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: Manager at every level as to focus towards future operational and accountingdata, taking into
consideration
past
performance,
present
trends
and
anticipated
economic
and
technologicalchanges. The nature, scope and level of control will be governed by the level of
manager exercising it.
Existence of goals and plans
: MANAGEMENT CONTROL SYSTEM is not possible without predetermined goals and plans.
These two provide a link between such future anticipations and actual performance.
Forward looking
: MANAGEMENT CONTROL SYSTEM is on the basis of evaluation of past performancethat
the future plans or guidelines can be laid down. Management Control involves managing the
overallactivity of the enterprise for the future. It prevents deviations in operational goals.
Continuous process:
It is a continuous process over the human and material resources. It demands vigilanceat every
step. Deciding, planning and regulating the activities of people associated in the common task of
attaining the objectives of the organization is a the primary aim of MANAGEMENT CONTROL
SYSTEM.
People oriented
: It is the managers, engineers and operators which implement the ideas and objectives of the
management. The coordination of the main division of an organization helps in smoother
operations andless friction which results in the achievement of the predetermined objectives.
Scope of control
MANAGEMENT CONTROL SYSTEM is an important process in which accounting
information is used toaccomplish the organizations objectives. Therefore the scope of control is
very wide which covers a very widerange of management activities.
Policies control
What is concept of free cash flow as applied to the organization?explain the process of
computation?
We define net cash flow as net income plus non cash adjustment which typically means net
income plusdepreciation though that cash flows cannot be maintained over time unless
depreciated fixed assets are replaced.So management is not completely free to use its cash flows
however it chooses. Therefore we define the termfree cash flows.
Free cash flow
is the cash flow actually available for distribution to investor after the company has made all the
investment in fixed assets and working capital necessary to sustain ongoing operation. When we
studied incomestatement in accounting the emphasis was probably on the firms net income,
which is accounting profit.However the value of companys operation is determined by the
stream of cash flows that the operations willgenerate now and in the future. To be more specific,
the value of operation depends on all the future expectedfree cash flows, defined as after- tax
operating profit minus the amount of new investment in working capital andfixed assets
necessary to sustain the business. Therefore the way for managers to make their companies
morevaluable is to increase their free cash flow
Uses of FCF:
1.Pay interest to debt holders, keeping in mind that the net cost to the company is the after tax
interestexpense.
2.Repay debt holders, that is, pay off some of debt.
3.Pay dividends to shareholders.
4.Repurchase stock from shareholders.
5.Buy marketable securities or other non operating assets.In practice, most companies combine
these five uses in such a way that the net total is equal to FCF. For example, a company might
pay interest and dividends, issue new debts, also sell some of its marketablesecurities. Some of
these activities are cash outflows (paying interest and dividends) and some are cash
inflows(issuing debt and selling marketable securities), but the net cash flow from these five
activities is equal to freecash flows.
Computation of free cash flows:
Eg:Suppose the company had a 2001 NOPAT of $170.3million and depreciation is only the non
cash charge whichis $100million then its operating cash flow in 2001 would be NOPAT plus any
non cash adjustment on thestatement of cash flows.
Operating cash flow =NOPAT +depreciation (non cash adjustment)= $17.03 + $100= $270.3
Company has $1,455million operating assets, at the end of 2000, but $1,800 at the end of 2001.it
made a netinvestment in operating assets of Net investment in operating assets = $18, 00
- $1,455 = $345million
If
net fixed
assets
rose from
$870million to
$1000million however
company
reported $100million of depreciation. So its gross investment in fixed assets would beGross
investment = net investment + depreciation= $130 + $100 = $230million
Company free cash flows in 2001 was FCF = operating cash flow gross investment in
operating assets= $270.3 - $445= - $174.7million
An algebraically equivalent equation isFCF = NOPAT - Net investment in operating assets=
$170.3- $345= - $174.7million
Even though company had a positive NOPAT, its very high investment in operating assets
resulted in anegative free cash flow. Because free cash flow is what is available for distribution
to investor, not only wasthere nothing for investors, but investor actually had to provide
additional money to keep the business ongoing.A negative current FCF not necessarily bad
provided it is due to the high growth or to support the growth. Thereis nothing wrong with
profitable growth; even it causes negative free cash flow in the short term
What is balance scorecard? what is the process of implementation and difficulties of
implementation?
5
of a
balanced
scorecard
in
four general
steps;1.Define strategy.
2.Define measure of strategy.
3.Integrate measures into the management system.
4.Review measures and result frequently.Each of these steps is iterative, requiring the
participation of senior executive and employees throughout theorganization
Define Strategy
The balance scorecard builds a link between strategy and operational action. As a result it is
necessary to beginthe process of defining a balanced scorecard by defining the organization goals
are explicit and what that targetshave been developed.
