Review Internal Control Procedures

Review internal control procedures

Contents

Key to resources 2

Introduction 3

The management information system 3

Transaction cycles and their related controls 5

Impact of a computer information system on an accounting system 12

Summary 16

This learning guide is based on the following resources:
Textbook
Adams K, Grose R and Leeson D (2004) Internal Controls and Corporate Governance (2nd edn), Pearson/Prentice Hall
(This textbook is based on the AUS 402 published in 2002. AUS 402 has been updated with the new standard ASA 315 under 2006 legislation).
CD-ROM
Adams K, Grose R and Leeson D (2004) Internal Controls and Corporate Governance – Instructor’s Manual (2nd edn), Pearson/Prentice Hall
Website
·  Australian Government Auditing and Assurance Standards Board: www.auasb.gov.au/. Select the link Standards and Guidance which brings you to the AUASB Standards and Pronouncements to obtain all the auditing standards. You can download ASA315 Understanding the entity and its environment and assessing the risks of material misstatement.

Key to resources

Resource / Textbook
1 / Performance criterion* 3.1 Define an accounting system, p49
2 / Attempt self-check questions 3.1a and 3.1b, p 88 and then do end of chapter questions 3.9 to 3.12, p 89
3 / Performance criteria 3.1, 3.2, 3.3, p 53
4 / Figure 3.1 Transaction cycles figure, p 54
5 / Attempt self-check question 3.2a (p 62) and end of chapter questions 3.14a and 3.15, p 90
6 / Attempt end of chapter question 3.14b, p 90
7 / Attempt self-check questions 3.2b and 3.2c (p 72) and end of chapter questions 3.14c and 3.20, p 90
8 / Attempt self-check question 3.2d (p 78) and end of chapter questions 3.14d, 3.17 and 3.23, p 90
9 / Attempt end of chapter questions 3.14e, 3.21, 3.22c and 3.25, p 90
10 / Attempt end of chapter questions 3.14f and 3.27, p 90 and then attempt case applications 3.36, 3.38 and 3.47
11 / Performance criterion 4.1 Impact of computer information system (CIS) on an accounting system p103-107
12 / Performance criterion 5.3 Describe the major categories of CIS application controls p135-138

* The term ‘performance criterion’ is the reference used in the textbook. It is not related to the performance criteria for the unit of competency addressed in the learning guide.

Introduction

The accounting system is a good place to start reviewing your organisation’s internal control procedures because the accounting framework and system is at the core of establishing any sort of internal controls.

The management information system

/ Now go to Resource 1
The location of this and all other resources for this learning guide is in the Key to resources at the front of this document.

An accounting system in effect acts as a control mechanism. That is, an accounting system attempts to safeguard an organisation’s resources against waste, fraud, error and inefficiency while at the same time attempting to ensure the reliability of accounting data.

It is also the framework to collect, record, classify, summarise, analyse and interpret information about financial transactions.

Design and implementation

Accounting systems do need to be thoughtfully designed if they are to be effective and produce what you want from them.

It all starts with systems analysis and risk assessment of control procedures.

On the way through the design stages; methods, processes, documents, reports, equipment and personnel are considered.

Finally it is down to implementation and review while maintaining the existing system to be run in parallel with the new.

Importance to management

Management information systems gather information across the whole organisation to give management the tools to plan, control and evaluate the entire range of activities.

What is it that management wants from the accounting system? It includes:

·  the ability to make decisions based on accurate, reliable and timely information

·  providing an effective means of control that gives assurance the business is conducted in an orderly and efficient manner; irregularities are detected and prevented and assets are safeguarded

·  knowing that the accounting system provides accountability and ensures the owners’ resources are used effectively and in the best interests of the owners (shareholders)

·  a system capable of accumulating the revenues and expenses of geographical locations, product lines and management structures

·  an accounting system designed to be flexible and meet organisational and legislative changes.

