Internal controls: Good or bad for Employees of Accounting Firms?

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Business leaders understand it is essential to have accurate financial data to drive operations and measure success. However, without the proper controls in place errors, fraud, and other issues can occur, hindering operational efficiency and growth.

While some small business owners assume internal control systems are only designed for larger organizations, these functions are crucial for companies of all sizes in all industries.

Internal control accounting systems are the policies and procedures used to ensure accuracy and reliability across accounting reports to:

Prevent fraud
Control risk
Proactively identify financial issues
Protect resources (both tangible and intangible) from theft and waste
Operate efficiently
Generate timely, reliable reporting
Measure progress towards business objectives and goals
Comply with applicable laws and regulations
Secure outside funding
Reassure investors

Controls can either be preventative, deterring fraud and mistakes, or detective, identifying issues after they have happened. Working in unison they can remedy existing problems and help to avoid future ones to strengthen ongoing business activities.

What are Internal Controls?
What Are the Seven Internal Control Procedures in Accounting?
What are the Common types of Internal Controls?
What are Some Examples of Internal Control?
How do you Create Internal Controls?
Why is Internal Controls Important
What are the Pros and Cons of Internal Control?
What is Internal Control Review?
Internal Control System in Accounting
Importance of Internal Control in Auditing
Internal Controls in Business
Concept of Internal Control
What is Internal Control And How Can it Protect a Company’s Assets?
Why Are Internal Controls Important in Accounting?
What Are The Advantages and Benefits of Using Internal Controls in a Company?
What Are The 5 Internal Controls?
What Are The 6 Principles of Internal Control?
Who is Responsible For Internal Controls?
What is Internal Control in an Organization?
What Are The Four Basic Purposes of Internal Controls?

What are Internal Controls?

Internal controls are the mechanisms, rules, and procedures implemented by a company to ensure the integrity of financial and accounting information, promote accountability, and prevent fraud.

Besides complying with laws and regulations and preventing employees from stealing assets or committing fraud, internal controls can help improve operational efficiency by improving the accuracy and timeliness of financial reporting.

Internal controls have become a key business function for every U.S. company since the accounting scandals in the early 2000s. In their wake, the Sarbanes-Oxley Act of 2002 was enacted to protect investors from fraudulent accounting activities and improve the accuracy and reliability of corporate disclosures.

This has had a profound effect on corporate governance, by making managers responsible for financial reporting and creating an audit trail. Managers found guilty of not properly establishing and managing internal controls face serious criminal penalties.

Importance to Auditors

The auditor’s opinion that accompanies financial statements is based on an audit of the procedures and records used to produce them. As part of an audit, external auditors will test a company’s accounting processes and internal controls and provide an opinion as to their effectiveness.

Internal audits evaluate a company’s internal controls, including its corporate governance and accounting processes.

They ensure compliance with laws and regulations and accurate and timely financial reporting and data collection, as well as helping to maintain operational efficiency by identifying problems and correcting lapses before they are discovered in an external audit.

Internal audits play a critical role in a company’s operations and corporate governance, now that the Sarbanes-Oxley Act of 2002 has made managers legally responsible for the accuracy of its financial statements.

Operational Efficiency

No two systems of internal controls are identical, but many core philosophies regarding financial integrity and accounting practices have become standard management practices. While internal controls can be expensive, properly implemented internal controls can help streamline operations and increase operational efficiency, in addition to preventing fraud.

What Are the Seven Internal Control Procedures in Accounting?

Internal controls are policies and procedures put in place to ensure the continued reliability of accounting systems. Accuracy and reliability are paramount in the accounting world. Without accurate accounting records, managers cannot make fully informed financial decisions, and financial reports can contain errors.

Internal control procedures in accounting can be broken into seven categories, each designed to prevent fraud and identify errors before they become problems.

The seven internal control procedures are separation of duties, access controls, physical audits, standardized documentation, trial balances, periodic reconciliations, and approval authority.

Separation of Duties

Separation of duties involves splitting responsibility for bookkeeping, deposits, reporting and auditing. The further duties are separated, the less chance any single employee has of committing fraudulent acts.

For small businesses with only a few accounting employees, sharing responsibilities between two or more people or requiring critical tasks to be reviewed by co-workers can serve the same purpose.

Accounting System Access Controls

Controlling access to different parts of an accounting system via passwords, lockouts and electronic access logs can keep unauthorized users out of the system while providing a way to audit the usage of the system to identify the source of errors or discrepancies. Robust access tracking can also serve to deter attempts at fraudulent access in the first place.

