Internal Control System Evaluation of Ethnic Store Ltd - Report Example

Running Head: Internal Control System Evaluation of Ethnic Store Ltd. Internal Control System Evaluation of Ethnic Store Ltd. name 13 May 2010 Report to find out internal weaknesses in Edward’s internal control system Edward’s financial could have performed well if the existing gaps in his business management could be bridged. The gaps exist in the shape of weaknesses in the internal control system, which are enumerated as follows: 1. No segregation of duties and lack of accountability: Edward does not assign specific responsibilities for different activities to various staff members, which results in one person having a control over the entire transaction right from the beginning till the end. This results in errors and low performance due to lack of accountability. A thorough observation of his business practices highlights that he has employed a single clerk to pay the wages, bills and deal with VAT returns, thus one person who records, authorizes and reconciles. Moreover, auditors instead of auditing the accounts for errors and fraud only, prepare the accounts too, which is a blunder in itself. Not only this, Edward also does not take complete responsibility as an owner to run the business, rather, he leaves the business activities upon the shoulders of his employees who can mal-perform because of the absence of accountability from the top management. 2. Absence of proper authorization by the management: Edward has failed to identify the fact that the management of a business has to set various rules and procedures, which the employees and employers have to remain adhered to. Such policies, rules and procedures lay out the guidelines for carrying out different activities in a business ranging from operational to long–term decisional activities. First all of all, Edward did not focus on the effect of employees’ performance on the overall business activities. He hired part time employees with lower quality skills and managing abilities. Moreover, the business does not follow specific procedures to keep a check on employees’ weekly performance; instead, employees themselves fill in the sheet and submit it for approval. There is no standard payment procedure as well; they are supposed to get checks for their wages but in case of haste, they are given the salary in cash form too. 3. Lack of adequate documentation and record keeping: Most importantly, Edward has ignored the need of having a managed and scrutinized system of keeping records and documentation for his business activities. It is evident from the observation that no records are maintained for inventory and cash management. His employees do not record the amount paid for goods or quantity of goods delivered, rather simply count the goods and ask the accountant to pay for the goods. Such a practice is not only harmful in short run but also in the long run, because, they can let go theft unchecked in the day to day activities, where as in the long run, any strategy regarding inventory management will not be easily devised, because of the absence of prior records. Similarly, they do not have a proper cash management system for both the cash coming in and going out. His employees do not even count cash for reconciliation with payments received and given out to suppliers. Not only this, but they also do not have policies to deal with day to day operational cash requirements and simply pay cash out of the available amount without keeping a check. Moreover, they do not practice recording the transactions according to the date of their occurrence, which obviously creates gaps in reconciliation. The extent of carelessness goes up to the owner signing blank cheques for payment which can directly result in theft. All these practices point to one fact that, Edward has not been able to keep a sound financial accounting system for his business, as a result of which neither record keeping nor operational management is appropriately carried out. 4. Poor physical control due to absence of technology: The absence of physical control is highlighted by the fact that Edward has selected a place as a warehouse which is not regularly visited, hence, inventory items can easily be stolen from there. Moreover, there are no security cameras installed in the shop or the warehouse, which further increases the lack of protection. He also does not maintain safe locks to keep cash safely at his shop or while transferring the money to the bank. Moreover, the store since does not have a proper accounting system, therefore maintains no recovery and backup files. Hence, if a data is lost, it is lost for good. Most importantly, Edward has not opted for a computerized accounting system for his business, which could have helped him keep a check on the business activities and maintain complete records for reconciliation and accountability. All in all, it has been observed that Edward’s overall business culture is marked with ignorance to internal management, absence of code of ethics along with standard operating procedures, lack of accountability and poor record keeping which can result in fraud and downfall in the business performance. Recommendations for improving internal control system After having thoroughly analyzed the internal control system at Ethnic Store Ltd and pointing out the weaknesses in the system, it is vital to mention, how can improvements be brought about, in the control system so as to mitigate the level of risk, the business gets exposed to, due to poor internal control systems. Following are some feasible suggestions that can help improve the system. 