Define Measures of Strategy
The next step is to develop measures in support of the articulate strategy. It is imperative that the
organizationfocuses on a few critical measures at this point; otherwise management will be
overloaded with measures. Also, itis important that the individual measures be linked with each
other in a cause effect manner
Integrated Measures into the management system
The balanced scorecard must be integrated with the organization formal and informal structure,
its culture, and itshuman resources practice. While the balanced Scorecard gives some means
for balancing measures, the measurescan still become unbalanced by others system in the
organization such as compensation policies that compensatethe manager strictly based on
financial performance.
Review Measures and result Frequently
Once the balance scorecard is up and running it must be consistently reviewed by senior
management. Theorganization should be looking for the following
How do the outcome measures say the organization is doing?
How do the driver measures say the organization is doing?
How has the organizations strategy changed since the last review?
How has the scorecard measures changed?The most important aspects of these reviews are as
follows;
They tell management whether the strategy is being implemented correctly and howsuccessfully
the strategy is working.
They show that management is serious about the importance of these measures.
They maintain alignment of measure to ever changing strategies
nor do they respond automatically to a new stretch targets. Inertia often works against
thecompany employees are accustomed to a self limited cycle of setting targets, missing
those targets and readjustingthe targets to reflect what was actually achieved. Without a method
for making improvement, improvements areunlikely to consistently happen no matter how good
the stretch goal sound.
Measurement overload
How many critical measures can one manager track at one time without losing? Unfortunately
there is no rightanswer to this question except it is more than 1 and less than 50. It too few then
the manager is ignoring measuresthat are critical to creating success. If it too many then the
manager may risk losing focus and trying to do too many things at once.
What are different methods to measure profits of a profit center in organization? what are different
measure each measure to convey to managers?
When financial performance in a responsibility center is measured in terms of profit, which is the
difference between the revenues and expenses, the responsibility center is called a
profit center.Profit as a measure of performance is especially useful since it enables senior
management to use onecomprehensive measure instead of several measures that often point
to different directions.There are two types of profitability measurements in a profit center, just as
there are for the organization as awhole. There is, first, a measure of management
performance,in which the focus is on how well the manager is doing. This measure is used
for planning, coordinating and controlling the day-to-day activities of the profit center. Second,
there is a measure of economic performance, in which the focus is on how well the profit
center is doing as an economic entity. The message given by these two measures may be quite
different.
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1)Contribution Margin:
The logic behind using contribution margin as a measure is that fixed expenses arenot
controllable by the manager, and therefore he should focus on maximizing the spread between
revenueand expenses. But the problem with this is that some fixed costs are controllable and all
fixed costs are partially controllable. A focus on the contribution margin tends to direct attention
away from this responsibility
2) Direct Profit:
This measure shows the amount that the profit center contributes to the general overhead
and profit of the corporation. It incorporates all expenses incurred in or directly traced to the
profit center,regardless of whether these items are entirely controllable by the profit center
manager. A weakness of thismeasure is that it does not recognize the motivational benefit of
charging headquarters costs.
3)Controllable Profit:
Headquarters expenses are divided into two categories: controllable and non-controllable. The
controllable expenses are controlled by business unit manager. Consequently, if these costsare
included in the management system, the profit will be after the deduction of all expenses that
areinfluenced by profit center manager.
4) Income before Taxes:
In this measure, all corporate overhead is allocated to profit centers. The basis of allocation
reflects
the relative
amount
of
expense
that
is incurred
for
each
profit
center.
If corporateoverheads are allocated to profit centers, budgeted costs, not actual costs, should
be allocated. Then the performance report will show an identical amount in the budget and
actual columns for such overheads.
5) Net Income:
Here, companies measure performance of domestic profit centers at the bottom line, theamount
of net income after income tax. There are two arguments 1) Income after tax is constant
percentageof the pretax income, so there is no advantage in incorporating income taxes 2) many
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decisions that haveimpact on income taxes are made at headquarters, and it is believed that profit
center manager should not be judged by the consequences of these decisions.
What is Interactive Control?
Interactive control alerts management of strategic uncertainties either trouble or opportunities
that become the basis for manager to adapt to a rapidly changing environments by thinking about
new strategies.1.A subset of the management control information that has a bearing on the
strategic uncertainties facing the buss becomes the focal point.
2.Senior executive take such information seriously.
3.Managers at all levels of the org focus attention on the information produced by the system.
Explain some of the factors which influence top management style and implication style on
top management control?
The management control function in an organization is influenced by the style of senior
management. The style of the chief executive officer affects the management control process in
the entire organization. Similarly, the style of the business unit manager affects the
unit's management control process, and the style of functional department managers affects the
management control process in their functional areas.
Differences in Management Styles
Managers manage differently. Some rely heavily on reports and certain formal documents;
others prefer conversations and informal contacts. Some are analytical; others use trial and error.
Some are risk takers; others are risk averse. Some are process oriented; others are
results oriented. Some are long-term oriented; others are short-term oriented. Some emphasize
monetary rewards; others emphasize a broader set of rewards.
