Examples of internal control and tests of control

1 Introduction

This chapter looks at internal control procedures commonly found in accounting systems relating to:

• Sales
  

• Purchases
  

• Wages and salaries
  

• Non-current assets
  

• Inventory

• Bank and cash

The aims of all systems should be to ensure that:

• Only genuine business transactions are processed (i.e. are valid)
  

• Transactions are complete. It must be possible to trace a transaction through from beginning to end – and in reverse order. This audit trail should be ‘watertight’
  

• Recording is accurate.
  

Think: “What could go wrong?” and try to devise a control that will prevent or detect errors.

The systems below are not universal, but they illustrate very typical approaches to internal controls.

2 Sales

2.1 Overview

The sales system can be represented as:

2.2 Granting credit and establishing a credit limit

Before any credit sales are made there should be control procedures in place to try to ensure that only credit-worthy customers are accepted. A suitable initial credit limit and payment terms should be established.

Controls therefore involve: examining the customer's most recent financial statements, enquiries to credit reference agencies and the customer’s bank.

2.3 Order processing

As soon as an order is received it should be recorded, for example, by entering details in a register. Later it should be possible to ensure that all approved orders have resulted in a sale.

Orders should be compared to the customer’s balance and credit limit to ensure the credit limit is not breached.

Order quantities should be compared to inventory levels to ensure that goods are available.

The customer should be informed if there is going to be a delay either because of credit or inventory problems.

If these checks are passed, then a multi-part pre-numbered despatch note should be raised. One copy will remain in number order in the order processing department. Other copies of the despatch notes are passed to the warehouse.

2.4 Despatch

The despatch notes are used to pick and pack the goods ordered. An independent check should be performed in the warehouse to ensure that the goods conform to what was ordered.

One copy of the despatch note can be packed with the goods (it will bear the customer’s order number so that this can be checked when received by the customer).

One copy will go with the despatch as a gate release copy. As goods leave the company, there is often a security gate where despatches are compared to despatch notes to ensure only authorised sales leave the premises.

One copy can be sent to the accounting department for an invoice to be raised. One copy can go back to the order processing department where it can be attached to the order to show that ordered goods have been despatched.

The file of orders should be reviewed regularly for long-outstanding orders awaiting despatch; these should be investigated.

The despatch note that accompanies the goods should be signed by the customer as proof of receipt and returned to the company where it can be filed in numerical order.

2.5 Invoicing

Invoices will be raised from the despatch notes and price lists. If manually raised, these should be independently arithmetically checked.

One copy of each invoice will be sent to the customer.

One copy attached to the despatch note to ensure that all despatches are invoiced. This copy can also be used to post the receivables ledger.

Invoices should be listed in a sales day book, then individual invoices posted to each customer’s account. The sum of the sales day book can be posted to the receivables control account. Regular reconciliations should be performed between the control account and the sum of the individual ledger accounts.

Copy invoices should be marked “Posted” and a regular review should be carried out to ensure that all invoices are accounted for and have been posted to the receivables ledger.

2.6 Receipt of payment

Receipts should be posted to each customer’s account and the cash book, and the sum of receipts posted to the control account. Postings to the cash book should show the invoice number of the invoice being paid

Aged receivables reports should be prepared regularly and slow payers followed up. A ‘Stop’ should be placed on the accounts of very slow payers to prevent the situation deteriorating.

Statements should be sent each month to customers both to remind them of what they owe and also to allow them to check the seller’s version of the account.

3 Purchases

3.1 Overview

The purchases system can be represented as:

3.2 Finding suitable suppliers and negotiating credit terms

Before any purchases are made there should be control procedures in place to try to ensure that suitable suppliers are used. A suitable supplier might be one where a good discount has been negotiated or where quality is very high. Sometimes companies have a policy to ensure that they have several suppliers for each type of purchase and that quotes are always received from each before an order is placed. A credit limit and payment terms should be agreed with each supplier.

3.3 Order processing

The store-keeper should regularly review inventory and raise a sequentially pre-numbered 2-part purchase requisition when an item of inventory is below or close to its reorder level. Inventory records should record the requisition number to ensure that the goods are not inadvertently ordered again. A copy of each requisition should be filed in stores in numerical sequence.

A copy of the requisition note is passed to the purchasing department which will raise a sequentially pre-numbered multi-part purchase order from a suitable supplier. The purchase price should be stated on the order. One copy will stay in the purchasing department, one will go to the goods received area of the warehouse and one copy will be sent to the supplier.

Long-outstanding orders and requisitions should be followed up: goods not received will hold up production and jeopardise sales.

3.4 Receipt of goods

When goods are received they should be checked to the order to ensure that they are what was ordered, counted and inspected for damage. A multi-part goods received note (GRN) will be raised when goods are received. This can be attached to the order and the two documents passed to accounts.

