From innocent but costly mistakes to fraudulent manipulations, all organizations are subject to significant risks that can jeopardize financial reporting or lead to the loss of corporate assets. That’s why it is imperative to establish a robust system of internal controls to reduce or prevent such threats to the organization.
Internal controls are policies, procedures, and other activities implemented by a company to assure that the company can achieve its objectives. Among those objectives are reliable financial reporting, compliance with laws and regulations, operational efficiency, and avoidance of fraud. There are three types of internal controls: detective, preventative, and corrective.
An internal control system is a company’s set of all internal controls and the tools the company uses to monitor those controls. The system should mitigate an organization’s risk of fraud and loss while promoting business objectives.
Every company will have its own unique system of internal control, depending on its size, industry, history, and operations. Risk assessments, however, are a crucial element of all internal control systems. A risk assessment catalogs all the risks that might threaten the company’s ability to achieve its objectives, and then considers whether the design and operation of the company’s internal controls delivers the protection the company needs.
Why Is Risk Assessment Important in Internal Controls?
Malicious actors can exploit weaknesses in internal control to evade even what might appear to be strong security tactics. In addition, with so much complexity and innovation in the modern enterprise, internal controls need constant monitoring and improvement to neutralize existing or emerging threats.
Internal controls and risk management are not goals in and of themselves. Rather, they must always be considered when establishing and implementing corporate initiatives for the achievement of objectives. Flaws in internal control can emerge when new initiatives are not coordinated with risk management principles.
A proper risk assessment process can help an organization manage risks and improve decision-making. It assures that efforts have been made to identify risk, implement preventative controls where possible, and mitigate harm.
The Committee of Sponsoring Organizations (COSO)’s framework for internal control is a versatile blueprint to help organizations design, implement, and evaluate internal controls. A system of internal control based on the COSO framework will have five components. Risk assessment is one; the others are:
- Control environment. This is the foundation of an organization’s internal control system. It sets management’s tone for expectations and the importance of internal controls within the overall company culture.
- Control activities. These are the policies, procedures, and mechanisms that make up the organization’s risk management strategy.
- Information and communication. Internally generated reports periodically summarize results from audits and control activities for auditors and stakeholders.
- Monitoring activities. Ongoing monitoring assures that control activities are implemented and enforced in day-to-day operations.
What Are the Different Types of Internal Control Risks?
To guard against risk, organizations must do more than set up internal controls and fraud prevention activities. Instead, companies should consider specific risks when implementing a comprehensive system of internal controls.
Common internal control problems include a lack of a sound internal control environment, poorly designed business processes, weak ethical values and integrity, and IT security risks. The most common issues can be classified into the following categories.
Inherent risk is the level of risk — for inaccurate financial statements, cybersecurity threats, compliance failures, and so forth — that exists when an organization puts no controls in place to guard against the threat.
Control risk is the risk that an internal control will fail to work as intended, and allow a threat to happen anyway. For example, a company policy might require the board of directors to approve all contracts above $100,000. If management then executes a $150,000 contract without board approval anyway, that indicates a control failure: the organization didn’t enforce its policy.
Residual risk is the level of risk that remains after the organization’s internal controls have been implemented. For example, a company may require two signatures for all payments over $40,000. There is a residual risk that a payment may still be fraudulent even after two signatures. If the organization is unwilling to accept this residual risk, it needs to modify the policy.
Operational risk refers to unexpected failures in the organization’s day-to-day operations caused by personnel, processes, or external factors. It is related to control and residual risks. They include fraud, security failure, legal breaches, environmental hazards, or natural disasters.
Compliance or Regulatory Risk
This is the risk of failing to comply with laws or regulations, such as the Foreign Corrupt Practices Act (FCPA) or the Sarbanes-Oxley Act (SOX). For example, a public organization that lacks strong internal controls over financial reporting is exposed to significant SOX compliance risk.
Best Practices for Risk Assessment
An effective internal control system starts with the five components of internal controls listed in the COSO framework. Comprehensive business planning and risk assessment reduces the risks that affect the achievement of objectives while adhering to internal controls. These best practices will guide the risk assessment process and the development of effective internal controls.
Conduct Internal Audits
Internal audits are critical to verify that a company’s internal controls and corporate governance are effective. SOX made managers legally responsible for the accuracy of financial statements. Robust audit procedures and routine audits are imperative to assure that internal controls are working as intended.
Develop Mitigation Plan With Controls for Each Risk
Risk assessments require a list of items to be assessed. The list should be presented in a clear, logically designed, easy-to-follow assessment form, and include corresponding mitigation plans for each risk. As a result, assessments will be more thorough and document relevant actions.
Identify Internal and External Risks
Risks come from a variety of sources. It helps to classify internal and external risks in your risk assessment to determine where internal controls will be most effective. Distinguishing different types of risks will enable you to define more effective internal controls.
Collect Employee Feedback
Employees can be the best critics to tell you whether processes and controls are working effectively. Collect employee feedback to understand if internal controls are unnecessarily cumbersome. Ask them for their perspectives on potential risks and ideas for improving your internal controls. Staff will appreciate internal control processes more when their inputs have been considered.
Monitor and Make Changes
Conducting a risk assessment and setting up internal controls are not one-time projects. A continuous commitment to risk management requires an organization to make modifications as needed to ensure internal controls are working as expected.
Make ZenGRC Part of Your Internal Control System
In the realm of organizational risk management and improved internal controls, ZenGRC is the expert. The ZenGRC risk assessment modules can provide valuable insight on where your reporting is lacking, so you can take quick action to compile the documentation you need.
ZenGRC is a governance, risk, and compliance platform that helps you set up, manage, and track progress within your risk management framework.
For example, it can assist you in prioritizing duties so that all employees know what they need to accomplish and when they need to do it. In addition, its easy-to-use dashboards simplify reviewing tasks that need attention and tasks already finished.
Its workflow tagging feature makes it simple to assign risk assessment, analysis, and mitigation operations tasks. In addition, the ZenConnect feature enables integration with popular tools, such as Jira, ServiceNow, and Slack, ensuring seamless adoption across your enterprise.
Hassle-free internal controls implementation and compliance is the Zen way! For a free consultation and demo of ZenGRC, schedule a demo.