Management style is influenced by the manager's background and personality. Background
includes things like age, formal education, and experience in a given function, such as
manufacturing ,technology, marketing, or finance. Personality characteristics include such
variables as the manager's willingness to take risks and his or her tolerance for ambiguity.
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of looseness tends to increase at successively higher levels in the organization hierarchy :higherlevel managers typically tend to pay less attention to details and more to overall results. The style
of the CEO has a profound impact on management control. If a new senior manager with a
different style takes over, the system tends to change correspondingly. It might happen that the
manager's style is not a good fit with the organization's management control requirements. If the
manager recognizes this incongruity and adapts his or her style accordingly, the problem
disappears. If, however, the manager is unwilling or unable to change, the organization will
experience performance problems. The solution in this case might be to change the manager
What are the objectives of Transfer Pricing?
Transfer price if designed appropriately has the following objectives:
It should provide each segment with the relevant information required to determine the optimum
trade-off between company costs and revenues.
It should induce goal congruent decisions-i.e. the system should be so designed that decisions
that improve business unit profits will also improve company profits.
It should help measure the economic performance of the individual profit centers.
The system should be simple to understand and easy to administer.
What is ideal transfer price in the situations of
a.Limited Market
b.Shortage of Capacity in the industry
The ideal transfer price in the situations of :
a. Limited Market
By limited market it means that the markets for buying and selling profit centers may be
limited.Even in case of limited market the transfer price that is ideal or satisfies the requirement
of a profit center system is the competitive price. In case if a company is not buying or selling its
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product in an outside marketthere are some ways to find the competitive price. They are as
follows:
1. If published market prices are available, they can be used to establish transfer prices.
However, these should be prices actually paid in the market-place and the conditions that exist in
the outside market should be consistent with those existing within the company .For example,
market prices that are applicable to relatively small purchases are not valid in this case.
2. Market prices are set by bids
. This generally can be done only if the low bidder has a reasonable chance of obtaining the
business. One company accomplishes this
by buying about one-half of a particular group of products outside the company
and one-half inside the company
.The company then puts all of the products out to bid, but selects one-half to stay inside. The
companyobtains valid bids, because low bidders can expect to get some of the business. By
contrast, if a companyrequests bids solely to obtain a competitive price and does not award
the contracts to the low bidder, itwill soon find that either no one bids or that the bids are of
questionable value.
1.If the production profit center sells similar products in outside markets, it is often possible to
replicate acompetitive price on the basis of the outside price.2.If the buying profit center
purchases similar products from the outside market, it may be possible to replicate competitive
prices for its proprietary products. This can be done by calculating the cost of the difference in
design
and
other conditions
of
sale
between
the competitive
products
and the
proprietary products.
a. Shortage of Capacity in the industry
In this case, the output of the buying profit center is constrained and again company profits may
not beoptimum. Some companies allow either buying profit center to appeal a sourcing decision
to a central person or committee. In this scenario a buying profit center could appeal a selling
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profit centers decision to sell outside.The person/group would then make a sourcing decision on
the basis of the companys best interests. In everycase the transfer price would be the
competitive price . In other words, the profit center is appealing only thesourcing decision.Even
if there are constraints on sourcing, the market price is the best transfer price. If the market price
can be approximated, it is ideal transfer price.
When do you use Cost Based Transfer Pricing?
We use cost-based transfer pricing
if there is no way of approximating valid competitive price.Transfer prices may be set up on the
basis of cost plus a profit, even though such transfer prices may be complexto calculate and the
results less satisfactory than a market-based price.Two aspects need to be considered for costbased transfer pricing:
1.The cost basis:
The usual basis is the standard cost. Actual costs should not be used because
productioninefficiencies will then be passed on to the buying profit center. If the standard costs
are used, there is a needto provide an incentive to set tight standards and to improve standards.
2.The profit markup:
In calculating the profit markup, there also are two decisions:
What is the profit markup to be based?
The simplest and most widely used base is percentage of costs. If this base is used, however,
no account is taken of capital required. A conceptually better base is a percentage of investment
.But there may be a major practical problem in calculating the investment applicable to a given
product. If the historical cost of the fixed assets is used, new facilities designed to reduce prices
could actually increase costs because old assets are undervalued.
What is the level of profit allowed?
16
The second problem with the profit allowance is the amount of the profit. The conceptual
solution is to base the profit allowance on the investment required to meet the volume needed by
the buying profit centers. The investment would be calculated at a standard level, with fixed
assets and inventories at current replacement costs. This solution is complicated and, therefore,
rarely used in practice.
Transfer Pricing is not an accounting tool comment with an illustration?
If a group has subsidiaries that operate in different countries with different tax rates,
manipulating the transfer prices between the subsidiaries can scale down the overall tax bill of
the group. For example the tax rate inCountry A is 20% and is 50% in Country B. In the larger
interest of the group, it would be advisable to showlower profits in Country B and higher profits
in Country A. For this, the group can adjust the transfer price insuch a way that the profits
in Country A increase and that in Country B get reduced. For this the group should fixa very high
transfer price if the Division in Country A provides goods to the Division in Country B. This
willmaximize the profits in Country A and minimize the profits in Country B. The reverse will
be true if the Divisionin Country A acquires goods from the Division in Country B.
