finance section and not the responsibility of the
sales section. In this way, salespeople are not tempted to adjust a person’s credit rating simply to
get a sale. When a credit sale is made, it is important that salespeople check the credit status of
the potential customer.
Recording
The use of control accounts and subsidiary ledgers is desirable where the number of accounts
warrant their use. This control occurs through comparison of the schedule of accounts receivable
with the control account in the general ledger.
Billing
A tax invoice is the main document that certifies a credit sale has taken place. An
adjustment/credit note certifies that a sales return or allowance has occurred. As well,
statements of account should be sent at regular intervals to accounts receivable so that cash
from these credit sales is collected as soon as possible. A statement of account is simply a list of
the transactions (goods sold on credit, cash received and so on) that have occurred and is in the
same form as a three-column ledger.
Statements of account also help to ensure that the business’s records are correct,
as most people receiving an incorrect statement will contact the firm. This, in
conjunction with spot checks made by the accountant or internal auditor to see that
statements of account agree with actual accounts receivable balance, help ensure
that the business’s accounting records are accurate.
If there is a large number of accounts receivable, a technique called cycle billing may be used.
Instead of sending out all accounts receivable at the end of each month and have a very heavy
workload at that time, cycle billing spreads this workload over the whole month. Customers are
grouped alphabetically and statements are sent out in a cycle during the month. For example,
statements for accounts receivable whose names start with A-F will be sent out on the first day of
every month, G-L on the 8th, M-S on the 15th and T-Z on the 22nd.
Reporting
Each accounts receivable must be monitored to ensure that debts are paid on time. The most
common technique used is called “ageing the accounts receivable”. A report is prepared setting
out the age of each account as current, up to 30 days past the due date, 60 days past the due date
and so on.
This report identifies slow-paying customers so that appropriate
action can be taken. The older the debt, the less likely it is that the
account will be paid. Accounts receivable must therefore be
constantly reminded of the debt. Generally, accounts receivable
are contacted by telephone and/or reminder notices (varying in
degrees of tact) are sent with overdue accounts. For example, the
first reminder may say, “Perhaps you have overlooked this account, please pay promptly”. The
final letter may say, “If payments are not received within 21 days, court action will be taken”.
If all procedures fail to collect the money owing, the account may have to be written off as a bad
debt.
Separation of duties
This is a very important principle of internal control. No person who handles the physical assets of
cash or inventories should also have access to the accounts receivable records. This is to ensure
that assets are not removed illegally and the records adjusted to cover up the fraud.
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INTERNAL CONTROL OVER ACCOUNTS PAYABLE
Proper authorisation
This should be obtained before goods are ordered. Suppliers should be approved on the basis of
price, quality and the ability to fill orders on time. Proper authorisation must also be obtained
before cheques are drawn to pay accounts. This ensures that each accounts payable is paid the
correct amount.
Recording
The use of control accounts and subsidiary ledgers (if suited to the style of the business) allows
greater control through comparison of the control account in the general edger with the schedule of
accounts payable.
Prompt payment
Procedures should be implemented to ensure that payments are made
promptly, especially within any discount periods. This means that the business
takes advantage of any discounts and maintains its reputation for prompt payments.
Separation of duties
People who handle the accounts payable records should not handle the payment of cash or the
receipt of inventories.
INVENTORIES
IMPORTANCE OF INVENTORIES
Inventories are important for several reasons. They are an integral part of profit determination.
They are used in calculating any inventory adjustment to be included in cost of goods sold and
therefore have a great bearing on the profit figure.
Gross profit = Sales – Cost of goods sold
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A figure for closing inventories must be obtained so that the Balance Sheet can be accurately
prepared. Closing inventories are one of the items of value owned on balance day.
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Inventories should be turned over as quickly as possible. The faster the turnover (sales), the
greater the opportunity to make profits.