Stores records and purchase department records should be updated from the copy goods received notes.

Inventory should be passed to stores where it should be correctly placed in the correct location.

3.5 Receipt of invoices

The GRN/order pair are in the accounting department, awaiting an invoice being received. When an invoice is received it should be checked to these documents to ensure that only invoices for properly ordered and received goods are processed. The invoice can be attached to the matched order/GRN.

Invoices should be analysed for expense category, input VAT etc. The analyses should be independently checked.

Invoices will be listed in a purchases day book. Individual invoices will be credited to the appropriate account in the purchase ledger, and the total of the purchases day book posted to the credit of the payables ledger control account. Appropriate expenses accounts should be debited.

Invoices should be marked ‘Posted’.

If Order/GRN pair are outstanding for a long period, the company should investigate why this is the case and, if so, alert the supplier that an invoice seems to be missing.

Monthly statements received from suppliers should be reconciled to the payables balances.

3.6 Payment

Payments might be made to every supplier after a set period of time, or a list of invoices outstanding might be printed out for manual approval and cash flow management.

Once payments have been made, the invoices should be stamped 'paid' or otherwise cancelled. Payments should be debited to individual supplier accounts and the total payments debited to the payables control account.

4 Wages and salaries

4.1 Overview

The wages and salaries system can be represented as:

4.2 Authorised recruitment

Recruitment of additional or replacement employees should be authorised at an appropriate level in the organisation. There should be a written record of the recruitment decision.

The employees’ bank details must be recorded.

4.3 Authorised rates of pay

The wage and salary rates should also be authorised at a senior level for new employees and for salary amendments. There should be authorised rate of pay forms for each employee and only authorised personnel should be able to alter rates.

4.4 Weekly/monthly pay calculations

Some pay calculations will be very simple. For example, many salaried employees will receive the same amount each month. There might occasionally be bonus payments to make and these require separate authorisation.

Some calculations are more complex. Hourly paid employees will be paid on the basis of time spent working and there might be overtime and shift allowances. In this case, there should be controls to ensure that staff are only paid for time or output. Typically, clock cards are used to allow the employee to record arrival time and leaving time on a time recording system. This has to be monitored to ensure that employees don’t clock each other out and in to inflate their hours.

Based on salaries or hourly rates/time, gross pay, tax and other deductions can be calculated. If this is done manually, it will have to be independently checked. Normally it will be done by computer.

4.5 Payments to employees, tax authorities etc

The payroll amounts should be scrutinised by a senior member of management who will be looking for unexpected differences from previous periods.

If wages are paid by cash, the payroll cash should be held securely until paid out. Employees need to present identification and must sign when they receive their wages. Special arrangements should be in place to allow substitute employees to pick up wages on behalf of absent colleagues.

Credit transfer payments are much easier and safer.

Every month, a senior member of management should ensure that deductions are paid over to the tax authorities etc.

4.6 Departure of employees

There should be standard systems and documentation in place to ensure that details of all leaving employees are sent to the payroll department.

Every year, all managers should be circulated with a list of their employees who are on the wages system and they should verify that the employee is still actually employed and that the rate of pay is correct.

5 Non-current assets

5.1 Overview

The purchases system can be represented as:

The controls needed here are very similar to those for other purchases, but there will be differences.

1. Capital expenditure is usually carefully budgeted because it is a long-term investment (whereas purchases of goods for resale should produce revenue reasonably quickly). Therefore, expenditure needs to be authorised by senior management or the board.
   

2. Once a non-current asset is bought, the company is ‘stuck with it’ for some years, so it is important to choose carefully.
   

3. A single purchase can be for a significant amount, so it is important to get competitive quotes.
   

4. The assets should be inspected every year to ensure that they are still there and are still being used.
   

As for the sales system, there must be controls to ensure that disposals of non-current assets are approved and completely and accurately recorded.

6 Inventory

In an integrated system, goods received increase inventory and create a purchase/payable entry; despatches reduce inventory and feed sales/receivables and cost of sales. Use authorised, sequentially numbered goods received and despatch notes, and reconcile stock records and their values to the general ledger. Missing or duplicate interfaces can misstate inventory, profit and liabilities together.

7 Bank and cash

These tests check whether controls operate throughout the period. Confirming the year-end bank balance or counting stock to verify a financial-statement amount is substantive work instead.

8 Tests of control

The precise internal control systems used by the client will be documented by the auditor. As previously described the auditor can use narrative, flowcharts ICQs or ICEQs (or a combination of methods).

The consistent and effective operation of the controls then needs to be tested: the auditor has to collect evidence that the control is operating properly.

Evidence about the operation of controls can be collected by:

• Enquiry and confirmation
  

• Inspection
  

• Observation
  

• Re-performance.
  

Some examples of evidence of controls operating were given in chapter 6. Here are some more examples of audit tests that tie in to some of the systems described above: