This bulletin replaces Procurement and Disbursement Guidelines bulletin G-9. The purpose of this bulletin is to help you understand the functions of internal controls in purchasing; what internal control is; how it relates to purchasing; and how checks and balances within an agency ensure the proper expenditure of public monies.

Management is responsible for assuring that proper internal controls are in place and operating as intended. We trust this information will alert you to possible weaknesses in your organization and demonstrate actions that can be taken to monitor compliance of your system of internal controls.

Internal controls are the methods, procedures, and policies used by organizations:

a. To promote operational efficiency and encourage adherence to management policy.

b. To safeguard assets against loss from unauthorized use or disposition.

c. To provide reasonable assurance of the accuracy, and the reliability of the financial records used to maintain control and accountability of these assets, and to aid in the preparation of financial statements.

d. To detect and deter fraud.

e. To provide assurance to management of the dependability of data used for making decisions.

Simply stated, internal control is a system of checks and balances.

The main characteristics of internal control include:

a. Separation of staff duties.

b. Written procedures of job descriptions, duties, and responsibilities.

c. Established levels of authorization.

d. Accurate record keeping.

e. Procedures for periodic management review and testing to ensure compliance

 

The purpose of an internal control system is to provide reasonable assurance that the objective of the system will be accomplished. The concept of reasonable assurance recognizes that the cost of internal control should not exceed the benefit derived. The benefit is measured by the degree to which the risk of failing to achieve a state objective is reduced. In the event weaknesses in the system are detected but the concept of reasonable assurance indicates that no action should be taken, management should be made aware of the situation and should approve the basis for not taking action. For example, actions should not be taken in those situations where improving the controls would not increase the probability of detecting errors, or would not disclose waste or abuse, or prevent an improper activity, or otherwise enhance compliance.

There are factors which tend to break down the effectiveness of any system of internal control. For example, in carrying out most control procedures, errors can be caused by misunderstanding of instruction, mistakes of judgment, carelessness, or other personal factors. Control procedures which depend upon segregation of duties can be circumvented by collusion. Similarly, management can intentionally circumvent internal control with respect to the estimates and judgments required in the preparation of financial statements. Also, the failure on the part of management to continue to evaluate and adjust internal controls as a result of a change in operations can result in existing controls being outdated and inoperable.

No one individual should have complete control over the entire purchasing function (purchasing, receiving, payment and inventory). The following are overall guidelines for internal control for these four functions.

a. Purchasing

1. Written operational procedures should indicate individuals authorized to initiate a purchase request, the flow of documents, and the required levels of approval.

2. The authorized individuals should be satisfied that the order represents the type and quantity of goods needed by the agency to carry out its mission.

--- If not, someone may be purchasing unauthorized goods, may be ordering goods not required by the operation, or may be ordering more than they need.

3. All purchases should be made in accordance with applicable laws, rules, and regulations.

--- If not, you may pay higher prices.

4. Purchases should be made from reliable vendors.

--- If not, you may be purchasing goods and paying a higher price for inferior goods or purchasing from a vendor where there may be a conflict of interest.

5. Procedures should require that purchase orders contain the complete terms of the transaction; the delivery point, and to whom vouchers on vendor's invoice should be sent to for payment. One copy of the purchase order should be forwarded to your finance office accounts payable operation and another copy to receiving.

--- If not, you may pay for goods you did not order at prices higher than you had agreed upon.

6. Procedures should provide for the separation of duties among personnel involved in preparing purchasing specifications, receiving responses to proposals, and evaluating proposals.

--- If not, specifications may be drawn too narrowly, precluding competition or proposals may not be evaluated equitably.

7. Procedures should provide for appropriate management review and approval for items to be purchased from a single source. The review process should investigate and document the need for the item and the extent of investigation of other possible suppliers or similar products.

--- If not, restrictive specifications may be drawn to favor a particular vendor.

8. Deviation and exceptions to established controls should be documented. The rationale for a deviation or exception should be justified, reviewed, and approved at an appropriate level of management.

--- Management must recognize that there are circumstances that may warrant a deviation or an exception. If you do not recognize it or document it, you may be opening the door for the exception to become the rule and a situation for collusive arrangements with vendors.

b. Control Over Goods Received

1. If possible, you should have a central receiving location that is separate from your purchasing, storing, and paying operations.

2. If possible, the goods should not be delivered to the person making the initial request or the person who issues the purchase order.

3. The goods should be counted and inspected for damage, and any damaged items should be noted on the vendor's bill of lading or shipping document.

4. A receiving report should be made out promptly and forwarded to accounts payable. The report should show the amount of items received.

--- If you do not institute the above controls, you could very well end up paying for goods you never received, never ordered, or goods of questionable quality. With the same person controlling the full operation, you may be setting the stage for collusive arrangements.

c. Control Over Payment

1. Accounts payable should compare the vendor's invoice to their copy of the purchase order and receiving report to verify the quantity received and the prices agreed upon to be paid; check the mathematical accuracy of the invoices; and make any adjustments resulting from damaged, rejected, or returned goods.

2. Accounts payable should prepare a voucher in accordance with applicable rules, charge the expenditure to the appropriate account, object code, etc., record the transaction in a voucher register and obtain the signatures of approval from the appropriate levels.

3. Accounts payable should submit the voucher and supporting invoices and documents to the Office of the State Comptroller for review and payment. They must check the daily warrant and payee listing issued by the Office of the State Comptroller against their voucher register to ensure that the correct vendor was paid, the correct amount was paid, and that the correct liquidation was made. Any discrepancies should be reported immediately to the Office of the State Comptroller so corrections may be made and the payment of interest minimized.