There is also a temptation to set up marketing subsidiaries in countries with low tax rates and
transfer products to them at a relatively low transfer price
.Transfer price is viewed as a major international tax issue. While companies indulge in all types
of activities tolower their tax liability, the tax authorities monitor transfer prices closely in
an attempt to collect the full amount of tax due. For this they enter into agreements whereby tax
is paid on specific transactions in one country only.But if companies set unrealistic transfer price
to minimize their tax liabilities and the same is spotted by the tax authority, then the company is
forced to pay tax in both countries leading to double taxation.
There have been instances where companies have fixed unrealistic transfer prices. The first
case relates toHoffman La Roche that imported two drugs Librium and Valium into UK at
prices of 437 pounds and 979 pounds per kilo respectively. While the tax authorities in UK
accepted the price, the Monopolies Commission did not accept the company's argument, since
the same drugs were available from an Italian firm for 9 pounds and 28 pounds per kilo.
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The company's lawyers argued the case before the Commission on two grounds viz.1. The price
was not set on cost but on what the market would bear and2. The company had incurred an R&D
cost that was included in the price.
These arguments did not go well with the Commission and the company was fined 1.85 million
poundsfor the manipulative practices adopted while fixing the transfer price.The second case is
of Nissan. The company had falsely inflated freight charges by 40-60% to reduce the profits.
The manipulation helped the company to hide tax to the tune of 237 million dollars. The next
year Nissan was made to pay 106 million dollars in unpaid tax in the USA because the
authorities felt that part of their US marketing profits were being transferred to Japan, as transfer
prices on import of cars and trucks were too high. Interestingly the Japanese tax authorities took
a different view and returned the double tax. With a view to avoid such cases from recurring,
Organisation for Economic Cooperation and Development issued some guidelines in 1995.
These guidelines aim at encouraging world trade. They evolved what came to be known as the
arm's length price. The principle states that the transfer price would be arrived at on the basis as
if the two . companies are independent and unrelated. The price is determined through:
Comparable Price Method where the price is fixed on the basis of prices of similar products or
anapproximation to one.
Gross Margin Method where a gross margin is established and applied to the seller's
manufacturing cost. In spite of all these efforts, it has to be admitted that setting a fair transfer
price is not easy. So the onus of proving the price has been put on the taxpayer who is required to
produce supporting documents. If the taxpayer fails to do this he is required to pay heavy
penalty. For example, in USA, failure to provide documentary evidence results in a 40% penalty
on the arm's length price. In UK the penalty is to the tune of 100% of any tax adjustment. Other
countries are also in the process of evolving tight norms for the same. Countries across the globe
also allow the taxpayer to enter into an Advance Pricing Agreement whereby dispute can be
avoided and so also the costly penalty of double taxation and penalty.
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By law NPO are allowed to make profit but are restrained from distributing it to owners
andmanagement This way they are non profit making organizations (from the owner's point of
view). Suchorganizations include religious, charitable and educational trusts. Prime goal of
management control systems insuch organization is enhancing the service spread first and if
possible then cost control rather and than operatingefficiency. On the financial front, they enjoy
many concessions from the government such as taxes, subsidies,grants etc so also they attract
special control from these assisting institutes.
Characteristics
:1. Absent of profit performance measure leads to problems in assessing the efficiency of the
organization. If theorganization shows large net income it may be because that NPO may not
be providing the services to theextent possible/ expected. If the organization shows net losses
it may show the NPO facing risk of bankruptcy.Hence non availability of clear-cut performance
yardstick makes the problem of control worst.
2. NPO's have contributed capital Plant: NPOs do not have shareholder as its stakeholder. The
capitalcontribution to the business comes by way of contributions to assets such as building and
equipments. Secondkind of contribution could be in the form of monetary assistance, which
entitles the organization to reap theinterest on it keeping the principal amount intact.
3. Operating Assets represents the resources used for running day to day activities. And the
contributed assetsare not allowed to mix up with the operating assets.
4. Fund accounting: NPO need to keep two types of financial statements one set for contributed
capital andanother for operating capital. The nature of the contributed capital is beyond control
of the
management
andtherefore
management
concentrates
on controlling
the
operating assets/investments.
5. Governance: Usually NPO are managed by trusts, who exercise less control on operational
matters. Hence performance control is less demanding from owners' point of view and difficult
from the point of view of management.These characteristics pose difficulty in pricing of
the product/services - what could be appropriate price? Usuallyit is set at total/full cost. The
more stress expected on allocation of scare resources. Though not stricter control, but a sense of
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control can be built among the managers by way of using budgets for various activities
andexpenses. Non profit basis makes performance evaluation quite impossible. But one can
make the things easier by concentrating on adherence to costs budgets, and enhancing the
service base.
