Internal controls became increasingly crucial after Enron and WorldCom were corrupted. The Sarbanes- Oxley Act of 2002, which governs reporting and testing of internal controls over financial reporting for public companies, stipulates the need for an efficient internal control system. Not only in publicly traded companies but also in privately held businesses, internal controls are essential because they create safeguards for an organization’s assets, reduce the likelihood of fraud, and prevent mistakes from going unnoticed in day-to-day operations.
Internal Controls Overview
What are the benefits of internal controls?
Internal controls give a business cohesion and consistency to establish protocol and order. Business owners create protocols, define parameters for how the procedure is carried out, and periodically evaluate controls for effectiveness and accuracy. An established internal control process outlines the organization’s financial transaction management procedures as well as the delegating of managerial and administrative responsibilities. Employees understand what is expected of them and how to carry out daily tasks when protocol and procedure are clear.
What are internal controls?
Internal controls are policies and practices implemented by a business to deter fraud, encourage accountability, and guarantee the accuracy of financial data. Every company’s internal controls are distinct and are created in accordance with the size and structure of the organization. Internal controls that are effective and efficient work to achieve business goals and safeguard the interests of the organization. Internal controls reduce unnecessary cost and effort incurred while also addressing risks to the business.
The core purposes of internal controls are to:
12 reasons internal controls are important
Here are 12 reasons why internal controls are crucial for safeguarding your company, customers, and assets.
1. It establishes the processes
Internal controls specify employee protocol and procedures so that staff members aren’t left in the dark about how to carry out their job responsibilities or which procedure to adhere to. Employees are promptly informed of changes to internal controls so they can work more effectively and make fewer mistakes. To improve employee comprehension and compliance with procedures, which can increase productivity and boost morale, internal controls are rigorously documented.
Example: The Lighting Co. publishes an annual revision of its employee handbook and lists the people who receive and review it. The business arranges departmental meetings to go over new procedures and address concerns about changes.
2. It improves process performance
As processes are put into place, ongoing evaluation of their efficacy aids management in determining whether they are effective or whether they require more attention. The accuracy of financial reporting, which management can rely on to make knowledgeable business decisions or judgments, improves as processes are improved.
Example: In 2020, The Lighting Co. s revenue decreased by 30% as a result of a decline in in-store traffic. The company’s management decides to concentrate on the website in order to increase web traffic and increase online sales.
3. It improves operational efficiency
Internal controls can increase operational efficiency by removing steps from a procedure or process that are redundant or unnecessary. This might entail automating manual controls or cost-effectively combining functions. The management can receive timely information to confirm that current operations are fulfilling the company’s objectives thanks to increased operational efficiency.
Example: The Lighting Co. has kept up a number of email accounts under the scrutiny of various employees to correspond with clients, vendors, and respond to social media requests. The business decides to combine customer emails and social media to a single inbox with one employee handling both after reporting a decline in email subscriptions.
4. It keeps duties separated
Internal controls guarantee that duties are separated to prevent conflicts of interest and lower the likelihood of financial mismanagement. Separating responsibilities creates a system of checks and balances so that nobody has access to all the information.
Example: Janet has access to client financial transactions because she works in accounts receivable. Internal controls forbid Janet from managing accounts payable in order to limit information sharing and the possibility of fraud.
5. It mitigates business risk
Limiting the company’s losses due to misappropriated or improperly handled funds by employees or management is one of internal controls’ functions. By detecting fraud or financial loss caused by theft or other illegal means, internal controls minimize loss. Controlling the reconciliation of bank statements and carrying out internal audits to protect inventory and assets are two examples of this. Before starting work, some internal controls may need the consent of vendors or employees.
Example: The Lighting Co. contracts with the local government to supply lighting for buildings or structures owned or controlled by the city Before they can work on government projects, internal controls require employees and vendors to pass background checks.
6. It organizes information
Organized data demonstrates that the business is ready in the event of a lawsuit or external audit. By developing systems to store client information or documents or by enforcing restrictions like requiring passwords to access data, internal controls safeguard the interests of the company and its clients. Organizing data makes it more effective by ensuring that financial information is safe but still accessible.
7. It produces timely financial statements
In addition to assisting management in decision-making about the company’s future, timely financial reports also safeguard stakeholders and the company’s reputation. Regular financial reporting fosters trust in the business and demonstrates its transparency by allowing for the early detection and correction of minor errors.
8. It reduces errors
Internal controls define protocols and procedures to minimize employee errors and make necessary improvements, which aid in the reduction of errors. By effectively training employees to reduce mistakes or misunderstandings, the company reduces income losses and dents in its reputation. Internal controls like employee training could start with an orientation and continue with ongoing training courses like picking up a new computer system or working method.
9. It improves accountability
Key personnel are in charge of monitoring and reporting throughout the year thanks to internal controls that define roles, ensuring that errors are found and corrections are made as soon as possible. Clear protocols that specify how data is transmitted, recorded, shared, and reported help establish accountability. Better accountability ensures that the business complies with legal and regulatory filing requirements.
10. It stabilizes operations
When operating procedures are in place, a business is better able to achieve its goals. Management has more control over how the business is run and whether procedures are being followed. A stable operation has clear information management procedures in place, employee roles that are defined, and detailed problem-solving procedures.
Example: The Lighting Co. According to an annual report, policies regarding employee time-off requests are not being followed. In order to ensure protocol is followed while still being fair to the employees, the company analyzes the data to see if the procedure is out-of-date, whether steps can be combined or removed, or how to implement a new process.
11. It reduces audit fees
By laying out clearly how internal controls are implemented and what happens as a result, established internal controls may lower the cost of external audits. Internal controls that are clearly mandated lessen the need for revisions or a complete rebuild after an external audit and review.
12. It recognizes the Sarbanes-Oxley Act
The Sarbanes-Oxley Act was created to maintain internal controls for financial reporting and to promote accountability. The act is a federal regulation that safeguards investors and makes sure businesses give reliable and accurate financial disclosures. Public companies of all sizes are required to submit an annual report that includes information about their internal controls. By adhering to the Sarbanes-Oxley Act, businesses can win over investors and demonstrate their integrity in the way they handle financial data.
What is the most important internal control?
Segregation of duties, proper authorization of transactions and activities, adequate documentation, physical control over assets and records, and independent performance checks are among the most crucial control measures.