Worked Solution
✓ Verified(a) General Considerations in Framing a System of Internal Check
Internal check is defined as the arrangement of duties of members of staff so that the work performed by one person is automatically and independently checked by another in the ordinary course of business. The primary objective is to detect and prevent errors and frauds. The following are the general considerations that must be kept in mind while framing an effective system of internal check:
1. No Single Person Should Control an Entire Transaction: The work relating to any transaction must be so divided that no single employee has exclusive control from beginning to end. Each transaction must pass through at least two or more hands, so that the work of one acts as a check on the other.
2. Proper Allocation and Definition of Duties: The duties of every employee must be clearly defined and allocated in writing. There should be no ambiguity or overlapping. Each employee should know exactly what he is responsible for and what falls outside his purview.
3. Rotation of Duties: Employees performing sensitive jobs should be periodically rotated so that no one person remains permanently in the same position. This prevents collusion and ensures that irregularities, if any, do not remain concealed for long.
4. Compulsory Leave: Every employee, particularly those handling cash or securities, should be required to take compulsory leave at regular intervals. During his absence, another employee takes over, which often brings irregularities to light.
5. Separation of Custody and Accounting Functions: The person who physically handles assets (cash, inventory, securities) must not be the same person who maintains the accounting records for those assets. This separation is a cornerstone of internal check.
6. Cross-Checking and Independent Verification: All postings and summaries must be independently cross-checked. For instance, the total of the purchase day book should be independently verified against creditors' ledger balances.
7. Use of Mechanical and Electronic Devices: Use of cash registers, accounting software, electronic access controls, and other devices reduces the possibility of manipulation and provides an automatic trail of transactions.
8. Proper Authorisation System: Every transaction must be authorized by an appropriate level of management before it is processed. No payment should be made, no purchase should be sanctioned, and no adjustment should be passed without proper written authority.
9. Physical Safeguards: Assets like cash, securities, and inventory must be physically safeguarded through locks, vaults, access restrictions, and periodic physical verification. This prevents misappropriation.
10. Periodic Reconciliation and Surprise Checks: Reconciliation of subsidiary records with control accounts (e.g., debtors control account with individual ledger balances), and surprise verification of cash and stock, act as a powerful deterrent against fraud.
11. The System Must Be Cost-Effective: The cost of maintaining internal check must not exceed the benefits derived. The system should be practical, workable, and proportionate to the size and nature of the business.
12. Review and Updation: The system of internal check must be periodically reviewed and updated to address new risks, changes in business operations, and technology advancements. A static system becomes ineffective over time.
A well-designed internal check system, while not a substitute for internal audit, significantly reduces the risk of undetected errors and frauds and strengthens the overall internal control environment of the organisation.
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(b) Audit Procedure for Verification of Payment of Dividends
Dividend is a distribution of profits by a company to its shareholders. The auditor must verify that dividends have been declared and paid in accordance with the provisions of the Companies Act 2013 and the company's Articles of Association. The following audit procedures should be adopted:
1. Verify Board and Shareholder Resolutions: For interim dividend, check the Board of Directors' resolution authorizing its declaration. For final dividend, verify the resolution passed at the Annual General Meeting (AGM) by the shareholders. The amount of dividend declared must not exceed the amount recommended by the Board (Section 123 of the Companies Act 2013).
2. Verify Compliance with Section 123 – Declaration out of Profits: Ensure that dividend has been declared only out of current year's profits or past accumulated profits (free reserves). Dividend cannot be declared out of capital. Verify that any transfer to reserves required by Rules has been complied with before declaration.
3. Verify the Register of Members / Dividend List: Reconcile the list of shareholders entitled to dividend with the Register of Members as on the record date or book closure date. The total number of shares and class of shares (equity/preference) should be verified.
4. Verify the Rate and Amount of Dividend: Calculate the total dividend payable independently by multiplying the paid-up share capital by the rate of dividend declared, and reconcile this with the total amount credited to the Dividend Pay-out Account.
5. Verify Dividend Warrants / Payment Records: Examine dividend warrants or payment advices issued to shareholders. In case of electronic payment (NEFT/RTGS), verify bank advice and payment records. Confirm that payments were made only to registered shareholders or their mandatees.
6. Verify Unpaid Dividend — Section 124: Any dividend remaining unpaid or unclaimed within 30 days of its declaration must be transferred to a separate Unpaid Dividend Account with a scheduled bank. Verify that this transfer has been made and the account is properly maintained.
7. Verify Transfer to IEPF — Section 125: Amounts remaining unclaimed in the Unpaid Dividend Account for 7 years must be transferred to the Investor Education and Protection Fund (IEPF). The auditor should verify compliance with this provision.
8. Verify TDS Deduction — Section 194 of the Income Tax Act 1961: Since Finance Act 2020, dividends are taxable in the hands of shareholders and companies are required to deduct TDS under Section 194 at the applicable rate before payment. Verify TDS deductions, Form 26Q filings, and TDS payment challans.
9. Verify Preference Dividend: If the company has issued preference shares, check that preference dividend (cumulative or non-cumulative) has been dealt with correctly. Verify arrears of cumulative preference dividend, if any, have been disclosed.
10. Verify Disclosure in Financial Statements: Confirm that the dividend declared after the balance sheet date but before the approval of financial statements is not recognised as a liability (as per AS 4 – Contingencies and Events Occurring After the Balance Sheet Date), but is disclosed as a note. Dividend declared before the balance sheet date must be shown as a liability.
Conclusion: The auditor should obtain a management representation letter confirming that all dividends have been paid in compliance with the Companies Act 2013 and other applicable laws, and that there are no outstanding disputes related to dividend payments.
Write it like this
1The skeleton
- Split your answer into two clearly headed parts (a) and (b) right away — examiners allocate 8 marks per part and literally scan for the heading before reading a single line; missing the split loses structure marks before you even begin.
- For part (a), number every consideration and lead with a bold heading (e.g. '1. No Single Person Should Control an Entire Transaction') — the model answer has 12 numbered points; you need at least 8 with headings because examiners award ½–1 mark per point and bold headings make counting effortless for them.
- For part (b), anchor every procedure to a section number — write 'Section 123', 'Section 124', 'Section 125', 'Section 194 of the Income Tax Act' in the same sentence as the procedure, because that's what converts a generic statement into an examiner-worthy one.
- State the dividend type (interim vs. final) explicitly in your first procedure point — distinguishing Board resolution for interim vs. AGM resolution for final is a high-signal move that signals you know the law, not just the audit steps.
- Close part (b) with the AS 4 disclosure point — noting that post-balance-sheet dividends are not recognised as a liability but disclosed as a note is the sleeper mark most students drop; one sentence here can be the difference between 7 and 8.
- Write a one-line conclusion for each part — keeps the answer tidy and signals to the examiner that your answer is complete, not cut short.
2Examiner-rewarded phrases
3Common trap
Heads up — most students write audit procedures for dividends as a plain checklist without any section numbers, then wonder why they scored 5/8. If you write 'verify that dividend is declared out of profits' without citing Section 123, the examiner gives you half the mark at best. Pin a section to every single point.