Physical Audits of Assets

Physical audits include hand-counting cash and any physical assets tracked in the accounting system, such as inventory, materials and tools. Physical counting can reveal well-hidden discrepancies in account balances by bypassing electronic records altogether.

Counting cash in sales outlets can be done daily or even several times per day. Larger projects, such as hand counting inventory, should be performed less frequently, perhaps on an annual or quarterly basis.

Standardized Financial Documentation

Standardizing documents used for financial transactions, such as invoices, internal materials requests, inventory receipts and travel expense reports, can help to maintain consistency in record keeping over time.

Using standard document formats can make it easier to review past records when searching for the source of a discrepancy in the system. A lack of standardization can cause items to be overlooked or misinterpreted in such a review.

Daily or Weekly Trial Balances

Using a double-entry accounting system adds reliability by ensuring that the books are always balanced. Even so, it is still possible for errors to bring a double-entry system out of balance at any given time. Calculating daily or weekly trial balances can provide regular insight into the state of the system, allowing you to discover and investigate discrepancies as early as possible.

Periodic Reconciliations in Accounting Systems

Occasional accounting reconciliations can ensure that balances in your accounting system match up with balances in accounts held by other entities, including banks, suppliers and credit customers.

For example, a bank reconciliation involves comparing cash balances and records of deposits and receipts between your accounting system and bank statements. Differences between these types of complementary accounts can reveal errors or discrepancies in your own accounts, or the errors may originate with the other entities.

Approval Authority Requirements

Requiring specific managers to authorize certain types of transactions can add a layer of responsibility to accounting records by proving that transactions have been seen, analyzed and approved by appropriate authorities. Requiring approval for large payments and expenses can prevent unscrupulous employees from making large fraudulent transactions with company funds, for example.

What are the Common types of Internal Controls?

The most common types of internal accounting controls include:

Separation of Duties

Assigning specific duties to each employee that divides accounting responsibilities is a basic control system to ensure that the people responsible for financial reporting are separate from the people tasked with making cash deposits and asset purchases.

Similarly, anyone conducting audits should be as far removed from financial duties as possible to ensure impartiality. The further apart these functions are in an organization, the lower the risk for fraud associated with each.

In small companies where there are not enough employees to separate duties completely, peer review can serve a similar “checks and balances” function to mitigate risk. While complacence and collusion can still result in erroneous reporting, requiring peer sign-off on reports and job functions can eliminate simple opportunistic theft.

Because fraud can occur at any level of an organization separation of duties is crucial at not just the top, among executive leadership, but at every step of the organizational hierarchy. In large organizations, rotating assignments among employees with the same job functions helps to isolate discrepancies and conduct thorough analyses of root causes.

Access Controls

Access controls keep people out to keep value in the organization.

Setting permission levels to safeguard data and physical assets is one of the most routine controls businesses use because they are so easy to implement. In password-protected areas, secure passwords and two-step authentication procedures make it difficult for employees to use others’ login credentials. Additionally, changing passwords frequently enables access controls to remain steadfast over time.

Access logs and usage history reports are automated features that can be used to regularly audit software systems to find discrepancies. They can also serve as evidence in identifying culprits when errors occur, or fraud is present.

Access controls can also be physical in nature allowing for more effective management of tangible assets, such as restricting badge access to employees who should not be allowed in certain areas. Other types of physical access controls include safes for cash or other valuables.

Required Approvals

Designating managers to be responsible for transaction authorizations is an internal control function that funnels purchase decisions through the most trusted employees. Authorizations may be required for large payments, unusual expenses, and unexpected cost increases.

In larger organizations required approvals may follow a hierarchy, necessitating multiple layers of the agreement before being finalized. The aim of this approach is to weed out unnecessary expenses at every level to minimize waste and reduce the incidence of fraud.

Asset Audits

Auditing is the most widely used internal accounting control.

Financial audits like cash reconciliations are performed regularly to verify that actual balances match accounting balances. Differences can be analyzed and investigated, where necessary, to result in accurate financial reports.

However, asset audits are not simply electronic in nature – they also include physical audits. Any time a cash drawer is tallied, or raw material counts are verified, an asset audit is being performed. These on-site audits should be performed regularly to ensure financial accuracy.

Counting cash should be done hourly or daily, while physical asset tracking is typically done quarterly or annually. Manually counting assets in this manner is crucial because fraud can occur off the books to bypass financial report audits.

In addition to these routine checks, detective asset audits should be performed as well. Utilizing surprise or random cash counts, for instance, helps to keep employees honest and focused on performing work fastidiously.

Templates

Standardizing financial documents creates consistency, which makes it easier during the auditing process. While some reports like a balance sheet or P&L statement have a standard format, other documents can vary substantially between business teams.

