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Internal Control

Publicly held companies are required to assess their internal control policies and procedures as part of their annual reporting process. Internal controls are the overall plan and all of the procedures the company uses (everything it does) in order to

• safeguard the assets,
• safeguard the accounting records, and
• facilitate compliance with laws and regulations.

Typically, internal controls are studied as a framework—The Internal Control–Integrated Framework, in particular, which was written by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in 1992. In order to achieve the three internal control goals listed above, the Integrated Framework describes five control elements:

• the control environment,
• risk assessment,
• control procedures,
• monitoring, and
• information and communication.

Each of these control elements will be addressed in greater detail below.

The Control Environment

This can best be described as the "tone at the top." Is the company interested in achieving and reporting financial success at any cost? Or is the company focused on honorable principles and strong leadership? The control environment is affected by the company's

• management philosophy,
• organization/structure, and
• human resource policies.

Risk Assessment

There should be routine reviews of the risks faced by the company. These risks can result from changes in laws, staffing, economic or environmental factors, and competitive threats. As a risk is identified, the company must evaluate its significance, determine its probability of occurrence, and then take action as needed.

Control Procedures

This is the area most closely linked to a course in financial and managerial accounting. Control procedures include a wide range of activities and policies, such as

• hiring qualified personnel and providing sufficient supervision;
• rotation of duties (as the risk of fraud is minimized if someone new will take over the job on a routine basis);
• mandatory vacations (as someone never wanting to take time off suggests he or she may be hiding something from the company);
• separating custody of assets from accounting for those assets;
• security devices and access restrictions, such as locks, limited computer access, and so on; and
• segregation of duties (separating the responsibility for and completion of related tasks).

Monitoring

Monitoring involves a review of the systems that are in place; it may mean watching how a process is completed or looking for unusual changes in employee or business behavior. If the business is suddenly refunding more than in the past, it might mean that an employee is creating bogus refund claims and pocketing the cash. What if an employee begins to take extravagant vacations? Where did the money come from?

It is important to be aware of (monitor) changes in the environment, whether in the employees or the processes.

Information and Communication

There are many ways that management can learn about improving internal controls. By participating in industry segment events and engaging in discussion about issues that other companies have identified, management will be alert to possibilities in their own company. It is important for management to communicate the processes and controls to the employees so that everyone can take ownership of and assume responsibility for maintaining the code of ethics.

Companies are interested in reasonably assuring their decision-makers that assets are properly safeguarded and accounting records are reliable. Internal control procedures are not foolproof, though—nor do they guarantee that fraud will not occur or that fraud will be caught. Controls are costly; companies must perform a cost-benefit analysis in order to decide which procedures are worth the cost of monitoring and analyzing. Stricter internal control methods often cost more money. In addition, internal control procedures are only as effective as the staff charged with following them. If two or more individuals work together, they can find ways to beat internal control procedures.  

Next, you will take a closer look at a couple areas for which a good internal accounting control system is critical: cash receipts, cash payments, and inventory control.