Financial Accounting

Learn the toughest concepts covered in your Financial Accounting class with step-by-step video tutorials and practice problems.

6. Internal Controls and Reporting Cash

Principles of Control Activities

Creating control activities based on these principles are essential to a strong system of Internal Controls that can prevent fraud.



Principles of Control Activities

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Alright the coast. So framework also defines principles of control activities. The control activities. Remember that's one of the components of internal controls. Well this is the big chunk. This is where most of our stuff happens for internal controls. These are the procedures we put in place the policies, this is where we're actually having our internal controls function. Let's check this out in a little more detail. So remember the control activities. These are the foundation, these are the foundation of the internal control uh efforts of the company. Right? So let's talk about the six principles that that Toso framework, the framework that defines how to make effective internal controls. Well let's discuss what those principles are. The first one is establishment of responsibility. Okay, so for any task there should only be one person responsible for a given task. Okay that way we know who was responsible, it can't be like oh you know who counted the cash in that register, Why there was one person who was uh responsible for that task, right? They were assigned that task, They were supposed to count the cash. So if there's any, you know misstatement in that cash register, we know whose responsibility it was. Okay so that was pretty easy. Let's go on to the next one separation of duties, separation of duties. This is one of the biggest topics in internal controls that they love to talk about and this is just to make sure that more than one person it is necessary to complete a task. Right? So notice the establishment of responsibility is that each person has their own specific job. Right? But when we think of a whole like big task, like purchasing inventory or something, right? Each little portion of that big idea of purchasing inventory, Well, each of those needs to be separated to a different person. Okay, so let's think about an example here. So there's gonna be one employee who purchases goods, excuse me, not purchases, orders the goods, sorry, there's one employee that orders the goods verifies the receipt of the goods and pays the supplier. So think of a situation where there's a company that has one person that does all of these these tasks okay, they call the supplier and order the goods, they get the goods, they verify that they got there and then they pay the supplier as well. This is a huge risk in internal controls. Let's see why. So what could be possible fraud? Well, when the employee makes the orders right, the the employee could order from a particular supplier because they are friends, right? He might just pick, hey, you know me and this guy go way back, I'm gonna order from him, you know, regardless of the price or the quality. Right? When, when we think about the company, the company would be very objective and pick the best supplier for them based on price and quality factors such as that, not just like, oh we're on friendly terms with this guy, I'm gonna order from him anyways, so that's not good, right? That's not making the best decision for the company. How about another one? Well the company Mapei Mapei false or inaccurate invoices because the invoices are not verified outside of this person. Right? So this person could just order, you know, fake goods, they could just write up an inventory, they're the ones who verify the receipt they could say, yeah, that stuff got here, right? Yeah, yeah, yeah. And they can pay basically themselves, they can make an account a fake invoice in the system and pay themselves, right? Because there's nobody outside verifying this information or the employee could just steal straight up. The employee could just steal the goods from the company right there in charge of all of the processes related to inventory. There's nobody who's going to be able to stop them. Okay? So what's a possible solution? Well, we have obviously separation of duties, right? Separation of duties. Okay. And to do that, we hire three employees where we have three employees, each one responsible for one of these tasks, right? So we would have one employee who orders the goods, right? So to be able to place that order, they would have to have uh the verification that this is the supplier we want to order from, and then there's another separate employee who's receiving the goods and that separate employee, make sure that the order matches with the received goods, right? So now they have their separate from the first person. So the first person couldn't just fake and order. Right? Because there's another person who's gonna verify that order and then there's the last person who's paying the supplier. Right? So notice how there's all this separation that make sure that one person can't just steal from the company. Right? So the separation of duties that's a huge part of our internal controls. So let's go on to the rest of these principles of of of our control activities. They're all pretty simple so we can kind of just going pretty quick documentation procedures. So we might have talked about this already about using pre number documents right? To make sure that all documents are accounted for. So very good example this is using checks that are numbered. So you might have check 101102103104105. Right? So if you look in your checkbook and you see or you look in the records and you see check one oh one. Check 102 and then check one oh four. But no record for 103. Right? There could be some issue there. So you want to be able to go back and check maybe that was a voided check. Right? What what could have been the issue with check one oh three or maybe the accountant right, wrote the check to his own personal bank account and then didn't put it in the records. But this this it's pre numbered. Make sure that our records are complete. Right? So pretty simple documentation procedures. Physical controls are pretty easy as well. So physical controls, this is literally locking the door, locking the door, having a safe for cash, write a password, anything that's physically keeping people out. Right. Okay. So pretty easy. Independent internal verification. So this is basically some sort of internal auditing procedure where a separate employee periodically checks another employees work, right? Just to make sure that everything is going. All right. And usually you want to do this kind of like on a surprise basis, right? Where they just like, okay, today's your check, they walk in and they check your stuff so you can't really prepare or hide stuff if you were committing fraud. Right? So remember all of these activities, Everything we're talking about is to help prevent fraud. And last is human resource controls. Right? So the the HR department could also have controls like bonding. So bonding employees. This isn't some sort of fetish thing. No bonding. This has to do with um insuring employees who handle cash. Okay, so any employee who handles cash, you get insurance for them just in case they steal cash while you're insured against it. And another benefit of this bonding is that the insurance company is going to do some sort of background check to make sure that the employee is, you know worth ensuring for them. So that gives a little extra uh security. Next this one is really interesting is mandatory vacations. This is a really cool one, mandatory vacations are good because it's usually when an employee's on vacation that fraud is discovered. Think about it there at work all the time and they're committing fraud. Maybe they're siphoning money out of the company's bank account. Well nobody's really checking on what they're doing until they leave on vacation and someone does their job for them right now. Someone comes in and does their job and they're like, hey something looks weird here and they get caught out. It's actually very true that a lot of fraud gets discovered while the employees on vacation. So a mandatory vacation that's going to help discover fraud. Last is background checks. Right? Obviously there's obvious advantage to doing a background check before you hire an employee, you're gonna hire more honest people when, when they have a clean record. Cool. Alright, so that's about it here, let's go ahead and move on to the next video