What are the 3 Types of Internal Controls?

Internal controls are policies, procedures, and technical safeguards that protect an organization’s assets by preventing fraud, errors, and other inappropriate actions. These controls fall into three categories: detective, preventative, and corrective.

Several internal control frameworks exist to help organizations implement internal controls as necessary, so those organizations can fulfill any regulatory compliance obligations they have or meet risk management guidelines handed down by their board of directors.

Perhaps the best-known framework is the Committee of Sponsoring Organizations (COSO) internal control framework.

A system of internal controls weaves together various processes and rules to assure an effective internal control process. Some examples of internal controls are internal audits, firewall deployment, training, and employee disciplinary procedures.

All organizations are subject to threats that might harm the organization and could result in asset loss. From inadvertent mistakes to fraud to cyber attacks, risks are present in every business.

The importance of internal controls lies in their ability to protect your organization from risks and consequences. For example, IT security controls reduce the risk of data breaches or malware infection. They help you find weak spots in your information systems and then shore up those weak spots. Internal controls limit what they can accomplish; hence it’s essential to have ongoing reviews and monitoring of your system.

Defining Your Organization’s Internal Controls

With the right internal controls, organizations can protect their assets, maintain accurate financial reporting, improve operational efficiency, and meet legal obligations. Defining the controls that your organization needs, however, requires careful planning and consideration. Internal controls are grouped into five larger “components.”

Control Environment. These are the controls that set the overall tone and culture within the organization. They include the organization’s commitment to integrity, ethical values, and the establishment of appropriate oversight responsibilities.

Risk Assessment. These controls identify and evaluate risks that could potentially hinder organizational objectives. By conducting comprehensive risk assessment, you can determine where internal controls are needed and how to implement them.

Control Activities. These are the specific policies and procedures implemented to address identified risks. Control activities can include:

• Separating duties among multiple people
• Implementing physical safeguards
• Establishing authorization procedures
• Maintaining proper documentation
• Conducting independent checks and reconciliations

Information and Communication. These controls establish reporting mechanisms to assure the effective flow of relevant information, both vertically and horizontally.

Monitoring. Continuous monitoring and periodic evaluations of internal controls are vital to identify deficiencies, assess their effect, and take corrective actions. This can be achieved through management reviews, internal audits, self-assessments, and feedback mechanisms.

With the growing reliance on technology, internal controls must also address risks associated with information systems. IT controls include measures to secure data, manage access, establish backup and recovery procedures, and implement IT governance frameworks.

Compliance controls are specifically tailored to regulatory requirements, maintaining proper documentation, and conducting regular compliance reviews to assure adherence to relevant regulatory laws, regulations, and internal policies.

Now let’s review the three types of internal control, regardless of their component: preventive, detective, and corrective.

What Are Preventive Internal Controls?

As the name implies, preventive internal controls are put in place to prevent an adverse event from occurring. For example, many software applications have built-in checks to avoid entering incorrect information.

Preventive controls are the best kind because they lessen the need to detect mistakes after the fact. Automated preventative controls are even better because they remove the need for human intervention and streamline auditing.

Examples of Preventive Internal Controls

Training programs, drug testing, firewalls, computer and server backups are all preventive internal controls that block undesirable events from occurring. So are the following.

Segregation of Duties

Separation of duties is designed to reduce the incidence of mistakes or fraud by assuring that no single employee has the potential to both perpetrate and hide errors or fraud in the course of their activities. Assigning one person to write checks and another employee to authorize the payments is one example of segregation of duties.

In general, the primary incompatible responsibilities that must be separated are:

• Performing transactions
• Authorization or acceptance
• Reconciliations
• Custody of assets

Access Controls

Access controls govern who or what has access to corporate assets, including IT systems. These controls are a crucial security concept that reduces risk to the company or organization.

Physical access control limits access to campuses, buildings, rooms, and physical IT assets. Security guards verifying ID credentials or access key cards may be employed to enforce physical access control.

Logical access controls restrict connections to computer networks, system files, and data. The principle of the least privilege (PoLP) is an information security standard that says users should only access system functions and data that are necessary for the user to do their job.

Pre-Employment Screening

Pre-employment screening is a procedure where employers check candidates’ backgrounds, screen them for drugs, check references, and assess their conduct. It is used in recruiting to screen out many undesirable candidates before investing in the onboarding process.

What Are Detective Internal Controls?

Detective internal controls detect an error problem after it has occurred. Ideally, detective internal controls will discover an issue before it becomes a significant problem.

Examples of Detective Internal Controls

Some examples of detective controls are internal audits, reconciliations, financial reporting, financial statements, and physical inventories.

Internal Audits

An internal audit evaluates compliance with company procedures, applicable laws, and international standards. Data and reports are reviewed to assure consistency and compliance.

Internal audits provide a value-added service to management and the board of directors by detecting and correcting weaknesses in a process before external audits discover them. This can protect the organization from loss of certification and regulatory fines (not to mention painfully high external audit fees).

Reconciliations and Financial Reporting

Reconciliations are performed to verify financial reporting among various sources. For example, comparing (or reconciling) a bank statement to a company’s internal records is one form of reconciliation.

