Internal Controls Affecting Liabilities and Equity

Internal Control over Accounts Payable

The term accounts payable (often referred to as vouchers payable for a voucher system) is used to describe short-term
obligations arising from the purchase of goods and services in the ordinary course of business. Typical transactions
creating accounts payable include the acquisition on credit of merchandise, raw materials, plant assets and office supplies.

Other sources of accounts payable include the receipt of services, such as legal and accounting services, advertising,
repairs and utilities. Interest bearing obligations should not be included in accounts payable but shown separately as
bonds, notes, mortgages, or installment contracts.

Invoices and statements from supplies usually evidence accounts payable arising from the purchase of goods or services
and most other liabilities. However, accrued liabilities (sometimes called accrued expenses) generally accumulate over
time, and management must make accounting estimates of the year-end liability. Such estimates are often necessary for
salaries, pensions, interest, rent, taxes and similar items.

In thinking about internal control over accounts payable, it is important to recognize that the accounts payable of one
company are the accounts receivable of other companies. It follows that there is little danger of errors being overlooked
permanently since the client’s creditors will generally maintain complete records of their receivables and will inform the
client if payment is not received. This feature also aids auditors in the discovery of fraud, since the perpetrator must be
able to obtain and respond to the demands for payment. Some companies, therefore, may choose to minimize their record
keeping of liabilities and to rely on creditors to call attention to any delay in making payment. This viewpoint is not an
endorsement of inaccurate or incomplete records of accounts payable, but merely recognition that the self-interest of
creditors constitutes an effective control in accounting for payables that is not present in the case of accounts receivable.

Discussion of internal control applicable to accounts payable may logically be extended to the entire purchase or
acquisition cycle.

Potential Misstatements - Accounts Payable

Description of Internal Control Weakness or Factors that

Examples
Misstatements Increase the Risk of Misstatement

Fraud:  Inadequate segregation of duties of record

 A bookkeeper prepares a check to keeping and preparing cash disbursements or
himself and records it as having been check signer does not review and cancel
issued to a major supplier. supporting documents.
Inaccurate recording of a
 Ineffective controls for matching invoices with
purchase or disbursement
Error: receiving documents before disbursements are
 A disbursement is made to pay an authorized.
invoice for goods that have not been
received.
Fraud:  Ineffective controls for matching invoices with
Misappropriation of
 Goods are ordered but delivered to an receiving documents before disbursements are
purchases
inappropriate address and stolen. authorized.
Error:  Ineffective controls for review and cancellation
Duplicate recording of  A purchase is recorded when an invoice is of supporting documents by the check signer.
purchases received from a vendor and recorded again
when a duplicate invoice is sent by the vendor.
Fraud:  Ineffective board of directors, audit committee,
Late (early) recording of
 Purchases journal "closely early" with this or internal audit function; "tone at the top" not
cost of purchase —
period's purchases recorded as having occurred conducive to ethical conduct; undue pressure to
"cutoff problems"
in subsequent period meet earnings target

Internal Control over Other Debts

Business corporations obtain substantial amounts of their financial resources by incurring debt and issuing capital stock.
The acquisition and repayment of capital is sometimes referred to as the financing cycle. This transaction cycle includes
the sequence of procedures for authorizing, executing, and recording transactions that involve bank loans, mortgages,
bonds payable, and capital stock as well as the payment of interest and dividends.

Internal Control over Debt

Authorization by the Board of Directors

Effective internal control over debt begins with the authorization to incur the debt. The bylaws of a corporation usually
require that the board of directors approve borrowing. The treasurer of the corporation will prepare a report on any
proposed financing, explaining the need for funds, the estimated effect of borrowing upon future earnings, the estimated
financial position of the company in comparison with others in the industry both before and after the borrowing, and
alternative methods of raising the funds. Authorization by the board of directors will include review and approval of such
matters as the choice of a bank or trustee, the type of security, registration with the SEC, agreements with investment
bankers, compliance with requirements of the state of incorporation, and listing of bonds on a securities exchange. After
the issuance of long-term debt, the board of directors should receive a report stating the net amount received and its
disposition as, for example, acquisition of plant assets, addition to working capital, or other purposes.

Use of an Independent Trustee

Bond issues are always for large amounts — usually many millions of pesos. Therefore, only relatively large companies
issue bonds: small companies obtain long term capital through mortgage loans or other sources. Any company large
enough to issue bonds and able to find a ready market for the securities will almost always utilize the services of a large
bank as an independent trustee.