1. Edward should hire more competent and trained staff. A strong internal control system can only function in a business which has honest staff with clear job description and responsibilities. Instead of using low wage employees having low productivity and high turnover, he should employ people who might charge a little higher but will produce quality work and prove to be beneficial in the long run. Moreover, he should maintain an appraisal system that can help him identify if employees are adhering to the set procedures during their operational activities, because without this, any internal control system will lose its effectiveness. 2. Separation of responsibilities and duties: It is highly recommended for Edward to segregate duties of his employees, so that not one person can have a complete influence on a transaction, because this can result in fraud and theft. He should take measures to separate accounting department from the day-to-day operational department activities. Moreover, he should make sure that accounting department personnel is not given any assets’ custody; this will not create a temptation for fraud (Campbell & Hartcher, 2008). For e.g. accountant should not store cash for daily activities. Not only this, but he also should separate the staff which is responsible for authorizing a transaction from the one which should record it. This will again check for intentional and unintentional errors. 3. Appropriate authorization: Edward must adopt rules and procedures which clearly define the authority to allow a particular action or transaction. For e.g. major decisions regarding orders and suppliers must be made by the owner and not the warehouse staff. 4. Proper documentation and updated record keeping. Edward has also been suggested to make his staff record details of each transaction that goes on every day. The objective is to keep the business transactions well documented so as to avoid any fraud or tempering. It is advisable that all the documents should be numbered and accounted for, so that there remains no ambiguity regarding the documentation. 5. Adequately devised procedures. It will be wise for Edward to create a procedures manual which can bring uniformity in operations at both of his shops, hence, can make controlling and monitoring a lot easier task. This can also help employees to hold no ambiguities with regards to operations and responsibilities. He should make sure that all employees fully understand his set procedures and follow them. 6. Improving security: He definitely should install security cameras and alarms form cash and inventory safety. Moreover, he should have a computerized access to the warehouse and a password protected safe for cash. 7. Periodic auditing: The entire system must be periodically audited to gauge the performance of the system and the business as a whole. However, he should make sure that he does not employ staff for auditing which has any part to play during operations, so that they do not hide a fault or fraud trying to save themselves. 8. Computerized Accounting system: He can bring in immense improvements in the internal control system if he chooses to switch from manual accounting to computerized accounting system. Advantages of a computerized system For businesses like Ethnic Store Ltd, switching from manual to computerized system is a blessing. Currently, Edward is having quite serious weaknesses which are posing strong threats to the business’ success. Therefore, it will be a wise decision to install computerized systems particularly, choosing a computerized accounting and information systems, which can prove beneficial for his business. The biggest advantages of the computerized system are high level accuracy and speedy work (Weber, n.d.). Edward’s employees are not able to manually keep records well, however, a computerized accounting system will not only make it convenient for them to keep the records updated, but the process will be a lot speedier than the manual record keeping. Hence, storing data on daily basis will enable storing information systematically, which can easily be accessed later on. Moreover, it will also help Edward to produce year end reports so as to measure the financial performance. This will enable him to identify any gaps that might exist between his actual and desired financial position. A computerized system automatically posts entries form general journal and ledgers into financial statements, hence they can be produced in no time (Weber, n.d.). This is specially a great option for small businesses like Ethnic store Ltd because; the chances of fraud and theft are quite high due to lower accountability. Therefore, with a computerized system, not only human errors like illegible handwriting etc. will be reduced, but Edward would also be able to keep a check on the transactions and daily progress. Last but not the least, a computerized system would work wonders for Edward if he would open up another shop because, firstly, it will make sure that the operations and procedures are uniform at both the places. Secondly, even in Edward’s absence in his shop, no fraud or theft can take place in the computerized system, thus he will be able to impeccably plan, organize, control and monitor his business activities and performance for both the shops. The purpose of different financial record keeping Record keeping by businesses, is one of the most essential activities to achieve success. It is regarded as one of the most important tools for managing and analyzing the overall business performance for both the short run and the long run (The importance of record keeping, Anon., 2009). It can help the business in different ways, some of which are as follows: 1. Helps in making financial statements for a business with precision and in no time. 2. Helps in cash management in the operational activities 3. Helps in recording the information which can later on assist in making sound financial decisions for the business. 