Financial reporting documents the company’s revenues, spending, cash flow, and financial health. It allows executives and investors to make more informed judgments on performance and opportunities for improvement. Unusual or unexpected figures in financial reporting and financial statements help detect inadvertent errors and inappropriate actions.

Physical Inventory Counts

Physical inventory counts are performed periodically to assure actual inventories match what is recorded in business systems and financial statements. Physical inventory values directly affect the balance sheet, so it’s imperative they are reflected accurately. Inventory discrepancy investigations can reveal system issues, inadvertent errors, and theft.

What Are Corrective Internal Controls?

Corrective internal controls are implemented after detective controls discover a problem. These controls could include disciplinary action, report filing, software patches or modifications, and new policies. They are usually put into place after a root cause investigation.

Examples of Corrective Internal Controls

Corrective internal controls, by nature, are specific to the typical flaws and risks of your company, previously evaluated through comprehensive risk assessments or detective controls such as audits.

Patch Management

Patch management is the delivery and installation of software updates. These patches are frequently required to remedy flaws (also known as “vulnerabilities” or “bugs”) in software.

Patches are commonly required for operating systems, applications, and embedded devices (such as network equipment). When a vulnerability is discovered after a piece of software has been released, a patch can remedy it. Proper patch management protects information security by preventing data breaches and leaks.

New or Updated Policies and Procedures

Policies and procedures may be updated when an audit or other detective control identifies a process gap. For example, root cause analysis on a physical inventory discrepancy may reveal that employees are inadequately trained on how to decommission parts that fail quality checks. Corrective controls would include updated work instructions and training.

Disciplinary Actions

Disciplinary actions are corrective actions taken in response to employee misbehavior, rule violations, or poor performance. Discipline can take several forms depending on the seriousness of the situation, including a verbal warning, formal warning, an unfavorable performance evaluation, or even termination.

Benefits and Limitations of Internal Controls

All processes and control activities are imperfect; mistakes and problems will inevitably be found. That’s why an ongoing review and analysis of internal controls should be a part of any organization’s regular processes.

Benefits of Internal Controls

Management is ultimately responsible for the control environment and the success of internal controls. The benefits of internal controls depend upon correct implementation and ongoing monitoring.

Early-Warning System

Internal controls serve as an early-warning system to identify issues before they become big problems. Quality checks prevent faulty products from being shipped to customers. The investigation into a decline in on-time delivery metrics may reveal a more significant problem on the horizon. Problems are easier to fix when you catch them early.

Prevent Fraud

Robust internal controls deter employees from engaging in misconduct. When employees can see process gaps, they may be tempted to perform minor inappropriate actions that eventually lead to major ones. With multiple checks and balances, however, fraud is much more difficult. Solid policies assure that employees understand the consequences of committing misconduct.

Avoid External Audit Findings and Regulatory Fines

Performing investigations and corrective actions on external audit findings can be arduous. If an external audit identifies a significant gap in processes or material misstatements, you could be exposed to losing industry certifications or substantial fines. Finding and fixing a problem before an external entity discovers it is always best.

If you still experience a data breach, robust internal controls can also protect you from hefty fines. If an investigation reveals that your organization acted with due diligence and had adequate controls, a regulatory agency may reduce penalties.

Limitations of Internal Controls

Despite the benefits, internal controls have some limitations. It’s crucial to be aware of the gaps left by internal controls to ensure that those risks are understood.

Collusion

Segregation of duties is one of the most prevalent internal controls businesses use. It separates tasks so that no one employee has the power to commit fraud. Still, a group of employees can get past this by collaborating in an elaborate process to disguise their fraud.

Human Error

Human error can be another disadvantage of internal controls, especially when relying on manual processes and judgment calls. Mistakes can be made during manual inventory counts, and poor judgment could degrade internal audit results. Automated systems should be employed to drive consistency and reduce human error wherever possible.

For example, scales can be used in stockrooms to verify inventory counts. Automated systems can help perform reconciliations among accounting and financial records. Solid auditing processes and management oversight will support rigorous internal auditing standards.

Unforeseen Circumstances

Internal controls rely on management anticipating all potential hazards and implementing mechanisms to prevent or mitigate them. Still, management cannot anticipate all potential challenges or events. Random variables or occurrences are prone to render internal controls ineffective.

Moreover, attempting to control unusual conditions can be costly, and a management team may instead decide to accept the risk. As a result, internal controls may be limited in their use under unexpected or extraordinary scenarios.

Enhance Your Internal Controls with ROAR

Internal controls are important, but creating them isn’t easy. Aside from risk assessments, procedures, reporting, and communication, all internal control schemes also need arduous documentation and reporting.

Small companies may begin by managing their controls with spreadsheets, but internal and external stakeholders increase as their business grows. As a result, preparing ahead of time for a more streamlined solution can save time and money in the long run.

Instead of using spreadsheets to manage your compliance requirements, use the RiskOptics ROAR Platform to streamline evidence and audit management for all of your compliance frameworks.

A single source of truth assures your organization is always audit-ready, thanks to its advanced features that enable straightforward risk assessment, analysis, and mitigation. You can also easily map controls across various compliance frameworks and monitor them to see which ones impact risk the most.

Get a demo to learn more.