The trustee is charged with the protection of the creditors’ interests and with monitoring the issuing company’s
compliance with the provisions of the indenture. The trustee also maintains detailed records of the names and addresses of
the registered owners of the bonds, cancels old bond certificates and issues new ones when bonds change ownership,
follows procedures to prevent over issuance of bond certificates, distribute interest payments, and distributes principal
payments when then bonds mature. Use of an independent trustee largely solves the problem of internal control over
bonds payable. Internal control is strengthened by the fact that the trustee does not have access to the issuing company’s
assets or accounting records and the fact that the trustee is a large financial institution with legal responsibility for its
actions.

Interest Payments on Bonds and Notes Payable

Many corporations assign the entire task of paying interest to the trustee for either bearer bonds or registered bonds.
Highly effective control is then achieved, since the company will issue a single check for the full amount of the
semiannual interest payment on the entire bond issue.

Internal Control over Owners' Equity

The three principal elements of strong internal control over share capital and dividends:

1. the proper authorization of transactions by the board of directors and corporate office,
2. the segregation of duties in handling these transactions (preferably the use payments), and
3. the maintenance of adequate records.

Internal Control on Equity

Control of Share Capital Transactions by the Board of Directors

All changes in share capital accounts should receive formal advance approval by the board of directors. The board of
directors must determine the number of shares to be issued and the price per share; if an installment plan of payment is to
be used, the board must prescribe the terms. If plant and equipment, services, or any consideration other than cash is to be
accepted in payment for shares, the board of directors must establish the valuation on the noncash assets received.
Transfers from retained earnings to the Share Capital and Paid-in Capital accounts, as in the case of stock dividends, are
initiated by action of the board. In addition, stock splits and changes in par or stated value of shares require formal
authorization by the board.

Authority for all dividend actions rests with the directors. The declaration of a dividend must specify not only the amount
per share but also the date of record and the date of payment.

Independent Registrar and Stock Transfer Agent

In appraising internal control over share capital, the first question that the auditors consider is whether the corporation
employs the services of an independent share registrar and a share transfer agent or handles its own capital share
transactions. Internal control is far stronger when tiie services of an independent share registrar and a stock transfer agent
are utilized because the banks or trust companies acting in these capacities will have the experience, the specialized
facilities, and the trained personnel to perform the work in an expert manner. Moreover, by placing the responsibility for
handling share capital certificates in separate and independent organizations, the corporation achieves to the fullest extent
the internal control concept of separation of duties.

Internal Control over Dividends

The nature of internal control over the payment of dividends, as in the case of stock issuance, depends primarily upon
whether the company performs the function of dividend payment itself or utilizes the services of an independent dividend-
paying agent. If an independent dividend-paying agent is used, the corporation will provide the agent with a certified copy
of the dividend declaration and a check for the full amount of the dividend. The bank or trust company serving as stock
transfer is usually appointed to distribute the dividend, since it maintains the detailed records of shareholders. The agent
issues dividend checks to the individual shareholders and sends the corporation a list of the payments made. The use of an
independent fiscal agent is to be recommended from the stand-point of internal control, for it materially reduces the
possibility of fraud or error arising in connection with the distribution of dividends.

In a small corporation that does not use the services of a dividend-paying agent, the responsibility for payment of
dividends is usually lodged with the treasurer and the secretary. After declaration of a dividend by the board of directors,
the secretary prepares a list of shareholders as of the date of record, the number of shares held by each, and the amount of
the dividend each is to receive. The total of these individual amounts is proved by multiplying the dividend per share by
the total number of outstanding shares.

Dividend checks controlled by serial numbers are dawn payable to individual stockholders in the amount shown on the list
described above. If the shareholders ledger is maintained on a computer master file, the dividend checks may be prepared
by the computer directly from this record. The stockholder list and dividend checks are submitted to the treasurer for
approval and signature. The checks should be reconciled by the treasurer with the total of shares outstanding and mailed
without again coming under control of the officer who prepared them.

Cash in the amount of the total dividend is then transferred from the general bank account to a separate dividend bank
account. As the individual dividend checks are paid from this account and returned by the bank, they should be matched
with the check stubs or marked paid in the dividend check register. A list of outstanding checks be prepared monthly from
the open stubs or open items in the checks register. This list should agree in total with the balance remaining in the
dividend bank account. Companies with numerous shareholders prepare dividend checks in machine-readable form, so
that the computer may perform the reconciliation of outstanding checks.