What Are Internal Controls And Why They Are Of The Essence

While it’s crucial for a business to have a top-shelf trust in its employees, things don’t always go as planned. Thus sometimes even the noblest employee in an organization can end up doing things that the management least expected, putting the business’s future in jeopardy. It’s therefore vital that every enterprise, regardless of size, protect itself from itself through the implementation of internal controls. Here is what you need to know about these controls.

What Are Internal Controls?

Internal controls refer to all the policies, procedures, and regulations enacted by the management of a business to safeguard its assets, uphold the integrity and reliability of its financial and accounting data, promote efficiency and accountability and at the same time, prevent fraud. To put it simply, internal controls are policies put in place to prevent employees from committing fraud.

These policies are part of the SOX Act, which was enacted following the Enron scandal in the early 2000s. They are part of the government’s efforts to safeguard the wellbeing of business owners. Therefore, management executives found guilty of not correctly implementing them may face hefty fines and even jail time. According to COSO, an excellent internal control framework usually covers the following areas

  • The control environment
  • Risk assessment
  • Control activities
  • Information and communication
  • Monitoring

Categories Of Internal Controls

Internal controls encompass a wide range of procedures. They can either be;

Preventive

Preventive controls, as the name suggests, are put in place to prevent or deter errors and irregularities. They are often more cost-effective because they prevent risks such as loss of assets from happening in the first place. Common preventive control activities include

  • Segregation or Separation of Duties

The separation of duties is the most common and also easiest to implement of all preventive control procedures. This control measure is normally used in the protection of illiquid assets such as cash. As the name implies, it requires a transaction to be handled by different employees.

 In other words, when implemented, no single employee is allowed to initiate, receive, record, or deposit cash on their own. For instance, the employee who gets the cash from the customer should not be the one who records or deposits it into the business account.

Since fraud can occur on any level of an organization, separation of duties is vital not only at the top but at every level of the entity’s hierarchy. To further increase this procedure’s effectiveness, businesses should rotate these duties appropriately every once in a while.

  • Authorization

This is yet another common preventive control activity among businesses. It involves setting permission levels to safeguard an enterprise’s data and liquid assets. Simply put, it means giving control over certain areas of business and its websites to specific employees or departments. For instance, setting passwords to a business accounting website, so employees from other departments don’t have access to accounting information, protects the integrity of an entity’s financial information.

Other than data, authorization as a preventive control measure can also be used to protect an organization’s physical or liquid assets. For instance, to prevent the loss of inventory, a business can regulate access to its warehouse by allowing badge access only to employees in the supply chain or inventory management department.

Or Detective

No matter how efficient preventive controls are, it’s impossible to identify every possible thing that can go wrong. Errors happen and are noticed way much later after they do. That is why other than preventive, an organization also needs to have detective controls in place.

These are often are designed to identify errors and irregularities that have already occurred. They seek to identify when and why a preventive control activity wasn’t effective. For instance, if sensitive financial information is leaked, detective controls are often used to identify when, why, how, and who among those with access to an organization’s accounting website leaked it. Common detective control activities include

  • Surprise cash counts, e.g., when petty cash assigned to each employee is counted randomly
  • Bank reconciliations
  • External audits

Benefits Of Internal Controls

Both preventive and detective controls are of the essence because

  • They Prevent Error Escalation

Through detective controls, a business is often able to identify and correct small errors before they become irreversible or too big to be corrected cost-effectively.

  • They Promote Accountability

One of the most significant benefits of internal controls is that they promote accountability. Every employee understands the significance of their duty and the consequences of not following it up. Internal controls also mean that the management will know who to question when something isn’t adding up.

  • They Promote Productivity

Part of internal controls means keeping your financial data in readiness for internal and external audits. Well organized data, in turn, makes it easy for the management to make data-driven decisions, which automatically means improved productivity.

  • They Ensure Compliance

As mentioned earlier, internal controls are part of the SOX act. Thus they are not optional. They are especially important in any business with shareholders, as any fraudulent activities will also affect them. Therefore, implementing these procedures protects not only the business from losses but from hefty fines associated with the act.

However, they can also have weaknesses. For instance, according to the COSO framework, effective internal controls are also dependent on the control environment. This means a high level or those given authorization over certain areas can always override the regulations.

Finally

Internal controls are of the essence to any business regardless of size. They prevent employees from taking advantage of your business and increase the likelihood of achieving and maintaining your entity’s objectives.Check us out today for more information on the ideal controls for your business.