Finance Business

Internal Controls- A Guide for directors

Internal Controls

Internal controls are accounting and auditing processes used in a company’s finance department to ensure the accuracy of financial reporting and regulatory compliance. It provides assistance to companies in complying with laws and regulations and preventing fraud. They also can help improve operational efficiency by ensuring that budgets are adhered to, policies are followed, capital shortages are identified, and accurate reports are generated for leadership.

Weak or ineffective internal controls, such as inadequate record keeping, may cause operational losses in an Organization. It also involves insider fraud that could have been prevented or discovered through effective control mechanisms before the fraud resulted in a loss in the Organization.

Despite emerging technological changes, the fundamental concept behind adequate internal controls is the same. It forms a foundation for an organization’s risk management system, safeguards assets, guards against fraud and financial mismanagement, and ensures compliance with laws, regulations, and institutional policies.

Components

Internal controls are an essential yet challenging part of any organization. Focusing on the five internal control components can help ensure good governance and provide a framework for the accounting system. Both accountants and audit teams should incorporate these components when they design and review the accounting system. It provides an efficient financial report for the Organization.

It designed to prevent errors and irregularities, identify problems and ensure corrective action is taken. Process owners within the financial department often perform controls and interact with the control structure daily, sometimes without realizing it, because controls are built into operations.

Fundamental concepts:

Internal control is a process, not relying on one event but a series of ongoing events that may occur in the behavior of an Organizational operation and should be an integral part of a business. The board of directors should give reasonable internal control, and all members play a significant role in this process. A well-designed internal control can not provide a reasonable outcome in an Institution.

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Regardless of size, each Organization must adopt methods to periodically assess risk and develop, implement, and review the System of internal controls.

An internal control framework has five interrelated components: control environment, risk assessment, control activities, information and communication, and monitoring. These components comprise the minimum level of internal control in an Organization.

To implement the framework, the leadership of a director in a company develops detailed policies, procedures, and practices to fit the Company’s operation. The Internal controls framework components are planned to build an effective system and processes. In that case, the Company may achieve the maximum benefit at the lowest price.

Control environment

The control environment in an Organization influences the effectiveness of internal controls. The control environment is an intangible factor. Yet, it is the foundation for all other components of internal control, providing discipline and structure and encompassing technical competence and ethical commitment.

Risk assessment

Risk assessment[1] is identifying risks in achieving the goals of an Organization and apprehending potential events, considering their likelihood of occurring and impact, and then implementing internal controls to mitigate them. The accounting team should always take a new monitoring approach since the risk can surface without warning. There can be susceptibility to fraud or errors. The changes may occur in the organizational structure, systems, and personnel.

Control activities

Control activities mean ensuring the proper controls are in place, as risk responses are effectively carried out, and comply with the policies and regulations. The control activities must give security over the assets. The control components are designed to prevent or reduce the risk in an organization.

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Information and communication

Communicating with the management about any lapses in Internal control is the best way to mitigate risks quickly. The structure must monitor, identify the risk and capture the exchanging information with the other entities. Such information and communication must be accurate and timely.

Monitoring

Audit teams should monitor internal controls and evaluate the control system’s effectiveness, designed to ensure they will identify risk and operating effectively. Monitoring is effective when it leads to identifying and correcting control weaknesses before they materially affect the achievement of the Company’s objectives.

Director

The role of the Director in charge of the Internal Control and Risk Management System is to supervise the functionality of said System, and it has the following tasks which the Corporate Governance Code has envisaged:

  • To implement the Guidelines established by the Board of Directors, ensuring the design, implementation, on and management of the Internal Control and Risk Management System, constantly verifying its adequacy and effectiveness, also ensuring alignment of such System with the dynamics of the operating conditions and legislative and regulatory framework.
  • To ensure the identification of the leading corporate risks, taking into consideration the characteristics of the activities carried out by the Company and its subsidiaries, periodically submitting them to the examination of the Board of Directors.
  • To promptly report to the Control, Risk and Sustainability Committee (or to the Board of Directors) on issues and problems emerging in the course of his activities or which have otherwise come to his attention so that the Committee (or the Board) may take appropriate action
  • To request the Internal Audit Unit to perform checks of specific operating areas and compliance with internal rules and procedures during business activities (when necessary); he informs the Chairperson of the Board of Directors, the Chairperson of the Control, Risk, and Sustainability Committee and the Chairperson of the Board of Statutory Auditors thereon
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Conclusion

The directors of an Organization must acknowledge their duty and responsibility for establishing, regulating, and maintaining an adequate internal control structure and procedures for financial reporting. Directors could also be required to conduct an annual review of the effectiveness of internal controls over financial reporting, explain the review’s outcome, and make a statement as to whether they consider the System to have operated effectively. Other requirements on directors are likely to require disclosure of the benchmark system used to make the assessment, any deficiencies in the control system, and associated remedial actions.

Read our Article: Internal Control System- Analysis of Benefits & Limitations

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