Internal Control

Definition of Internal Control:

Internal control is the process, effected by an entity's Board of Trustees, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories:

  1. Reliability of financial reporting,
  2. Effectiveness and efficiency of operations, and
  3. Compliance with applicable laws and regulations.

Types of Internal Controls:

  1. Detective: Designed to detect errors or irregularities that may have occurred.
  2. Corrective: Designed to correct errors or irregularities that have been detected.
  3. Preventive: Designed to keep errors or irregularities from occurring in the first place.

Limitations of Internal Controls:

No matter how well internal controls are designed, they can only provide reasonable assurance that objectives have been achieved.  Some limitations are inherent in all internal control systems.  These include:

  1. Judgment: The effectiveness of controls will be limited by decisions made with human judgment under pressures to conduct business based on the information at hand.
  2. Breakdowns: Even well designed internal controls can break down.  Employees sometimes misunderstand instructions or simply make mistakes.  Errors may also result from new technology and the complexity of computerized information systems.
  3. Management Override: High level personnel may be able to override prescribed policies and procedures for personal gain or advantage.  This should not be confused with management intervention, which represents management actions to depart from prescribed policies and procedures for legitimate purposes.
  4. Collusion: Control systems can be circumvented by employee collusion.  Individuals acting collectively can alter financial data or other management information in a manner that cannot be identified by control systems.

Internal Control Objectives

Internal Control objectives are desired goals or conditions for a specific event cycle which, if achieved, minimize the potential that waste, loss, unauthorized use or misappropriation will occur.  They are conditions which we want the system of internal control to satisfy.  For a control objective to be effective, compliance with it must be measurable and observable.

Internal Audit evaluates Mercer's system of internal control by accessing the ability of individual process controls to achieve seven pre-defined control objectives.  The control objectives include authorization, completeness, accuracy, validity, physical safeguards and security, error handling and segregation of duties.

  • Authorization - The objective is to ensure that all transactions are approved by responsible personnel in accordance with specific or general authority before the transaction is recorded.
  • Completeness - The objective is to ensure that no valid transactions have been omitted from the accounting records.
  • Accuracy - The objective is to ensure that all valid transactions are accurate, consistent with the originating transaction data and information is recorded in a timely manner.
  • Validity - The objective is to ensure that all recorded transactions fairly represent the economic events that actually occurred, are lawful in nature, and have been executed in accordance with management's general authorization.
  • Physical Safeguards & Security - The objective is to ensure that access to physical assets and information systems are controlled and properly restricted to authorized personnel.
  • Error handling - The objective is to ensure that errors detected at any stage of processing receive prompt corrective action and are reported to the appropriate level of management.
  • Segregation of Duties - The objective is to ensure that duties are assigned to individuals in a manner that ensures that no one individual can control both the recording function and the procedures relative to processing the transaction.

A well designed process with appropriate internal controls should meet most, if not all of these control objectives.

Major Components:

  1. Control environment: Factors that set the tone of the organization, influencing the control consciousness of its people. The seven factors are (ICHAMPBO):
    • I - Integrity and ethical values,
    • C - Commitment to competence,
    • H - Human resource policies and practices,
    • A - Assignment of authority and responsibility,
    • M - Management's philosophy and operating style,
    • B - Board of Director's or Audit Committee participation, and
    • O - Organizational structure.
  2. Risk Assessment: Risks that may affect an entity's ability to properly record, process, summarize and report financial data:
    • Changes in the Operating Environment (e.g. Increased Competition)
    • New Personnel
    • New Information Systems
    • Rapid Growth
    • New Technology
    • New Lines, Products, or Activities
    • Corporate Restructuring
    • Foreign Operations
    • Accounting Pronouncements
  3. Control Activities: Various policies and procedures that help ensure those necessary actions are taken to address risks affecting achievement of entity's objectives (PIPS):
    • P - Performance reviews (review of actual against budgets, forecasts)
    • I  - Information processing (checks for accuracy, completeness, authorization)
    • P - Physical controls (physical security)
    • S - Segregation of duties
  4. Information and communication: Methods and records established to record, process, summarize, and report transactions and to maintain accountability of related assets and liabilities.  Must accomplish:
    1. Identify and record all valid transactions.
    2. Describe on a timely basis.
    3. Measure the value properly.
    4. Record in the proper time period.
    5. Properly present and disclose.
    6. Communicate responsibilities to employees.
  5. Monitoring: Assessment of the quality of internal control performance over time.

What can happen when Internal Controls are weak or non-existent?

When we recommend improving controls within a department, we often hear three basic arguments for not implementing our recommendations:

  1. There is not enough staff to have adequate segregation of duties.
  2. It is too expensive.
  3. The employees are trusted and controls are not necessary.

These arguments represent pitfalls to unsuspecting management.  Each argument is in itself a problem that needs to be resolved.

  1. The problem of not having enough staff or other resources should be discussed with your supervisor.  In most cases, compensating controls can be implemented in situations where one person has to do all of the business-related transactions for a department.
  2. If implementing a recommended control seems too expensive, be sure to consider the full cost of a fraud that could occur because of the missing control.  In addition to any funds that may be lost, consider the cost of time that would have been spent by the department during the time of an investigation of the matter, and the cost of hiring a new employee.  Fraud is always expensive and the prevention of fraud is worth the cost.
  3. Finally consider the issue of trust.  Most employees are trustworthy and responsible, which is an important factor in employee relations and departmental operations.  However, it is also the responsibility of administrators to remain objective.  Experience shows that it is often the most trusted employees who are involved in committing frauds.

Departments conducting research are good examples of areas where sound internal controls are needed.  Research departments that have grants and contracts with outside sponsors are at risk that inappropriate charges will be posted to the project account, perhaps affecting current or future funding.  Each department not only has the responsibility to ensure that all of their transactions are have been processed properly, but also to ensure that other researchers are not "hiding" improper transactions in the department's accounts.