Accounting system outputs

These refer to the following processes:

·  collecting, recording and storing data

·  sorting and summarising data

·  generating financial reports

·  generating miscellaneous reports.

Need for timely and accurate information

There is no point in producing reports and other information for management that is not current and relevant, particularly where corrective action needs to be taken.

An example of this could be where products coming off the assembly line are faulty or damaged in greater numbers than expected, or where actual labour costs are exceeding budget projections well above an allowable margin.

Shareholders (owners) at annual general meetings have been complaining for years about annual financial statements that include significant transactions that are at least twelve months old. What also irritates shareholders is that at the same time management and boards receive current detailed monthly reports.

/ Now go to Resource 2
It’s time to attempt some self-check and end of chapter questions.
You will find the answers to self-test questions at the end of the chapter in the textbook. The answers to end of chapter questions and case studies are found in Instructor’s manual for the textbook.

Transaction cycles and their related controls

/ Now go to Resource 3
This resource examines:
·  the internal control objectives for transaction cycles
·  the nature of the transaction system cycles
·  the information flow and the need for essential internal controls for each transaction cycle.
/ Now go to Resource 4
The flow chart depicts the typical transaction cycles of manufacturing and retail organisations. It shows how the funding resources move within an organisation.
You will see three headings have been used for each cycle:
·  Internal control objectives for the < > cycle
·  Nature of the < cycle
·  Information flow and the need for controls within the < > cycle.

A transaction cycle identifies the sequence of events that relate to a specific transaction, eg purchase and accounts payable cycle. In a transaction cycle you can see:

·  capital introduced by the owners

·  non-current assets acquired and disposed of

·  funding of working capital to:

– purchase goods and services

– provide credit to customers

– hold inventory

– hold cash for emergencies

·  conversion of materials, labour and overhead to produce finished goods

·  sale of finished goods

·  collections from customers

·  payment of creditors

·  payment of employees

·  cash returned to working capital to start the cycle again

·  profits (if any) distributed to owners.

Purchases and accounts payable cycle

Internal control objectives

The primary objective is to ensure that the organisation accepts liability only for those goods and services which it has purchased and which are necessary for its efficient operation.

Nature of the cycle

This relates to:

·  types of transactions

·  accounting records affected

·  personnel involved.

Information flow and the need for controls

This includes:

·  requisitioning goods and services

·  preparing purchase order

·  receiving, counting and inspecting goods

·  storing inventory

·  recording the liability

·  paying the liability

·  preparing and signing cheques

·  credit note procedures

·  reconciling accounts.

Some control objectives may include:

·  sufficient segregation of duties between initiating purchase orders, recording receipt of invoices and credit notes, receiving goods, inventory accounts, accounts payable, cash payments and banking duties

·  management supervision and review existing at all stages. This includes comparing actual with budgeted inventory purchases.

/ Now go to Resource 5
It’s time to attempt some self check and an end of chapter question.

Inventory and production cycle

Internal control objectives

The primary objective is to ensure that inventory is protected and production is controlled and run on a cost-effective basis.

Nature of cycle

This relates to:

·  types of transactions

·  accounting records affected

·  personnel involved.

Information flow and the need for controls

Major functions could be:

·  initiating production

·  requisitioning materials

·  purchasing raw materials

·  issuing raw material

·  commencing production

·  transferring production to finished goods

·  control over raw materials, work in process and finished goods inventory.

Some control objectives may include:

·  issuing a production report which accumulates material and labour costs

·  installing a standard cost system to control raw material price and usage, labour rates and hours and overhead incurred and budget

·  a perpetual inventory system provides the best control as it enables regular reconciliations to be carried out between actual inventory on hand and inventory records

·  properly authorised documentation to allow release of:

– finished goods against a customer’s purchase order

– raw materials against a requisition duly signed by departmental management.

/ Now go to Resource 6
It’s time to attempt an end of chapter question.

