What is internal control?Internal controls are the policies, procedures, and activities that protect organizations from financial, operational, and strategic risks. Every organization that deals with online business activities or has a digital presence needs internal controls to protect against cybersecurity threats and to ensure compliance with data protection regulations.
The advantage of internal controlsAs business activities and volumes expand and reliance on manual intervention increases, human error, omissions, and fraudulent manipulation can also increase significantly.
- Increased security - The first and foremost benefit of internal controls is the enterprise-wide protection they provide. Your business is significantly less vulnerable with a defense plan in place. Every business is at risk from business disruption, cyberattacks, market shifts, and more. By preparing ahead of time for these inevitable situations, you can sail through them successfully and move your business ahead.
- Helps reduce audit fees - Properly established internal controls reduce the need for external audit fees. When an organization provides a clear framework for the implementation of internal controls and their findings, it reduces the need for reviews or the need to rebuild all internal controls after external audit and verification.
- Timely preparation of financial statements - Timely preparation of financial statements helps management make future decisions for the company beforehand and also protects stakeholders and the company's reputation. Regular financial statements help identify and correct small mistakes that help build trust and demonstrate company transparency.
- Recognition of the SOX act - The main purpose of establishing SOX was to maintain accountability in an organization. Internal controls via efficient and effective financial reporting do the same. The SOX act is a federal law enacted to protect investors and ensure that the organization provides reliable and accurate financial information. By complying with the SOX law, companies gain confidence in investors and in the company's financial data management. Know more about SOX compliance with VComply
- Enhances accountability - Well-designed internal controls created with specific roles for key members help reduce errors and improve process performance. This leads to improved accountability when clear data transfer, data recording, and data sharing protocols are followed. Enhanced accountability means the company meets legal and regulatory reporting requirements.
- Helps keep duties segregated - Internal controls ensure that tasks are separated for different people as this prevents conflicts of interest and reduces the likelihood of financial mismanagement. Segregation of duties also ensures that a system of checks and balances is put in place so that not every person has access to all the data.
- Organized information - Properly organized data from any organization helps prepare for events such as litigation and external audits. Internal controls protect customers' interests by creating systems that archive customer data or documents, or by imposing restrictions. Organizing information also helps improve efficiency by ensuring the security of financial data that are accessed.
- Saves money - External financial reports are more reliable when good internal controls are in place. Additionally, the ability to see what is being done to avoid losses will help you improve those efforts and better allocate your funds. The controls also minimize lost profits caused by business disruption and avoid litigation and other forms of compensation that are often necessary for your customers after a risk event has occurred.
- Helps mitigate compliance risks - Compliance risks threaten an organization by exposing to legal penalties, financial fraudulent activities and material loss, resulting from failure to abide by the rules and regulations. Having internal controls in terms of compliance management in place, helps mitigate the risks and potential exposure to any potential losses arising from noncompliance with laws, regulations and standards.
- Stringent regulatory compliances - Many laws and regulations require organizations to use internal controls to achieve specific outcomes. These laws specifically require companies to use specific frameworks, as using a recognized framework brings discipline and transparency to your compliance efforts. This, in turn, reduces the likelihood of compliance violations that could lead to costly enforcement actions.
- Improves operational efficiency - Operational efficiency can be improved through the application of internal controls as this helps eliminate unnecessary and duplicate steps in a process or procedure. Improving operational efficiency allows management to obtain timely information about the organization that helps to review current operations and verify whether or not business goals are being met.
- In addition, internal control compliance is designed to ensure the achievement of operational objectives including the effectiveness of operations, accurate, reliable and timely financial reports, and compliance with the country’s laws and regulations. Simply put, internal control compliance plays an important role in ensuring that the organization’s operational, strategic, compliance, and reporting goals are met.
The different types of internal controlThere are three main categories of internal controls: preventive, detective, and corrective.
