Internal Controls for Dummies

Today, I’ll be going a little off tangent with my usual marketing advice for some accounting tips.  Not many people know the importance a good internal control system. Those who are especially vulnerable are entrepreneurs who operate on a happy-go-lucky management system with little or no experience in managing people. But firstly, what is internal control?  It is a process that is undertaken to achieve a certain objective – and in accounting terms, produce reliable and accurate financial statements. 

The need for a strong internal control system has been recognised by all companies. However, they also desire to maintain a trusting relationship with their employees. In order to maintain a balance between the two, companies review the five essential aspects of an internals controls system - the control environment, risk assessment, implementation, report and review.

Establishing Control Environment 

Firstly, companies establish an honest control environment through attitude and example. A strong sense of integrity and ethics should be possessed by the management, which their managing style and philosophy reflects.

Risk Assessment

The second step involves a risk assessment in all areas of the company. Here, the firm identifies the external and internal risk factors that may compromise the firm’s operation.

Implementation

The implementation of control activities follows, which include using an information processing system that limits a single person’s power, the segregation of duties, and the physical protection of sensitive assets.

Report and Review

The success of the internal control structure is then measured through a reporting process. This step encapsulates the gathering of pertinent information. Finally, the companies review their internal control system in periodically. Adjustments are made according to changing external and internal environmental forces to ensure control systems continue to be effective and relevant. 

An example of a company that is excelling in internal controls is the camera manufacturer Nikon Corporation. Defining the responsibilities of every employee is its ‘Rules Governing the Authority of the Organisation and Personnel.’ Moreover, Nikon has established an internal audit department that serves as an independent auditor for its internal control systems. Similarly, McDonalds have a ‘Standard of Business Conduct’ that promises its customers ethical and fair trade practices, as well as continuous improvement in its corporate governance and internal controls.

Before you read the following, I advise you to NOT follow the actions of the individuals in the case studies below. They are purely for exemplary purposes. You will get caught (and damage your karma in the process).

Anyway, a recent case study that describes a pear shaped internal control system is the Olympus Corporation’s accounting scandal in 2011. Losses of ¥1.7billion were covered up by top management through improper bank transfers as well as the process of expensing significant loses dating from 1990.  Failures of the internal controls system in this scenario can be observed in the control environment, which failed due to the dishonest corporate culture of the board executives. In addition, pressure placed on its accountants and its auditors to sign off falsified financial statements are further examples of a bad control environment.

Another recent example detailing the ramifications of a failed internal control system involves the firm EPAC Salary Solutions and its accountant Demetres Zacharoudes. Zacharoudes had the job of reconciling payments to determine reimbursement on motor charge cards. Between November 2011 and April 2012, he had siphoned off $1,024,144.76 by falsifying reports. Money was then diverted to private accounts from EPAC. In this case, the main internal control failure is not segregating the duties of handling cash and record keeping.  

Ultimately, corporate culture cannot supersede the complexities of human nature. But what it CAN do is work towards an environment where dishonest practices are discouraged. Moreover, limiting a single employee’s power will significantly contribute towards smooth operation of a firm. 

What types of internal control fiasco did you experience? Comment below! 


Ling Lee

at Digital Marketing and Personal Branding


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Wendy Huang

Wendy Huang , Full Time Blogger and YouTuber at A Custom Blog in 4 Minutes

Thanks for some great case studies :)