Auditing Principles and Practices

Internal Control

Internal control is the whole system of controls — financial and non-financial — established by the management of an organisation to safeguard its assets, ensure the accuracy and reliability of accounting records, promote operational efficiency, and encourage adherence to prescribed managerial policies. In the context of a government office, it is the plan of organisation, together with all the methods, procedures and practices adopted by the office to ensure that its resources are used lawfully, efficiently and for the intended purpose.

The concept rests on the principle of checks and balances: no single person should handle a transaction from beginning to end, so that the work of one employee is automatically verified by another.

Essential Elements of an Effective Internal Control System

1. Control environment (organisational plan) There must be a clear organisational structure with well-defined authority, responsibility and accountability. Duties should be assigned in writing, and every employee must know to whom he or she is answerable. The attitude of top management — its honesty, discipline and commitment to controls — sets the tone for the whole system.

2. Segregation of duties The functions of authorisation, custody of assets, and recording must be separated. The person who approves a payment should not be the one who makes it or records it. This prevents both concealment of errors and misappropriation of funds.

3. Proper authorisation and approval Every transaction must be approved by the competent authority within the limit of its delegated power. Budgetary control, sanction orders and delegation of financial powers are the usual tools.

4. Adequate accounting and documentation All transactions must be supported by authentic vouchers, bills, receipts and subsidiary records, entered promptly in the books. Pre-numbered documents, control accounts and reconciliation of bank statements help ensure completeness and accuracy.

5. Physical safeguards and custody Cash, stores, equipment and other assets must be kept under lock and key, with restricted access, periodic physical verification, and comparison of the physical balance with book balance. Rotation of staff on sensitive posts reduces the risk of collusion.

6. Independent verification and internal audit An internal audit or inspection unit, independent of the operating staff, should periodically check records, procedures and compliance with rules, and report to top management.

7. Personnel quality Honest, competent and adequately trained staff, appointed through proper procedures and given fair remuneration and supervision, are the backbone of any control system.

8. Monitoring and review Controls must be reviewed and updated from time to time to suit changed circumstances; otherwise they become routine formalities.

Role in Prevention of Fraud and Errors

Prevention of errors: Errors arise from ignorance, carelessness or fatigue — wrong posting, wrong totalling, omission of entries. Segregation of duties, cross-checking, reconciliation and independent verification detect such errors at the source before they pass into the final accounts. Arithmetic and accounting controls ensure accuracy and reliability of records.

Prevention of fraud: Fraud involves intent — misappropriation of cash or stores, teeming and lading, fictitious payments, collusive purchases. Internal control prevents it because:

• Division of work makes concealment difficult — the work of one employee is checked by another, so a fraud cannot be carried on for long without detection.
• Physical safeguards and periodic verification prevent theft of cash and stores.
• Authorisation limits prevent fictitious or excess payments.
• Internal audit and surprise checks create a psychological deterrent; employees know they will be checked.
• Rotation and leave arrangements break up collusive arrangements, since a fraudster's work is handled by someone else during leave.

Thus internal control does not merely detect fraud and errors after they occur; it builds a system of automatic checks that makes their occurrence difficult. Its limitations, however, should be noted: collusion between two or more employees, management override, and the cost of controls can weaken even a well-designed system.