Introduction to Internal Controls

5.4. Purchase cycle

The purchase cycle is particularly vulnerable to fraudulent activities such as fictitious vendors and fraudulent billing practices.

  • A company uses pre-numbered purchase orders and sales invoices. All missing or skipped orders/invoices should be investigated.
  • There is coordination between the receiving department, the purchasing department, and the accounting department. Purchasing agents should send a copy of the properly approved purchase order to receiving managers and the accounting department. Receivers at warehouses should reject goods that donít conform to the purchase order, or goods that donít have a matching purchase order, and should send completed receiving reports to the accounting department. The accounting department then receives an invoice from the vendor. The accounting department should only pay for invoices that have a matching purchase order and receiving report. This is known as the three-way match.
    • Itís a good idea to send the receiving department a ďblankĒ copy of the purchase order, which doesnít list the number of items ordered. This way, the receivers must physically count items instead of just checking off a number thatís given to them in advance (the receiver may just sign off on the purchase order without counting).

5.5. Fixed asset cycle

Fixed assets can negatively affect the general ledger for many years if not accounted for properly. The risks in this cycle relate to initial recording, movement, and disposal of assets.

  • Although a yearly inventory of fixed assets is not necessary, an inventory should still be performed every few years.
  • Acquisitions should be controlled in the same way as other purchases (a three-way match between purchase order or contract, receiving report, and invoice).
  • Disposals should be properly approved by an individual who doesnít have custody of the asset.

5.6. Revenue cycle

The primary risk in the sales cycle is a shipment to the wrong customer or a shipment with the wrong goods. Otherwise, sales cycle controls are related to other cycles (inventory, cash receipts, etc.).

  • There should be coordination between the shipping department, the sales department, and the accounting department. The shipping department should not send anything away without a proper sales invoice, and the accounting department should not record a transaction without a customer contract or purchase order, a matching invoice, and a matching shipping report. Just as in the purchase cycle, this is an example of a three-way match.

5.7. Payroll cycle

Payroll can be a significant expense for companies, especially service organizations. Business risks here include paying the wrong amount and paying the wrong people.

  • The payroll department should make sure that time cards are properly approved by each employeeís manager.
  • If direct deposit is not utilized, someone not otherwise involved with payroll should hand out checks. Any unclaimed checks should be investigated.
  • For direct-deposit payroll systems, an individual other than the person preparing the payroll data should approve a payroll preview in order to catch mistakes or fictitious employees.
  • All new hires and terminations should be properly approved, and terminated employees should be promptly removed from all access to payroll.
  • Pay changes should be documented in employee files.

5.8. Financial reporting cycle

The most perfect cycle-specific control system canít guard against errors and control overrides by management. The following controls help protect against misstated financial reports, and they are at least partially linked to all main accounting cycles presented above.

  • Formal reviews should be in place over journal entries. For example, if a staff accountant prepares an entry, the controller should review and approve it. If the controller prepares an entry, the CFO should review and approve it.
  • Financial statements and management reports (e.g., budget to actual) prepared by the accounting system should be reviewed for reasonableness. A monthly financial review by executives and perhaps the board of directors is also a good idea. Frequent high-level reviews can detect unusual trends that might indicate mistakes or fraud.
  • A company should have written policies about any significant accounting treatments, such as revenue recognition and fixed asset capitalization. These written policies help to assure that accounting treatments are consistent throughout the organization.
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