Creating and using the same templates for estimates, invoices, purchase orders, funding requests, receipts, and expense reports creates comparability across like items during an audit. Streamlining these items is an important internal accounting control that businesses tend to overlook in the rush to implement more obvious control systems.

Trial Balances

Double-entry accounting ensures that books are always balanced. However, errors and fraud can still exist in a double-entry accounting system, which is why trial balances should be used in conjunction with this method. Trial balances are a form of accounting control that infuses additional reliability into the system by keeping an internal record of credits and debits to allow businesses to identify issues early on.

Reconciliations

Bank, supplier statement, and credit card reconciliations can factor into other accounting control systems, however conducting these reconciliations is an internal control in and of itself as well. Understanding which items have cleared, are in-transit, or have not yet posted allows businesses to uncover errors and fraud. Furthermore, performing regular reconciliations informs strategic business decisions and day-to-day operations.

Data Backups

Data backups are the most forgotten internal accounting control system. Because accurate financial data requires technological interaction between platforms, loss of financial inputs can skew reporting and muddle audits. When technology fails, past reports and vital data can go missing, delaying reporting and impairing essential accounting functions.

Backing up computer files to the cloud safeguards data from loss when computers become corrupted or servers fail.

Implementing the proper accounting controls is meaningless unless employees are equipped to act when they notice a problem or detect suspicious activity. Formal policies must be created to educate employees on how to respond when issues arise.

All employees should know who they can tell when there is suspicion of error or malicious intent and what kind of response to expect. Furthermore, their anonymity needs to be protected after doing so.

What are Some Examples of Internal Control?

Internal controls are policies and procedures companies use to help prevent errors and fraud, which can include theft, embezzlement, favoritism or math errors in financial documents.

You don’t need to be a certified public accountant or have a finance degree to institute helpful internal controls in your business or set policies for your employees to follow.

Check Co-Signers and Authorized Signers

One of the most common internal controls for small businesses is the requirement that checks be co-signed. This helps prevent one person from writing a check to himself or approving an inappropriate payment.

If your business writes many checks each month, you might institute a policy that only requires two signatures on checks that are more than a certain dollar amount, such as $500. Make sure you have a signature card at your bank with the signatures of authorized signers. This allows the bank to check signatures before paying any check.

Bank Reconciliations

Many businesses record all of their payments and receipts in a general ledger, which is a record of the company’s financial transactions. The entries in a ledger are based on checks written, cash paid and cash, electronic deposits or credit card payments received.

To help spot math errors and fraudulent entries, perform a bank reconciliation each month, comparing your bank statement to your general ledger.

Your bank statement will include all of the deposits you made or received electronically and show all of the payments you made. It will also include any bank fees you paid, allowing you to include those in your general ledger.

Procurement Procedures

To make sure you get the most value when making purchases, create an internal control that sets policies for making purchases. This can include only using approved vendors, requiring competitive bids from contractors or conducting a price check of several vendors before choosing one.

This might include requiring your office manager to check online prices at several office stores before ordering office supplies, furniture or other equipment.

Reimbursement Policies

Create a formal employee expenditure policy to help reduce high travel, lodging, entertainment and meal costs. If you allow employees to book their own travel and lodging when attending conferences or trade shows, they might book flights and rooms that earn them the most reward points, rather than choosing the lowest-cost bookings.

Require that all travel expenses be approved by a supervisor in advance and that all expense reimbursement forms include receipts.

Audits

Having a third party review purchases, financial records, time sheets, expense reimbursements and other business activities can help spot and reduce errors and fraud. Internal audits allow one employee or department to review the work of another.

External audits bring in an outside contractor or firm to review the work of your staff. This might include hiring a certified public accountant to review your books each month or quarter. Performing an inventory review can help you spot whether or not you have a problem with theft, over-delivery or breakage.

How do you Create Internal Controls?

Designing an internal-control system for your business takes planning and an understanding of the detailed operations of the company. Internal controls serve several purposes, but the main ones are to ensure that the business operates as intended and to prevent opportunities for employees to misappropriate goods or money.

Internal controls allow a business owner the peace of knowing everything is working properly without having to personally oversee every facet of the operation.

Review each of the major processes in your business: production, inventory management, accounts receivable, accounts payable, bank reconciliation and any other process where it might be possible to perpetrate a fraud by theft or concealment.

Put names or job titles on each part of the process that an individual is responsible for. If you are not sure how a process works, spend time “in the field” and watch the process or ask questions of those responsible.

Assess each step of each process for weaknesses in control that would allow an opportunity to steal company assets. Focus on areas where a single individual has both custody of assets and the accounting for them.

