Basic Concepts of Accounting.
In the business world, small, medium-sized and large firms must all engage in accounting activities. Accounting happens daily in any form of business since inventories have to be recorded on the day’s transactions. For medium and large organizations, they can not present their accounts on a day to day basis; hence the accumulated accounts are prepared maybe after every three months or according to the accounting period used by the firm. Accounts go a long way in showing the performance of a firm, for instance when a firm is experiencing loses, this shows the company is performing badly in the market. On the other side, if profits are realized, the performance of the firm in the market is said to be good (Ladda 2009). However, not all the accounts presented forward by businesses are true. At times, some organizations tend to present falsified accounts to present a picture of a firm which is doing well or bad in business for personal gain, yet the opposite is true. Some firms might exaggerate profits to attract investors while others might undervalue their profits to pay less taxes. Others might present accounting showing losses to get away with some liabilities or expenses. To ensure that the accounts presented by a business are true and accurate, the auditing process is undertaken. Basic Concepts of Accounting.
Auditing is a situation where the accounts of an organization are tested and analyzed for consistency and accuracy. Further, the audit ensures that the disclosure by the firm of all the financial and non-financial assets is up-to-date with the current markets. In summary, auditing ensures that the accounts paint a fair view of the business as it is performing under current economic conditions. The audit process is also used to make sure that the books of accounts are always maintained properly and the accounting procedure used every time is similar. Finally, the process of auditing ensures that the accounts presented by the organization and the accounting procedures used conform to the accounting standards, procedures and regulations set by the law.
Internal control is an aspect which tends to merge accounting and the audit processes. Internal control is defined as the process through which the accounting and audit procedures undertaken by a firm are in line with the objectives and aims of the firm. For instance, a firm might have a five-year growth plan, and for it to be achieved the firm must make profits within the five-year set term, however, if a loss is experienced in one of the years, it means the accounts do not relate to the objectives of the firm. The firm is expected to correct this by identifying the cause of the loss and making relevant corrections. For the objectives of the firm to be achieved through internal control, there must be effectiveness and efficiency in the operations of the organization. From the accounts presented, the effectiveness and efficiency of the firm can be analyzed. Other than the above, internal control ensures that the financial reporting of the organization is done in a legit sound manner which complies with the set laws and policies. To check all the above, the process of auditing comes in. On a greater perspective, internal control is viewed as the first lines of defense firms make use when it comes to risk management. Later in the paper, it will be clear how internal control and risk management get to work hand in hand. Basic Concepts of Accounting.
Components of Internal Control
Internal control is so broad since it relates to almost all activities undertaken by the firm. To cover all the relevant areas, internal control has been broken down to five major components. These components are as follows:
Internal control sets the platform through which all activities of the organization should take place. This includes controlling the actions of all members of staff and the executives too in the organization. To broaden how internal control affects the overall business environment in a firm, a look at the day to day activities of an organization should be used as an example. Let’s take an example of a firm which is involved in the sale of consumer goods, such as a convenience store, e.g. Wall-mart. Basic Concepts of Accounting.
On every single day, stock is received by the various stores, upon receivership of the stock, it should be recorded in the general ledger as purchases. If the stock is paid for on the same day, this should be included and supported by documents such as invoices, bank statements. If the purchases are not paid immediately, then the supplier should be recorded as a creditor to the firm. Wherever sales are made, this should be recorded because it leads to the deduction of stock and whenever the customer pays for the goods, cashiers will issue sales receipt. It is possible to account for what has been sold and sales unpaid. This whole process shows how the staff members are committed to the objectives of the firm by ensuring that profits are realized. There are other financial processes and non-financial activities which take place and need to be recorded. This provides a platform through which every financial or non-financial activity taken by the firm is backed by legitimate documents (Rezaee 54).
Internal control goes a long way in ensuring that firms can manage their risks. On its own, risk management is a broad topic, but to shorten it can be merged with internal controls. Through internal controls, firms can identify risks, especially financial risks and come up with measures on how to deal with the risk. Various models and assumptions are used in the process of identifying and managing risks. For instance, most firms are faced with the risk of fuel prices uncertainty. Through internal control, firms can identify when fuel prices are expected to shoot, and in return, they buy stock in bulk to avoid the risk of high prices.
For the objectives of a firm to be achieved, the flow of information and communication in a firm should be effective. Whenever communication and information flow is effective, it is easy to identify issues, capture them in the management system and act on them. This allows for the smooth running of all areas in an organization. An example is where a certain area such as the HR department is functional, but a manager notices that the production is low than normal due to inadequate employees. The manager forwards this to the management, and in return, funds are released to hire more workers. It is important to consider that the funds released are an expense to the organization.
This is quite straight forward since internal control is all about the controlling of activities infirm, especially financial activities. Internal control oversees that all the procedures set aside by the firm are followed effectively, for instance when every purchase takes place in the organization it must be recorded.
This is another important role played by internal control in any organization. Whenever the activities in a firm are not monitored, especially financial activities, they are prone to illegalities such as fraud. Through the process of internal control, it is possible to monitor the running of all the financial and nonfinancial activities of the firm. The monitoring of the financial and non-financial activities of the firm introduces us to the topic of how and when internal control affects the audit of public companies.
When, Where and How Internal Control Affects the Audit of Public Companies
For most of the public companies, there exist three main examples of when internal control affects the audit of public companies. In the first instance, public companies are under strict watch from the government. The government is interested in public companies mainly for tax remittance reasons. Further, the public companies employ several workers who are paid, and the salary is subject to taxation too (Rezaee 45). Several accounting organizations, bank and trade unions are interested in the financial statements of organizations too. Accounting organizations are interested in auditing these accounts and in ensuring that they comply with set standards. Trade organizations are interested in ensuring the rights of workers are adhered to when it comes to insurance policies and remittance of bonuses. Finally, banks are interested parties because most organizations owe banks huge amounts of borrowed money. Finally, the firm itself is interested in its accounts. This is the main reason why audits are carried out in firms. The management is keen to identify illegal activities and loopholes within the organization. Since the paper is all about internal control,s we shall disregard all the other reasons why the government or other organizations are interested in the financial accounts and focus on the internal control and how it affects auditing within public companies.
Effect of Internal Controls on Auditing in Public Companies
Internal controls in public companies mainly focus on how the resources belonging to a certain firm are used, monitored and measured. To understand how internal control affects auditing, we have first to identify some illegal activities which take place within the firm.
Fraud is a situation where some members of the organization make use of resources belonging to the organization, especially finances for their gain. Take an example where a firm sells a piece of land for $1.5 million, but in the account statements, the figure included is $1 million without explanations on where the extra $0.5 million went. In such a situation, through internal control, the firm was able to identify the discrepancies, but to trace the entire cash flow, and where the money was diverted, auditing comes into place. Hence, in detecting and analyzing fraud, auditing follows the money trail from the point of the first transaction to the last point.
Most organizations suffer from illegal use of their properties. The most affected properties include land, buildings, and motor vehicles. Internal control is meant to protect the properties owned by an organization, and in an effort for this to happen, regular auditing of the properties is conducted. Taking the case of motor vehicles, most organizations pay extra fuel costs and maintenance costs for their vehicles, yet most of the costs were incurred when the vehicle was not on official duties. Overall such practices increase the expenses of a company leading to reduced profits or losses. When it comes to auditing of motor vehicle expenses, companies make sure they only cover for the expenses of the vehicles during official duty. Expenses included in the accounts in most cases are greater compared to expenses incurred on official duties. In the firm, vehicle GPS management system firms can accurately calculate expenses incurred during official duties. The responsible person for the extra costs is expected to cater to them, and in most cases, the companies deduct these expenses from their salaries.
Further, through internal control, firms can evaluate the market value of their tangible resources such as land, machinery, and other equipment. Through the audit procedure, firms can include the resale value of their properties and compare it to the original price. By using this approach, firms can evaluate whether the price of a certain resource has appreciated or depreciated and the best period to dispose the item. In audit procedures, items should be disposed when they can fetch the highest possible profit or when the loss to be incurred is at its minimum.
In organizations, there are intangible assets too. These assets include the shares and securities owned by the company or the trademarks belonging to an organization. In protection of such assets, for instance, the securities of an organization, auditors dig deep into the accounts of an organization to evaluate whether, in the valuation process, the shares/securities were overvalued or undervalued. If they were undervalued, who are likely to be the beneficiaries and are they workers or executives within the firm, and if so, do they benefit directly or indirectly through the use of third parties. In the case of overvaluation, the same procedure is followed too. Basic Concepts of Accounting.
This is one of the major reasons why internal controls are carried out in an organization and audits. For any firm to operate in a given region, it must seek approval from the government. This enables the government to regulate the industry. Other than regulation, the government is interested in the collection of various taxes from the organizations. The collection of taxes is done from the accounts presented forth by the organization (Dereck 6). Most organization carries out audit as a form of internal control to make sure that before they make their accounts public, they capture the real business position of the organization, especially taxes remitted. Whenever the government feels that a certain company engaged in illegal tax activities, it sends external auditors to verify the authenticity of the accounts and report their findings to the government. Basic Concepts of Accounting. Basic Concepts of Accounting.
From the above analysis, the research has taken a systematic path from the process of accounting to auditing and finally to internal control. The final bit has illustrated certain examples of how internal control affects audit in public companies. If all accounts were authentic, internal controls in accounting and audits could not be carried, but due to illegal activities, the processes have to be carried. The process of auditing exposes many rots in an organization, and the culprits often face dire consequences which include jail terms. Basic Concepts of Accounting.
Dereck, M. The Changing Audit Process. London: Routledge Press, 2006.
Ladda, A. Basic Concepts of Accounting. Laxmi Book Publication, 2009.
Rezaee, Z. Financial Statement Fraud and Detection. New York: Wiley and Sons Press, 2002.