Introduction to internal controls

January 11, 2015

In this article, we’ll cover the basics of internal controls. Internal controls represent a concept that is absolutely fundamental to any well-managed business. They are also one of the foundations of financial statement audits.

1. What is an internal control?

Internal controls are a company-wide system of policies and procedures that provide some assurance that the company is operating effectively, that the company is following all applicable laws, and that the company's financial reporting process is sound. For large multinational corporations, the system of internal controls could involve dozens of layers of interconnecting controls that range from a corporate ethics manual all the way down to an input control in a database that makes sure the product identification number entered into the inventory system is valid.

It’s almost easier to explain what happens when there is no established system of internal control. Without controls in place, employees could steal assets without ever getting caught. The company could be breaking laws and the owners would never know until an officer shows up at the front door with a search warrant. The corporate balance sheet could show inventory that doesn’t exist. The point is that a management team that does not take internal controls seriously is just asking for trouble.

2. Examples of internal controls and why they are important

Background and reference checks for all new employees – A standard background check policy is a no-brainer, along with mandatory pre-employment drug screens. These checks can help a company avoid future problems involving employees showing up to work impaired or getting into altercations with clients. Imagine the liability for a company if it doesn’t screen its drivers and a delivery man causes a fatal wreck while under the influence of drugs.

Management prepares a budget and analyzes substantial variances – A budget is an important tool for directing operations throughout the year and for pinpointing potential areas of improvement. Following up on the budget process with an analysis of budget to actual variances highlights problem operational areas and helps management produce more precise budgets in the future.

Electronic locks and biometric entrance procedures for inventory warehouses – This control reduces the threat of inventory theft because only authorized individuals have access to inventory.

Establish a lockbox system with the bank – A lockbox system is an arrangement in which the bank collects customer payments on behalf of the company. This control reduces the opportunity for employees to steal or misplace customer payments.

Password protection and encrypted data on employee laptops – Without these controls, sensitive data could fall into the wrong hands if the laptop were stolen or lost.

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