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 beginning your risk management journey and need further information on internal controls, this post has the information you need.
Internal controls are the protocols, procedures, and activities that protect organizations from financial, operational, and strategic risk. Any industry with an IT environment also needs internal controls to protect the business from cybersecurity threats and to assure regulatory compliance.
Accounting internal controls assure that a company’s accounting system follows U.S. Generally Accepted Accounting Principles. Other internal controls apply to particular industries, such as the financial sector, healthcare, nonprofits, manufacturing, and retail.
This guide is designed to help business owners understand the basics of internal control and the key elements that will help you 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 that 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 decide how best to prevent those risks or how to mitigate their effects.
Controls are not the same as compliance; rather, they are a part of your compliance plan. Developing a cohesive system of internal controls is a requirement of most compliance frameworks, but the controls themselves are not sufficient to prove compliance in most cases.
Internal controls are identified as either primary controls or secondary controls. Primary controls are imperative; these are crucial measures to defend your operations from risk. Secondary controls are not your first line of defense. Instead, they help maintain your efficiency of operations.
Internal controls range from simple solutions such as using two-factor identification to more complex options like cybersecurity software.
Bear in mind that internal controls are not limited to technological solutions. Physical security measures, regular staff training, audits, and investigations are all examples of internal controls too. The controls you employ will depend on your company’s threats and the potential damage from each hazard.
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 already, to fix the problem before it causes further issues. Quality checks, reconciliation of bank statements, inventory counts, internal audits, and external audits are all examples of detective controls.
Corrective controls are those that take place after your detective controls have determined why an event occurred. A short-term corrective action will fix the immediate issue at hand, and a long-term corrective control 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. Having these systems in place will prevent lost profits and help you grow your business moving forward.
In addition, robust internal control procedures can help you:
The most apparent benefit of internal controls is the protection they provide. In addition, 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.
It’s possible some of your controls are redundant or that they are protecting 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.
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 avoid lawsuits and other forms of compensation that are often necessary for your customers after a risk event occurs.
Improve Client and Board Confidence
Clients and stakeholders, both present and future, require a certain level of assurance that you’re doing everything you can to protect their interests. With controls in place, you’ll be able to communicate your risk management efforts clearly to both customers and board members, which can, in turn, give you an edge over any less prepared competitor.
Peace of Mind
Finally, having these 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 level 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 your goals for the company as a whole. Examining the direction in which you’d like to take your organization can help you narrow down your approach to policies and procedures and view your risks and opportunities under 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 compliance objectives (imposed by government regulators or industry standards).
What Challenges Are You Facing?
Again, these challenges are not just 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 breach can affect your financial performance because the losses affect your income and reserves. So it would help if you had controls that document your breach responses.
While the process to design internal controls generally focuses on financial reporting and controls, 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, which is how internal control design connects to your IT environment.
What are the Five Elements of Internal Control?
While designing the controls for your organization, consider the five components outlined by the Committee of Sponsoring Organizations (COSO)’s framework for internal control, widely considered the industry standard.
Your control environment is the context in which your internal controls operate: your standards, infrastructure, processes, organizational commitment, and workplace practices. These foundational structures establish the expectations for and importance of integrity within your corporate culture. Your control environment will demonstrate a culture of accountability and responsibility to your entire staff as well as to potential investors.
A risk assessment is necessary to develop successful internal controls. It would be impossible to defend your company against risks effectively without first evaluating what those risks are and what you stand to lose should they occur.
Therefore, 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 decisions and monitor the results.
By completing your risk assessment, you’ll have a solid foundation for developing your internal controls and your risk management system as a whole.
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 and should be embedded throughout your company’s framework and the lifecycle of any given project.
In addition to designing these control activities, you should thoroughly document them to demonstrate your risk management and compare your results as risks change in the future.
Information and Communication
It would be best to integrate clear communication into your risk and compliance programs. 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, both for ongoing monitoring and assuring that the controls you put in place now remain effective over time.
The threats your company faces will change as time moves on 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 that they’ll continue to function down the line. Instead, you’ll need to monitor your controls regularly to make sure 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.
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 that an organization’s resources are used for their intended purposes, minimizing the risk of misuse. 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 external auditor’s scope, time, and fees. It 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 investment. 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. It can, however, be challenging to know where to begin when designing an internal control structure for your organization.
Even if you have controls in place, you may be using outdated techniques to stay on top of your security efforts. To maintain effective operations and protect your company from threats, you need a solution that will allow you to see every risk your company faces.
Manage Internal Controls with ZenGRC
ZenGRC 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.
It is a single source of truth that 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 of 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. ZenGRC also offers easy reporting, making external and internal audits less painful.
Schedule a demo today to learn more about how ZenGRC can take your company out of your spreadsheets and into a new, more secure future.