Internal Control Affecting Assets PDF

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Module 15 – INTERNAL CONTROL AFFECTING ASSETSModule Objectives:After studying the module, you should be able to: ​Describe the internal control over the major components of assets of a business enterprise namely: ➢ Cash ➢ Financial Investments ➢ Receivables: Accounts and Notes and related revenue ac...

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Module 15 – INTERNAL CONTROL AFFECTING ASSETS

Module Objectives: After studying the module, you should be able to: • Describe the internal control over the major components of assets of a business enterprise namely: ➢ Cash ➢ Financial Investments ➢ Receivables: Accounts and Notes and related revenue accounts ➢ Inventories and related Cost of Goods sold ➢ Property, Plant and Equipment • Understand the potential misstatements (due to fraud and errors) of the asset accounts and how weakness in internal control increases the risks of misstatements.

Course Materials: 1. INTERNAL CONTROL OVER CASH TRANSACTIONS Most of the processes relating to cash handling are the responsibility of the finance department, under the direction of the treasurer. These processes include handling and depositing cash receipts; signing checks; investing idle cash; and maintaining custody of cash, marketable securities, and other negotiable assets. In addition, the finance department must forecast cash requirements and make both short-term and, long-term financing arrangements. Ideally, the functions of the finance department and the accounting department should be integrated in a manner that provides assurance that: • All cash that should have been received was in fact received, recorded accurately and deposited promptly. • Cash disbursements have been made for authorized purposes only and · have been properly recorded. • Cash balances are maintained at adequate, but not excessive, levels by forecasting expected cash, receipts and payments related to normal operations. The need for obtaining loans for investing excess cash is thus made known on a timely basis. A detailed study of the business processes of the company is necessary in developing the

most efficient control procedures, but there are some general .guidelines to good cash handling practices in all types of business. These guidelines for achieving internal control over cash may be summarized as follows: • Do not permit any one employee to handle a transaction from beginning to end. • Separate cash handling from record keeping. • Centralize receiving of cash to the extent practical. • Record cash receipts on a timely basis. • Encourage customers to obtain receipts and observe cash register totals. • Deposit cash receipts daily. • Make all disbursements by check or electronic funds transfer; with the exception of small expenditures from petty cash. • Have monthly bank reconciliation prepared by employees not responsible for the issuance of checks or custody of cash. The completed reconciliation should be reviewed promptly by an appropriate official. • Monitor cash receipts and disbursements by comparing recorded amounts to forecasted amounts and investigating variances from forecasted amounts. Potential Misstatements – Cash Receipts Potential Misstatements – Cash Disbursements

2. INTERNAL CONTROL OVER FINANCIAL INVESTMENTS The most important group of financial investments consists of marketable stocks and bonds because they are found more frequently and usually are of greater peso value than the other kinds of investment holdings. Other types of investments often encountered include commercial paper issued by corporations, mortgages and trust deeds, and the cash surrender value of life insurance policies. The internal auditors also must be concerned with derivatives

that are used to hedge various financial and operational risks or for speculation. Derivatives are financial instruments that "derive" their value from other financial instruments, underlying assets, or indexes. For example, a simple derivative would involve a commitment by a company to purchase a commodity at a certain price at some point in the future. Other derivatives are much more complex, involving, for example, relationships between fluctuations in European interest rates and the price of copper. The major elements of adequate internal control over financial investments include the following: • Formal investment policies that limit the nature if investments in securities and other financial instruments. • An investment committee of the board of directors that authorizes and reviews financial investment activities for compliance with investment policies. • Separation of duties between the executive authorizing purchases and sales of securities and derivative instruments, the custodian of the securities, and the person maintaining the records of investments. • Complete detailed records of all securities and derivative instruments owned and the related provisions and terms. • Registration of securities 'in the name of the company. • Periodic physical inspection of securities on hand by an internal auditor or an official having no responsibility for the authorization, custody, or record keeping of investments. • Determination of appropriate accounting for complex financial instruments by competent personnel. In many concerns, segregation of the functions of custody and record keeping is achieved by the use of an independent safekeeping agent, such as a stockholder, bank or trust company. Since the independent agent has no direct contact with the employee responsible from maintaining accounting records of the investments in securities, the possibilities of concealing fraud through falsification of the accounts are greatly reduced. If securities are not placed in the custody of an independent agent, they should be kept in a bank safe-deposit box under the joint control of two or more of the company's officials. Joint control means that neither of the two custodians may have access to the securities except in the presence of the other. A list of securities in the box should be maintained in the box, and the deposit or withdrawal of securities should be recorded on this list along with the date and signatures of all persons present. The safe-deposit box rental should be in the name of the company, not in the name of an officer having custody of securities. Complete detailed records of all securities and derivative instruments owned are essential

to satisfactory control. These records frequently consist of a subsidiary record for each security and derivative instrument, with such identifying data as the exact name, face amount or par value, certificate number, number of shares, date of acquisition, name of broker, cost, terms and any interest or dividend payments received. Actual interest and dividends should be compared to budgeted amounts, and significant variances should be investigated. The purchase and sale of investments often is entrusted to a responsible financial executive, subject to frequent review by an investment committee of the board of directors. Potential Misstatements – Financial Investments

