Designing a successful risk management program can be daunting, especially if one is unfamiliar with the vocabulary used to describe risk prevention efforts. If you’re just starting your risk management journey and need further information on internal controls, this guide can help.
Internal controls are the protocols, procedures, and activities that protect organizations from financial, operational, and strategic risk. Any organization with an IT environment – which, these days, is really all organizations – also needs internal controls to protect itself from cybersecurity threats and to assure compliance with privacy regulations.
Accounting internal controls assure that a company’s financial reporting follows the U.S. Generally Accepted Accounting Principles. In addition, other internal rules apply to particular industries, such as the financial sector, healthcare, nonprofits, manufacturing, and retail.
Internal controls are crucial for all of those issues. This guide is designed to help business owners understand the basics of internal control and the key elements that will help you to develop functional internal controls for your company. You can start at the beginning or use the links on the left to skip the section you need.
What is a System of Internal Controls?
An internal control system is a collection of safeguards and procedures your organization implements to protect your company from any threats it might face. Controls are the component of your risk management plan that allows you to detect possible risks, and then decide how best to prevent those risks or mitigate their effects.
Controls are not the same as compliance; they are a part of your compliance plan, but the entire plan is much larger. Developing a cohesive system of internal controls is a requirement for most compliance frameworks.
Internal controls are identified as either primary controls or secondary controls. Primary controls are imperative; they are crucial measures to defend your operations from risk. Secondary controls help to maintain your efficiency of operations.
Internal controls range from simple solutions, such as using two-factor identification, to more complex options, such as annual or monthly audits to search for suspicious activity.
Bear in mind that internal controls are more than technology solutions. Physical security measures, regular staff training, audits, and investigations are also examples of internal controls. The controls you employ will depend on your company’s threats and the potential damage from each hazard.
What Is the COSO Internal Control Framework?
The Committee of Sponsoring Organizations (COSO) developed a framework for internal controls, first unveiled in 1992 and then overhauled for the modern era in 2013. The COSO framework is one of most popular control frameworks in use today.
The COSO framework contains three control objectives: effective regulatory compliance, reliable financial reporting, and efficient operations. Organizations can use the framework to create and execute internal controls that align with changing business and operating environments.
What Are the Pros and Cons of Using the COSO Internal Control Framework?
Using the COSO framework makes it easier to carry out business activities consistently, per a set of internal controls. Depending on how those controls are created, they can increase effectiveness while lowering hazards.
Using the COSO framework also puts your company in a better position to identify fraudulent conduct — whether that misconduct is carried out by customers, trusted staff, or cybercriminals. In addition, vulnerabilities can be addressed since the framework emphasizes risk mitigation and adherence to recognized best practices.
Some businesses also discover that implementing thoughtfully designed internal controls allows them to improve the effectiveness of business procedures. This might save expenses and increase revenue for the company.
All that said, the COSO framework has its drawbacks. The framework can be challenging to implement, usually for two reasons. First, the framework’s relatively broad scope means that it lacks a lot of prescriptive advice; executives need to put its broad principles into practical context on their own.
Second, that generalized organizational structure can make implementation challenging. Organizations frequently discover that some of their processes might fit into more than one category within the framework; or don’t fit nicely into any categories. As a result, companies often have to make some difficult choices while putting the framework into practice.
What are the Three Types of Internal Controls?
Internal controls can generally be divided into three categories:
Preventative controls are measures used to keep an adverse event from occurring in the first place. This broad category encompasses everything from keycard entrance controls, to segregation of duties, to complex password requirements. Preventative controls are adopted after a risk assessment has determined what risks might affect different areas of your company.
Detective controls are used to study transactions and see whether any failures have occurred. This allows executives to fix a problem before it causes further issues, but as the name implies, detective controls only detect issues after they’ve taken root. Quality checks, reconciliation of bank statements, inventory counts, internal audits, and external audits are all examples of detective controls.
Corrective controls are implemented after your detective controls have determined why an event occurred. A short-term disciplinary action will fix the immediate issue, and long-term disciplinary authority intends to reduce or eliminate the likelihood of recurrence.
Corrective controls could include:
- Implementing a more vigorous training procedure
- Updating your policies
- Investing in new technology to protect against emerging threats
Why are Internal Controls Important?
The purpose of internal controls is to prevent risk events and to protect your company’s ability to maintain operations should an event occur. These systems will prevent lost profits and help you grow your business.
In addition, robust internal control procedures can help you:
The most apparent benefit of internal controls is the protection they provide. Your organization will be considerably less vulnerable with a defense plan in place.
All companies are at risk from business interruptions, cyber-attacks, market changes, and more. By preparing for these inevitabilities in advance, you’ll be able to weather them successfully and keep your business moving forward, come what may.
You may already have some control measures in place. Still, it can be challenging to know how those controls function within your entire risk landscape without any formal framework or system.
Some of your controls may be redundant, or protect one area while causing issues for another. Examining and developing your internal controls with an eye on the big picture will keep you organized and highlight areas that need further safeguards.
External financial reporting is more reliable with good internal controls in place. In addition, the ability to pinpoint what’s being done to prevent loss will help you improve those efforts and better allocate your funds.
Moreover, controls will minimize lost profits caused by business interruptions, and help to avoid lawsuits and other forms of compensation that are often necessary for your customers after a risk event occurs.
Stronger Regulatory Compliance
Many laws and rules require that organizations have internal controls in place to achieve certain outcomes – say, financial reporting according to proper accounting rules, or protection of consumer data, or standards for anti-corruption. Few of these laws expressly direct companies to use specific frameworks, but using a recognized framework brings discipline and transparency to your compliance efforts. That, in turn, reduces the chance of compliance violations that could result in costly enforcement actions.
Peace of Mind
Finally, having internal controls in place can help you and your colleagues move forward with the certainty that your company can recover if something should go wrong. This confidence will carry into how you run your business overall and help you find opportunities to grow your business.
How Do You Design Internal Controls?
If you are developing the internal control process at your organization, ask yourself the following questions:
What Are Your Objectives?
Objectives refer not only to your reasons for designing your controls but also to the goals for your company. Clarifying the direction in which you’d like to take your organization can help you narrow your approach to policies and procedures and view your risks and opportunities through the lens of your overall intentions for the future.
You can have operational objectives (“What do we want to achieve this year?”), reporting objectives (“All financial statements must be reliable”), and COSO compliance objectives (“We will protect customer data as required by law”).
What Challenges Are You Facing?
Again, these challenges are more than those that prevent you from creating an internal control system. Instead, the challenges stop you from moving your company in the desired direction.
Are you lacking capital or staff? Are your tools and procedures up-to-date and functioning as needed? This information is relevant to creating your controls, and should be kept in mind as you prepare your risk management plan.
What Does Reporting Look Like at Your Organization?
When designing controls, your company needs to determine how its business processes integrate reliable financial reporting and information systems.
Control design needs to explain how your information systems record events and conditions. For example, a data breach can affect your financial performance because the losses affect your income and reserves. Therefore, it would help if you had controls documenting your breach responses.
While internal controls generally focus on financial reporting and management, organizations need to remember that modern-day solutions involve software and hardware. Unlike the days of hand-written ledgers, modern businesses use digital tools to track their general ledger information; hence your internal control design must encompass your IT environment.
What are the Five Elements of Internal Control?
The COSO internal control framework is organized into five components. When designing your system of internal control, you should consider how that system can incorporate all five.
Your control environment is the context in which your internal controls operate: your standards, corporate culture, processes, organizational commitment, and workplace practices. These foundational structures establish the expectations for, and the importance of, integrity within your corporate culture. Your control environment will demonstrate a culture of accountability and responsibility to your entire staff and potential investors.
A risk assessment is necessary to develop successful internal controls. You cannot effectively defend your company against risks unless you first evaluate what those risks are and what you stand to lose should they occur.
Your risk assessment should consider every possible threat, even those that are unlikely or haven’t been problems in the past. A risk assessment is composed of the following steps:
- Identify the risks
- Determine their potential impact
- Design appropriate control measures
- Record your decision-making and monitor the results
By completing your risk assessment, you’ll have a solid foundation for developing your internal controls and risk management system.
Control activities put your company’s risk management strategies into practice. They are your internal policies, procedures, and mechanisms to protect your organization from risk. These activities might identify, prevent, or monitor risk tolerances and should be embedded throughout your company’s framework and any project’s lifecycle.
In addition to designing these control activities, you should thoroughly document them to demonstrate risk management and compare your results as risks change.
Information and Communication
Integrating clear communication into your risk and compliance programs would be best. This communication should move in all directions; management and your board of directors should communicate their expectations downward, and your staff should share their experiences and results upward.
This information is vital for your entire organization for ongoing monitoring activities and assuring that the controls you put in place remain effective over time.
The threats your company faces will change as time progresses and your company grows. For example, technology develops and changes, new contractors might be brought on, and legal requirements can shift from year to year. Those changes all need to be considered.
As such, it’s not enough to set your controls and then hope they’ll continue functioning. Instead, you’ll need to monitor your controls regularly to ensure that they still serve their purpose and revise your plans should any of your rules be insufficient.
How do Internal Controls Affect Business Operations?
Internal controls assure that a company complies with federal and state laws and regulations in managing financial information and sensitive data. In addition, a solid internal controls program can improve operational efficiency and provide accurate financial reporting during internal or external audits.
Here are some of the benefits of internal controls for your business environment.
Internal controls aim to provide reasonable assurance that goals are accomplished, such as operational effectiveness, reliable financial reporting, and adherence to applicable laws and regulations.
Mitigates Risk and Improves Process Performance
An effective internal control environment assures an organization’s resources are used for their intended purposes, minimizing the risk of fraud, waste, or abuse. It also allows for greater efficiency when transparent processes and guidelines are outlined.
Reduce External Audit Fees
Organizations with solid internal controls can reduce the scope, time, and fees involved in any external audit of your operations. Effective internal control can also reduce the need to review and rebuild the program after an external auditor’s review.
Indicates Greater Confidence in Your Finances
Stakeholders will have more faith in your financial statements. Internal controls and compliance with the Sarbanes-Oxley Act (SOX) suggest a higher level of management control over finances. Internal control mechanisms can save money and lessen the number of issues during a sale if implemented before becoming public or being bought.
How Does Automation Improve Internal Control Development and Monitoring?
The importance of internal controls can not be overstated, but knowing where to begin when designing a system of internal control can take time and effort. Or, even if you have controls, you may use outdated techniques to stay on top of your security efforts.
Automation can address many of those concerns. Here’s how.
Decreases the Risk of Turnover in the Control Environment
An organization’s control environment becomes stressed when personnel come and go, because manual control processes depend on a person performing them. As a result, the control environment and control execution suffer when employees depart (taking valuable knowledge with them) or new ones arrive (who might need time to understand their duties).
Automating control activities removes that human element from the picture. Technology can perform the control without fail, repeatedly. That consistency also supports the overall control environment for the company.
Boosts Disaster Recovery Protocols
Internal controls are primarily associated with fraud prevention or accurate financial reporting. Disaster prevention and recovery, however, are a crucial component of the internal control environment too.
Regular server backups would be one instance of this. A company may always use the previous day’s backup to proceed if a server goes down due to environmental issues or a malicious assault. This is especially useful in the current climate, as businesses operate across several locations and throughout the globe. Using automated server backups can be beneficial.
Enables Effective File Management
Automation can store files in one central, secure location; and then move around or otherwise process those files at specified times according to predetermined rules. For example, after a month-end close, files can be locked using automation. You can use it to remove duplicate entries from a GL and automate journal entries during the close process.
All these processes improve the internal control environment by identifying and avoiding potential material misstatements.
Improves Preventative Measures
Although preventative controls are simple, staff members may overlook them owing to their intrusiveness. For instance, if left to their own devices, employees might only sometimes change their passwords. This straightforward preventative measure may be automated, requiring staff members to set new passwords routinely.
Authentication on mobile devices may be automated in the same manner that password cycling can. Any compliance department should place a high priority on preventing the sharing of sensitive, non-public information. For example, automated rules can be applied to emails from mobile devices to determine when information is shared with a third party.
Manage Internal Controls With Reciprocity ZenRisk
ZenRisk is an integrated software platform that streamlines and centralizes your risk and compliance efforts, giving you a real-time view of your entire company’s risk management landscape.
A single source of truth assures your organization is always audit-ready. Policies and procedures are revision-controlled and easy to find in the document repository. Workflow management features offer easy tracking, automated reminders, and audit trails. Insightful reporting and dashboards provide visibility to gaps and high-risk areas.
With all your information housed in a single cloud-based space, you can manage and automate your controls effectively, leaving your employees more time to move your company forward. ZenRisk also offers easy reporting, making external and internal audits less painful.
Schedule a demo to learn more about how ZenRisk can take your company out of your spreadsheets and into a new, more secure future.