Preventive controlsPreventive controls are measures taken to prevent an undesirable event from occurring in the first place. This broad category includes everything from key card access controls to segregation of duties and complex password requirements. Preventive controls are implemented after a risk assessment has determined which risks could affect different areas of your organization. Examples Examples of the preventive type of internal control include the use of video surveillance or strategic placement of security personnel at points of entry, verification of identification data, and restricted access. Furthermore, firewalls, computer and server backups, training programs, and even routine drug testing are all types of preventive internal controls, which are put in place to prevent the loss of assets and the occurrence of harmful events. Two main preventive control measures are:
Detective controlsDetective controls are used to examine transactions and determine if errors have occurred. This allows executives to fix a problem before it causes more problems. Ideally, detective internal controls will discover an issue before it becomes a significant problem.
Internal audit and incident management software can help you simplify the audit management process.Financial reporting and reconciliations Reconciliations are conducted to verify financial reporting between different sources. For example, comparing a bank statement to a company's internal records is one form of reconciliation. Financial reports document the company's income, expenses, cash flow, and financial health. It enables executives and investors to make more informed judgments about performance and opportunities for improvement. Unusual or unexpected numbers in financial reports and financial statements help identify unintentional errors and inappropriate actions.
Corrective controlsThe third type of internal control is corrective internal control. They are those controls that are performed after detective internal controls have identified a problem. Sometimes even if all existing preventive controls are working as planned, it falls short. If an error or deficiency is discovered within the current security regime, corrective internal controls are implemented with identifiable internal controls to address previous deficiencies.
- Implement a more rigorous training process
- Update the policies
- Invest in new technology to protect against new threats
Implementing internal controlsInternal controls consist of five main components, established by the Committee of Sponsoring Organizations (COSO) and providing guidance to companies around the world. Known as the COSO framework, these five components are:
Control activitiesControl activities provide a reasonable level of assurance that the entity's objectives will be met. Although absolute assurance is not possible due to cost, collusion, human error, and management's ability to override controls, having an internal control process can reduce the risk proponent to a significant level.
- Authorization to initiate or approve transactions should be limited to designated personnel. Permissions can be restricted by the type of transactions or the number of transactions.
- Segregation of duties means that a single employee is not responsible for all phases of a transaction.
- In general, an employee with physical access to an asset should not also be responsible for the accounting records related to that asset.
- Assets should be physically protected. Access to assets should be restricted. Reconciliations of assets to accounting records must be made regularly and reconciliation of items must be done in a timely manner.
- Physical assets must be counted regularly and the results of the counts must be compared with accounting records.
- Inconsistencies should be reported to the appropriate administrators and investigated.
- Transactions must be properly documented and records must be kept in an organized manner.
Control environmentBefore dealing with any of the other components, the second most important step is to create the control environment. The control environment examines the behavior of top management and their ability to implement the necessary controls. It examines everything from the ethics of an organization's top management to their integrity in dealing with any issues that may arise. The top management sets the tone for the rest of the organization including human resource policies and procedures, management philosophy, and organizational structure. The control environment also includes the involvement of management and the board of directors to ensure that internal controls are being followed, as well as how employee responsibilities are assigned and managed.
Risk assessmentOnce the control environment has been established, the next component to consider is risk assessment. Assessing a company's risks is essential as the risks must be identified before a control procedure is implemented.
- Public scandal
- Revenues not received or if received, not accurately documented
- Improperly recorded assets are not used efficiently
- Assets that cannot be used to achieve the unit's goals and objectives for personal use
- Information used for decision-making is not reliable, current, or available
Information and communication systemThe purpose of the information and communication system is to ensure that employees are aware of the objectives and goals of the unit, how they are to be achieved, and who is responsible for the specific tasks assigned to them. The information and communication system should also provide managers with reports containing operational, financial, and compliance information to monitor progress toward set goals and objectives. Using this, managers and stakeholders can make data-backed decisions.
- Written corporate policies and procedures.
- The goals and objectives of the unit
- Documented unit policies and procedures
- Evaluation of performance
- Organization chart information and communication system that ensures employees know what they are supposed to achieve and how to do it.
