INTERNAL CONTROL

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The internal controls are all measures taken by an organization for the purpose of (1) protecting I its resources against waste, fraud, or inefficient use; (2) ensuring the reliability of accounting data; (3) securing compliance with management’s policies; and (4) evaluating the performance of all employees, managers, and departments within the organization.

Thus, all measures and procedures intended to assure management that the entire business is operating according to management’s plans and policies may be described as internal controls.

Collectively, the internal controls in force throughout the organization are called the internal control structure (or the system of internal control).Relationship Between the Accounting System and the Internal Control Structure The primary objective of an accounting system is to provide useful financial information to decision makers.

The objective of the internal control structure is to keep the business “on track”, operating in accordance with the policies and plans of management. These two systems are closely related; in fact, each depends greatly upon the other.

The accounting system depends upon internal control procedures to ensure the reliability of accounting data. Many internal control procedures, on the other hand, make use of accounting data in keeping track of assets and monitoring the performance of departments.

The need for adequate internal control explains the nature and the very existence of many accounting records, reports, documents, and procedures. Thus, the topic of internal control and the study of accounting go hand-in-hand.

Accounting Controls and Administrative ControlsInternal controls fall into two broad categories: accounting controls and administrative controls. Accounting controls are measures that relate directly to the protection of assets or to the reliability of accounting information.

An example is the use of cash registers to create an immediate record of cash receipts. Another example is the policy of making an annual physical count of inventory even when a perpetual inventory system is in use.

Administrative controls are measures designed to increase operational efficiency; they have no direct bearing upon the reliability of the accounting records. An example of an administrative control is a requirement that traveling salespeople submit reports showing the names of customers called upon each day. Another example is the requirement that airline pilots have annual medical examinations.

Here, we will emphasize internal accounting controls those controls that have a direct bearing upon the reliability of accounting records, financial statements, and other accounting reports. Bear in mind, however, that sound administrative controls also play a vital role in the successful operation of a business.

Guidelines to Achieving Strong Internal Control Establish Clear Lines of Responsibility. Every organization should indicate clearly the persons of departments responsible for such functions as sales, purchasing, receiving incoming shipments, paying bills, and maintaining accounting records.

The lines of authority and responsibility can be shown in an organization chart. The organization chart should be supported by written job descriptions and by procedures manuals that explain in detail the authority and responsibilities of each person or department appearing in the chart.

Establishing Routine Procedures for Processing Each Type of Transaction. If management is to direct the activities of a business according to plan, every transaction should go through four separate steps; it should be authorized, approved, executed, and recorded. For example, consider the sales of merchandise on credit.

Top management has the authority and responsibility to authorize credit sales to categories of customers who meet certain standards. The credit department is responsible for approving a credit sale of a given dollar amount to a particular customer.

The transaction is executed by the shipping department which ships or delivers the merchandise to the customer. Finally, the transaction is recorded in the accounting department by an entry debiting Accounts Receivable and crediting Sales.

Subdivision of Duties. Perhaps the most important concept in achieving internal control is an appropriate subdivision or separation of duties. Responsibilities should be assigned so that no one person or department handles a transaction completely from beginning to end.

When duties are divided in this manner, the work of one employee serves to verify that of another and any errors which occur tend to be detected promptly. To illustrate this concept, let us review the typical procedures followed by a wholesaler in processing a credit sale.

The sales department of the company is responsible for securing the order from the customer; the credit department must approve the customer’s credit before the order is filled; the stock room assembles the goods ordered; the shipping department packs and ships the goods; the billing department prepares the sales invoice; and the accounting department records the transaction.

Each department receives written evidence of the action by the other departments and reviews the documents describing the transaction to see that the actions taken correspond in all details. The shipping department, for instance, does not release the merchandise until after the credit department has approved the customer as a credit risk.

The accounting department does not record the sale until it has received documentary evidence that (1) an order was received from a customer, (2) the extension of credit was approved, (3) the merchandise was shipped to the customer, and (4) a sales invoice was prepared and mailed to the customer.

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