An internal check system can prove very valuable to any business. It is a system that helps to streamline the flow of work by proper allocation of job responsibilities among staff members. An auditor also looks into the effectiveness of the internal check system while performing his auditing work. In this blog, we have thrown light on the meaning, principles, advantages and disadvantages of an internal check system from the perspective of auditing.
What is Internal Check in auditing?
Internal check deals with the arrangement of duties of staff in a company to carry out and process business transactions. It divides work among staff in such a manner that every aspect of a transaction gets recorded by a distinct person. By segregating duties, an internal check helps in fixing responsibility for different tasks. For example, access to books of accounts and other records is limited in most businesses. It is taken care of that the person who is responsible for physical custody of assets (e.g., a cashier) is not the same person who records the transactions of collections or payments in the ledger.
In an internal check system, appropriate work responsibilities are assigned to all in such a manner that work performed by one always gets automatically checked by another and so on. This enables a smooth flow of work in the company.
To reduce the possibility of fraud, an appropriate internal check system can be designed for many items such as cash sales, credit sales, purchases, wage payments, and so on. Let us take the example of a school. Assume salary payments at a school are made in the following ways. The Pay Bill is prepared by A. B double-checks the computations and enters them into the records. C approves & authorizes the payment. Thereafter, D issues the payment in cash or by check.
We can see from this example that there is a division of labor and that several people are involved in carrying out and recording a specific financial transaction rather than just one. By having such a system in place, it becomes easier to identify the person responsible for a particular error, default, etc., and thus it helps in fixing responsibilities.
Objective of internal check in auditing
The main goal of an internal check system is to decrease the possibility of fraud and errors being committed by any member of the staff and to make it more difficult. This is so because if any fraud is to be committed, two or more people must team up. And a sound internal check system prevents this from happening by ensuring that the work of every staff member is examined by one another. It helps to detect fraud and errors easily and correct them promptly. It kind of ensures that the accounting system produces reliable and adequate information.
Moreover, an internal check system helps in fixing responsibilities. It helps to assign each person’s duties and obligations in such a way that he can be held accountable for any lapse on his part.
Essential considerations or principles
Some general considerations in an internal check system are as follows:
- There should be proper distribution of administrative and financial powers among different persons. For example, the power to order a product and the power to issue cheques should be handled by different persons.
- There can’t be independent control of a single person over any particular aspect of the business.
- A person who has physical custody over assets should not be having any access to books of accounts.
- The distribution of responsibilities in a business should be made in such a way that the work of one person should come under the review of another.
- Job rotation should be implemented whereby duties of staff must be shuffled every now and then without giving them prior notice.
- Every employee must be encouraged to take a leave at least once a year so that any frauds done by him may be located when he is absent.
- At the time of stock taking at the end of a month, trading activities should be suspended.
- Automatic devices should be used to maintain cash registers to prevent misappropriation of cash.
- Each transaction should travel a certain route and should pass through various hands.
- All books, vouchers, and documents should be properly organized and easily accessible.
Auditor’s duty with regard to Internal Check while performing his auditing work
For the auditor, the soundness of the internal check system and the manner in which it is implemented in the organization are important. The work of the external auditor becomes much easier if the internal check system is effective. He no longer has to review transactions in detail or on a routine basis because the internal check system does it for him.
If the internal check system is not effective, the auditor must decide the extent of detailed checking he or she has to do to be satisfied that the company’s records are authentic. As a result, the auditor must first determine whether the internal check system in force is weak or defective, after which he must conduct a thorough examination of the accounting records.
If he fails to do so, he may be held accountable for any errors or frauds that go undiscovered. He must not be careless or negligent in his duties. He should design the audit program after taking into consideration the weak points of the system. He should also advise improvements to the management in order to strengthen the internal check system.
It should be highlighted that the presence of a sound internal check system in an organization greatly assists the auditor in his audit work, but it does not reduce his legal liability in any way. He continues to be accountable for his negligence regardless of how good or bad the internal check system is and how much reliance has he placed on it.
What’s the difference between Internal Check, Internal Audit and External Audit?
An internal check system means that the work of one employee is automatically checked by another while the work is still being done, whereas an internal audit means that the work is checked after it has been completed by one. While internal check deals with a system of allocating duties among the staff, an internal audit is an independent review of operations and records of a company, performed by staff specifically aligned for this purpose. Employees within the company are involved in both of these processes, as opposed to external audits, which are performed by outsiders. Further, internal audit and internal check are two of the internal control procedures implemented by the company’s management to ensure supervision of the work performed by personnel who maintain financial records. Indeed, internal checks and internal audits are a subset of the internal control system operating in a company.
Advantages and disadvantages of internal check
Some of the commonly acknowledged advantages of an effective internal check system are as follows:
Advantages for the business:
- Division of work: The internal check system involves a proper and logical division of work among the employees of the company, taking into account their unique qualifications, experience, and area of specialization.
- Detection of fraud and errors: Because no single employee is allowed to handle a job completely from start to finish, and the work of each employee is automatically verified by the other, this aids in the early identification and discovery of errors and frauds, and the possibility of committing errors and frauds is also minimized.
- Increased efficiency: Since work is evenly distributed, a sound system of Internal Check in the company increases the overall efficiency of work among the staff members.
- Acts as a moral check: The knowledge of subsequent examination of each employee’s work by others serves as a strong deterrent to the commission of errors and frauds.
- Accuracy of accounts: Having an internal check system in place establishes the genuineness and accuracy of the accounts to a great extent.
- Increased profits: Overall efficiency and economy in operations result in more earnings and larger pay-outs for owners or shareholders.
Advantages for the external auditor:
- Timely preparation of final accounts: The Statement of Profit & Loss and Balance Sheet are prepared without any loss of time.
- Convenience: The statutory auditor may conveniently be relieved of extensive checking of the transactions when an organization is having a sound internal check system. He can run a few tests here and there and avoid the tedious task of checking everything thoroughly. But remember, he cannot be relieved of his liability if he is found negligent.
Disadvantages of internal check:
Dependence on one another may sometimes prove detrimental to the timely completion of the work. The day-to-day work will be severely disturbed if one employee is absent. The following are some of the drawbacks of an internal check system:
- Expensive for small firms: It is quite costly for small businesses to implement an internal check system.
- Quality may be sacrificed: Quality of work might suffer in an internal check system because the members of the staff place greater emphasis on being quick and do not care if their work suffers as a result.
- Carelessness among high officials: The likelihood of certain responsible and high officials becoming careless rises as they feel, though not necessarily, that nothing can go wrong under a strong internal check system.
- Disorder: In case the internal check system is not properly organized, there will be chaos and disorder in the flow of work in the business.
- Disputes: The possibility of disputes among employees may increase when a company adopts an internal check system.
- Auditor’s risk: If the auditor does not carry out his own tests and procedures and instead relies on the output of the system, his work cannot be free of errors if the internal check system itself proves to be flawed. Thus, in a way, the auditor’s responsibility increases when he relies on internal checks and does selective checking only. He may be held liable if any fraud or errors go undetected.
Takeaway: Internal check in auditing
An internal check system is not only beneficial for the company but also the auditor. When the auditor finds that a good internal check system is in place, he may reduce the extent of his detailed checking and apply test checks. But when the question arises that “Can a good internal check system reduce the liability of the auditor?” The answer is no. The system of Internal Check can decrease to a great extent the workload of the auditor but does not decrease the liability of the auditor.
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