May 02, 2021

Internal Controls: The Complete Guide

by Arielle Kushner

internal controls

Ensuring your finance team is working at their best isn’t always easy. You must consider many things to guarantee your operations run smoothly–accounting management and your internal controls are a big part of this. 

Without accurate accounting records, managers and financial leaders cannot make fully informed financial decisions, reporting, and monetary reviews to help your business grow. 

This guide will provide you with a complete overview of internal controls and why it matters to the health of your growing business. We will cover:

  • What internal control is
  • The internal control procedures of auditing
  • Who is responsible for internal controls
  • Common issues with internal control systems
  • What makes for effective internal controls
  • Why good control procedures and financial management matters
  • Optimization with automation, and
  • How fintech is making internal controls easier

The main takeaway is that, while internal controls contribute to stakeholders’ workloads and can delay processes and procedures, especially if auditing is manual, implementing and applying internal controls effectively is required to increase a company’s financial security and efficiency. Rules are followed for a reason, and a company’s internal controls are no different. 

All companies, big and small, are vulnerable to financial damage like fraud, embezzlement, and discrepancies. Internal controls are needed to regulate and automate away common errors in financial processes as a result.

What are internal controls?

Internal controls are processes and records internal to a company, specializing in upholding and maintaining financial and accounting integrity of information. For example, internal controls are vital to prevent fraud. 

Optimization and automation are critical when ensuring the effectiveness of internal controls. Companies view and use these controls as an “interlocking set of activities,” ensuring redundancy beyond normative operating procedures within an organization. Assets are safeguarded, errors (especially manual) are minimizable, and operations are conducted in a manner befitting the company. 

Internal controls help finance teams mitigate and nullify risk, as well as ensure consistency when producing financial statements. When criminals can defraud even Amazon out of goods, every company needs robust controls in place!

Types of internal control

Companies primarily use three types of internal controls – detective, preventive, and corrective controls. These three control types can either be used in isolation or combination, depending on the intended use. 

  • Detective Controls: Detective controls constitute internal control that highlights any significant issues in the company’s accounting process. These controls commonly involve legal compliance, quality control, and fraud prevention. Detective controls are high-level and top-down.
  • Preventive Controls: Preventive controls are a form of internal control that patch “holes” in the financial management system before becoming a problem. Preventive controls are performed regularly to maintain organization and proactive prevention of errors and irregularities.
  • Corrective Controls: Corrective controls are a form of internal control which aims to resolve any errors found by internal detective controls. Corrective processes run a fine-tooth comb with accounting controls to ensure the same mistakes or potential hiccups do not happen again.

These forms of internal controls are all useful to help prevent and react to company procedural issues before, during, and after processes are run. 

What are the internal control procedures in accounting?

Internal controls in accounting are paramount to mitigate as much financial risk as possible while ensuring company processes and fulfilling procedures smoothly.

Internal control procedures in accounting consist of:

  • Separation of Duties: Separation of duties is essential when performing financial transaction processes. No one person should ever wholly take responsibility for any process. Accounting practices can be split quickly without introducing significant downtime or delays. For example, bookkeeping, deposits, reporting, and auditing, accompanied with managerial oversight, can be split using a separation of duties. Separation of duties helps to minimize any single employee from committing fraudulent acts.
  • Access Controls: Access controls determine which groups and accounts have access to particular processes and procedures within the company. Access control can restrict which employees can access a private data center and which employees can sign off on computer processes like accessing logs, for example. Access to sensitive computer records is often restricted, so that information is only made available to those who need it to conduct specific tasks. Doing so reduces the risk of information theft and the risk of asset theft by modifying ownership records. Access control is a tradeoff between accessibility and security, giving temporary access to those who need it. 

  • Physical Audits: Physical audits are necessary to introduce redundancy. Computerized systems, no matter how efficient, can still err from time to time. Hand-counting any physical assets tracked in the accounting system, such as inventory, materials, and tools, are some ways to perform physical audits. For smaller-scale operations, counting cash can be conducted daily or even several times per day, depending on your company’s processes and procedures.

  • Standardized Documentation: Invoices, internal materials requests, inventory receipts, and travel expense reports can help maintain record-keeping consistency over time. Standardizing processes and procedures is a popular means of ensuring documentation is present for all financial processes. A stakeholder can integrate standardization into existing financial processes for minimal setup and maximal efficiency.

  • Trial Balances and Account Reconciliations: Trial balances and account reconciliation add an extra layer of protection and reliability through double-entry accounting. Calculating regular trial balances, weekly or daily, is recommended, and can provide users with an insight into the efficiencies of their financial systems. Close and regular monitoring is also vital to help catch discrepancies like human error or fraud as soon as possible and to prevent future discrepancies of a similar nature. Account reconciliations are a means for a business to verify account balances between internal accounts and external third-party accounts; another means to help discover discrepancies like mismanaged finances, fraud, or even just human error.

  • Approval Authority: Specific managers must authorize certain types of transactions. This system can add a layer of responsibility to accounting records by proving that transactions have been seen, analyzed, and approved by appropriate authorities. To minimize human error, make sure the stakeholders at every level of the procurement or financial management process completely understand their role, impact, and how to achieve what they need to competently. 

