CHAPTER 16

INTERNAL CONTROL AFFECTING ASSETS

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:

1. All cash that should have been received was in fact received, recorded accurately and
deposited promptly.

2. Cash disbursements have been made for authorized purposes only and have been properly
recorded.

3. 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:

1. Do not permit any one employee to handle a transaction from beginning

to end.
2. Separate cash handling from record keeping.
3. Centralize receiving of cash to the extent practical.
4. Record cash receipts on a timely basis.
5. Encourage customers to obtain receipts and observe cash register totals. 6. Deposit cash
receipts daily.
7. Make all disbursements by check or electronic funds transfer, with the exception of small
expenditures from petty cash.
8. 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.
9. Monitor cash receipts and disbursements by comparing recorded amounts to forecasted
amounts and investigating variances from forecasted amounts.
Potential Misstatements - Cash Receipts

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:

1. Formal investment policies that limit the nature of investments in securities and other financial
instruments.
2. An investment committee of the board of directors that authorizes and reviews financial
investment activities for compliance with investment policies.
3. 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.
4. Complete detailed records of all securities and derivative instruments owned and the related
provisions and terms.
5. Registration of securities in the name of the company.
6. 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.
7. 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 achieved by the use of an
independent safekeeping agent, such as a stockholder, securities, the possibilities of concealing
fraud through falsification of the employee responsible from maintaining accounting records of
the investments in 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.

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 amounts; 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.

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:

1. The custodian of notes receivable does not have access to cash or to general accounting
records.
2. The acceptance and renewal of notes be authorized in writing by a responsible official who
does not have custody of the notes.
3. 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.

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 inventories is used in this chapter to include:

1. goods on hand ready for sale, whether the merchandise of a trading concern or the finished
goods of a manufacturer;
2. goods in the process of production; and
3. good to be consumed directly or indirectly in production, such as raw materials, purchased
parts, and supplies.

Internal Control over Inventories and 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.
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:

1. Land, such as properly used in the operation of the business, has the significant
characteristic of not being subject to depreciation.

2. Buildings, machinery, equipment and land improvements, such as fences and parking lots,
have limited service lives and are subject to depreciation.

3. 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 amounts,
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 essential to the preparation of reliable
financial statements. Errors in expenditures for the assets and related expenses make strong
internal control 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 plants 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:

1. 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.

2. 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.

3. A reporting procedure assuring prompt disclosure and analysis of variances between

authorized expenditures and actual costs.

4. 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.
5. A policy requiring all purchases of plant and equipment to be handled through the purchasing
department and subjected to a standard routine for receiving, inspection and payment.

6. 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.

7. A system of retirement procedures, including serially numbered retirement work orders

(bottom), stating reasons for retirement and bearing appropriate approvals.

CHAPTER 17

INTERNAL CONTROL 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.

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 for 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
the 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.