Impact of material weaknesses in internal controls on operational performance

October 17, 2015

Most companies have some internal controls over financial reporting in place. However, few companies may realize that such controls are not only a compliance requirement (i.e., for public companies), but also that such controls impact the operational performance. In this article we will discuss how material weaknesses in inventory-related internal controls can impact operational performance.

1. Internal controls over financial reporting

Internal controls over financial reporting (hereafter, internal controls) are required for public companies and are desired for private companies.

Internal controls (over financial reporting) are targeted towards the manual and technological processes that bring transactions from initiation all the way to the financial reports. They are designed to prevent or detect errors that could lead to the release of false financial information to concerned parties.

Internal controls are typically categorized by business process or cycle.  For example, there may be internal controls for inventory, procure to pay, cash and treasury, financial reporting, order to cash, and so forth.  Such categorization is a flexible way to group controls.

Sometimes there is a view that internal controls are mostly a compliance exercise that has no significant impact on a company’s operational performance (i.e., management may view internal controls as a necessary evil instead of a tool to increase the company’s performance).  Is it really so?

An article called “Does Ineffective Internal Control over Financial Reporting affect a Firm’s Operations? Evidence from Firms’ Inventory Management” The Accounting Review 2015, indicates that is not the case.

2. Internal controls impact operational performance

The authors of the named study performed an analysis of companies with and without material weaknesses in internal controls related specifically to inventory.  They looked at two commonly accepted measures of how inventory is managed: inventory turnover ratio and inventory-related impairments.

The results are quite interesting because they indicate that material weaknesses in internal controls impact inventory management and operational performance.  The study authors found that:

  • Companies with material weaknesses in inventory-related internal controls on average have an inventory turnover ratio of 8.37 (43 days) while companies without such material weaknesses have an inventory turnover ratio of 14.03 (26 days).  That is a difference of 17 days.  There are other implications of longer inventory turnovers, but one is unavailability of cash invested in inventory.  For example, if a company has $1,000,000 invested in inventory, the 17 days difference means the company unnecessarily keeps $395,349 (i.e., $1,000,000 ÷ 43 days x 17 days) frozen and not available for paying supplies, making investments in securities or equipment, etc.
  • Inventory turnover ratios increase after companies remediate material weaknesses related to inventory-related internal controls.
  • Companies with material weaknesses in inventory-related internal controls are more likely to report inventory impairment (due to poorer inventory management, etc.).
  • Companies that successfully remediate material weaknesses in inventory-related internal controls report significant increases in sales, gross margin, and operation cash flows.
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