4. Helps in analyzing the financial situation of a business at any time during a year. 5. Helps in saving time in looking for a piece of information at the time of need. 6. Helps in monitoring the cost and performance of employees. 7. Helps in identifying gaps between the actual and the required state of business during a particular year, in other words, it enables one to check the overall performance to achieve the set goals. 8. Helps in immediately identifying problem areas and devise solutions for them. 9. Enables one to meet the legal obligation for maintaining records. 10. Helps in providing systematic presentation of a business to bankers and auditors. 11. Helps in detecting fraud, theft and other mal practices. 12. Last but not the least, accurate and systematic record keeping will enable one to plan, manage, control and organize your business in a way so as to make it outdo the competitors. Importance and application of fundamental accounting concepts To interpret information present in financial statements of various companies, analysts employ fundamental accounting concepts, which help them to form uniform assumptions while comparing performances among different companies (Meigs, et al,. 1999 ). Since the base concepts are similar; the interpretation of the analysis does not vary from person to person. Therefore, in order to properly analyze and interpret financial statements, it is important to understand the meaning and implication of key accounting concepts. 1. Separate Entity: Accounting records are kept for the business and not for the owners. Business is a separate entity (Meigs, 1999, p. 43). 2. Monetary units: information has to be recorded in monetary terms or currency. Therefore, these financial statements are not very equipped to display an effect of non-monetary aspect on the business performance (Meigs, 1999, p. 44). 3. Going concern: It is an assumption that the business will continue in the foreseeable time in future (Meigs, 1999, p. 43). It allows companies to exhibit their assets value as not what it would be priced if they were to be sold, but as assets which will generate future revenue. 4. Cost: Assets are stated at their book value, i.e. the value at the time of purchase. Hence, it becomes difficult to predict the market value of the assets (Meigs, 1999, p. 43). However, the financial statements do show a decrease in asset value with the passage of time due to being used up in operations. For e.g. Machine                 $12,000   purchase price of the machine Less depreciation  $  2,000   amount deducted as a depreciation expense Net Machine:          $  10,000   net book-value of the asset. (This figure is not the market value and indicates nothing about it) 5. Dual aspect: Company owns assets, owes liabilities and the difference between what the business owes and owns is its equity (Meigs, 1999, p. 43). This concept makes sure that each increase on one side is offset by decrease on the other side of the equation, Assets = Liabilities + Equity. 6. Principle of Objectivity: This concept makes it evident that information should be recorded on the basis of documents for e.g. invoices; and not on biased and personal opinions (Meigs, 1999, p. 45). 7. Time Period: It means that company’s financial statements are made for a specific time period, for e.g. monthly, quarterly or yearly 8. Conservatism: This concept implies that revenue should not be recognized without being certain, whereas expenses should be recognized as soon as possible (Meigs, 1999, p. 44). This does not overstate revenues and in turn, avoids incorrect representation of financial position of a company. 9. Realization: In a business, revenues must be recognized only when they are earned or realized in the shape of cash or accounts receivable (Meigs, 1999, p. 44). For e.g. if your company gets a contract of constructing a school, you will not show the entire contract amount as the revenue earned, but will show the amount of revenue as and when earned. 10. Matching principle: It requires to record expenses against revenue earned, during the same accounting period (Meigs, 1999, p. 44). For e.g. if you have earned $10,000 in two months, then you should record related expenses during the same time period, to exactly identify the amount of income actually earned. 11. Consistency: A company should maintain consistency in the methods adopted for reporting (Meigs, 1999, p. 45). For e.g. if a company has chosen LIFO inventory valuation system, then should adopt the same every year. However, if the changes in operations occur, then the accounting policies and methods can be altered, which is always mentioned in the financial statements. References Campbell, S., Harcther, J.,2008. Internal Controls for Small business. [Online] Available at: http://cpaaustralia.com.au/cps/rde/xbcr/cpa-site/internal-controls-for-small-business.pdf [Accessed 13 May 2010] Department of Economic, Industry Development and Innovation, 2009. The Importance of Record Keeping. [pdf] Queensland: Department of Economic, Industry development and innovation. Available at: www.ajml.com.au/.../The%20importance%20of%20record%20keeping.pdf [Accessed 13 May 2010] Meigs, R.F., Williams, J.R. & Bettner, M.S., 1999. Accounting- The basis for Business Decision. 11th ed. United States of America: Irwin McGraw-Hill Weber, M., n.d. Manual Accounting Versus Computerized Accounting. [Online] (Updated May12 2010) Available at: http://www.experience.com/alumnus/article?channel_id=accounting&source_page=breaking_in&article_id=article_1173385201144 [Accessed 13 May 2010] Read More