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Because large amounts of money are invested in inventories, adequate
controls must be implemented so that theft and other losses are kept to a
minimum. Store cameras, store detectives, inspection of shopping bags and
mirrors are methods used to prevent theft by customers.
The quantity of inventories must be continually monitored. Neither too
many nor too few inventories should be kept on hand. If the level of
inventories held by the business is too high and goods are not selling,
then money is being tied up and not being used to generate profit. This is
why many businesses have a clearance sale – to reduce the price and
convert slow-moving inventories to cash so that faster-moving inventories
can be purchased. If the level of inventories held by the business is too
low, sales will be lost to competitors and goodwill will diminish.
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The quality and type of inventories are very important. The business should try to have
available for sale the right goods, at the right place, at the right time. A constant check must be
made to ensure that inventories are not out of date, the wrong colour or size, or of poor quality,
otherwise sales will suffer.
Also, the procedures for controlling inventories depends on the size of the business:
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If the business is large, these functions are shared between different departments and internal
controls must be built into the system.
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If the business is small, each of the functions could be performed and supervised by the owner
so that control measures are more easily implemented.
Stocktaking (physical stocktake or physical inventory)
If a business keeps inventories as part of its normal operation, an annual
physical stocktake is a necessity.
Stocktaking is the process of listing, counting and valuing unsold inventories on hand.
A stocktake is necessary for two main reasons:
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It is needed to determine the value of the inventories on hand at a particular date. This value is
used in the Balance Sheet.
It is the only way of determining actual inventories on hand. If the perpetual inventory system
is used, the figure arrived at can also be compared with what should have been on hand. It
can them be seen whether goods have been lost through theft or spoilage.
INTERNAL CONTROL OVER THE PURCHASE OF INVENTORIES
The ordering of goods is dependent upon three factors:
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the reorder point, which is a predetermined minimum amount of an item that a business would
like to maintain
the reorder quantity, which is the quantity to be ordered when the reorder point is reached
the lead time, which is the amount of time it takes from when a business places an order to
when the product actually arrives.
Generally, the longer the lead time (if, for example, the goods have to come from overseas), the
higher the reorder point and the higher the reorder quantity. The shorter the lead time (if, for
example, the supplier is in the same city), the lower the reorder point and the lower the reorder
quantity.
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When the goods are ordered, a purchase order or an order form is despatched to the
supplier.
When the goods are received, a delivery docket or despatch docket will accompany the
goods. Care must be taken to ensure that the goods received are in fact the goods ordered.
An original tax invoice may be received at the time of delivery or at a later date.
If goods are returned by us (purchases returns), an original adjustment/credit note will be
received.
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INTERNAL CONTROL OVER THE SALE OF INVENTORIES
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Orders may be received over the counter, by post, by telephone, from travelling salespeople or
electronically by electronic data interchange (EDI) or from a website.
If orders are not received electronically, they are generally entered onto a standardised sales
order to be processed by the organisation.
When the order is filled, details of the transaction are recorded on an original tax invoice and
an original despatch docket. The original despatch docket will accompany the goods and the
original tax invoice can accompany the goods or be sent later. Copies are kept by our
business.
If goods are returned to us (sales returns), an original adjustment/credit note will be sent and
a copy kept by us.
If goods are sold for cash, a cash register summary is generally used.
INTERNAL CONTROL OVER STORED INVENTORIES
Because inventories represent such a large investment by the business, loss through theft,
damage, deterioration or obsolescence lead to lower sales and therefore lower profit. Adequate
controls must therefore be implemented. These controls are generally exercised over location,
security and turnover.
Location
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Inventories should be warehoused where they are readily accessible by those people
authorised to handle them. At each location, inventories of a similar nature should be stored
together.
In a retail situation, the goods should be displayed in the most appropriate way in order to
maximise exposure, but minimise the risk of loss through theft.
Security
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The warehouse must be locked and only authorised personnel should have access to the keys.
Burglar alarms and adequate security staff should be employed.
