Internal control refers to the policies and procedures adopted by the management of an entity to support the achievement of its objectives. These objectives include the orderly and efficient conduct of business, adherence to management policies, safeguarding of assets, prevention and detection of fraud and errors, accuracy and completeness of accounting records, and timely preparation of financial statements.
Internal control is considered the entire system of financial and other controls established by the management to ensure the conduct of the business. It encompasses internal checks, internal audit, and all other forms of control. According to the American Institute of Certified Public Accountants, internal control comprises the plan of organization and all the coordinated methods and measures adopted within a business to safeguard its assets, check the accuracy and reliability of accounting data, promote operational efficiency, and encourage adherence to prescribed managerial policies.
Objectives of Internal Control
The primary purpose of internal control is to ensure adherence to prescribed policies and to provide reasonable assurance that plans and procedures laid down by the entity are being followed. Internal control systems are also designed to prevent and detect fraud and errors through inherent checks. Additionally, these systems are essential for promoting operational efficiency by preventing duplication of efforts, protecting against waste, and ensuring the optimal use of resources.
One of the vital objectives of internal control is the safeguarding of assets and records from unauthorized access, use, or disposal. It also ensures that all transactions are recorded accurately and promptly, in appropriate accounts, and in the correct accounting period. Finally, internal control systems play a crucial role in facilitating the timely preparation of financial information, which is only valuable when provided promptly.
Limitations of Internal Control
Despite its importance, internal control systems are not foolproof and have inherent limitations. These limitations are highlighted in the Standard on Auditing 315, previously known as AAS 6, issued by the Institute of Chartered Accountants of India.
Firstly, the implementation of an internal control system involves the expenditure of time and money. The management’s focus on making the system cost-effective can sometimes compromise its effectiveness. Internal control systems are generally more focused on routine transactions, so unusual or irregular transactions may not receive adequate attention.
Human error is another significant limitation, particularly when new employees are involved in the internal control process without adequate orientation. Additionally, the possibility of collusion among employees can lead to the circumvention of internal controls, making fraud more likely.
There is also a risk that individuals responsible for exercising control may abuse their authority. Examples include embezzlement of cash by a cashier or misappropriation of goods by a storekeeper. Changes in conditions may render established procedures ineffective over time, leading to the deterioration of the internal control system. Furthermore, manipulations by management can undermine the objectives of internal control, especially when management override becomes a norm.
Internal Control and Auditor
The responsibility for introducing an internal control system within an organization lies with the management. However, it is of great interest to the auditor, who must study and evaluate the system to determine the extent to which it can be relied upon during the audit. A robust internal control system can simplify the auditor’s work and increase efficiency, but this does not absolve the auditor of responsibility.
The auditor remains fully responsible for carrying out the audit with due diligence and professional care, regardless of the internal controls in place. Reliance on internal control must be supported by proper evaluation and testing, and the auditor must be prepared to perform additional procedures if the control system proves ineffective.
Tools to Study and Evaluate an Internal Control System
Several tools are available to help auditors study and evaluate internal control systems. One common method is narrative recording, which involves preparing a comprehensive written description of the internal control system actually in use. This approach is often adopted by small businesses and requires actual testing to validate the records.
Another useful tool is the checklist, which consists of a series of instructions followed or answered by audit staff. Responses typically include yes, no, or not applicable. These completed checklists help management evaluate the effectiveness of the control system.
The internal control questionnaire is another tool used by auditors to assess the adequacy of internal controls. It includes a comprehensive series of questions designed to elicit yes, no, or not applicable responses. These questionnaires are completed by the relevant employees, and the auditor prepares a report based on the responses, highlighting deficiencies and offering suggestions for improvement.
Flowcharts offer a graphical representation of internal controls. Using standardized symbols, they depict the various controls in place and help identify weaknesses or inefficiencies in the system.
Internal Check
Internal check serves as a tool for implementing internal control. It involves organizing staff duties in such a way that one person’s work is automatically checked by another, thereby minimizing the chances of errors and fraud. This system ensures that duties are assigned in a complementary manner and that there is a natural built-in verification process.
Internal check is an integral part of the overall internal control system. It is primarily concerned with job allocation and is embedded within the accounting process itself. Its primary function is to ensure that errors and frauds are automatically prevented or detected during the normal operation of bookkeeping.
Main Objectives of Internal Check
The main purpose of internal check in an organization is to arrange duties so that one person’s work complements and verifies another’s. This arrangement ensures that no transaction goes unrecorded, thereby maintaining the reliability and accuracy of the accounting system.
