Why is it important to have good internal controls?

Internal controls can be thought of as checks and balances to prevent errors and losses in various areas of a business. Good inventory controls prevent losses and misstatements while helping in managing inventory levels. Since inventory is quite expensive, any measure to protect this investment should be considered.

Savings

  1. When controls are in place, a firm is likely to save money and be run more efficiently. Management can make better decisions about inventory and sales because the data it receives is real and relevant. A manager may decide to cancel an order or to return a shipment because of the documentation available, usually due to internal control requirements. Other savings are related to taking advantage of discounts, as payment processes related to inventory are enhanced with proper internal controls. By paying bills early or on time, the firm is in a better position to negotiate terms and other conditions over the supply chain, saving money over the long run.

Public Filings

  1. Public firms must file internal control reports with the United States Securities and Exchange Commission, attesting that controls are working properly. This requirement is specific to the Sarbanes-Oxley Act of 2002, which was enacted after many financial scandals, including the Enron fiasco. For executives to sign this report, they must have assurances about controls' effectiveness and other detailed information. There are not many choices in this area for many firms, which have controls in inventory as part of the entire control package. Most businesses don't want to disclose that their internal controls are not working well in inventory (or any other area), and therefore, they keep their controls up and going by conducting periodic testing and evaluations.

Reliability

  1. Another important benefit of internal controls is that it improves the reliability of accounting information, including management reports. Confidence matters in the financial area. Investors and bankers appreciate internal controls, which can build up a firm's reputation and dependability. A business with strong controls that are regularly evaluated and tested is not just a fly-by-night outfit -- it's perceived as a well-managed, growing business that is expected to succeed. For example, if you see $400 as inventory balance in a report from a firm with strong controls, you're more likely to trust the number and to make good decisions based on that amount.

Standardization

  1. A "side-effect" of good internal controls involves the standardizing of processes and procedures. Work flows that comply with internal controls are usually desirable, and most businesses maintain them on a daily basis. Controls permeate firms and become the "normal" status, helping to bring a business to a higher level of operation with more organization and less confusion. Official policies and procedures can be set up based on controls, such as a procedure to require tagging all inventory items as they arrive in the warehouse. Such level of standardization helps in training new employees, decreasing errors and the chances for fraud or theft. When a transaction doesn't follow the expected process, it stands out and can be identified easily.

Internal controls are accounting and auditing processes used in a company's finance department that ensures the integrity of financial reporting and regulatory compliance. Besides complying with laws and regulations and preventing fraud, internal controls can help improve operational efficiency by ensuring budgets are adhered to, policies are followed, capital shortages are identified, and accurate reports are generated for leadership.

  • Internal controls are the mechanisms, rules, and procedures implemented by a company to ensure the integrity of financial and accounting information, promote accountability and prevent fraud.
  • Besides complying with laws and regulations, and preventing employees from stealing assets or committing fraud, internal controls can help improve operational efficiency by improving the accuracy and timeliness of financial reporting.
  • Internal audits play a critical role in a company’s internal controls and corporate governance, now that the Sarbanes-Oxley Act of 2002 has made managers legally responsible for the accuracy of its financial statements.

Internal controls have become a key business function for every U.S. company since the accounting scandals in the early 2000s. In their wake, the Sarbanes-Oxley Act of 2002 was enacted to protect investors from fraudulent accounting activities and improve the accuracy and reliability of corporate disclosures. This has had a profound effect on corporate governance, by making managers responsible for financial reporting and creating an audit trail. Managers found guilty of not properly establishing and managing internal controls face serious criminal penalties.

The auditor’s opinion that accompanies financial statements is based on an audit of the procedures and records used to produce them. As part of an audit, external auditors will test a company’s accounting processes and internal controls and provide an opinion as to their effectiveness.

Internal audits evaluate a company’s internal controls, including its corporate governance and accounting processes. They ensure compliance with laws and regulations and accurate and timely financial reporting and data collection, as well as helping to maintain operational efficiency by identifying problems and correcting lapses before they are discovered in an external audit. Internal audits play a critical role in a company’s operations and corporate governance, now that the Sarbanes-Oxley Act of 2002 has made managers legally responsible for the accuracy of its financial statements.

No two systems of internal controls are identical, but many core philosophies regarding financial integrity and accounting practices have become standard management practices. While internal controls can be expensive, properly implemented internal controls can help streamline operations and increase operational efficiency, in addition to preventing fraud.

Regardless of the policies and procedures established by an organization, only reasonable assurance may be provided that internal controls are effective and financial information is correct. The effectiveness of internal controls is limited by human judgment. A business will often give high-level personnel the ability to override internal controls for operational efficiency reasons, and internal controls can be circumvented through collusion.

The U.S. Congress passed the Sarbanes-Oxley Act of 2002 to protect investors from the possibility of fraudulent accounting activities by corporations, which mandated strict reforms to improve financial disclosures from corporations and prevent accounting fraud.

Internal controls are typically comprised of control activities such as authorization, documentation, reconciliation, security, and the separation of duties. And they are broadly divided into preventative and detective activities.

Preventive control activities aim to deter errors or fraud from happening in the first place and include thorough documentation and authorization practices. Separation of duties, a key part of this process, ensures that no single individual is in a position to authorize, record, and be in the custody of a financial transaction and the resulting asset. Authorization of invoices and verification of expenses are internal controls.

In addition, preventative internal controls include limiting physical access to equipment, inventory, cash, and other assets.

Detective controls are backup procedures that are designed to catch items or events that have been missed by the first line of defense. Here, the most important activity is reconciliation, used to compare data sets, and corrective action is taken upon material differences. Other detective controls include external audits from accounting firms and internal audits of assets such as inventory.

Auditing techniques and control methods from England migrated to the United States during the Industrial Revolution. In the 20th century, auditors' reporting practices and testing methods were standardized.

Internal controls are the mechanisms, rules, and procedures implemented by a company to ensure the integrity of financial and accounting information, promote accountability, and prevent fraud. Besides complying with laws and regulations and preventing employees from stealing assets or committing fraud, internal controls can help improve operational efficiency by improving the accuracy and timeliness of financial reporting.

The Sarbanes-Oxley Act of 2002, enacted in the wake of the accounting scandals in the early 2000s, seeks to protect investors from fraudulent accounting activities and improve the accuracy and reliability of corporate disclosures.

Internal controls are broadly divided into preventative and detective activities. Preventive control activities aim to deter errors or fraud from happening in the first place and include thorough documentation and authorization practices. Detective controls are backup procedures that are designed to catch items or events that have been missed by the first line of defense. 

Separation of duties, a key part of the preventive internal control process, ensures that no single individual is in a position to authorize, record, and be in the custody of a financial transaction and the resulting asset. Authorization of invoices, verification of expenses, limiting physical access to equipment, inventory, cash, and other assets are examples of preventative internal controls.

Detective internal controls attempt to find problems within a company's processes once they have occurred. They may be employed in accordance with many different goals, such as quality control, fraud prevention, and legal compliance. Here, the most important activity is reconciliation, used to compare data sets, and corrective action is taken if there are material differences. Other detective controls include external audits from accounting firms and internal audits of assets such as inventory.