MonitoringMonitoring ensures that the internal control system is working as designed. It must be conducted by supervisors and be focused on high-risk areas. Monitoring identifies changes in circumstances that may require modification to the internal control system.
- Timely review of transactions to ensure compliance with policies and procedures related to departmental accounting records.
- Reviews of high-risk accounts or records, including employee payrolls and vacation records, trend assessments, review of supporting documentation, and unexpected counts of cash and other assets.
- Documentation of software for employee licenses.
- Reviews of tangible personal property and related records.
- The follow-up to grievances, rumors, and allegations requires supervisory or management oversight.
How to test internal controls?A test of control describes a systematic and methodical testing procedure used to evaluate internal controls. The objective of auditing the controls is to determine whether these internal controls are sufficient to detect or prevent the risk of asset mismanagement or unforeseen threat. A strong internal control system is essential for organizations to maintain accurate financial records.
Inventory creationBefore establishing a reliable testing process, you should consider all important controls and document their activity in detail. When you have a complete and consistent control library, you can identify the basic details of each control and its impact on different departments or business units in the organization. It is not necessary to fully document all controls prior to testing, but an inventory of key controls can make the test easier and more effective.
Prioritization of required testingTypical organizations have hundreds or even thousands of controls documented. Testing all of these controls is not viable but the list needs to be streamlined and simplified for each individual test. For each control under consideration, determine its impact on the organization and use this information to determine the type and frequency of testing to be performed.
Designing the right test approach for controlThe test approach is often dictated by the type of control. If the organization relies on a control to mitigate significant risks, it should assess it more frequently. You can also perform a design evaluation of the control before testing its functionality.
Documentation and trackingAlthough it may seem like a simple concept, an important aspect of test control is prioritizing and correcting problems found during testing. These fixes should be tracked until they are complete. The best practice is to verify fixes by running the test program again after giving time to fix to verify that all issues have been fixed.
What is the difference between internal check vs internal control?Although internal check and internal control imply similar functions and often are used synonymously, they differ largely in their scope of work.
Limitations of internal controlsThough internal controls provide a plethora of benefits to organizations, it does have limitations as well, if improperly implemented.
CollusionSegregation of duties is one of the most commonly used internal controls in organizations. It is highly recommended to separate tasks so no employee has the power to commit fraud. However, employees can overcome this by working together through an elaborate process to cover up their fraud.
Human errorHuman error can be another disadvantage of internal controls, especially when it comes to the reliability of manual processes and discretionary decisions. For example, errors can be made with manual inventory counts, and poor judgment can affect internal audit results.
Management overrideThe risk pertains here is that certain individuals with management authority have the authority to approve an exception to internal control. For example, the Chief Information Security Officer may have the authority to authorize elevated access privileges for individuals, but doing so inappropriately could undermine your access management controls.
System errorsThe risk of automated system controls crashing without warning can prove to be a nightmare. An increasing number of companies are relying on automated system controls to maintain the security, availability, and integrity of their systems. However, if the setting to enforce encryption is overridden in a system update, you may lose an important privacy control if no one is made aware of the change.
MisjudgmentThe risk denotes that you have misidentified controls to adequately mitigate the risk of your business or operating environment. Identifying appropriate internal controls is more of an art than a science, and you may find that the industry-leading vulnerability scanner isn't right for your organization after you've identified the overlooked vulnerabilities.
How can VComply help in your internal control plan?For starters, developing an internal control framework for the organization can be an overwhelming and time-consuming activity. Most organizations don't know where to start and wander off to find the right controls to begin with which wastes valuable time and effort.
- Automated control assignment, delegation, review, reporting, and evaluation of the effectiveness of organizational control.
- You can leverage the library of predefined regulations and compliance and control frameworks.
- Collaborate with teams and stakeholders using VComply’s control workspace.
- Automate your risk assessments and identify gaps.
- Link controls to risk and implement risk mitigation methods.
- Assign policies and content frames to generate automatic reports.