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company should be the same as the goals of the individual business segments. Corporate goals
can be communicated by budgets, organization charts, and job descriptions.
Goal Congruence- Meaning
Individuals work in different hierarchies and handle different responsibilities & may have
different goals. Butthey must come together as far as Companys Goal is concerned (there action
must speak Cos language.)
Goal Congruence
Example 1
The HR manager has devised a HR training program to enhance the skills of its sales
personnel,with an objective to enhance their productivity But if company is in strategic need of
attaining a certain salesvolume in a given quarter, it can not do so on account of non availability
of personnel.
Example 2
The marketing department has planned an impressive advertising campaign, which promises
goodreturns, But say due to cash crunch Companys current financial position may not let to
lose the strings
Example 3
Production Manager may get a good applause for reducing cycle time; But at what cost?
Buildingup the high inventory i.e. higher investment in current assets. While doing so he just
overlooked the financialinterest of the company. After completing the given activity in
more efficient manner the concerned manager scores the point/s on his score card. Whether his
actions are leading to scoring of points on the organizationsscore card too? if it is so then only
one can say the organization is marching towards a common goal.Every individual working in an
organization has got his own motive to do the work. Individuals act in their owninterest, based
on their own motivations. And it is always not necessarily consistent with the Cos goal. In a
goalcongruence process, the actions the people are led to take in accordance with their perceived
self interest are alsoin the best interest of the organization i.e.
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Goal congruence ensures that the action of manager taken in their best interest is also in the best
interest of the organization.
Informal factors that influence goal congruence:
External factors set of attitudes of the society, work ethics of the societyInternal factors
(Factors within the organization)
Culture-Common beliefs, shared values, norms of behavior & assumptions
Implicitly accepted and explicitly built into.
What is a responsibility centre? List and explain different types of Responsibility Centers?
Responsibility centers:
A responsibility center is an organization unit that is headed by a manager who is responsible for
its activities. Ina sense, a company is a collection of responsibility centers. Each of which
is represented by box on the on theorganization are responsibility centers for section work shifts
or other small organization units. At a higher levelare departments or business units that consist
of several of these smaller units plus staff and management peoplethese larger units are also
responsibility center. And from the stand point of senior management and the board of directors,
the whole company is responsibility center although the term is usually used to refer to unit
within the company.
underfunding may result in adverse consequences for the company as a whole (reduced sales
because of bad customer service experiences, for example). Because the cost centre has
a negative impact on profit (at least on the surface) it is a likely target for rollbacks and layoffs
when budgets are cut. Operational decisions in a contact centre, for example, are typically driven
by cost considerations. Financial investments in new equipment, technology and staff are
often difficult to justify to management because indirect profitability is hard to translate
to bottom-line figures. Business metrics are sometimes employed to quantify the benefits of a
cost centre and relate costs and benefits to those of the organization as a whole. In a contact
centre, for example, metrics such as average handle time, service level and cost per call are used
in conjunction with other calculations to justify current or improved funding
b) Profit Center
A responsibility centre is called a profit centre when the manager is held responsible for both
costs (inputs)and revenues (outputs) and thus for profit. Despite the name, a profit centre can
exist in nonprofits organizations(though it might not be referred to as such) when a responsibility
centre receives revenues for its services. A profit centre is a big segment of activity for which
both revenues and costs are accumulated: A centre, whose performance is measured in terms of
both - the expense it incurs and revenue it earns, is termed as a profit centre.The output of a
responsibility centre may either be meant for internal consumption or for outside customers.
Inthe latter case, the revenue is realized when the sales are made. That is, when the output is
meant for outsiders,then the revenue will be measured from the price charged from customers. If
the output is meant for other responsibility centre, then management takes a decision whether to
treat the centre as profit centre or not. In fact,any responsibility centre can be turned into a profit
centre by determining a selling price for its outputs. For instance, in case of a process industry,
the output of one process may be transferred to another process at a profit by taking into account
the market price. Such transfers will give some profit to that responsibility centre.Although such
transfers do not increase the Companys assets, they help in management control process.
c) Investment Centre
An investment centre goes a step further than a profit centre does. Its success is measured not
only by itsincome but also by relating that income to its invested capital, as in a ratio of income
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to the value of the capitalemployed. In practice, the term investment centre is not widely used.