Appropriate documentation must be completed when inventories enter and leave the
warehouse.
In a retail store, various measures can be adopted to stop pilfering by staff and shoplifting by
customers. These include bag inspections, video cameras, dye markers and store detectives.
Inventories must be adequately insured.
Turnover
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Inventories should be turned over as quickly as possible. The faster the turnover (sales), the
greater the opportunity to make profits.
It is most important that measures be taken to ensure that items that are purchased first are
sold first. In this way, inventories will be rolled over and old stock will not be left standing on
shelves or lying at the bottom of bins.
A minimum of one stocktake must be taken each year. Stocktakes determine the amount and
condition of inventories on hand. They help to detect slow-moving inventories and those out of
date or damaged. Steps may have to be taken to dispose of unsuitable inventories.
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NON CURRENT ASSETS
Non-current assets are assets, other than current assets, that are purchased by the
business and are not intended for resale but are used within the operation of the
business to earn revenue, and will normally be kept and used for longer than one
accounting period. Current assets are those assets which are in the form of cash or
will be converted into cash within the financial year, such as inventories and accounts receivable.
When non-current assets are classified in the Balance Sheet, they are grouped under the following
headings Property, Plant and Equipment, Intangible Assets and Investments.
These assets are specifically acquired because they will help the business grow, it is therefore
necessary to ensure appropriate controls are implemented over these long-term assets.
INTERNAL CONTROLS OVER PROPERTY, PLANT AND EQUIPMENT
The most important control over Property, Plant and Equipment is the Property, Plant and
Equipment register. When a business has more than one item of Property, Plant and Equipment, it
is desirable that a register be kept to record details of each asset. A register enables:
 Proper control over such assets through the use of the control account/subsidiary ledger
technique.
 Accurate accounting for property, plant and equipment.
INTERNAL CONTROLS OVER THE PURCHASE OF PROPERTY, PLANT & EQUIPMENT
Authorisation – The purchase of an item of Property, Plant and Equipment is a major decision,
therefore requires higher level management to authorise such purchases.
Selection – As the purchase of an item of Property, Plant and Equipment will commit the business
to large payments of money, it is important all facts are known before purchase. Eg. Performance,
reliability, anticipated repair costs, cost of delivery, etc.
Proof of ownership – The purchase of Property, Plant and Equipment is usually accompanied by
proof of ownership, such as title deeds to property. These need to be kept in a safe or a bank
safety deposit box.
Payment of cash – Once the purchase is authorised, it becomes a normal cash payment and
details are recorded in the Property, Plant and Equipment register.
INTERNAL CONTROL OVER THE STORAGE OF PROPERTY, PLANT & EQUIPMENT
Location – All assets should be identified by some means, usually by a number. The Property,
Plant and Equipment register identifies assets owned and their location.
Maintenance – It is essential that all assets are kept in good working order.
Protection – The assets need to be protected against theft and damage. Adequate insurance
should also be maintained against any unforeseen circumstances.
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INTERNAL CONTROL OVER THE DISPOSAL OF PROPERTY, PLANT & EQUIPMENT
Authorisation – To prevent an unauthorised employee selling valuable assets, proper
authorisation must occur when disposing of assets.
Physical disposal – This can take place in the form of outright sale, tender, trade-in or scrapping.
Whichever method is adopted, the best possible price should be obtained, and this, too, should be
authorised.
Receipt of cash – For all money received from the disposal of an asset, a receipt must be issued
and the money put through the cash receipts journal. Disposal of the asset is then recorded in the
Property, Plant and Equipment register.
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Internal Controls Revision Question
Terri Maker owns Merry Music Makers, a music store, and employs an
accountant, an accounts clerk, two cash register operators, and a part-time
sales assistant. After analysis of the cash, credit and inventories procedures
undertaken in her business, she explained the current practices:
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The cash register operators totalled the cash they received for the day and passed
the cash and the receipts to the accountant. The accountant recorded the receipts
in the cash receipts journal.
