What is the role of internal control in financial reporting?

Internal control enhances the reliability of financial reporting and helps to ensure that financial statements are free from major misstatements. This is important because stakeholders such as business owners, investors and lenders all rely on financial reports to make decisions. Without internal control, businesses face an array of exposures that can drastically alter revenue generating capability.

Errors and Omissions

1. Errors in financial statements are more likely to occur without a system of internal control and can happen for a variety of reasons, despite accounting personnel's best efforts. If reconciliations, which are a form of control, are not performed on a regular basis, account balances may not balance back to bank statements or supporting schedules. While some errors are to be expected, internal controls mitigate the risk of material misstatements to the lowest possible level. Material misstatements are significant enough to influence the decision-making of financial statement users.

Illegal Acts

1. Bribes and other transactions that break laws are something that systems of internal control are designed to prevent. Small companies that are trying to enter foreign markets are often faced with corruption and must work hard to avoid illegal dealings. Illegal acts recorded or unrecorded in financial statements have drastic consequences for companies. Despite the effectiveness of internal controls, it is possible for groups of employees or managers to collude and manipulate account balances to cover up illegal acts.

Misappropriation of Assets

1. Company assets such as inventory and petty cash are always under the threat of misappropriation. For this reason, the segregation of duties enhances internal control and improves the accuracy of financial reporting. It is imperative that company personnel separate the custody of assets from the recordkeeping function and the authorization of transactions. Otherwise, assets can be misappropriated and the theft concealed through manipulation of general ledger accounts. Internal controls mitigate internal and external threats to assets and cash accounts to manageable levels.

Fraud

1. Fraudsters can distort financial statements in order to deceive investors and business owners. Management’s bonuses are often tied to company performance, and unscrupulous leaders may adjust account balances to increase their compensation. Internal controls are designed to keep management from manipulating financial statements and deceiving relevant stakeholders. In tough economic times when companies are struggling, unusually good performance is an indicator that there may be something wrong with financial statements. Internal and external auditors can help to uncover fraud and accounting improprieties.

   With the corruption of Enron and WorldCom, internal controls became more and more important. An effective internal control system is a requirement of the Sarbanes- Oxley Act of 2002 which regulates reporting and testing of internal controls over financial reporting for public companies. Internal controls play a critical role not only in public companies but also in private companies, because internal controls establish safeguards to an organization’s assets and minimize the opportunities of committing fraud and allowing errors to go undetected in an organization’s daily operations.

   In this article, we will discuss the importance of internal controls in accounting to help you to establish an effective internal control system in an organization.

   1. Internal Controls help to understand and mitigate risks.

   Internal controls are usually established based on a risk-oriented approach to ensure that your organization focuses on high risk areas. For example, when an employee accuses that the petty cash is locked, you may immediately sense that stealing cash is a risk. Understanding risks will help you to determine if there are adequate controls to mitigate the risks in those areas. You may question if there are other internal controls in place to mitigate the risk, such as whether the petty cash gets reconciled and reviewed? Who is responsible for preparing the reconciliation and who reviews and approves it? How often does petty cash get reconciled?

   A risk assessment, a necessary first step, provides a foundation to establish internal controls. Please refer to the article: Internal Control Risk Assessment for more details about internal control risk assessment.

   2. Internal Controls help to address financial statement assertions.

   One of purposes of internal controls is to safeguard the organization’s assets and thus address financial statement assertions (existence, rights, completeness and accuracy). A familiar example is performing a physical count of inventory used internally by all organizations. Count inventory and track them in the accounting system to ensure the existence. Count cash receipts in retail sales before recording them to verify accuracy.

   3. Internal Controls help to prevent and detect fraud.

   Segregation of duties (SOD) is a fundamental element of internal control. Internal controls including proper SOD help to prevent fraud. The principle of SOD is to share responsibilities in a key process such that no one individual should perform two of the three functions: custody, recording and authorization. When the three responsibilities are properly segregated, fraud can be effectively prevented or detected. For example, when an accountant both receives and records cash, the accountant could commit fraud easily. But when the accountant receives cash and another accountant records the cash, committing fraud won’t be that easy. At the same time, the Accounting Manager reviews the cash records and reconciliation to detect any errors or fraud, which makes committing fraud even harder. For more detail about SOD, please refer to the article: Segregation of Incompatible Duties.

   Another familiar internal control to prevent fraud is to limit access to only authorized personnel, such as preventing unauthorized personnel from getting access to a warehouse and stealing inventory for resale. Another access content might involve allowing only accounting employees to access accounting systems.

   4. Internal controls help to prevent misstatement of financial statements.

   Internal controls helps to prevent errors and misstatement of financial statements. For example, reconciliation is a critical internal control procedure in accounting and can ensure the account balances on the balance sheet are correct to prevent misstatement of financial statements. Reconciliation also helps management and other users to detect errors and understand the company operations. We will provide some best practices about reconciliation in a download file.

   5. Internal controls help to establish company practices.

   If you do not have documental evidence of internal controls, you cannot prove internal controls exist. Most organizations have documentation for their internal controls, i.e. flowcharts and/or narratives, because documentation is critical to communicate internal controls with your external auditors and within your organization, quality documentation can be used to train new employees. By following internal controls documentation, employees get a better understanding of the company processes and practices, which helps to establish the company’s practices.

   If you have any comments about the importance of internal controls in accounting, please feel free to contact us. Also, we have provided some best practices about account reconciliations that can be downloaded by selecting the button below.

   Download Best Practices for Account Reconciliation

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   Emma Zhang is an experienced audit professional, with more than six years of internal audit & Sarbanes Oxley (SOX) compliance focusing on operations, accounting, internal controls and process improvement. Competencies include operational auditing, accounting, management consulting, Sarbanes Oxley (SOX) compliance, audit planning and risk assessments, operational/financial planning and analysis, and data analysis. Emma is a resourceful, creative thinker and analytical problem solver with demonstrated ability to independently manage tasks from planning through execution in dynamic, fast-paced, and time-sensitive environments. Emma is a CPA with a CFE certificate. Emma is also a Blackline Certified Implementation Professional and helps clients to implement Blackline system.

   What is internal controls over financial reporting?

   ICFR refers to the controls specifically designed to address risks related to financial reporting. In simple terms, a public company's ICFR consists of the controls that are designed to provide reasonable assurance that the company's financial statements are reliable and prepared in accordance with GAAP.

   Why are internal controls important in financial statements?

   Good internal controls are essential to assuring the accomplishment of goals and objectives. They provide reliable financial reporting for management decisions. They ensure compliance with applicable laws and regulations to avoid the risk of public scandals.

   What is internal controls in financial accounting?

   Internal accounting controls are the various methods, mechanisms, and procedures that firms use to ensure the validity and accuracy of their financial statements. These internal controls are implemented, maintained, and monitored by the company's senior management and the board.

   Who is responsible for internal control over financial reporting?

   Management is responsible for establishing internal controls. In order to maintain effective internal controls, management should: Maintain adequate policies and procedures; Communicate these policies and procedures; and.