For example, if one employee has control over the cash register and also is responsible for reconciling it at the end of the night, the employee has the opportunity to steal money and hide it by falsifying the reconciliation.

Another example is having a single employee responsible for opening the incoming mail and also being responsible for recording the accounts-receivable checks that arrive in the mail.

Change the procedures for those areas where you have assessed weak internal controls. Separate the custody function from the reporting function wherever possible. While you may not have enough employees to have different people do each job, alternate functions amongst the employees you do have to segregate incompatible functions wherever possible.

Document the new procedures thoroughly and familiarize employees with them. Solicit feedback from the employees as to how efficient the new procedures are.

It is important to make sure that the procedures make sense from a business and operational point of view and not just as a control. Adjust the procedures according to feedback but always keep in mind the purpose of the controls.

Implement a mandatory vacation policy, if you have not done so already. The majority of chronic-theft problems in businesses are allowed to continue because no one else ever performs the functions of the thief. When thieving employees are forced to take a vacation and someone else fills in for them, they cannot keep concealing the crime. This policy can prevent theft as well as uncover it if it does happen.

Why is Internal Controls Important

Internal control enhances the reliability of financial reporting and helps to ensure that financial statements are free from major misstatements.

This is important because stakeholders such as business owners, investors and lenders all rely on financial reports to make decisions. Without internal control, businesses face an array of exposures that can drastically alter revenue generating capability.

Errors and Omissions

Errors in financial statements are more likely to occur without a system of internal control and can happen for a variety of reasons, despite accounting personnel’s best efforts. If reconciliations, which are a form of control, are not performed on a regular basis, account balances may not balance back to bank statements or supporting schedules.

While some errors are to be expected, internal controls mitigate the risk of material misstatements to the lowest possible level. Material misstatements are significant enough to influence the decision-making of financial statement users.

Illegal Acts

Bribes and other transactions that break laws are something that systems of internal control are designed to prevent. Small companies that are trying to enter foreign markets are often faced with corruption and must work hard to avoid illegal dealings.

Illegal acts recorded or unrecorded in financial statements have drastic consequences for companies. Despite the effectiveness of internal controls, it is possible for groups of employees or managers to collude and manipulate account balances to cover up illegal acts.

Misappropriation of Assets

Company assets such as inventory and petty cash are always under the threat of misappropriation. For this reason, the segregation of duties enhances internal control and improves the accuracy of financial reporting. It is imperative that company personnel separate the custody of assets from the recordkeeping function and the authorization of transactions.

Otherwise, assets can be misappropriated and the theft concealed through manipulation of general ledger accounts. Internal controls mitigate internal and external threats to assets and cash accounts to manageable levels.

Fraud

Fraudsters can distort financial statements in order to deceive investors and business owners. Management’s bonuses are often tied to company performance, and unscrupulous leaders may adjust account balances to increase their compensation. Internal controls are designed to keep management from manipulating financial statements and deceiving relevant stakeholders.

In tough economic times when companies are struggling, unusually good performance is an indicator that there may be something wrong with financial statements. Internal and external auditors can help to uncover fraud and accounting improprieties.

What are the Pro and Cons of Internal Control?

Internal controls are put into place so an organization’s activities, policies and plans are efficiently integrated to best achieve business goals.

Other purposes of internal control are to protect a firm from mismanagement or fraud, to ensure the company’s actions are within the bounds of the law, and to compile financial and managerial data that can be evaluated so that feedback can be given and implemented. Ultimately, the information gathered will be presented to the company’s directors, board and/or shareholders.

History of Internal Control

The “internal control” was first defined in 1948 by the American Institute of Accountants, but internal control practices have existed since ancient times.

According to the website joeinvestoronline, Hellenistic Egypt had a dual system of internal controls in place for tax collecting, with one set of bureaucrats collecting taxes while another oversaw them. Since 1977, all American publicly owned corporations are legally required to abide by a strictly defined and enforced set of internal-control standards.00:0809:16

Pros

The advantages of internal control are obvious, since they lead to a more efficiently run organization. Strong internal controls will ensure a company’s resources are utilized only for their intended purposes, greatly minimizing the risk of resource misuse.

Internal control also prevents any financial irregularities by detecting them quickly and thus resolving any issues that arise in a timely manner. In addition, having strong internal controls in place can prevent a company’s employees from being accused of any irregularities or misappropriations of funds.

Cons

Internal control also has the potential for disadvantages. If internal controls are badly planned or executed, employee frustration or apathy may result. In addition, an internal control system that is too rigidly designed to allow for adaptation to a particular organization may be difficult to sustain.

