Internal Control Structure

Learning Objectives

To understand the components of an organization’s internal control structure

To know the objectives and limitations of internal control

To learn which characteristics of a control environment promote accurate and reliable data

To learn which characteristics of an accounting system promote accurate and reliable data.

To describe good control procedures.

Example Situation 1

The policy of installing a security system in the house is part of the control environment in the house.

The objective» is to safeguard property and life.

Threat» from intruders.

Risk» of loss of assets/life from this threat.

The control reduces the risk

Example Situation 2

The policy of issuing a driver's licence and the procedure to obtain the licence is part of the control environment on the road.

The objective» safety on the road.

Threat» from people driving on the road not understanding the

rules of the traffic.

Risk» of accidents and loss of assets, health and life.

The control reduces the risk

Example Situation 3 When the person writing the check cannot also enter the

corresponding cash journal entry, there is a control environment in the accounting department.

The objective» is to safeguard the assets of the company» to ensure accurate and reliable information.

Threat» from somebody wanting to commit a fraud.

The risk» is loss of assets and inaccurate records.

The control reduces the risk

The Pattern

In each of the above examples, there is an objective (usually safety)

there is a threat to the objective there are risks associated with those

threats, and there is a control which counteracts the

risk from the threat. The controls are usually in the form of

policies and/or procedures.

Why do we have

Police on the road ? State laws ? Federal Laws ? Rules ? Regulations ? Policies ? Procedures ?

For Controls

How Do controls provide freedom?

Internal Controls

An organization's internal control structure consists of the policies and procedures established by management to achieve organizational objectives.

What are the Objectives ?

Objectives of Accounting Controls:» Safeguard Assets» Ensure Accurate and reliable accounting

data Objectives of Administrative Controls

» Promote Operational Efficiency» Encourage adherance to management's policies

What are the Threats ?

Errors» Unintentional» Clerk enters wrong amount on check» Procedures can be designed to check for

unintentional errors. Irregularities

» Intentional» Management Fraud» Defalcation

What are the risks ?

Inaccurate records Unreliable data Loss of assets

» Cash» Inventory

Internal Control Structure

A company's Internal Control structure tries to fight the threats to minimize the risk so as to meet the objectives.

Reasonable Assurance

Note that risks can be minimized but not totally removed.

Total removal of risk will be extremely costly and often not cost justified.

Internal control policies and procedures are intended to provide reasonable but not absolute assurance that management's objectives are attained.

The above bullet point is called the concept of reasonable assurance.

Limitations of Controls

There are always limitations of controls What are the limitations of Accounting Controls ?

» Errors : e.g. a valid journal entry with wrong amounts.

» Collusion: when two or more employees conspire to commit a theft and conceal it.

» Management Override. The cost of overcoming these limitations can be

enormous.

Components of anInternal Control Structure

Control Environment» Those circumstances surrounding an

organization’s accounting system that influence the effectiveness of the accounting system and control procedures

The Accounting System» Methods and records used to identify, assemble,

analyze, classify and report accounting transactions

Control Procedures

The Control Environment

Internal Control Structure

The Control Environment

Accounting Systems

Internal Control Structure

The Control Environment

Accounting Systems

Control Procedures

Internal Control Structure

Control Environment

Management's philosophy and operating style Organizational structure Audit Committees Methods of assigning authority and responsibility Management control methods Personnel policies and practices External Influences Computer Controls and Policies

Personnel Policies and Practices

Training Recognition for work well done Adequate Pay Background check Job Rotation Required Vacation Bonding

The Accounting System Debit and Credit Analysis Chart of Accounts Standard Journal Vouchers Trial balance

» Transpositions» Misfootings» Abnormal Account Balances

Control Accounts» Sum of Subsidiary Ledger Accounts

Contol Procedures

Proper procedures for Transactions» Prompt recording» Visual checking» Balancing» Batch controls» General Authorization» Specific Authorization

Security for Assets and Records» physical security» Fixed responsibility

Contol Procedures Contd.. Segregation of duties

» Authorize Transactions» Record Transactions» Maintain Custody of Asset

Adequate Documentation and Records» Forms control» Prenumbered Documents

Independent Verification of Performance» Independent Auditors» Internal Auditors

Evaluating Internal Controls

Control Risk Assessment» Likelihood that controls do not

prevent/detect material misstatement Technically done for each management

assertion for each transaction stream

Management Assertions and Transaction Streams

Transaction Streams» Sales» Cash Receipts» Inventory/AP» Other Cash

Disbursements» Payroll» Etc.

Management Assertions» Completeness» Existence/Occurrence» Valuation/Gross» Valuation/Net» Rights/Obligations» Presentation/Disclosure

Steps in CRA

» Evaluate Internal Control Environment – Evaluate potential management override– Evaluate computer controls--Computer auditor

» Document Accounting Processes » Document Controls» Make Preliminary CRA» Test Controls» Make CRA based on Control Tests