Updated July 20, 2023
Introduction to Internal Controls
Internal controls are defined as steps, procedures, and rules set by the business to ensure that the financial and accounting information is of the highest integrity, to help promote accountability, and help the company detect grey areas where fraud can happen, eventually preventing it from happening.
Internal controls are the various procedures and steps implemented by different business firms to ensure the highest integrity of their financial and accounting information and to promote accountability. Internal controls also come in handy to detect the concern areas of fraud and stop them from happening. Apart from the above-discussed functions, internal controls also come to use in operational efficiency, which enhances the accuracy and timeliness of financial reporting.
Accounting controls were established based on the Sarbanes-Oxley Act of 2002 after a lot of fraud was reported in early 2000 at many US companies. The act was mainly introduced to protect investors from fraudulent accounting activities and enhance company disclosures’ reliability.
Objectives of Internal Controls
The objectives of internal controls are as follows:
- To ensure that all the transactions data-contrast=” auto”> about the business is conducted according to the guidelines of the authorized management.
- To make sure every transaction gets systematically recorded on a sequential basis.
- Grant enough security to the company’s assets to prevent them from being used unauthorizedly.
- To compare assets recorded in the books with the existing ones and to this in a fixed interval to find any discrepancy.
- To systematically evaluate the complete accounting process used in the authorization of transactions?
- Conduct proper checks and controls to review if the entire organization is in good shape and to find any loopholes.
- To make sure optimum utilization of resources is taking place within the firm.
- Ensure the financial statements are prepared following the accounting concepts and principles guidelines.
Principles of Internal Controls
- The first and foremost principle of accounting control is establishing responsibilities.
- Maintaining records in sequential order is very important.
- The segregation of duties is also an essential principle of accounting control.
- Rotation of employees on a mandatory basis is needed.
- The usage of technology control is a must.
- Regular independent audits or reviews must be conducted.
- Insuring assets must be done by bonding with key employees.
How Does it Work?
Internal controls are guided by the Sarbanes-Oxley Act of 2002 when there were a lot number of fraud cases reported in early 2000 at many US companies. Corporate governance came under a lot of pressure, where managers were responsible for the financial reporting, and an audit trail was created. Managers who were found guilty of any discrepancy were penalized and faced criminal penalties.
Internal and external audits also came into existence. Generally, external auditors are independent auditors hired to test the books of accounts and thus need to give their opinion on the same. On the other hand, an internal audit evaluates the business’s internal controls and plays a crucial role in the company’s operations and corporate governance.
Components of Internal Control
- It is essential to the other four components and sets up the structure at the top of a business firm and decides on the discipline and design of the organization.
- Risk Assessment: Identification and analysis of risk which could stop a firm from achieving its goals.
- Control Activities: These are the steps and procedures to ensure the organization that all the directives given by the management are being followed.
- Information and Communication: This is related to the timely transfer of information that helps other employees perform their responsibilities.
- Monitoring: This is conducted by top management, enabling them to see that all controls are well in place and performed without any gap.
Examples 0f Internal Control
- Bank Reconciliations: One very basic example of internal control can be bank reconciliations, where the records of all payments and receipts which are recorded in a business ledger are reconciled to the bank statement to see if there is any discrepancy.
- Audit: Audit is one of the most prominent examples of internal control. An external party is hired to give their opinion on the accuracy and integrity of the company’s books of account.
- Procurement Policies: One area where internal control can be applied is the company’s procurement policies. The firms can establish a set mechanism and vendor list to procure the required items and demonstrate a thorough check on them.
Responsibilities of Internal Controls
The responsibilities of internal controls are as follows:
- The CEO is the prime connect for applying internal control and makes sure he passes practical directives to his managers to conduct the business.
- Internal controls ensure there is no scope for fraud in the system and prevent it from happening.
- Internal control ensures that the financial and accounting information has the highest integrity and reliability.
- Internal controls assure that all the necessary accounting principles have been followed.
- It also protects the interest of the stakeholders who have invested in the company.
Scope of Internal Controls
- The scope of internal control is for the firm’s overall governance and may reach broader areas like risk management and technology control.
- It ensures that accounting transactions are reliable and recorded by following the accounting principles.
- It is related to the distribution of authority and has a scope in the organization’s decision-making process.
Limitations
- The Control system may turn out to become redundant with time.
- It may not prevent the collusion of two or more people.
- It still cannot fully safeguard a firm from human error.
- Most of the controls will tend to go towards transactions of the usual nature.
- It also bears a cost to implement the same in the business.
Conclusion
Internal control forms the crux of any business if appropriately applied. Indeed the benefits of it are a lot more than the limitations it faces. Internal controls instill the concept of assurance and reliability in the firm, and stakeholders also find such firms reliable enough to park their savings.
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