Internal controls, as defined in accounting, are methods applied by a company to ensure the integrity of financial and accounting information and meet the organizational objectives in operational and profitability targets. Internal controls guarantee reliable financial reporting as well as compliance with laws, regulations and policies and communicate management strategies throughout the organization.
Especially for small business owners, it is particularly important to put measures in place that can protect their company’s financial and management procedures and ensure compliance with the federal and state laws and regulations. In fact, internal controls establish protocols on how to report money inflows as well as how to handle administrative and management tasks.
What do internal controls achieve?
According to the Sarbanes-Oxley Act (SOX), public companies are forced to maintain internal controls in their financial reporting. The SOX introduced in 2002, mandated strict reforms to improve financial disclosures from small and large companies, including details of their internal controls in their annual reports. In doing so, the SOX helps any company to prove its integrity with respect to accounting and management and prevents accounting fraud.
- Preventing fraud
The design of internal control procedures focuses primarily on preventing errors or reducing fraud occurring from undetected errors. If the top-down control procedures are properly designed, then due diligence is performed by management and corporate governance produces great operational results. Because internal controls include reporting and audit reviews, it is easier to uncover potential mishandling of company money, thereby protecting the company’s financial integrity.
- Reducing errors
By putting in place internal control procedures, businesses can reduce accounting errors that could harm their profitability and reputation. For instance, employee training on accounting processes and procedures eliminates the probability of accounting mistakes that could cost the company lots of money, along with ruining its reputation.
- Organizing data
With internal controls, financial data and information are organized in a way that employees can anticipate any documentation filing quickly and effectively. In fact, organized data can increase productivity as there is not time lag in performing duties. Also, internal control procedures allocate distinctive duties to each employee so that a system of checks and balances is put in place.
Components of effective internal control
Since they are integral elements of any company’s financial and management policies, internal controls should include certain components that can make them effective. These components aim at protecting organizational resources against waste and fraud; guaranteeing accuracy in accounting information; ensuring compliance with the organizational policies, and assessing organizational performance in all organizational units.
In this context, the components of effective internal control are the following:
- Strong management ethics to ensure integrity in the key internal control procedures.
- Close monitoring of internal control activities of the management to ensure effectiveness in internal control and operational systems. In fact, internal control processes may change or fail, rendering internal controls ineffective or useless. Because internal control is only effective when properly designed and operating as intended, quality should be monitored periodically to ensure that internal controls continue to provide the required protection.
- Active involvement of the boards of governance in the internal control activities. Duties should be separated so that board members perform their due diligence effectively to ensure integrity in inspection and approval of accounting data.
- The existence of a state-of-the-art IT system to lower the risk of errors or fraud in financial reporting.
Internal controls in accounting should capitalize on organizational efficiency by including activities that apply to the type, size, and structure of the company. Internal control policies should be communicated to the accounting personnel on a regular basis so that organizational performance is enhanced and basic activity-level control procedures are effectively performed. Finally, internal controls are best implemented when they encompass interactions between different divisions of the company, thereby creating a blend of accounting practices that ensure financial integrity.
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