Internal controls are simply defined as the mechanisms, procedures, and rules that are implemented by a business or an organization to improve and maintain its operational effectiveness and its overall efficiency. The aim is to maintain accurate financial reporting and to ensure that the organization complies with laws and policies.
The internal controls system plays a critical role in the success of many companies, yet many small business owners completely fail to pay attention to them. In fact, auditors simply take one look at a company’s internal control structure and are able to determine just how well the business is run and where it might be lacking.
It’s also important to understand that the internal control structure changes depending on the nature and size of the business.
How Do You Define Internal Controls?
Internal controls are designed to provide reasonable assurance about the achievement of different objectives such as:
- The reliability of financial reporting
- The safekeeping of company assets
- The effectiveness of company operations
- The company’s ability to comply with regulations
Without a properly functioning control system, the input is likely to be wrong, and as such, the business is going to suffer in its entirety. Good internal control systems are critically important to achieving objectives and goals. They also provide reasonable and reliable fiscal reporting that can help the management make informed decisions.
Here are a few reasons why a robust internal control system is of such importance.
They Help in Identifying and Mitigating Risks
Internal controls are created to mitigate risks in the workplace. For instance, in certain departments where risks are high, the internal controls are more stringent. Such is the case with cash. In case an employee complains that petty cash is locked out, you will almost immediately think that the employee was interested in stealing the cash.
Understanding the risks is important and it’s going to help you figure out whether there are adequate controls in specific areas or not. For instance, a questioning mind will wonder if there are appropriate controls in place, or if more could be added. For instance, just locking the petty cash might not be a wise solution.
Instead, like most entities, petty cash should be carefully tallied and reconciled at the end of the month or the week. It is also important that petty cash is only requested by a person with sufficient authority in the business. The frequency of reconciliation should also be taken into account.
A Thorough Risk Assessment
The major reason why internal controls are important is because they help in a thorough internal control risk assessment. Without a set of internal controls in place, the organization won’t be able to figure out whether it is exposed to sufficient risk or not.
Addressing Assertions About the Financial Statements
There are several assertions that go into the making of financial statements, and internal controls are important for addressing these and more importantly, safeguarding them. These include existence, accuracy, rights, and completeness. Let’s explain each of these individually.
Existence: the figures shown in the financial statements actually correspond to amounts that exist.
Accuracy: the given figures are accurate and have been calculated with precision.
Rights: the organization has rights over the given figures.
Completeness: the given figures have been checked for completeness.
A common example of this is the performance of a physical inventory count. Almost every organization in the world holds physical stock counts at the end of specified periods, and they are primarily designed to track and ensure the existence of stock in the first place.
Accuracy is verified as well thanks to managers and staff who are present to oversee the calculations and the stock count.
Internal Controls Mitigate Fraud
One of the simplest internal controls that can be implemented in the workplace is the segregation of duties. It is a fundamental element in the internal control system and simply relates to companies taking steps to ensure that one employee is hired for a specific task.
Ideally, no employee should perform two of the following three functions: authorization, recording, and custody. If one employee is in charge of custody, another should be kept in charge of authorization. As long as these three main responsibilities are segregated, fraud can be dramatically reduced and prevented.
Here’s a simple example: if an employee is responsible for receiving the cash and then accounting for it too, it’s going to be pretty easy for them to change the figures and commit fraud. But, if one employee is receiving the cash and another is authorizing the transaction, the figures can be tallied and reconciled. If there is a discrepancy, it will be instantly identified.
By mitigating fraud in the workplace, organizations are simply able to reduce their losses as well. For instance, inventory won’t be lost or stolen, and money from the workplace won’t be misappropriated either. This is important as it will help the business sustain itself in the long run, especially smaller entities that thrive on limited profit margins.
Preventing Misstatement of Fiscal Statements
A misstatement on the financial statements could prove to be a serious problem and can have a dire impact on the company’s trust with its shareholders. In case of an audit, the report could be qualified as well, or worse, a disclaimer of opinion could be issued.
If appropriate financial controls are in place, financial misstatements are going to be avoided to a considerable extent. Errors are also going to be mitigated and reconciliation will become much easier. When appropriate controls are in place, it automatically ensures misstatements are avoided because the figures are cross-checked.
For instance, information from the profit and loss ledger is recorded in the income and loss statement. It is checked and tallied, and from there it’s taken to the balance sheet. As a result of these controls, financial statements remain free of errors.
High Company Standards
One of the key tenets of internal control lies in the documentation of everything. All the internal controls in the workplace are carefully documented, and without them, internal controls simply cannot exist. By documenting these internal controls, a company can increase its standard of function and performance.
It also allows auditors to generate an opinion about whether the organization takes internal control seriously and whether they have taken appropriate steps to ensure that the information passing through the channels is reliable and accurate. More importantly, the documentation in the workplace is going to help with training new employees as well.
If an organization does not have an internal control function or committee, it should consider creating one. The recommendations from the internal control committee, though not independent, could play an important role in helping auditors tally the balances for nonessential balances in the accounts.
These are just some of the things that you should know about the importance of internal controls and why they play such an important role in modern organizations in a rapidly evolving commercial climate.