Perhaps the biggest disadvantage to internal control is that it may cause a company’s auditors to become over-dependent on the internal control system, which may lead them to relax other measures of checking for fraud and errors.

What is Internal Control Review?

An internal control review is an overall assessment of an organization’s internal control system across each business area to determine if it’s functioning as intended and if it’s able to manage the risks that the company may face in its day-to-day operations.

An internal control review provides company leaders with assurance about the effectiveness of its internal control environment. Internal controls protect a company from financial loss as well as help the organization maintain reliable financial reporting and operate more efficiently and securely.

The best way for a company to ensure that it’s internal control system is operating efficiently is with an internal control review. An internal control review highlights vulnerabilities in a company’s internal control environment and identifies processes that can be strengthened.

What does evaluating internal controls involve?

An internal control review typically tests whether the internal controls are working as designed. Evaluating internal controls involves:

Identifying the internal control objectives relevant to the company.
Reviewing the applicable policies and procedures and the documentation standards for each of them.
Discussing the internal controls with the appropriate stakeholders.
Observing the control environment.
Testing transactions as appropriate.
Sharing findings, concerns, and recommendations with senior management and/or the board of directors.
Determining that the company has taken corrective action on identified vulnerabilities in a timely manner.

Effective internal controls are an organization’s first line of defense to protect its assets, prevent and detect errors, and mitigate risk. Internal controls allow a company to proactively evaluate and monitor its programs to eliminate deficiencies in a timely manner.

An internal control review analyst performs an internal control review to determine if there are any internal control deficiencies in a company’s internal control system and provides recommendations to improve or strengthen the internal controls.

According to the framework of the Committee of Sponsoring Organizations of the Treadway Commission (COSO), the five components of internal control are:

Control environment: Involves the company’s attitude about internal controls. This is the foundation for all the other internal control components. The board of directors and senior management establish the tone at the top regarding the importance of internal control and expected standards of conduct.
Risk assessment: Includes identifying and analyzing a company’s risks and forms the basis for how the risks should be managed.
Control activities: Actions established by the policies and procedures that help ensure management directives are carried out. Control activities are performed at all levels of the entity and at various stages within business processes, and over the technology environment.
Information and communication: Systems or processes that support identifying, capturing, and exchanging information that allows people to carry out their duties.
Reporting and monitoring: Processes that identify, monitor, and report on the quality of the internal controls.

Developing an effective internal control system involves establishing:

Policies and procedures, including organizational structure, job descriptions, authorization matrix;
Segregation of duties and responsibilities;
Authorization and approval process;
Performance monitoring and control procedures;
Safeguarding assets, completeness, and accuracy;
Manpower management;
Independent internal audit function;
Regulatory compliance and risk management.

Internal Control System in Accounting

Without accurate accounting records, managers cannot make fully informed financial decisions, and financial reports can contain errors. Internal control procedures in accounting can be broken into seven categories, each designed to prevent fraud and identify errors before they become problems.

The seven internal control procedures are separation of duties, access controls, physical audits, standardized documentation, trial balances, periodic reconciliations, and approval authority.

Separation of Duties

For small businesses with only a few accounting employees, sharing responsibilities between two or more people or requiring critical tasks to be reviewed by co-workers can serve the same purpose.

Accounting System Access Controls

Physical Audits of Assets

Standardized Financial Documentation

Daily or Weekly Trial Balances

Calculating daily or weekly trial balances can provide regular insight into the state of the system, allowing you to discover and investigate discrepancies as early as possible.

Periodic Reconciliations in Accounting Systems

Occasional accounting reconciliations can ensure that balances in your accounting system match up with balances in accounts held by other entities, including banks, suppliers and credit customers.

Approval Authority Requirements

Requiring approval for large payments and expenses can prevent unscrupulous employees from making large fraudulent transactions with company funds, for example.

Importance of Internal Control in Auditing

Internal controls are one of the most essential elements within any organization. Internal controls are put in place to enable organizations to achieve their goals and missions. Management is responsible for the design, implementation, and maintenance of all internal controls, with the Board responsible for the overall oversight of the control environment.

Strong internal controls allow for organizations to achieve three main objectives. These three objectives are: accurate and reliable financial reporting, compliance with laws and regulations, and effectiveness and efficiency of the organizations operations.

In order to achieve these objectives an internal control framework needs to be applied and followed throughout the organization. The five components of the internal control framework are control environment, risk assessment, control activities, information and communication, and monitoring.