Internal check also reduces the likelihood of errors and fraud by incorporating automatic checks. It helps fix responsibility by clearly dividing work and assigning duties based on capacity and qualifications. Moreover, it enhances the efficiency of the accounting staff by distributing work in a structured and manageable way.
Advantages of Internal Check
The internal check system offers several advantages. It imposes a moral check on employees and promotes integrity within the organization. By fixing responsibilities, it becomes easier to identify the source of any irregularity. The system minimizes the likelihood of fraud and errors by detecting them early in the process.
Since internal check is based on the division of labor, they improve efficiency. It facilitates the preparation of accurate and complete records during each balancing period. Additionally, it helps speed up audit procedures by enabling test checks and ensures the prompt preparation of financial statements.
Disadvantages of Internal Check
While beneficial, internal check systems are more suitable for large organizations. Smaller businesses often cannot afford the additional costs involved. Lack of coordination among staff can hinder the effectiveness of internal checks. Over-reliance on the system by auditors may lead to complacency and careless work.
Moreover, internal checks do not guarantee the prevention of all errors and fraud. There is always a risk that employees may conspire to manipulate the system. Therefore, although internal check is a valuable tool, they must be supplemented with proper oversight and regular evaluation.
Duties of an Auditor in Respect of Internal Check
The auditor has specific duties concerning the internal check system. Firstly, the auditor should obtain a written statement from the company detailing the internal check system in place. The effectiveness of the system must be independently evaluated, and the auditor should not rely solely on its presence.
The auditor must identify any weaknesses that could lead to fraud or errors. Based on the size of the business, the auditor may determine the extent to which reliance can be placed on the internal check system. If the auditor is not satisfied after conducting test checks, a more detailed analysis should be performed.
Cash transactions, in particular, require scrutiny and should not be subjected to test checking even if the internal check system seems effective. If the system is found to be inefficient, the auditor should provide suggestions for improvement. If these recommendations are not implemented, the auditor should clearly state that responsibility cannot be assigned to them in case of future discrepancies.
Difference Between Internal Control and Internal Check
Internal control refers to the broader system of financial and non-financial controls set up by the management to ensure smooth functioning of the organization. It encompasses all types of checks and audits, including internal checks and internal audits. Internal check, on the other hand, is a narrower concept that involves the division of duties among employees in such a way that the work of one person is automatically verified by another in the normal course of operations.
The objective of internal control is to ensure the safeguarding of assets, accuracy, and completeness of records, and compliance with management policies. Internal check focuses specifically on the prevention and detection of errors and fraud along with fixing accountability.
Internal control is more flexible and is updated with changes in the business environment. Internal check tends to remain more static and consistent over time. Internal check is essentially a part of internal control, dealing specifically with how staff responsibilities are allocated to achieve automatic checks.
Internal Check as Regards Certain Transactions
Internal check systems must be tailored to the nature of business activities. The design and implementation of these checks vary depending on the type of transaction. Several areas are commonly subjected to internal check procedures, including cash handling, sales, purchases, and payroll.
Cash Receipts
All correspondence, including inward mail and remittances, should be handled by a responsible official who is not directly involved with accounting or cash handling. There should be a dedicated cashier for dealing with all cash receipts, and this individual must not have access to the books of accounts.
Pre-numbered and pre-printed receipt books should be used for all collections, and any spoiled receipts should be cancelled properly but retained. Unused receipts must be kept securely. If any alteration is made to a receipt, it should be initialed appropriately.
All cash collected must be deposited in the bank daily, and pay-in slips should be prepared by someone other than the person making the actual deposit. Counterfoils of all receipts should be preserved. Surprise cash verifications should be conducted periodically by a responsible officer. A clear segregation should exist between those responsible for receiving, accounting for, and safeguarding cash.
Cash Sales at the Counter
Only authorized salespersons should be allowed to sell goods over the counter, and each should be assigned a specific number. Cash memos must be pre-printed and sequentially numbered.
When a customer makes a purchase, the salesperson generates four copies of the cash memo. Three are handed to the customer, who proceeds to the cashier. The cashier collects the payment, returns two stamped copies to the customer, and retains one for records. A gatekeeper checks the goods and collects one copy of the cash memo, while the customer retains the other.
At the end of the day, the cashier, salesman, and gatekeeper prepare separate summaries, which are then reconciled to detect any discrepancies. All cash collected from sales must be deposited in the bank daily.
Cash Sales by Travelling Salesman or Agents
Organizations that employ travelling salesmen for direct sales and collections must have a robust internal check system. Salesmen should be authorized to issue official receipts and must deposit all collections daily either to the cashier or directly to the company’s bank account.
They are also required to submit daily sales and collection reports. Salesmen should not retain cash for any extended period, and no collection should remain outstanding. Periodic rotation of sales territories can help prevent fraud or manipulation by salesmen.
