1. Internal Control Procedures
Chapter 3:
Internal Control Systems

2. Accounting Subsystems
In an Accounting System you will find many subsystems, such as accounts payable, accounts receivable, payroll, inventory, to name a few. Easier to divide an accounting system up into smaller parts and design specific controls for those subsystems.

3. Subsystem and Transaction Cycle Analysis
Subsystem approach is based around Balance Sheet grouping of accounts. Another approach is to base it on the transaction cycle analysis – base it on the revenue cycle or the expenditure cycle. This is called the cycle approach.

4. Subsystem and Transaction Cycle Analysis
The two approaches are not exclusive and overlap each other. It’s not just the subsystem or the transaction cycle that is the focus – it’s the internal controls within the subsystem and the transaction cycle.

5. Limitations of Internal Control
General Accounting Controls
Include:
Segregation of Duties
Proper authorisation procedures
Adequate documents and records
Physical controls to safeguard assets
Independent verification and reconciliations
Company practice and procedures manuals
Clearly defined lines of authority and responsibility

6. Limitations of Internal Control
Smaller entities who have fewer employees may find it hard to implement some of these general accounting controls such as segregation of duties.

7. Inherent Limitations
Even in the best designed and operated system there is still a chance of inadvertent errors (genuine mistakes) and intentional fraud (collusion). Control Risk can never be zero.

8. Inherent Limitations
Limitations in controls need to be identified; these can be due to:
Human Error
Collusion between employees
Management override of controls
Operational changes
Unusual transactions
Lack of continuity
Errors
Fraud

9. Fraud Definition
Fraud is any unlawful act of deception made for personal gain at the expense of another individual. In a corporate environment this usually involves a misappropriation of company assets by means of deliberate misrepresentation, concealment, embezzlement or extortion.

10. Difference Between Fraud and Error
The term “error” refers to an unintentional misstatement in the financial report.
The term “fraud” refers to an intentional act by one or more individuals involving the use of deception to obtain an unjust or illegal advantage.

11. Fraud – Who and Why
According to KPMG’s 2010 Fraud and Misconduct Survey, of internal frauds approximately:
10% were committed by senior executives or directors
30% were committed by management
60% were committed by employees
In any fraud there are usually 3 factors present:
Motivation – pressure or incentive to commit the fraud
Opportunity – usually due to poor internal controls
Rationalisation – the person’s ability to accept the risk committing the fraud

12. Internal Control and Fraud
An auditor should:
Be aware of the weaknesses in the internal control system,
Knows the general attitudes and morale within the organisation and the moral standards of the community, and
Be aware of the temptations, i.e. loopholes in the internal control system, can go a long way towards control of errors and fraud.

13. Some Types of Error and Fraud
False representations or concealment of facts
Use of property for personal gain.
Bribery
Collusion
Management fraud

14. Accounting Error and Fraud
In the accounting system these types of errors and fraud may manifest as:
Erroneously recorded transactions.
Invalidly recorded transactions.
Unrecorded transactions.
Improperly valued transactions.
Ownership misstatements.
Transactions recorded in wrong period.
Improperly classified and calculated transactions.

15. Examples of Fraud Specific examples of fraud include:
Use of corporate credit card for personal expenses
Claiming “reimbursement” of expenses which were never incurred/paid
Stealing cash or inventory
Supplying false invoices
Resubmitting invoices
Setting up false employees on the payroll

16. Detection of Fraud
Standard systems and procedures – improper actions are recognisable
Persistence with unexplained errors, discrepancies and omissions
Ask open-minded questions
Be alert to false documents
Be alert to unusual employee behaviour – such as refusal to take holidays
Develop a memory for information and association

17. Deterring Fraud
Adequate system of internal control will include the following procedures:
Analytical review procedures.
Segregation of duties.
Adequate authorisation procedures and independent checks.
Spot checks by management.
Good staff recruitment procedures.
Established system of disciplinary action for wrongdoers
Regular internal audits.

18. Fraud Prevention Conduct a risk assessment
Enforce an ethical work culture
Ensure senior management engagement
Set up ethical hotlines/whistleblower facilitation
Provide staff training/updates
Ensure segregation of duties
Have regular auditing and monitoring
Perform rigorous employee due diligence

19. Indicators of Possible Fraud
Discrepancies in the accounting records.
Conflicting or missing evidence.
Problematic or unusual relationships between the auditor and management.