Who is responsible for internal controls?

While some employees may have more influence when determining a company’s internal controls, all employees contribute to a company’s financial risk and security. 

Some everyday interactions employees have with internal controls, and the responsibilities of these employees are as follows:

  • A board of directors oversees the entire organization, providing governance over the management team.
  • Internal auditors routinely examine all processes, looking for correctable failings with either new controls or tweaks of existing controls.
  • Employees with access contribute data or information to internal controls processes and procedures to accomplish tasks and projects. 

The bottom line is that everyone, whether a C-level executive or a member of a business or finance work team, that interacts with and uses internal controls is responsible for upholding the security such controls provide.

Common issues with internal control systems

Internal controls, like any auditing system, are not perfect. There is always room for improvement. For example, control activities may frequently slow down the natural process flow, which can reduce its overall efficiency. However popular a metric, efficiency is not the only factor a company has to consider when determining success. 

The development of a system of internal control requires management to balance risk reduction with efficiency. Adding internal controls might result in management accepting a certain amount of risk to create a strategic profile that allows a company to compete more effectively.

Smaller operations may employ purely manual accounting and analog financial processing. This may increase the potential risk of fraudulent activities, human error, or discrepancies that fintech or standardized financial systems may pick up on. For example, Daniel Berenbaum, Vice President Finance and Asia Pacific Chief Financial Officer of Global Foundries, believes that “the risk of human error is high with manual processes. Additionally, you don’t always achieve the level of transparency that you would like.” 

Tradeoffs are typical, but a company must expect them to dissuade lower morale and improve internal control mechanisms. 

Finally, cutting corners can be an issue, as internal controls may delay processes. Employees required to complete specific tasks within a period may flaunt rules and regulations to accomplish work faster, even if that means increasing financial risk to the company. 

However, controls, internal or not, only work if stakeholders like employees are obeying them. If an employee does not understand the internal control procedures or completely bypasses them, the accounting system becomes inaccurate and does not pass through the proper reviews.

What makes for effective internal control?

While the specifics of internal controls themselves are dependent on the company, its goals, and industry, general guidelines can be beneficial to any company. External factors like the law may influence some controls, and other internal controls may be initiated due to a CEO’s or finance leader’s concerns over a specific financial process or procedure. However, several means exist to ensure the effectiveness of internal controls.

Here is a four-step process you can follow to ensure your internal controls work:

  • Follow the system and organizational structure: This ensures the chain of command is laid out and only granted to those who need it.
  • Maintain strong company and ethical values/integrity: Believing in internal controls and your financial management system improves adherence.
  • Foster open and transparent communication: Stakeholders and employees should feel comfortable voicing their concerns or reporting any red flags. Adequately training staff with policies, procedures, and operations can aid in fostering awareness and open dialogue.
  • Ensure increased oversight: You can increase the safety of your assets by having a third party or a trusted member of your company review your company’s accounts.

Your workplace should have adequate internal controls already in place, as well as guidelines to maximize the effectiveness of these controls.

Why effective control procedures and financial management matter

Implementing robust internal controls is a means to an end. However, once implemented, stakeholders have to follow those controls. Naturally, as a company grows, the amount and depth of implementing internal controls like purchase approval processes will grow too – primarily if the company dedicates itself to growing among new audiences and markets. A system of internal controls tends to increase in comprehensiveness as an organization increases in size.  

Control costs 

Companies live and die by budgetary controls. On average, companies lose between approximately 10%-20% of their projected savings to maverick spending each quarter. Internal controls help by catching and curtailing unnecessary spending to ensure better company health.

Ensure compliance

Compliance is necessary and straightforward to implement. Having the appropriate people with the proper controls and access within the audit system will optimize the financial system. Accountability is key. Compliance maintains the organization of your company or business, no matter the size. 

Eliminate fraud and protect your assets 

While manual errors in finance may never be 100% nullified, they are minimizable to a great extent by simply following internal control protocols. You can do this by maintaining visibility over the actions of involved stakeholders. Minimize risks at every step of the way for more streamlined and efficient financial operations and transactions. 

Companies are not immune to fraud, a multi-billion dollar industry, no matter how well their internal controls are implemented and followed. There is always room for error, so complacency is not an option.

Optimization with automation 

Moving from manual to automated tasks will allow finance teams to focus on value-added activities that positively grow or impact the organization. Financial and reporting controls, and other finance functions can work across the organization to create added value and enhance performance.  

While it may be tempting to optimize and automate first, the most crucial step is to outline and implement internal controls. Once implemented, you can then audit company progress and evaluate whether (and at what point) controls need optimizing and automation. You can also optimize and automate incrementally using Agile project management practices.

Internal controls play an important role in creating a rigid system your organization needs to navigate financial processes. Investing in automated fintech solutions like modern financial management systems will boost your company’s efficiency and growth in the digital age. Giving your team a solid infrastructure to carry out important financial procedures correctly will not only enable this growth, but will act as a safety net in preventing foundational mistakes that have long-term adverse effects.

Interested in implementing a spend management system that simplifies and streamlines your business’s existing process? Check out Approve.com and request a free demo today!

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