Instead, the term profit centre is used indiscriminately to describe centers that are always
assigned responsibility for revenues and expenses, but mayor may not be assigned responsibility
for the capital investment. It is defined as a responsibility centre in whichinputs are measured in
terms of cost / expenses and outputs are measured in terms of revenues and in whichassets
employed are also measured. A responsibility centre is called an investment centre, when
its manager is responsible for costs and revenues as well as for the investment in assets used by
his centre. He is responsible for maintaining a satisfactory return on investment i.e. asset
employed in his responsibility centre. The investmentcentre manager has control over revenues,
expenses and the amounts invested in the centres assets. Themanager of an investment centre is
required to earn a satisfactory return. Thus, return on investment (ROI) isused as
the performance evaluation criterion in an investment centre. He also formulates the credit
policy, which has a direct influence on debt collection, and the inventory policy, which
determines the investment in inventory.The Vice President (Investments) of a mutual funds
company may be in charge of an Investment Centre. In theInvestment Centre, the manager in
charge is held responsible for the proper utilization of assets. He is expectedto earn a satisfactory
return on the assets employed in his responsibility centre. Measurement of assets employed poses
many problems. It becomes difficult to determine the amount of assets employed in a
particular responsibility centre. Some of the assets are in the physical possession of the
responsibility centre while for someassets it may depend upon other responsibility centers or the
Head Office of the company. This is particularlytrue of cash or heavy plant and equipment.
Whether such assets should be included in the figure of assetsemployed of the responsibility
centre and if included, at how much value, is a difficult question. On account of these
difficulties, investment centers are generally used only for relatively large units, which have
independent divisions, both manufacturing and marketing, for their individual products.
Internal control
Internal control is defined as a process affected by an organization's structure, work and authority
flows, people and management information systems,designed to help the organization
accomplish specific goals or objectives.
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[1]It is a means by which an organization's resources are directed, monitored, and measured .It
plays an important role in preventing and detecting fraud and protecting the organization's
resources, both physical (e.g., machinery and property) and intangible (e.g., reputation or
intellectual property such as trademarks). At the organizational level, internal control objectives
relate to the reliability of financial reporting, timely feedback on the achievement of operational
or strategic goals, and compliance with laws and regulations. At the specific transaction level,
internal control refers to the actions taken to achieve a specificobjective (e.g., how to ensure the
organization's payments to third parties are for valid services rendered.)Internal control
procedures reduce process variation, leading to more predictable outcomes
Describing Internal Controls:
Internal controls may be described in terms of: a) the objective they pertain to; and b) the nature
of the controlactivity itself.Objective categorizationInternal control activities are designed to
provide reasonable assurance that particular objectives are achieved, or related progress
understood. The specific target used to determine whether a control is operating effectively
iscalled the control objective. Control objectives fall under several detailed categories; in
financial auditing, theyrelate to particular financial statement assertions, but broader frameworks
are helpful to also capture operational and compliance aspects:
1.Existence (Validity): Only
valid
or authorized transactions
are processed
(i.e.,
no invalid transactions)
2.Occurrence (Cutoff): Transactions occurred during the correct period or were processed timely.
3.Completeness: All transactions are processed that should be (i.e., no omissions)
4.Valuation: Transactions are calculated using an appropriate methodology or are
computationallyaccurate.
5.Rights & Obligations: Assets represent the rights of the company, and liabilities its obligations,
as of agiven date.
6.Presentation & Disclosure (Classification): Components of financial statements (or other
reporting) are properly classified (by type or account) and described.
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training about evaluation. Sometimes, leaders do not realize that they have the responsibility
toverify to the public that the nonprofit is indeed making a positive impact in the community.
When programevaluations are not performed well, or at all, there is little feedback to the
strategic and program planningactivities. When strategic and program planning are done poorly,
the entire organization is adversely effected.
Evaluation of cross-functional processes
Cross-functional processes are those that span several systems, such as programs, functions and
projects.Common examples of major processes include information technology systems and
quality management of services. Because these cross-functional processes span so many areas of
the organization, problems in these processes can be the result of any type of ineffective
planning, development and operating activities.
Organizational evaluation
Ongoing evaluation of the entire organization is a major responsibility of all leaders in the
organization. Leaderssometimes do not recognize the ongoing activities of management
to actually include organizational evaluations but they do. The activities of organizational
evaluation occur every day. However, those evaluations usuallyare not done systematically. As
a result, useful evaluation information is not provided to the strategic and program planning
processes. Consequently, both processes can be ineffective because they do not focus on
improving the quality of operations in the workplace.
Why Balance Score Card is considered superior to other methods of Performance
Appraisal?Prepare Balance Score Card for any organization you are familiar with.
What is the Balanced Scorecard?
The rationale for the development of the Balanced Scorecard was a growing dissatisfaction with
traditional, financial measures of performance. These measures suffer from a number of serious
drawbacks in that they take a short-term, lagged (i.e., historic) view of performance. The
shift towards flexible, lean production/service systems in many firms has strengthened the
requirement for performance measurementsystems to become more broadly based, incorporating
both non-financial and external measures of performance.According to Kaplan and Norton, the
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different
organizational
goals.
Comment
on goal
of
shareholder
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many corporations, the goals originally set by the founder persist for generations. Examples are
Henry Ford, Ford Motor Company; Alfred P. Sloan, General Motors Corporation;Walt Disney,
Walt Disney Company; George Eastman, Eastman Kodak; and Sam Walton, Wal-Mart.
Economic Goals
Shareholder's value, Earning per share and Market value, all relate to maximizing shareholder's
value, which isnot a desirable goal, because what is 'maximum' is difficult to determine.