3. INTERNAL CONTROL OVER RECEIVABLES Accounts receivable include not only claims against customers arising from the sale of goods or services; but also a variety of miscellaneous claims such as loans .to officers or

employees, loans to subsidiaries, claims against various other films, claims for tax refunds and advantages to suppliers. Sources and Nature of Notes Receivable Notes receivable are written promises to pay certain amounts at future dates. Typically, notes receivable is used for handling transactions of substantial amount; these negotiable documents are widely used. In banks and other financial institutions, notes receivable usually constitutes the single most important asset. Internal Control of Accounts Receivable and Revenue To understand internal control over accounts receivable and revenue, one must consider the various components, including the control environment, risk assessment, monitoring, the (accounting) information and communication system, and control activities. Control Environment Because of the· risk of intentional misstatement of revenues, the control environment is very important to effective internal control over revenue and receivables. Of particular importance is an independent audit committee of the board of directors that monitors management's judgments about revenue recognition principles and. estimates, as well as an effective internal audit function. Management should establish a tone at the top of the organization that encourages integrity and ethical financial reporting. These ethical standards should be communicated and observed throughout the organization. Also, incentives for dishonest reporting, such as undue emphasis on meeting unrealistic sales or earnings targets, should be eliminated. Potential Misstatements – Revenue – Receivables

Internal Control over Notes Receivable As previously stated, a basic characteristic of effective control consists of the subdivision of duties. As applied to notes receivable, this principle requires that: • The custodian of notes receivable not have access to cash or to general accounting records. • The acceptance and renewal of notes be authorized in writing by a responsible official who does not have custody of the notes. • The write-off of defaulted notes be approved in writing by responsible officials and effective procedures adopted for subsequent follow-up of such defaulted notes.

4. INTERNAL CONTROL OVER INVENTORIES AND COST OF GOODS SOLD The interrelationship of inventories and cost of goods sold makes it logical for the two topics to be considered together. The controls that assure the fair valuation of inventories are found in the purchases (or acquisition) cycle. These controls include procedures for selecting

vendors, ordering merchandise or materials, inspecting goods received, recording the liability to the vendor, and authorizing and making cash disbursements. In a manufacturing business, the valuation of inventories also is affected by the production (or conversion) cycle, in which various manufacturing costs are assigned to inventories, and the cost of inventories is then transferred to the cost of goods sold. Sources and Nature of Inventories and Cost of Goods Sold The term inventory is used in this chapter to include: • goods on hand ready for sale, whether the merchandise of a trading concern or the finished goods of a manufacturer; • goods in the process of production; and • Good to be consumed directly or indirectly in production, such as raw materials, purchased parts, and supplies. Internal Control over Inventories arid Cost of Goods Sold The importance of adequate internal control over inventories and cost of goods sold from the viewpoint of both management and the auditors can scarcely be overemphasized. In some companies, management stresses controls over cash and securities but pays little attention to control over inventories. Since many types of inventories are composed of items not particularly susceptible to theft, management may consider controls to be unnecessary in this area. Such thinking ignores the fact that controls for inventories affect nearly all the functions involved in producing and disposing of the company's products. Potential Misstatements – Inventory / Cost of Goods Sold

5. INTERNAL CONTROL OVER PROPERTY, PLANT AND EQUIPMENT The term properly, plant and equipment includes all tangible assets with a service life of more than one year that are used in the operation of the business and are not acquired for the purpose of resale. Three major subgroups of such assets are generally recognized: • Land, such as properly used in the operation of the business, has the significant characteristic of not being subject to depreciation: • Buildings, machinery, equipment and land improvements, such as fences and parking lots, have. Limited service lives and are subject to depreciation. • Natural resources (wasting assets), such as oil wells, coal mines, and tracts of timber, are subject to depletion as the natural resources are extracted or removed. Acquisitions and disposals of property, plant and equipment are usually large in dollar amount, but concentrated in only a few transactions. Individual items of plant and equipment may remain unchanged in the accounts for many years. Internal Control over Plant and

Equipment The amounts invested in plant and equipment represents a large portion of the total assets of many industrial concerns. Maintenance, rearrangement and depreciation of these assets are major expenses in the income statement. The total expenditures for the assets and related expenses make strong internal control essential to the preparation of reliable financial statements. Errors in measurement of income may be material if assets are scrapped without their cost being removed from the accounts, or if the distinction between capital and revenue expenditures is not maintained consistently. The losses that inevitably arise from uncontrolled methods of acquiring, maintaining, and retiring plant and. equipment are often greater than the losses from fraud in cash handling. In large enterprises, the auditors may expect to find an annual plant budget used to forecast and control acquisitions and retirements of plant and equipment. Many small companies also forecast expenditures for plant assets. Successful utilization of a plant budget presupposes the existence of reliable and detailed accounting records-for plant and equipment. A detailed knowledge of the kinds, quantities and condition of existing equipment is an essential basis for intelligent forecasting of the need for replacements and additions to the plant. Other key controls applicable to plant and equipment are as follows: • A subsidiary ledger consisting of a separate record for each· unit of property. An adequate plant and equipment ledger facilitate the auditor's work in analyzing additions and retirements, in verifying the depreciation provision and maintenance expenses, and in comparing authorizations with actual expenditures. • A system of authorization requiring advance- executive approval of all plant and equipment acquisitions, whether by purchase, lease or construction. Serially numbered capital work orders are a convenient means of recording authorizations. • A reporting procedure assuring prompt disclosure and analysis of variances between authorized expenditures and actual costs. • An authoritative written statement of company policy distinguishing between capital expenditures and revenue expenditures. A dollar minimum ordinarily will be established for capitalization; any expenditures of a lesser amount automatically classified as charges against current revenue. • A policy requiring all purchases of plant and equipment to be handled through the purchasing department arid subjected to a standard routine for receiving, inspection and payment. • Periodic physical inventories designed to verify the existence, location and condition of all property listed in the accounts and to disclose the existence of any unrecorded units. • A system of retirement procedures, including serially numbered retirement work orders (bottom), stating reasons for retirement and bearing appropriate approvals. Potential Misstatements – Property, Plant and

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