The first component, control environment, is crucial since it’s the foundation for the four other components of internal control. The control environment sets the tone at the top of an organization and provides discipline and structure. Within the control environment there are several factors that include the following:

Ethical Values and Integrity

Management and employees must show integrity. If management displays issues of lack of integrity, it can trickle down to the employees causing internal control issues and opportunities for fraud.

Human Resource Policies & Procedures

Control difficulties can be avoided by sound hiring procedures, training of new employees, and appropriate discipline.

Organization Structure

Organizations that have a clear understanding of who reports to whom within an organization will limit the chance for internal control issues.

Participation of Those Charged with Governance

It is important for those charged with governance (audit committee, board of directors, etc.) to be involved with the organization and monitor internal control functions.

Philosophy of Management & its Operating Style

If management incorporates the importance of internal control in its operating style, employees will know the seriousness of the matter.

Internal Controls in Business

Internal controls play an essential role in every company’s success, yet many business owners don’t have a clear understanding of what they are or why they are important.

A company’s internal control structure is unique to it just like your fingerprints are unique to you—one size does not fit all. Internal controls should be both effective and efficient for your particular organization.

For example, the internal control structure for a Fortune 500 company will not necessarily be appropriate for a small owner-operated business. It is essential for a company’s management team to carefully design an internal control structure that addresses the risks to the organization without burdening it with unnecessary costs and effort.

Establishing Processes

Business owners develop standardized processes and procedures for their staff to understand and follow. They inform their employees of the desired operations, and they expect that their employees will support them as they perform their daily tasks.

Documented established procedures bring cohesiveness and order to a company because everyone knows exactly what is expected of them.

Segregation of Duties

Properly designed internal controls can ensure that an organization has adequate segregation of duties, providing a system of checks and balances. For example, the employee who deposits checks should not be the same employee who reconciles bank statements. Proper segregation of duties can also play a role in reducing fraud or theft.

Reducing Fraud and Theft

Effective internal controls can reduce and likely prevent fraud and theft. Internal controls may include approving new vendors and employees as well as keeping valuable inventory and check stock in secured locations.

Producing Timely and Accurate Financial Statements

Internal controls can help employees capture and record transactions within the accounting records and ultimately produce timely and accurate financial statements. Accurate and timely financial statements are critical to both internal and external stakeholders and will aid management in making decisions and effectively planning for the future.

Reducing Errors

Errors in a company’s accounting records can damage relationships with customers, vendors, and employees and ultimately result in a loss of income. Properly designed internal controls should help your company prevent or identify errors.

Automation of processes and controls and proper levels of review can prevent errors from entering into the accounting system that could result in damage to a company’s reputation.

Concept of Internal Control

Internal audits evaluate a company’s internal controls, including its corporate governance and accounting processes. They ensure compliance with laws and regulations and accurate and timely financial reporting and data collection, as well as helping to maintain operational efficiency by identifying problems and correcting lapses before they are discovered in an external audit.

Regardless of the policies and procedures established by an organization, only reasonable assurance may be provided that internal controls are effective and financial information is correct. The effectiveness of internal controls is limited by human judgment.

A business will often give high-level personnel the ability to override internal controls for operational efficiency reasons, and internal controls can be circumvented through collusion.

What is Internal Control And How Can it Protect a Company’s Assets?

Internal controls are a series of policies and procedures that a business owner puts in place for the following purposes:

Protecting assets: internal controls protect assets from accidental loss or loss from fraud.
Maintaining reliability: internal controls make sure that management has accurate, timely, and complete information.
Ensuring compliance: internal controls keep accounts in compliance with the many federal, state, and local laws and regulations affecting the operations of a company.
Promoting efficient operations: internal controls create an environment where managers and staff can maximize efficiency and effectiveness.
Accomplishing objectives: internal controls provide a mechanism for management to monitor the achievement of operational goals and objectives.

The responsibility for maintaining internal controls falls on administrative management. Members of the management team are responsible for communicating to staff their duties and expectations within an internal control environment. They are also accountable for ensuring that other areas of the internal control framework are dealt with consistently.

Why Are Internal Controls Important in Accounting?

Internal controls play a critical role not only in public companies but also in private companies, because internal controls establish safeguards to an organization’s assets and minimize the opportunities of committing fraud and allowing errors to go undetected in an organization’s daily operations.

1. Internal Controls help to understand and mitigate risks.

Internal controls are usually established based on a risk-oriented approach to ensure that your organization focuses on high risk areas. For example, when an employee accuses that the petty cash is locked, you may immediately sense that stealing cash is a risk. Understanding risks will help you to determine if there are adequate controls to mitigate the risks in those areas.

