Are you curious about how an internal control system can help you manage your business? With the right internal control measures in place, you can safeguard your business from risks, ensure compliance, and make informed decisions.
In simple term internal control system is rules and regulations adopted by an entity. These rules and regulation can be operational system or Financial System. The effective operation of internal controls depends on how they were applied, the consistency with which they were applied and by whom they were applied.
Operation controls as the name suggests are designed to ensure that day to day actions are consistent with established plans and objectives. Corrective actions are taken where needed. For eg: Training, Motivation, Leadership, Discipline or Termination
Likewise Financial controls are designed to ensure that financial transaction are conducted and recorded appropriately to prevent, detect and correct the misstatement on timely basis.
Good Internal controls are made up of five components:
A. Control environment: It is the attitude of entity’s employees toward the entity’s rules and regulations. Employees are the entity’s major asset. Its factor includes:
- Business integrity: Conducting business with a moral and ethical framework is crucial for any organization. Both executives and middle managers must abide by the values, ethics, and behavioral expectations set by the company. Emphasis should be placed on practicing sound business principles and adhering to a code of conduct that includes contributing positively to society and treating employees and the public at large with respect.
- Business value: Ethical businesses view value creation as not just earning profit but also they feel obligated to create value for customers for mutual exchange of value, one that builds strong bonds of loyalty. (Eg: Building Trust on character, quality, and value provided, Making people valued in every interaction)
- Competence of entity’s personnel: Skills, expertise, qualification, focus, empowerment, trust, training, communication, and aligning entity and personnel interest through stock-based pay for performance, the motivational program to honor employees whose contributions make a difference in important ways.
- Management philosophy and operating style: Attitude of management toward financial reporting, organizational objectives, approaches to minimize risks
- Organizational structures: Assigning authority and responsibility. The control environment will be influenced if every individual knows that they will be held accountable. Organizations should hold every employee accountable for their activities and business practices. The organization shall take responsibility for financial reporting for its accuracy and timeliness.
B. Control Activities: They are policies and procedures that help ensure necessary actions are taken to address risks to achievement of entity’s objectives and that help ensure management directives are carried out. As we know there are operational control and financial control.
1. Operational Control: It is used to regulate the internal process necessary to monitor and direct company in short term. It controls result, plans liquidity, helps in improving effectiveness in use of existing resources.
- Liquidity planning refers to the process of creating a cash flow forecast for a specific period of time. It involves estimating a company’s solvency by analyzing the inflow and outflow of funds, both long-term and short-term. A cash flow statement helps to gain visibility of upcoming cash requirements and predict the financial future of the business.
- Liquidity planning involves comparing the liquid assets and liquid liabilities of an entity. Liquid assets refer to current assets that can be easily converted to cash, and liquid liabilities refer to short-term debts or current liabilities. The net amount helps to determine net liquid asset with the company and helps entity to plan those asset. Entity also maintain liquid ratio (Liquid ratio=Current assets/ current liabilities) above which the amount could be invested(making additional money through liquid planning) or pay debts. In case of investing in stocks there is need of seller and buyer, sometimes seller cannot find buyer and have to ask for less money for selling such stock and same for buyer, such stock are called illiquid assets.
Another is controlling results and improving effectiveness in use of existing resources. This could be done by preparing a budget for all cost- Budgeted price and quantity of raw material for one unit of output, Budgeted labor rate and hour for one unit of output, and doing similar for other overheads then comparing them with actual cost. We compare in such a way that how budgeted profit and actual profit have varied by bifurcating each part of costs. For instance: Variance in profit due to raw material rate, raw material quantity consumed for each output. Details about budgeted costs and calculating variance in actual costs is mentioned on another article.
2. Financial control: It aims to reduce chances of fraud and error before they occur as well as it apply detective control designed to find errors and problems after the transaction has occurred. Following are the some of examples:
- Separation of duties: It involves dividing financial tasks among different individuals to prevent any single person from having complete control over a transaction, reducing the risk of both erroneous and inappropriate actions. Examples are: Ideally no single person should initiate, approve, record, reconcile, handle, and review reports. All units should attempt to separate functional responsibilities to ensure that errors unintentional or intentional, cannot be made without being discovered by another person. In case of small departments, when separation of duties is not possible due to a small department size, tier2 compensating controls must be put in place. As one person detailly enters the transactions and make reconciliation at the end of each month. Another person will be responsible for finances and checks the reconciliation and entry for 1st person role.
- Authorization and approval: Pre approval of actions and transactions to ensure that all transactions are approved by responsible personnel in accordance with their authority
- Physical controls: Physical control over assets. This can occur through the use of locks, safes, or other environmental controls. Access is to be restricted to those with authority to handle them.
- Reconciliations: Comparisons to be made between similar records maintained by different personnel to verify transaction details are accurate and that all transactions are properly recorded. Regular reconciliation of financial statements and accounts is essential to detect and rectify discrepancies. Additionally, periodic review of financial processes and reports helps identify control weakness or inefficiencies that require attention. Eg. Performing a reconciliation from bank statements to check register/records. Balancing/reconciling cash on hand to sales or transaction activity on the cash register totals.
- Leveraging existing technology
- Working with internal audit to reevaluate and respond to risks
- Modernizing and investing in innovative technology solutions.
