Finance Business

Internal Controls: Definition, Importance and 5 types of elements

Internal controls are used for accounting and auditing processes in a company’s finance department. It also ensures the accuracy of a business’s financial reporting and regulatory compliance. It helps companies to manage laws and regulations to prevent fraud and misrepresentation of data. However, it can also help to improve operational efficiency by ensuring that budgets are complied with, policies are being followed, capital shortages are being identified, and accurate data reports are generated for leadership.

People are what make internal work. While the responsibility for reasonable control ultimately rests with leadership, all members play essential roles. No matter how well designed and operated, the control can provide only reasonable assurance.

Importance

• It evaluates a company’s internal data, governance, accounting processes, and efficiency.
• It ensures the company is complied with laws and limitations and provides accurate and timely financial reporting.
•  It also builds operational efficiency by identifying problems and correcting gaps before they are discovered in an external audit.

Internal audit is essential in a company’s operations and corporate governance. Now the two systems of control are identical. Still, many core financial integrity and accounting philosophies have built standard management practices. Sometimes, they can be expensive but adequately implemented controls can help streamline operations, increase operational efficiency, and prevent fraud.

Components

Internal control is a process implemented by the organisation to provide reasonable assurance in achieving the goals through effective operation and governance. The company’s financial part falls into a separate category.

An internal control framework has five co-related components: control environment, risk assessment^[1], control activities, information and communication, and monitoring. These components include the minimum level of control, and an organisation needs to have a basis against which control is evaluated.

To implement the framework, the leaders develop detailed procedures, policies and practices to fit their company’s operations. It ensures that they are built into and integral to operations. In that case, the company will achieve the maximum benefit for the lowest cost.

Safeguarding the organisation’s assets:

• Verify the data accuracy and reliability of its accounting data.
• Promoting operational efficiency
• Encouraging adherence to policies for accounting

Control environment

The control environment influences the effectiveness of controls within the organisation. It is an intangible factor and the foundation for all other components, and it provides discipline and structure and encompasses technical competence and ethical commitment to the organisation.

The control activities typically comprised authorisation, documentation, reconciliation, security, procedure, laws and the separation of duties and responsibility. They are divided into two types such as preventative activities and detective activities.

Preventative control activities aim to detect fraud, error, and misrepresentation from happening in the first place and include thorough documentation and authorisation practices. Separation of duties is an essential part of this process. It guaranteed that no single individual could authorise, record, or be in the custody of a financial asset. Authorisation of invoices of bills and verification of expenses are also included in the controls.

Additionally, preventative controls include limiting physical access to equipment, inventory, cash, and other assets.

Any detective controls are backup procedures designed to detect items missed in the first line. The essential activity is reconciliation, which compares data and takes corrective action upon finding material differences. Other detective controls comprise external audits from accounting firms and internal audits of inventory.

Risk assessment

Risk assessment is identifying risks to achieving the company’s objectives and analysing potential threats to the company, considering their apprehension of occurring and impact on achieving the company’s objectives and deciding how to tackle future risks. Leaders of a company should be aware of potential future risks and should check for high-risk areas where: There is any susceptibility to or history of waste, fraud, or errors.

Changes have occurred in the organisational structures, systems, operations and personnel Controls, which have not been reviewed for a substantial period.

Control Activities

Control activities help to ensure the organisation builds an effective system where the risk responses are positively carried out and includes procedures, policies and approvals, authorisations, security over assets, reconciliation,  and segregation of duties and power. It helps to design to prevent or reduce the future risk of a company.

Information and communication

The control structure must provide for identifying, capturing and exchanging information with outside parties. Information communicated should be accurate and timely.

Monitor

Monitoring evaluates the effectiveness of an organisation’s internal controls and is structured to ensure that the controls continue to operate effectively. Monitoring is effective when it leads to identifying and correcting control weaknesses before they affect the achievement of the chapter’s objectives.

Succession Planning

After leadership changes, it is up to the incumbent leadership group to review with and train the incoming leaders on the control process the organisation has adopted.

Limitations

Other than the policies and procedures established by an organisation, it can only provide reasonable assurance that a company’s financial information is accurate and the record is maintained correctly.

The impact of controls can be limited. For instance, a business may give high-level personnel the ability to override controls for operational efficiency benefits.

Moreover, controls can be circumvented through collaboration, where controls usually separate employees’ work activities and where they work together in secret to conceal fraud or other misconduct.

Conclusion

Internal controls are a company’s mechanisms, rules, and procedures to ensure the integrity of financial statements and accounting information, promote accountability and stability, and prevent fraud and misrepresentation. Other than complying with laws, procedures and regulations and preventing employees from stealing assets from an organisation or committing fraud or cheating. Internal controls can improve operational efficiency by improving the accuracy and timeliness of financial reporting.

Also Read: Internal Controls- A Guide for directors