Cash Payments
The individual responsible for making cash payments must not be involved in cash receipts. Wherever possible, payments should be made through cheques or electronic transfers such as NEFT, RTGS, or IMPS.
Only authorized officials should sign cheques, and payments above a certain threshold should be approved by a designated officer. Unused cheques must be kept securely. For every payment, a supporting voucher must be prepared and serially numbered.
All vouchers must be stamped as paid to prevent double payments. Receipts must be obtained for all payments. Counterfoils of issued cheques and the paid vouchers should be maintained and preserved. All disbursements must be recorded in the cash book. Bank reconciliation statements must be prepared regularly by someone other than the cashier.
Payment of Wages and Salaries
For organizations, especially manufacturing companies with a large workforce, an effective internal check system is crucial for wage and salary payments. The system should be designed to prevent errors in timekeeping, the inclusion of non-existent workers, manipulation of wage sheets, and misappropriation of funds.
Time and piecework records must be maintained properly, along with overtime logs. Wage sheets should be prepared by an independent official and include all relevant details such as employee name, time worked, rates, overtime, deductions, and net payable amounts. All calculations should be verified, and the person preparing the wage sheet should sign it before disbursement.
Wages should be paid by someone not involved in preparing the wage sheet. Workers must appear in person and prove their identity when receiving wages. Disbursements should ideally be made in the presence of departmental foremen, and receipts must be obtained from the workers. Arrangements should also be made for unclaimed wages. A separate bank account dedicated to wage payments is advisable for tracking purposes.
Cash Purchases
For cash purchases, the process must begin with a purchase requisition authorized by a competent official. Purchases should be made after comparing tenders or quotations to secure favorable terms. Upon receipt of goods, an independent person should verify their quantity and quality.
Invoices must be cross-checked with purchase orders and goods receipt notes. Payment should be made only upon proper authorization. All transactions should be accurately recorded in the purchase and cash books.
Credit Sales
The sales department should maintain a register of incoming purchase orders. Before processing, the credit department should evaluate the customer’s creditworthiness. Upon approval, a copy of the order is forwarded to the dispatch department.
The storekeeper issues the goods, and the dispatch department prepares a statement for verification. Once confirmed, an invoice is prepared and reviewed by a responsible officer. Upon dispatch, entries are made in the dispatch register and the sales book.
Invoices are sent to the customer, and periodic follow-up is conducted for collections. Goods returned by customers must be recorded in the goods inward register. Credit notes are prepared and approved by a responsible officer, and corresponding entries are made in the sales return book.
Purchases
When a department needs materials, a requisition slip must be filled out and approved. The purchase department then seeks quotations from suppliers and issues purchase orders in multiple copies for different departments.
Upon receipt, goods are inspected and recorded in the goods inward register. The invoice is checked against the purchase order and delivery records before payment is processed. Goods returned to the supplier must be recorded in the purchase return book, and a debit note should be issued.
Consideration in Executed and Executory Contracts
Consideration can either be executed or executory. In an executed contract, the act constituting the consideration is already performed, such as when A has already delivered goods to B in exchange for a promise of payment. In executory contracts, the consideration is to be provided in the future, for example, when A agrees to deliver goods next week, and B promises to pay upon delivery. Both forms are recognized under Indian law, as long as they meet the other essential requirements of a valid contract.
Unilateral and Bilateral Contracts
The doctrine of consideration also applies differently in unilateral and bilateral contracts. In a unilateral contract, one party makes a promise in exchange for the act of another, like a reward offer for finding a lost pet. Consideration here is fulfilled by the performance of the act. In a bilateral contract, both parties exchange mutual promises, and each promise is consideration for the other. For example, in a sales agreement, the seller’s promise to deliver goods is consideration for the buyer’s promise to pay, and vice versa.
Consideration Must Be Lawful
Section 23 of the Indian Contract Act stipulates that the consideration must be lawful. A consideration is unlawful if it is forbidden by law, defeats the provisions of any law, is fraudulent, involves injury to a person or property, or is opposed to public policy. For example, a promise to pay someone in return for committing a crime cannot be enforced, as the object and consideration are both unlawful.
Consideration Must Have Some Value
The law does not require the consideration to be adequate, but it must be real and of some value in the eyes of the law. Even something nominal, such as Re. 1, can be sufficient if given voluntarily. However, it must not be illusory, impossible, or unlawful. Courts will generally not evaluate the fairness of the bargain unless there is evidence of fraud, coercion, or undue influence. The test is whether something of value has been exchanged, not whether it was a fair deal.