C. Risk assessment: Risk identification is the identification and analysis of relevant risks to achievement of the objectives, forming a basis for determining how the risks should be managed.
- There are many factor to consider while performing a risk assessment, including industry in which your company operates, general economic conditions, the size and complexity of your organization, regulatory changes, your companies operational strategies and objectives. Other factors such as what activities across the enterprise do you currently monitor?, what question do you regularly hear from your board of directors and other stakeholders?, Bottom line being if the results matter to you or your stakeholders, they should be assessed.
Level of risk, some of them are as follows:
- Estimates and judgements: Estimation may be used because primary activity data based on direct measurement of an activity is unavailable or prohibitively costly to accumulate. Estimation may be used to develop expectations about the future. Developing information for sustainable business inherently requires assumptions about the future, such as useful life of existing facility and machines based on both physical and transitional risk related to climate change.
- Due diligence risk due to third party information: Sustainable business management and reporting depends on the availability and quality of third party information. Gathering information from its suppliers, customers. This reliance on third party data raises risks.
- Assess fraud risk: An organization considers the risk that management will engage in fraudulent activities such as intentional misstatements or misappropriation of valuable resources. Points of focus should be:
- Consider various types of fraud- for instance: risk of using technology to knowingly misstate information or misappropriate resources. As part of the risk assessment process, the organization conducts brainstorming sessions to consider scenarios that could result in fraudulent activities.
- Assesses incentives and pressures: Employees often face ambitious deadlines to achieve targets and outcomes. There may be expectations for meeting targets and delivering encouraging messages to the employees. Unidentified risk and limited resources to satisfy objectives contribute to this pressure. This encourages incomplete and inaccurate reporting
- Assesses opportunities for illegal activities, and fraud: Eg. Modification of records, making misstatements or ommissions to the market and other stakeholders, misappropriating resources meant for organizational use
- Assesses attitudes and rationalizations: Employees may view sustainability as trivial rather than integral which creates risks that organizational policies and oversight are less than effective because management lacks incentives to carry out assigned responsibilities to sustainability.
- Reassessing materiality and decision usefulness: As conditions change, the metrics or assessments of what information is material (under regulatory definitions) or decisions useful for management and other stakeholders will change. An organization must consider all factors—both internal and external—in setting guideposts.
- Understanding the most important risks to your organization and designing relevant internal controls to mitigate those risks can be key differentiators as your business grows and evolves. Although internal controls have inherent limitations when they are designed and operating properly, they can help your company manage and mitigate risks, as well as potentially provide valuable business insights.
D. Monitoring of controls: It assesses the quality of system performance over time. Considering mix of ongoing and separate evaluations, rate of change, Monitoring controls must be considered with the organization’s actual business, transactions, operations, processes, and expectations, Review its controls over the period of time as time goes by, assessment of controls must be done objectively and without undue bias.
- Engaging competent professionals to assess control effectiveness ensures accurate information and resource utilization.
- .An effective internal audit function provides assurance independent of management, and, with the right competencies, it can provide assurance related to controls over sustainable business information. Internal audits can also facilitate the work of external assurance providers when engaged.
- Management may initiate additional audits that function as monitoring controls in high-risk areas, including workers’ health and safety, product safety, or cybersecurity. These audits often have a specific purpose, such as reducing regulatory enforcement risks. They are referred to as second-line audits and are designed to supplement existing controls.
- Material weaknesses identified by independent auditors
- A meaningful monitoring system may lead to strategic reassessment and an organizational reflection on its commitment to carrying out its purpose and objectives
E. Information and communication: The organization communicates internally to support internal control, including objectives and responsibilities. The organization acquires and utilizes relevant and reliable information to support its internal control system.
- Leveraging existing finance, IT and internal audit competencies: The professional in these functions have a trained mindset and specific skills that, when employed, can help ensure that organizational decisions are based on information that is valid, reliable, and relevant.
- Creating a traceable audit trail: One of the fundamentals of good oversight and control is maintaining information and documentation about the process itself. This means that an organization retains the data so that it can trace the review and approval process. It documents the steps that are taken and ensures the information is presented meaningfully to represent the organization’s underlying activities.
- Revisiting and modernizing process and procedures over specific area, such as technology, safety, procurement, environment, talent, etc. Looking to existing internal control can accelerate the organizations meeting its objectives. This can reflect existing enterprise-wide knowledge: Staff who know the organization, its business, operations, and policies and processes. Internal audit may then evaluate competencies and gaps to redirect resources.
- Data visualization tools enable the highlighting of the most important combinations of data through KPIs and metrics. Data visualization tools can be leveraged to facilitate the tracking and presentation of KPIs as well as monitoring environmental, social, and governance(ESG) related metrics that inform progress toward the achievement of business objectives. Through automatic data feeds and the use of dashboards for digestible presentation, these tools can aid in the aggregation and analysis of business information, and ultimately, support strategic decision-making and reporting.
- Employees may have unique and important perspectives on driver, direction, and pace of change in various areas of business. Open channel communication or informal communication allows business to see what is out there and what is on the horizon.
- Management provides multiple channels for communication, such as one-on-one meetings, dedicated email addresses, and hotlines, to receive suggestions, complaints, and other feedback. These communications could helps strive towards business objectives, including a workplace that is free from harassment, embraces diversity and inclusivity, and pays fully to employees.