Although optimizing shareholder valuemay be one goal, but there are other stakeholders in the
business also such as customers, employees, creditors,community and so on. Again, shareholder
value is usually equated with the market value of the company's stock.But market value is not an
accurate measure of the worth of shareholders' investments. Besides, such value can be obtained
only when the share is traded in the stock exchange.It is interesting to note that Henry Ford's
operating philosophy was 'satisfactory profit', not 'maximum profit'. He said, "A reasonable profit
is right, but not too much. So, it has been my policy to force the price of thecar down as fast as
production would permit and give the benefit to the user and laborers, with resulting surprisingly
enormous
benefit
ourselves
every organization
local community where it issituated, and the public at large. It is very difficult to incorporate in
Management Control System such goals astaking pride in an organization which cares for the
society and renders service to the public. Of course, anyconcrete structural programme indicating
its operational expenses, methods of providing service, personnelinvolved in rendering service
and the nature of the service in details can, however, be mentioned through anappropriate
system.
Profitability
In a business, profitability is usually the most important goal.
Return on investment can be found by simply dividing profit (i.e., revenues minus expenses)
by investment, but this method does not draw attention to the two principal components: profit
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margin and investmentturnover.In the basic form of this equation, "investment" refers to the
shareholders' investment, which consists of proceeds from the issuance of stock, plus retained
earnings.One of management's responsibilities is to arrive at the right balance between the
two main sources of financing: debt and equity. The shareholders' investment (i.e., equity) is the
amount
of
financing
that
was
notobtained by debt, that is, by borrowing. For many purposes, the source of financing is not rele
vant;"investment" thus means the total of debt capital and equity capital."Profitability" refers to
profits in the long run, rather than in the current quarter or year. Many currentexpenditure (e.g.,
amounts spent on advertising or research and development) reduce current profits but
increase profits over time.Some CEOs stress only part of the profitability equation. Jack Welch,
former CEO of General ElectricCompany, explicitly focused on revenue; he stated that General
Electric should not be in any business in whichits sales revenues were not the largest or the
second largest of any company in that business. This does not implythat Welch neglected the
other componentsof the equation; rather, it suggests that in his mind there was a close correlation
between market share andreturn on investment.Other CEOs, however, emphasize revenues for a
different reason: For them, company size is a goal. Such a priority can lead to problems. If
expenses are too high, the profit margin will not give shareholders a goodreturn on their
investment. Even if the profit margin is satisfactory, the organization may still not earn a
goodreturn if the investment is too large.Some CEOs focus on profit either as a monetary amount
or as a percentage of revenue. This focus does notrecognize the simple fact that if additional
profits are obtained by a greater than proportional increase ininvestment, each dollar of
investment has earned less.
Maximizing Shareholder Value
In the 1980s and 1990s the term shareholder value appeared frequently in the business literature.
This concept isthat the appropriate goal of a for-profit corporation is to maximize shareholder
value. Although the meaning of this term was not always clear, it probably refers to the market
price of the corporation's stock. We believe,however, that achieving satisfactory profit is a better
way of stating a corporation's goal, for two reasons.First, "maximizing" implies that there is
a way of finding the maximum amount that a company can earn. Thisis not the case. In deciding
between two courses of action, management usually selects the one it believes will increase
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profitability the most. But management rarely, if ever, identifies all the possible alternatives and
their respective effects on profitability. Furthermore, profit maximization requires that marginal
costs and a demandcurve be calculated, and managers usually do not know what these are. If
maximization were the goal, managerswould spend every working hour (and many sleepless
nights) thinking about endless alternatives for increasing profitability; life is generally
considered to be too short to warrant such an effort.Second, although optimizing shareholder
value may be a major goal, it is by no means the only goal for mostorganizations. Certainly a
business that does not earn a profit at least equal to its cost of capital is not doing its job; unless it
does so, it cannot discharge any other responsibilities. But economic performance is not the
soleresponsibility of a business, nor is shareholder value. Most managers want to behave
ethically, and most feel anobligation to other stakeholders in the organization in addition to
shareholders.Example: Henry Ford's operating philosophy was satisfactory profit, not maximum
profit. He wrote let mesay right here that I do not believe that we should make such an awful
profit on our cars. A reasonable profit is right, but not too much. So it has been my policy to
force the price of the car down as fast as production would permit, and give the benefits to the
users and laborers-with resulting surprisinglyenormous benefits to ourselves.By rejecting the
maximization concept, we do not mean to question the validity of certain obvious principles.A
course of action that decreases expenses without affecting another element, such as market share,
is sound. Sois a course of action that increases expenses with a greater than proportional increase
in revenues, such asexpanding the advertising budget. So, too, are actions that increase profit
with a less than proportional increasein shareholder investment (or, of course, with no such
increase at all), such as purchasing a cost-saving machine.