Consideration and Motive
The motive for entering into a contract should not be confused with consideration. While motive is the reason why a party enters into a contract, consideration refers to what is being exchanged. For instance, A may promise to pay B for helping his son out of friendship (motive), but the payment itself is the consideration. Indian courts focus on the legal substance of the consideration rather than the underlying intent or reason.
Consideration in Case Law
Several important Indian cases have discussed and clarified the concept of consideration. In Durga Prasad v. Baldeo (1881), the court held that acts done voluntarily and not at the promisor’s request do not constitute valid consideration. In Abdul Aziz v. Masum Ali (1914), a promise to donate money for a mosque without any request or benefit to the promisor was held unenforceable due to a lack of consideration. However, in Kedarnath v. Gorie Mohammad (1886), where a donation was promised for building a town hall and liabilities were incurred based on the promise, the court enforced the promise due to incurred obligations.
Consideration in the Context of Gifts and Voluntary Services
A gift, when given without expecting anything in return, is generally not enforceable as a contract because of the absence of consideration. However, once a gift is completed and delivered voluntarily, it is legally valid and cannot be revoked. Similarly, voluntary services, unless they are rendered at the desire of the promisor, do not amount to consideration. For instance, if A voluntarily repairs B’s car and then demands payment, B is not legally bound to pay unless he had requested the service.
Exceptions to the Rule “No Consideration, No Contract”
Section 25 of the Indian Contract Act outlines certain exceptions where a contract may still be valid even in the absence of consideration. These exceptions are significant in understanding the flexibility of contract law in India.
Agreement Made on Account of Natural Love and Affection
An agreement made out of natural love and affection between close relations is enforceable without consideration, provided it is in writing and registered. For example, if a father promises in writing and registers the document to give property to his son due to affection, this promise can be enforced even though no consideration is exchanged.
Promise to Compensate for Past Voluntary Services
If a person has done something for another voluntarily and the other person later promises to compensate for it, this promise is valid even without fresh consideration. The condition is that the act must have been done voluntarily and not under any contractual obligation. For instance, if A saves B’s child from drowning and later B promises to reward A, the promise is enforceable.
Promise to Pay a Time-Barred Debt
A promise to pay a debt that is no longer legally recoverable due to the lapse of the limitation period can be valid if the promise is made in writing and signed by the debtor. This is an exception because technically, there is no consideration, as the legal obligation has expired, yet the law recognizes the renewed promise.
Completed Gifts
Although gifts do not involve consideration, once a gift is completed (i.e., delivered and accepted), it is valid and irrevocable. The donor cannot later challenge the validity of the gift on the groundsothe f the absence of consideration.
Agency Contracts
Under Section 185 of the Indian Contract Act, no consideration is necessary to create an agency relationship. An agent may act on behalf of a principal without receiving consideration, and such an agency is legally recognized.
Charitable Subscriptions
If liabilities are incurred based on the promise to donate (such as beginning construction based on a promised donation), then the promise may be enforced even if the subscription itself lacked consideration at the time it was made.
Doctrine of Privity of Contract and Consideration
The doctrine of privity of contract holds that only those who are parties to a contract can sue or be sued on it. However, Indian courts have adopted a more flexible approach, especially in cases involving family settlements, trust arrangements, or where a third party is the beneficiary of a contract. Indian law has carved out exceptions allowing third parties to sue if they are the intended beneficiaries, particularly when consideration moves from someone other than the promisee.
Importance of Consideration in Modern Contract Law
In modern commercial and legal practice, the concept of consideration continues to serve as a foundational principle, ensuring that contracts are based on a mutual exchange. However, courts are increasingly focusing on the intent to create legal relations and actual reliance on promises, sometimes allowing flexibility in the strict interpretation of consideration, especially in equity and consumer protection contexts. This trend reflects an evolution toward substance over form, where fairness and the actual conduct of parties take precedence over technicalities.
Criticisms of the Doctrine of Consideration
Legal scholars and jurists have criticized the doctrine of consideration for being overly rigid and sometimes producing unjust results. The requirement for consideration can exclude enforceable obligations merely because no value was exchanged at the time of the agreement. Critics argue that the focus should instead be on the intention to be bound and the existence of a bargain, regardless of consideration. Some legal systems, like those in continental Europe, do not require consideration at all for a contract to be valid.
Conclusion
Consideration under the Indian Contract Act plays a crucial role in validating agreements and ensuring a mutual exchange between parties. While it is generally necessary for forming a contract, the law also provides several exceptions where a contract can be valid without it. The concept, though rooted in traditional English law, has been adapted in India to suit evolving commercial and social realities. With the increasing emphasis on equity, justice, and intention, the role of consideration may further evolve in the future to accommodate more pragmatic approaches to contract enforcement.