Payroll cycle

Internal control objectives

The primary objective is to ensure that only bona fide employees are paid for actual work performed and payroll costs are correctly assigned to the appropriate accounts and cost centres. A payroll report is submitted to management on a timely basis.

Nature of the cycle

This relates to:

·  types of transactions

·  accounting records affected

·  personnel involved.

Information flow and the need for controls

Major functions could be:

·  hiring and firing employees

·  authorising pay rates and allowance

·  timekeeping functions

·  preparing payroll

·  authorising payroll

·  method of payment

·  unclaimed wages

·  recording the payroll.

Some control objectives could include:

·  detection and reconciliation of discrepancies in control totals and exception reports

·  reconciliation of information related to hours worked by employees and hours worked by individual employees on each job with the previously mentioned control totals

·  preparation of each period’s payroll for the accounting department.

/ Now go to Resource 7
It’s time to attempt some self-check and end of chapter questions.

Sales and accounts receivable cycle

Internal control objectives

The primary objective is to ensure that all revenues from trading activities are properly identified, recorded, collected and banked.

Nature of the cycle

This relates to:

·  types of transactions

·  accounting records affected

·  personnel involved.

Information flow and the need for controls

Some functions could be:

·  receiving and accepting customer orders

·  approving credit

·  releasing goods from store

·  shipping goods

·  recording the sale and preparing the invoice

·  recording credit note details

·  receiving money from customers by mail

·  banking receipts

·  collecting debt

·  completing reconciliation and preparing monthly statements

·  over-the-counter or cash sales.

Some control objectives could include:

·  checking that each customer has a satisfactory credit rating

·  invoice preparation (for credit sales) based on an authorised customer sales order

·  overdue accounts promptly followed up

·  receipts (credit and cash) adequately protected from theft and misappropriation – segregation of duties

·  credit entries to the accounts receivable account to be authorised.

/ Now go to Resource 8
It’s time to attempt some self-check and end of chapter questions.

Cash and bank accounts

Internal control objectives

The primary objective is to prevent:

·  misappropriation of cash

·  falsifying accounting records to conceal such misappropriations.

More specifically the objectives could include:

·  physical controls:

– segregation of duties that split handling and custodianship of cash from responsibility of maintaining cash records

– bank accounts and interest-earning deposits are used for business purposes only

– all cash transactions and bank accounts are properly recorded, classified, controlled and summarised in the financial statements

– all cash receipts are banked intact daily

·  working capital controls:

– idle cash surpluses are invested to earn interest

– sufficient cash funds are set aside to meet normal operating payments, emergencies and unexpected investment opportunities.

/ Now go to Resource 9
It’s time to attempt some end of chapter questions.

Non-current assets

Internal control objectives

The primary objective is to ensure that these assets are purchased or acquired on the best possible terms and in the best interests of the organisation.

More specifically the objectives could include:

·  controls over acquisition and recording:

– acquisitions are properly:

o approved

o authorised

o recorded in the accounting records

o recorded in an asset register

o evidenced by title deeds, loan and security documents

o depreciated or amortised according to effective life

– acquisitions are part of:

o the overall strategic plan

o the budget constraints (capital rationing)

·  controls over non-current asset use and security:

– strict restriction on employee use

– installation of security systems

– identification, numbering and labelling of each asset ensuring that it relates to the asset register

– adequate and up-to-date insurance cover

– strict controls over disposals to ensure transactions are at arm’s length

– proceeds from disposals are at market value.

/ Now go to Resource 10
It’s time to attempt some end of chapter questions and case applications.

Impact of a computer information system on an accounting system

/ Now go to Resource 11
This resource addresses the characteristics of a computer information system in the context of organisational structure, nature of processing, design of procedural aspects and computer service bureaus.

When computers started to replace manual accounting systems, critics were quick to point out that the data seemed to disappear into the computer, reducing audits to counting petty cash.