Any cash received by mail was recorded and receipted by the accountant in a cash
remittance book.
The accounts clerk was given the money at the end of the day with a deposit slip
already completed by the accountant. If the accounts clerk was too busy, he would
lock the cash in the safe for the night and go to the bank whenever he could the
next day.
On Friday, the part-time sales assistant would be paid in cash from the cash
register.
Other employees would be paid by cheque or direct deposit.
As soon as any invoices were received, the accountant would place them in a
folder. At the end of the month, the accountant had the authority and proceeded to
prepare and sign the cheques.
The accounts clerk kept a petty cash system for small payments. On the rare
occasion that the fund did not balance, money was transferred from the cash
register to the petty cash fund.
Each month a bank statement was received and the accountant was responsible for
the reconciliation process. The accountant then informed Ms Maker of the cash
position of the business.
All staff are trustworthy and are permitted to purchase stock by completing a
purchase order form. Any staff member unloads all stock received and stack it on
the shelves.
The business does not have any way of knowing what stock should
be on hand.
Overdue account notices are sent out once an account is 60 days
overdue.
As Ms Maker’s auditor, analyse control, or procedural, weaknesses that you have found
and which could be improved.
Recommend major processes which need to be addressed.
A full explanation is required.
Prepare your answer in report format, approximately 600 words, and provide any
additional information.
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INTERNAL CONTROLS EXTRA REVISION QUESTION
You work as a junior accountant for Williams and Sons, Chartered Accountants. Your
employers have presented the following case study to you.
Read the case study and apply your knowledge of accounting internal controls in the areas
of cash, inventories, credit transactions and non-current assets to determine whether
appropriate procedures have been followed. Give your recommendations to improve the
situation.
The case study is as follows:
Bruton’s Shoe Store, 100 Goondoon Street, Gladstone specialises in
selling shoes. Ms Tracy Bruton owns and manages the business which
has two full-time employees and two part-time employees. Ms Bruton has
asked you to investigate the controls in place in the areas of cash, credit, inventories and
non-current assets and make recommendations to improve internal control in these areas.
Ms Bruton ensures that all staff frequently try different tasks so they become skilled in
most areas. She also allows any of the staff to order stock for the store, by completing an
order form when they believe that levels are low. When inventories are received from the
supplier, any of the staff available help to unload and store the goods in the storeroom.
Ms Bruton bases inventory levels on past experience and the advice of her staff. When
the monthly statements are prepared, she makes an estimate at the end of the month for
closing inventories, except at the end of the financial year when a complete physical
stocktake is undertaken.
The Accounts Manager, Michael Dickson, keeps control of all accounts in the business
and operates a general ledger only. Michael collects all the money, records all financial
transactions, and completes the banking twice a week. The Accounts Clerk, John
Charles, is not permitted to enter any accounting data and basically does general office
duties, so Michael has more time to do the books. The business has approximately 200
accounts receivable and 100 accounts payable, which are both maintained manually.
Accounts payable usually operate on the terms 5/10, n/30 and accounts receivable
generally settle accounts within 90 days. Michael gives John a list of overdue accounts so
that reminders can be sent out once an account is 60 days overdue.
During the month, John places any unpaid invoices into a folder and gives these to
Michael on the 30th of each month, in order for him to pay them. Michael has authority to
sign cheques to pay for these invoices if Ms Bruton is not available.
The full-time staff are paid on a weekly basis through a direct deposit from the business’s
bank account to their own bank accounts. The part-time staff, however, are paid from the
cash in the till. This saves Michael having to write out a cheque.
The business has a number of laptops for staff to work on. As there was a lack of space
the laptops were stored in a cupboard with the cleaning products. Ms Bruton required a
laptop, however, when he went to the cupboard there were none left, no one knew where
they all were.
Prepare a report to Ms Bruton highlighting areas of control in which you
would implement changes and state why these changes are necessary.
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