These principles assume, in all cases, that the course of action is ethical and consistent with the
corporation'sother goals.An organization's pursuit of profitability is affected by management's
willingness to take risks. The degree of risk-taking varies with the personalities of individual
managers. Nevertheless there is always an upper limit;some organizations explicitly state that
management's primary responsibility is to preserve the company's assets,with profitability
considered a secondary goal. The Asian .financial crisis during 1996-1998 is traceable,
in large part, to the fact that banks in Asia's emerging markets made what appeared to be highly
profitable loans without paying adequate attention to the level of risk involved
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to
be
considered
is
the
stockholders
who
ownstock because they think it will be more profitable than investing more in any other way. The
absenteestockholder is not' of any value to the customer or to the worker, since he has no
knowledge of nor interest in thecompany other than greater dividends and advance in the price of
his stock." Donald F. Hastings, chairman andchief executive officer, emphasized that this was
still the company's philosophy in 1996.
Explain and illustrate with one example differences between 3 forms of internal audit
Financial, Operational & Management. Financial Audit
Financial Audit is a historically oriented, independent evaluation performed by internal auditor
or externalauditor for the purpose of attesting to the fairness, accuracy and reliability of the
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financial data, providing protection for the entity's assets; evaluating the adequacy
and accomplishment of the system (internal control)designed, provide for the aforementioned
Fairness and Protection, Financial data, while not being the onlysource of evidence, are the
primary evidential source. The evaluation is performed on a planned basis rather than a request".
Institute of Internal Auditor:Financial audit takes care of the protective aspect of the business and it does not normally carry
outconstructive appraisal function of the business operations. It helps in detection and prevention
of fraud. It alsoverifies whether documentation and flow of activities arc in conformity with the
internal control system introduced and developed within the organization. It helps coordinating
with statutory auditor to help them in proper discharge of their function. Besides, financial audit
also ensures compliance with statutory laws especially in financial and accounting matters.
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and, if practicable, included after the company has beenforded on opportunity to comment on
them.
Management Audit
It is a complex task closely related with the process of management. It is highly result oriented. It
requiresinter/multi-disciplinary approach as it involves examination, review and appraisal of
various policies and actionsof management on the basis of certain norms/standards.It undertakes
comprehensive and critical review of all organizational activities with wider perspective.It goes
beyond conventional audit and audits the efficacy of the management itself.Definition:It's a
comprehensive and constructive examination of an organization, the structure of a company,
institutionor branch of government or of any components thereof, such as division or department
and its plans, objectives,its means of operations and its use of human and physical facilities.
objectives
To ascertain the provision of proper control at different levels, their effectiveness I in
accomplishing management goals.
Ascertain objectives of the organization are properly communicated and understood at all levels.
To reveal defects or irregularities in any of the elements examined and to indicate what
improvements are possible to obtain the best results of the operations of the company.
To assist the management to achieve the most efficient administration of its operations.
To suggest to the management the ways and means to achieve the objectives if the management
of the organization itself lacks the knowledge of efficient management.
It aims to achieve the efficiency of management and assess the strength and weaknesses of
the organization structure, its management team and its corporate culture.
To ascertain the provision of proper control at different levels, their effectiveness in
accomplishing management goals.
Ascertain objectives of the organization are properly communicated and understood at all levels.
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To reveal defects or irregularities in any of the elements examined and to indicate what
improvements are possible to obtain the best results of the operations of the company.
To assist the management to achieve the most efficient administration of its operations.
To suggest to the management the ways and means to achieve the objectives if the
management of the organization itself lacks the knowledge of efficient management.
It aims to achieve the efficiency of management and assess the strength and weaknesses of
the organizationstructure, its management team and its corporate culture.
To help the management at all levels in the effective and efficient discharge of their duties
andresponsibilities.The auditor must apprise managerial performance at all levels of the
organization. The audit starts right atthe top level of the management. It studies the managerial
performance at all the levels of management. Theaudit has to study the decision-making system
of the organization and also the level of autonomy granted to themanagers at different levels of
the organization. The authority and responsibility given at the different levels of the
management. One of the most important things that the audit must study is that the mangers at
various levelsuse the authority.
Conducting Management Audit
Management audit requires an interdisciplinary approach since it involves a review of all aspects
of management functions. It has to be conducted by a team of experts because this requires
3 varieties of skills,which one individual may not possess.The team may consist of management
experts, accountants, and the operation research specialists, theindustry experts and even social
scientists.The auditors must have analytical mind and ability to look at a management function
form the point of viewof the organization as a whole. They therefore have to be properly trained
in this aspect. They need to havethrough knowledge of the management science and they should
be acquainted with the salient features of variousfunctional areas.Under financial audit, the entire
emphasis is on macro-aspect, the individual transactions being- scrutinizedfor check of the
aggregates. It is concerned with examination of transactions recorded in the books of account.
Itreviews the procedure and internal checks, and scrutinizes individual transactions for the
purpose of verification,of Profit and Loss Account and Balance Sheet. Financial audit is not
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