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  Date:8th September 2009

 Compiled by: M Sathya Kumar  

Internal Audit of an SME (Engineering Unit ) — Assurance and Consulting Role 

Background :

The Managing Director of an engineering unit based in Greater Noida (UP) has been in touch with a partner of a Chartered Accountant firm since they first met a few months back at a conference organised by a Chamber of Commerce in Mumbai. As the Managing Director (MD) was progressive in his views, the CA suggested the institution of ‘internal audit’ at the manufacturing unit. The Managing Director felt that since the turnover is only Rs.80 crores and he, along with his family members (brothers and uncles), controls most of the operations like procurement, finance, manufacturing, etc., the internal audit would not yield any significant benefit.

The CA suggested a plan of internal audit to be a half-yearly feature with a fortnight being spent by a Chartered Accountant and a semi-qualified staff member, and he himself would be available for four days each quarter. The internal audit would cover ‘process review’ and suggest improvements.

In addition, it was proposed that each area like rocurement, production, marketing, etc. (areas to be decided after discussing and studying the functions at the unit during the first review) be rated on a scale of 1 to 10 and scores given on basis of audit findings. This would signify areas of risk and poor management. As these scales are subjective, it would be arrived at after discussing with the auditee in each area. Cumulatively score would be given for the unit every half year. Hence, the internal audit every half year would be akin to the annual health check-up of a person. This idea and approach appealed to the Managing Director and he accepted the proposal to carry out the first internal audit on trial basis.

Based on the above background, the partner-incharge of the firm had a meeting with his audit manager to chalk out a plan to achieve the above objectives and ensure that the internal audit service is really beneficial to the SME. The success of the first half-yearly internal audit would demonstrate the value-added role of internal audit to the MD of the engineering unit.

In the first half year it was decided that the team would focus on all major areas like Procurement, Stores including Inventory, Production, Despatches, Production, Marketing, Human Resources, and Finance & Accounts.

Throughout the internal audit, it was agreed amongst the internal audit team members, that education and awareness for institutionalised systems and procedures including importance of decisions to be taken on scientific basis rather than ‘rule of thumb’ would be emphasised. This is particularly relevant in SME where the decisions are mainly taken on ‘rule-of-thumb’ basis.

Based on the internal audit carried out, given below are a few of the observations :

1.0 Procurement and Stores :

• Raw materials which formed 45% of the cost of sales were purchased personally by the MD. It was observed that he had strict control over cost. However, since the unit was cash surplus and the interest rate on cash credit was only 9%, it was pointed out that the unit should make payment to raw material creditors immediately on receipt and avail of cash discount of 2% per month — that is — 4% for two months, the period of credit availed of by the unit. This amounted to savings of 1% to 1.5% over the cost of purchases, which was a substantial saving in cost.

• There was lax control over consumables, as the family members neglected this area assuming it to be of little value compared to other activities. This had led to weak control over this area. It was noticed that bills for small consumables were booked twice and paid out twice. Items which were to be got as free supply along with bigger equipment/s were paid out, as it was not marked out properly in stores.

• In case of ‘Open Orders’, the rate was confirmed at some point of time; however, there was no periodical review of the rates stated in the Orders. Total purchases under such orders amounted to Rs.8 lacs for the six months ended September 30th, 2007.

The rates currently stated in the Open Orders appeared to have been negotiated some time back and there were no comparative quotations to validate the rates mentioned in these Orders.

All such Open Orders needed to be preceded by rate confirmation after considering quotations from a specific minimum number of suppliers. The suggestion to implement a plan for purchase and recording was made.

• High-value consumable like diesel was being purchased from a dealer rather than directly from oil company. Purchase of diesel directly from the oil company was suggested and implemented, resulting in some savings in cost. This also reduced the chances of buying adulterated diesel.

2.0 Marketing :

Marketing was being handled by two uncles and two brothers of the MD. They had divided the clients and interacted with the allocated clients without any co-ordination amongst themselves. This led to some confusion over supplies to customers, as there was no single person responsible for marketing.

• Almost all orders procured were supplied late and this led to levy of liquidated damages costing lacs of rupees every year. There was total absence of planning for avoiding late deliveries. More than the levy of liquidated damages, this was affecting the reputation of the unit.

• Further, since the economy was passing through a upswing, there was no dearth of orders, but due to absence of proper analysis, the unit did not concentrate on high-contribution orders. They felt that they were doing a great job, but a three-month analysis proved otherwise. The unit’s market share of high-contribution items was low when compared to other competitors. The high contribution orders went to their competitors. The internal auditor recommended corrective action, which when implemented, resulted in better co-ordination and the compensation for late deliveries was substantially reduced. This step improved both profitability and client relationship.

3.0 Finance & Accounts :

• There were idle funds in bank accounts and at the same time there was cash credit limit being utilised at 9%. Idle funds needed to be transferred to cash credit account. Further as a resultof review of bank accounts undertaken, dormant bank accounts were identified and closed.

• Credit rating by Crisil was undertaken and a triple-A rating ensured that the bank interest on cash credit was reduced by half a percent by the bank. The credit rating was also used to assure the vendors and customers about the excellent financial position of the unit.

There were numerous observations in various areas and each area was rated from 1 to 10 rating scale. Overall, the unit got 5 and it was agreed that all observations would be acted upon for improvement. It was also agreed that with improvements and another cycle of internal audit after six months, the unit would try to get better rating.

Also, the observations were divided into measurable cost savings and process improvements, and responsibility being given to heads of departments for the same. The observations would also be reviewed internally in the unit’s monthly management meeting of the heads of departments).

Conclusion :

The Managing Director appreciated the efforts of the internal audit team and desired that the internal audit be carried out on a quarterly basis. He specially appreciated the ‘understanding of the business’ by the partner of the C.A. firm and his suggestions for ‘process improvements’ and ‘cost savings’. The Managing Director also arranged for the partner to speak at the local industry forum for SMEs, where his company’s case study was presented to other SMEs. This led the internal auditing function to be elevated to providing ‘business solutions’.

Article by Deepjee Singhal Manish Pipalia renowed Chartered Accountants who are experts in Internal audits

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