You may question if there are other internal controls in place to mitigate the risk, such as whether the petty cash gets reconciled and reviewed? Who is responsible for preparing the reconciliation and who reviews and approves it? How often does petty cash get reconciled?

A risk assessment, a necessary first step, provides a foundation to establish internal controls.

2. Internal Controls help to address financial statement assertions.

One of purposes of internal controls is to safeguard the organization’s assets and thus address financial statement assertions (existence, rights, completeness and accuracy). A familiar example is performing a physical count of inventory used internally by all organizations.

Count inventory and track them in the accounting system to ensure the existence. Count cash receipts in retail sales before recording them to verify accuracy.

3. Internal Controls help to prevent and detect fraud.

Segregation of duties (SOD) is a fundamental element of internal control. Internal controls including proper SOD help to prevent fraud. The principle of SOD is to share responsibilities in a key process such that no one individual should perform two of the three functions: custody, recording and authorization.

When the three responsibilities are properly segregated, fraud can be effectively prevented or detected. For example, when an accountant both receives and records cash, the accountant could commit fraud easily. But when the accountant receives cash and another accountant records the cash, committing fraud won’t be that easy.

At the same time, the Accounting Manager reviews the cash records and reconciliation to detect any errors or fraud, which makes committing fraud even harder.

Another familiar internal control to prevent fraud is to limit access to only authorized personnel, such as preventing unauthorized personnel from getting access to a warehouse and stealing inventory for resale. Another access content might involve allowing only accounting employees to access accounting systems.

4. Internal controls help to prevent misstatement of financial statements.

Internal controls helps to prevent errors and misstatement of financial statements. For example, reconciliation is a critical internal control procedure in accounting and can ensure the account balances on the balance sheet are correct to prevent misstatement of financial statements.

Reconciliation also helps management and other users to detect errors and understand the company operations. We will provide some best practices about reconciliation in a download file.

5. Internal controls help to establish company practices.

If you do not have documental evidence of internal controls, you cannot prove internal controls exist. Most organizations have documentation for their internal controls, i.e. flowcharts and/or narratives, because documentation is critical to communicate internal controls with your external auditors and within your organization, quality documentation can be used to train new employees.

By following internal controls documentation, employees get a better understanding of the company processes and practices, which helps to establish the company’s practices.

What Are The Advantages and Benefits of Using Internal Controls in a Company?

Let’s look at some specific benefits that an Internal Audit function can provide to an organization and its management:

The scope of the internal audit is defined by management or the Board (not an outside agency or adversarial entity)
Internal Audit “reports” directly to management or the Board (not an outside agency or adversarial entity)
Improves the “control environment” of the organization
Makes the organization process-dependent instead of person-dependent
Identifies redundancies in operational and control procedures and provides recommendations to improve the efficiency and effectiveness of procedures
Serves as an Early Warning System, enabling deficiencies to be identified and remediated on a timely basis (i.e. prior to external, regulatory or compliance audits)
Ultimately increases accountability within the organization.

So with a properly staffed internal audit function, management would have, at its fingertips: an advocate, a risk manager, a controls expert, an efficiency specialist, a problem-solving partner and a safety net.

What Are The 5 Internal Controls?

Here are the five components of internal controls:

Control environment: This term refers to the attitude of the company, management, and staff regarding internal controls. Do they take internal controls seriously, or do they ignore them? Your client’s environment isn’t very good if, during your interviews with management and staff, you see a lack of effective controls or notice that previous audits show many errors.
Risk assessment: In a nutshell, you should evaluate whether management has identified its riskiest areas and implemented controls to prevent or detect errors or fraud that could result in material misstatements (errors that cause net income to change significantly). For example, has management considered the risk of unrecorded revenue or expense transactions?
Control activities: These are the policies and procedures that help ensure management’s directives are carried out. One example is a policy that all company checks for amounts more than $5,000 require two signatures.
Information and communication: You have to understand management’s information technology, accounting, and communication systems and processes. This includes internal controls to safeguard assets, maintain accounting records, and back up data. For example, to safeguard assets, does the client tag all computers with identifying stickers and periodically take a count to make sure all computers are present? Regarding the accounting system, is it computerized or manual? If it’s computerized, are authorization levels set for employees so they can access only their piece of the accounting puzzle? For data, are backups done frequently and kept offsite in case of fire or theft?
Monitoring: This component involves understanding how management monitors its controls and how effectively. The best internal controls are worthless if the company doesn’t monitor them and make changes when they aren’t working. For example, if management discovers that tagged computers are missing, it has to put better controls in place. The client may need to establish a policy that no computer gear leaves the facility without managerial approval.

What Are The 6 Principles of Internal Control?

