Internal Controls

Learning Outcomes
By the end of this module, you will be able to:

1. Define and explain the need for internal controls

2. Identify the principles of internal control
3. Provide examples of internal controls'
4. Describe common controls over cash receipts and disbursements.

What are Internal Controls?

You probably encounter them every day at work; you see them in action when you purchase something
at the store and you may even implement them at home. But chances are, you have never recognized
them!

We're talking about internal controls - those policies and procedures that every company has (or should
have!) in place to:

• Protect our assets

• Promote efficient operations
• Maintain reliable accounts records
• Encourage adherence to company policy

As you work through this module, try to think of examples from your own experience. Chances are, you
are surrounded by internal controls and never knew it. By the end of this module, some of the policies
that you thought were strange or ridiculous might start to make more sense. (Or not - maybe it's just a
ridiculous policy - that happens too!)

Principles of Internal Controls

We use 5 basic principles to ensure our policies and procedures are providing adequate control.

Proper Authorization
Definition: All transactions or events undertaken by a company must be approved by an appropriate
person. This approval must be documented.

Examples:

• A raise in pay for an employee must be approved by a Manager before it is changed in the
system.
• An HR Manager must approve a new hire before they can be set up in the system.
• An invoice must be approved before it is paid.
• A purchase order must be completed and approved before an order is placed.
Segregation of Duties
Definition: Where possible, duties should be split between individuals to prevent and/or detect fraud
and error.

In smaller companies, ideal segregation of duties can never be achieved. When this happens,
compensating controls must be used - for example - if there is only one person on staff to handle all
payroll functions, a Manager should sign off on all changes made to employee information (e.g. banking,
address, new hires, etc.)

Examples:

• The person who processes payroll should not have authority to set up new hires or change
employee information.
• Duties of ordering purchases and receiving them should be done by two separate people.
• The person responsible for handling cash should not also have access to the accounting records.
A third person should be responsible for balancing the bank with the accounting records.
• A person who has authority to grant discounts should not be able to also provide cash refunds.

Safeguarding of Assets
Definition: All assets (cash as well as non-cash) must be protected from misuse and theft.

Examples:

• Any cash on site....

• Appropriate levels of insurance should be maintained to reduce risk of loss.
• Key employees should be bonded.

Appropriate Documentation
Definition: Standardized forms for financial transactions, such as invoices, purchase orders, inventory
receipts and travel expense reports can help to ensure accuracy and consistency. Pre-numbered forms
for invoices and cheques will help to ensure against loss or theft.

This paperwork can then be used as back up documentation to support transactions in the accounting
records.

Examples:

• A purchase order must be used for all purchases.

• An employee personnel form must be completed for all new hires.
• Every cheque written must be accompanied by documentation explaining its purpose.
• A customer invoice must be accompanied by a shipping document.

Verification
Definition: There must be systems in place to ensure that the policies and procedures are being
followed.

In a nutshell, policies and procedures are not effective if they are not being followed. The Verification
principle makes sure we're following the rules.
Examples:

Managers, supervisors or an internal audit department should review:

• Individual pay rates and salaries actually paid to ensure they are accurate.
• Employee expense reports to ensure all claims are supported by receipts and appropriately
approved.
• Payments to ensure they all have properly approved purchase orders and that the goods were
actually received before payment.
• Shipping documents to ensure that an invoice was created for every item that was shipped from
the warehouse.
• Inventory records to ensure all goods ordered and shipped are properly accounted for.

Control Over Cash

• Cash is an important asset for every company.
• Control of cash on hand and access to it is critical.

Cash includes:

• Currency and coins

• Deposits in bank accounts
• Other items acceptable for deposit (cheques and blank cheques)

We need special controls over:

• Cash Disbursements
• Cash Receipts

Cash Disbursements Procedure

1. All disbursements - with the exception of petty cash - are made by cheque.
2. All cheques are:
• numbered
• payable to either a specific individual or company
• signed by two authorized persons if it is over a specified amount.
3. All payments are substantiated with an approved supplier invoice (and other appropriate
documents such as a purchase order and receiving report).
4. A bank reconciliation is prepared monthly.