--- If the above procedures are not followed, you could end up paying an incorrect amount because goods were not reported accurately. Also, payments to vendors may be rejected or delayed if you fail to submit proper documentation, signatures, coding, etc., with the payment.

d. Controls Over Inventory

1. A perpetual inventory record should be maintained using receiving reports and requisitions.

2. Management should have a periodic physical verification of items on hand and a comparison made to the perpetual inventory records.

3. Any discrepancies noted in the physical verification should be investigated and documented in writing as to any resolution of the differences.

--- If the above procedures are not followed, items could be stolen or pilfered without management's knowledge.

 

It is not enough that control procedures have been installed. Management must make a systematic review to determine that the controls are being correctly interpreted and applied. The review of internal controls involve: determining the procedures which are in effect; determining how the procedures are actually carried out; and appraising the adequacy of the procedures in relation to the standard guidelines established above.

a. Review of Procedures
Management should inquire and observe the basis used in determining agency needs and, where practicable, test the actual practices that are used.

1. A review of purchase orders should show who does the purchase of the various items; whether the purchases were properly originated; whether the purchase order was properly completed and authorized; and that the merchandise was received in a useable state.

2. A review of purchasing for specific transactions should show whether bidding was required; whether the appropriate number of quotes or bids were solicited; whether the bid tabulations are in agreement with the bids submitted; the extent to which there is a follow-up of non-responsive vendors; that there is adequate justification for award to other than the low bidder; and that there is adequate justification and approval for single source or non-competitive awards.

3. A review of the bidders' file and price lists should show whether the bidders' list (if used) is an adequate and current source of prospective vendors, whether the price lists are in conformance with the vendor's bid; and that the prices appear to be reasonable on their face.

4. A review of the actual receiving records should show whether merchandise was recorded as received in a log; and that the information recorded in the voucher received block is accurate.

5. A review of the vouchers and supporting documentation should indicate whether the voucher is filled out properly, expenditures charged to the appropriate account, adequately supported by such documents as the original invoice, purchase order, receiving reports, etc., and is mathematically accurate; whether the transactions were approved by the appropriate levels; whether the current procedures are designed to ensure expeditious handling of vouchers for prompt payment; and whether the voucher register is maintained properly and a review made of daily warrants to ensure correct and prompt payment by the Office of the State Comptroller.

b. Standards of Appraisal

In appraising the adequacy of the internal procedures, the standard guidelines established should represent preferred practices under normal conditions and should be basic yardsticks for the reviewer. This does not mean that the transactions involved cannot be handled in another way. It means that to the extent the actual practice does not conform to the standard, there must be proper justification or other types of protection or offsetting advantages.

Where the current practice does not conform to the standards, the seriousness of the situation must be determined; why the deviation exists; are there reasons to justify it; and what action should be taken to correct it?

Audits by themselves may not disclose evidence of improprieties, but they do point out the transactions which could be indications of poor business practices and flags that irregularities have taken place. The full impact of these flags are generally disclosed in complaints, undercover operations, investigations, and hearings.

In those cases, a review of the auditor's findings in relation to the disclosure made can show a pattern which should raise questions about the agency's procurement practices. For example:

a. There were purchases of equipment which were first leased for a few months and then bought without competition.

b. An agency was buying goods without competition and paying prices substantially in excess of the manufacturer's list price or suggested retail price.

c. There were instances where items obtained without competition cost substantially higher than the amount paid for these items when bought through competition.

d. There was evidence of buying material at different time intervals from several suppliers with different names, but all had the same mailing address, telephone number, and office employees.

e. Buying from suppliers who were not the low bidder, but agreed to meet the low bidder's price.

f. The purchase of the materials and the report of delivery were signed by someone other than the one who should or usually signs for the material.

g. Material was purchased in quantities much greater than the amount purchased by a similar size user.

 

The cases outlined below briefly demonstrate instances where there was a breakdown within a system of internal controls:

a. A federal investigation of purchasing practices of a western state disclosed that a number of county commissioners whose duties were to construct and maintain county roads used their offices to extort bribes and kickbacks from suppliers. The kickbacks ranged from 10 to 50 percent of the order when the materials were delivered. These 50 percent deals were referred to as "split ordering". In those instances, the paperwork was falsified to show materials received, when in fact, nothing was delivered.

b. Housing authority superintendents were charged with regularly demanding kickbacks and bribes of at least 10 to 15 percent of the invoice value of goods before placing orders with vendors. They were approving invoices to the authority by vendors for supplies that were never delivered for which they received a 50 percent kickback. They also used as many as eight different company names to circumvent the authority's bidding requirements of $500 for emergency purchases or contracts with individual vendors in order to obtain bribes.

c. Regular and emergency purchases totaling over $60,000 were being made from a spouse of an employee who was in the accounts payable section of an agency. A review of a number of transactions showed limited or no bidding and the prices charged were excessive. Management was not aware of the situation until we questioned a number of purchase orders where the prices were higher than the prices the items could be purchased at retail.

d. A department did not require file receipts for merchandise received. As a result, the department paid a $20,000 bill twice and also paid $2,500 for material it did not receive.

e. There was no procedure for coordinating computer acquisitions between the central office and various vendors. Both were developing systems often resulting in a duplication of effort. Although the central office maintained information systems to support the vendor's need for client data, six centers spent over $630,000 to independently automate client data for program evaluation at the same time there were processing similar data on the central office system.

f. A department did not have standards for either linen usage or clothing replacement nor was there adequate inventory records at the institution to properly account for these items. Auditors could not identify the extent of waste or determine whether the items were used properly.

g. A department circumvented their bidding requirements by splitting large purchases into several transactions. They bought 60 solar shades at various times at a cost of $130 per shade. When they competitively bid 40 shades at one time, the cost was only $99 from the same vendor.