Six control procedures protect assets, promote effective operations, and ensure accurate accounting and record keeping: (1) creating a document trail, (2) establishment of responsibilities, (3) segregation or separation of duties, (4) physically protecting assets, (5) establishment of policies and procedures, and (6) reviewing operating performance.

Here are the internal control principles with some practical examples of related control activities and procedures.

Establish a document trail
Prepare the proper documents (source documents) to support business activities that have occurred.

Use prenumbered purchase orders for purchases.
Use prenumbered invoices to bill customers and account for any missing invoices.
Use a preestablished chart of accounts (all accounts in the general ledger).

Establish responsibilities
Assign responsibilities to persons accountable for functions within an organization.

A bank teller or cashier is responsible for reconciling his or her assigned cash tray and ensuring that there is no cash or fund shortage at the end of a shift.
The manager is responsible for authorizing expenditures within his or her own operating department or cost center.
Disbursement checks greater than $2,500 must have two signatures.

Segregate or separate duties
Do not make employees responsible for all parts of a process or business transaction. Establish responsibilities and divide workflow to prevent fraud or other unethical practices.

Buyers should not approve payment of invoices from suppliers (review and approval).
Personnel handling cash (custody of assets) should not do the record keeping (recording of transaction).
Credit limits should be authorized by the credit manager, not by the sales personnel.
Goods received must be checked and verified by the receiving department.

Physically protect assets
Restrict access to assets or information based on assigned responsibilities.

Use a safe to store valuables such as cash or jewelry.
Restrict access to systems and information using passwords and firewalls.
Store inventory in a warehouse or separate area with restricted access to employees with custodial responsibilities.
Have a good inventory control system.
Perform bank reconciliations.
Dispose of confidential information properly by shredding documents and completely removing data from electronic devices before redeploying or disposing of them.

Establish policies and procedures
Establish and communicate well-designed and clear policies and procedures.

Provide fair and equitable hiring policies and practices.
Provide fair and equitable guidelines for promotions and salary increases.
Clearly communicate and provide access to policies, including a code of ethics.
Make it mandatory for employees to take vacation time, and rotate duties and responsibilities.

Review operating performance
Conduct operational reviews and operational audits with an internal audit team.

The team reports to the audit committee to enhance objectivity of the reviews.
The team conducts a biannual review of operating departments and reports its findings to the audit committee.
The team periodically reviews the efficiency and effectiveness of operations and controls.
The team recommends corrective action.

Who is Responsible For Internal Controls?

Management is responsible for establishing and maintaining the control environment. Auditors play a role in a system of internal controls by performing evaluations and making recommendations for improved controls.

Furthermore, every employee plays a role in either strengthening or weakening the Institution’s internal control system. Therefore, all employees need to be aware of the concept and purpose of internal controls.

What is Internal Control in an Organization?

Internal controls are the systems used by an organization to manage risk and diminish the occurrence of fraud. The internal control structure is made up of the control environment, the accounting system, and procedures called control activities.

Several years ago, the Committee of Sponsoring Organizations (COSO), which is an independent, private-sector group whose five sponsoring organizations periodically identify and address specific accounting issues or projects, convened to address the issue of internal control deficiencies in the operations and accounting systems of organizations.

What Are The Four Basic Purposes of Internal Controls?

Internal control is relevant to everyone in the workplace. It represents our moral responsibility to understand and comply with University policies and procedures, as well as to hold ourselves and one other accountable.

The primary purpose of internal controls is to help safeguard an organization and further its objectives. Internal controls function to minimize risks and protect assets, ensure accuracy of records, promote operational efficiency, and encourage adherence to policies, rules, regulations, and laws.

This definition reflects certain fundamental concepts:

Internal control is a process. It is a means to an end, not an end in itself.
Internal control is affected by people. It involves not only policy manuals and forms, but also people functioning at every level of the institution.
Internal control is geared to the achievement of objectives in several overlapping categories.
Internal control can be expected to provide only reasonable assurance to an institution’s leaders regarding achievement of operational, financial reporting, and compliance objectives.

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Bottom Line

An internal control review is beneficial because it encourages compliance with the company’s internal control policies and procedures. It also improves the effectiveness and efficiency of operations.

In addition, an internal control review confirms the reliability of an organization’s financial reporting and ensures compliance with applicable laws and regulations. It also identifies and prevents errors and irregularities in a timely manner and provides senior management with a thorough understanding of the company’s internal control methods.

A strong internal control environment is key to ensuring that an organization continues to thrive. An internal control review helps identify potential weaknesses in a company’s internal controls and provides practical recommendations to improve the internal controls and reduce risk.