When petty cash is used, only one individual has access to the fund.

Cash Receipts Procedure

1. Cash is received by a person other than the one responsible for maintaining the accounts
receivable records.
2. The person responsible for receiving cash prepares a list of cash received and gives that list to
the person responsible for maintaining the accounts receivable records.
3. All cash receipts are deposited to the bank account daily.
 4. Cash deposit slips are approved by a senior person who is not involved in maintaining the
accounts receivable records.
5. Whenever cash is counted, at least two persons are present to verify the count.
6. Access to any cash kept on site is restricted and the cash is stored in a locked box or safe.
7. If cash registers are used, reconcile cash in drawer with cash register tape.
8. Prepare a monthly bank reconciliation.

Cost of Control
• The extent of internal controls will vary based on nature and size of organization.
• The cost of implementing the internal controls must not exceed their benefits
• Where the cost is excessive, alternative, compensating controls should be devised.

Limitation of Internal Control

Despite the best effort of internal control, errors and fraud still happen.

If there is a will, there is usually a way for:

• Human error, unintentional. Caused by:

o Negligence
o Fatigue
o Misjudgment
o Confusion
• Fraud – Intent to defeat internal controls for personal gain. Usually requires collusion.

Warning Signs of Missing or Poor Internal Controls

Accounting Records:

• Increase in customer records

• Missing documents
• Differences between bank deposits and cash receipts
• Delays in recording

Employees:

• Lifestyle changes
• Too close of a relationship with suppliers
• Refusal to take vacation or sick leave
• High employee turnover in a particular area

Cash/ Accounts Receivable:

• Excessive number of voids, discounts and returns

• Unauthorized bank accounts
• Sudden activity in a dormant banking accounts
• Customer complaints that they are receiving non-payment notices
• Abnormal number of expense items, supplies, or reimbursement to one employee
Payroll:

• Inconsistent overtime hours for a department

• Overtime charged during a slack period
• Overtime charged for employees who normally would not have overtime wages
• Budget variations for payroll by department
• Employees with duplicate Social Security numbers, names, and addresses
• Employees with few or no payroll deductions

Purchasing/ Inventory:

• Increasing number of complaints about products or service

• Increase in purchasing inventory but no increase in sales
• Abnormal inventory shrinkage
• Payments to vendors who aren’t on an approved vendor list
• High volume of purchases from new vendors
• Purchases that bypass the normal procedures
• Vendors without physical addresses
• Vendor addresses matching employee addresses

Learning Check – Internal Control Principle

Identify the internal control principle that is being followed in each of these procedures:

1. At the end of every month, a Manager reviews all cash deposit slips to ensure they are approved
by a senior person.
2. Cash is received by a person other than the one responsible for maintaining the accounts
receivable records.
3. Access to any cash kept on site is restricted and the cash is stored in a locked box or safe.
4. All payments are substantiated with an approved supplier invoice (and other appropriate
documents such as a purchase order and receiving report).
5. Whenever cash is counted, at least two persons are present to verify the count.

Internal control principles:

A. Authorization
B. Documentation
C. Safeguarding
D. Segregation
E. Verification

Answer:

1. Authorization
2. Segregation
3. Safeguarding
4. Documentation
5. Verification
Summary
In this module we have explored:

1. Internal controls and their purpose.

2. The five principles of internal control including examples.
3. Common controls over cash receipts and disbursements.

Module Checklist
Check off each item below to confirm you have successfully completed all items in the module.

• I have read through all the content screens.

• I successfully completed the Knowledge Check.
• I have posted any questions I have to the Discussion Board.

You have now completed Internal Controls!

Remember to check the timeline before you proceed to the next module to ensure you have completed
any assignments as required. Check with your instructor if you have any questions.

Now that we have an understanding of financial accounting recording procedures and control
mechanisms, we can move on to the next module and introduce management accounting concepts.