A sound system of internal controls must be in place to safeguard your business, ensure accuracy in financial matters, and be in full compliance with appropriate regulatory bodies. Internal controls are considered to be a crucial part of corporate governance that provides the framework for effective risk management and operations.
To design an internal control system that is best suited for your organization, you need to understand the nature, approaches, and types of internal control activities available. Note that there is no one-size-fits-all when it comes to internal controls. The system of internal controls appropriate for your organization depends on the size, structure and nature of your business operations.
In this article, we’ll explore the nature, approaches, and types of internal control and how to choose the best one for your company.
Nature of Control
This refers to the fundamental characteristics of internal controls. Internal control can be divided into two types: manual and automated.
1. Manual Controls
These refer to controls that are carried out by individuals without the use of technology, computers, or any form of mechanization. These controls help to ensure the completeness, validity, and accuracy of operations and transactions in an organization. The beauty of manual controls is that they are flexible and adaptable to unique situations, but they have a higher risk of human error and manipulation. These include tasks such as reconciling accounts, approving and reviewing transactions.
Examples of manual controls include assigning a manager or a high-level staff member to approve certain transactions, such as purchases or expense reimbursements before they can be processed, document reviews, physical inventory counts, segregation of duties, and compliance checks.
The advantage of manual controls is that they can be adaptable to unique situations that automated systems might not handle well and they allow for the application of human judgment, which can be critical in complex or nuanced situations. However, the limitation of manual controls is that they are prone to errors and manipulations, and they are time-consuming and labour-intensive.
2. Automated Controls
These refer to controls that are performed automatically by software or systems. They are integrated into information systems to allow for execution. These controls are designed to enhance the accuracy, efficiency, and reliability of transactions and operations by leveraging technology. They are particularly valuable in large-sized organizations that carry out high transaction volumes or complex processes. They are more consistent and efficient than manual controls but are dependent on systems and software to function.
Examples include system-generated reports and notifications, automated approval workflows, real-time transaction monitoring, automated access controls, automated data validation checks, audit trails and logs, fraud detection systems, and automated backup and recovery.
The advantage of automated controls goes beyond ensuring consistency, efficiency, and accuracy; they support scalability, which is essential for organizations that are growing and expanding. The limitations of automated controls include high initial setup controls, complexity, dependence on IT systems, and limited flexibility.
Complement the automated controls with the manual controls to address areas where human judgment is essential to creating a balanced and comprehensive internal control system.
Internal Controls: Approaches
The approaches to internal controls refer to the different strategies for implementing and maintaining effective internal control systems. There are two major approaches: preventive and detective controls. To choose the best approach for your organization, you have to analyze your risk profile, size, industry, and regulatory requirements.
1. Preventive Controls
These are proactive measures designed to prevent errors and fraud from occurring. They aid in minimizing and preventing risk and ensure the business processes operate as intended. They are critical aspects of the internal environment because they help to maintain the reliability and integrity of financial reporting, compliance, and operational efficiency.
Examples include segregation of duties, access controls, physical controls (locked storage rooms, security cameras, and alarm systems to protect inventory, cash, or sensitive documents), standard operating procedures (SOPs), budgetary controls, contractual safeguards, and pre-approval of transactions. These preventive controls might be costly to set up and implement but they are worth it. However, it is essential not to become overly reliant on preventive controls or underestimate the need for detective controls
2. Detective Controls
These are specific internal controls designed to identify and detect errors, irregularities, or fraud that have already occurred. Unlike preventive controls, which aim to stop issues before they happen, detective controls are focused on uncovering problems after they have arisen. They are reactive, focusing on detecting and addressing issues to minimize damage.
They play a crucial role in an organization’s internal control framework by enabling timely identification of issues and allowing for corrective actions to be taken to mitigate further risks. Detective controls can be used to assess the effectiveness of the preventive controls and identify areas that need improvement.
Examples of detective controls include reconciliations, audits (internal and external), variance analysis, periodic compliance reviews, physical inventory counts, reviews of user access logs, transaction reviews and sampling, and reviewing customers’ complaints and feedback.
A combination of preventive and detective controls is required to ensure a potent internal environment.
Types of Controls
There are five major types of controls. A combination of these five types makes up a comprehensive internal environment framework that covers all aspects of your organizational operations, ensuring everything is well-protected against risks. They are as follows:
1. Approval Controls
These involve implementing a system requiring authorization from appropriate personnel before transactions or processes can proceed. Examples include management approval of expenses, contracts, or purchase orders, or approval of purchase orders before procurement.
2. Review Controls
These are post-transaction reviews conducted by management or other responsible parties to ensure accuracy. This type of control helps to identify irregularities, errors, or discrepancies. Examples include reviewing financial reports, budget comparisons, and variance analysis.
3. Reconciliation Controls
These controls involve comparing different sets of data and financial reporting documents to ensure consistency and accuracy. Common reconciliations include bank reconciliations, accounts receivable reconciliations, and inventory reconciliations.
4. Physical Controls
These controls focus on safeguarding physical assets such as cash, inventory, and equipment. Examples include locking cash registers, securing inventory in warehouses, fixing CCTV cameras around the office, and restricting access to sensitive areas.
5. Segregation of Duties
This involves dividing responsibilities among different individuals to reduce the risk of error or fraud. By ensuring that no single person has control over all aspects of a transaction, the organization can prevent unauthorized actions and reduce the likelihood of mistakes. For example, employees responsible for approving transactions and payments should be different from those processing them.
Final Words
Understanding the nature, approach, and types of internal controls is essential for choosing the best fit for your company. Whether you need manual or automated controls, preventive or detective measures, or a combination of approval, review, reconciliation, physical, and segregation of duties controls, our experts are here to guide you.
At Mac Adebowale Professional Services, we help you establish a robust internal control framework tailored to your company’s unique needs. Contact us today at emails@macadebowale.com or macadebowaleadvisory@gmail.com, and let’s work together to protect your assets and drive your business forward.
