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Senior executives have long sought ways to better control the enterprises they run. Internal controls are put in place to keep the company on course toward profitability goals and achievement of its mission, and to minimize surprises along the way. They enable management to deal with rapidly changing economic and competitive environments, shifting customer demands and priorities, and restructuring for future growth. Internal controls promote efficiency, reduce risk of asset loss, and help ensure the reliability of financial statements and compliance with laws and regulations.
Because internal control serves many important purposes, there are increasing calls for better internal control systems and report cards on them. Internal control is looked upon more and more as a solution to a variety of potential problems.
Internal control means different things to different people. This causes confusion among businesspeople, legislators, regulators and others. Resulting miscommunication and different expectations cause problems within an enterprise.
Problems are compounded when the term, if not clearly defined, is written into law, regulation or rule.
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This report deals with the needs and expectations of management and others. It defines and describes internal control to: 1. Establish a common definition serving the needs of different parties. 2. Provide a standard against which business and other entities--large or small, in the public or private sector, for profit or not--can assess their control systems and determine how to improve them. Internal control is broadly defined as a process, effected by an entity's board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories: 1. Effectiveness and efficiency of operations. 2. Reliability of financial reporting. 3. Compliance with applicable laws and regulations. The first category addresses an entity's basic business objectives, including performance and profitability goals and safeguarding of resources.
The second relates to the preparation of reliable published financial statements, including interim and condensed financial statements and selected financial data derived from such statements, such as earnings releases, reported publicly. The third deals with complying with those laws and regulations to which the entity is subject. These distinct but overlapping categories address different needs and allow a directed focus to meet the separate needs. Internal control systems operate at different levels of effectiveness. Internal control can be judged effective in each of the three categories, respectively, if the board of directors and management have reasonable assurance that: They understand the extent to which the entity's operations objectives are being achieved. 1. Published financial statements are being prepared reliably. 2. Applicable laws and regulations are being complied with. 3. While internal control is a process, its effectiveness is a state or condition of the process at one or more points in time. Internal control consists of five interrelated components.
These are derived from the way management runs a business, and are integrated with the management process. Although the components apply to all entities, small and mid-size companies may implement them differently than large ones. Its controls may be less formal and less structured, yet a small company can still have effective internal control. The components are: Control Environment The control environment sets the tone of an organization, influencing the control consciousness of its people. It is the foundation for all other components of internal control, providing discipline and structure. Control environment factors include the integrity, ethical values and competence of the entity's people; management's philosophy and operating style; the way management assigns authority and responsibility, and organizes and develops its people; and the attention and direction provided by the board of directors. Risk Assessment Every entity faces a variety of risks from external and internal sources that must be assessed. A precondition to risk assessment is establishment of objectives, linked at different levels and internally consistent. Risk assessment is the identification and analysis of relevant risks to achievement of the objectives, forming a basis for determining how the risks should be managed.
Because economic, industry, regulatory and operating conditions will continue to change, mechanisms are needed to identify and deal with the special risks associated with change. Control Activities Control activities are the policies and procedures that help ensure management directives are carried out. They help ensure that necessary actions are taken to address risks to achievement of the entity's objectives. Control activities occur throughout the organization, at all levels and in all functions. They include a range of activities as diverse as approvals, authorizations, verifications, reconciliations, reviews of operating performance, security of assets and segregation of duties.
Pertinent information must be identified, captured and communicated in a form and timeframe that enable people to carry out their responsibilities. Information systems produce reports, containing operational, financial and compliance-related information, that make it possible to run and control the business.
They deal not only with internally generated data, but also information about external events, activities and conditions necessary to informed business decision-making and external reporting. Effective communication also must occur in a broader sense, flowing down, across and up the organization. All personnel must receive a clear message from top management that control responsibilities must be taken seriously. They must understand their own role in the internal control system, as well as how individual activities relate to the work of others. They must have a means of communicating significant information upstream. There also needs to be effective communication with external parties, such as customers, suppliers, regulators and shareholders.
Internal control systems need to be monitored--a process that assesses the quality of the system's performance over time. This is accomplished through ongoing monitoring activities, separate evaluations or a combination of the two. Ongoing monitoring occurs in the course of operations.
It includes regular management and supervisory activities, and other actions personnel take in performing their duties. The scope and frequency of separate evaluations will depend primarily on an assessment of risks and the effectiveness of ongoing monitoring procedures. Internal control deficiencies should be reported upstream, with serious matters reported to top management and the board. There is synergy and linkage among these components, forming an integrated system that reacts dynamically to changing conditions. The internal control system is intertwined with the entity's operating activities and exists for fundamental business reasons. Internal control is most effective when controls are built into the entity's infrastructure and are a part of the essence of the enterprise. "Built in" controls support quality and empowerment initiatives, avoid unnecessary costs and enable quick response to changing conditions. There is a direct relationship between the three categories of objectives, which are what an entity strives to achieve, and components, which represent what is needed to achieve the objectives.
All components are relevant to each objectives category. When looking at any one category--the effectiveness and efficiency of operations, for instance--all five components must be present and functioning effectively to conclude that internal control over operations is effective. The internal control definition--with its underlying fundamental concepts of a process, effected by people, providing reasonable assurance--together with the categorization of objectives and the components and criteria for effectiveness, and the associated discussions, constitute this internal control framework.
Can Do Internal control can help an entity achieve its performance and profitability targets, and prevent loss of resources. It can help ensure reliable financial reporting. And it can help ensure that the enterprise complies with laws and regulations, avoiding damage to its reputation and other consequences. In sum, it can help an entity get to where it wants to go, and avoid pitfalls and surprises along the way. What Internal Control Cannot Do Unfortunately, some people have greater, and unrealistic, expectations.
They look for absolutes, believing that: Internal control can ensure an entity's success--that is, it will ensure achievement of basic business objectives or will, at the least, ensure survival. Even effective internal control can only help an entity achieve these objectives. It can provide management information about the entity's progress, or lack of it, toward their achievement. But internal control cannot change an inherently poor manager into a good one. And, shifts in government policy or programs, competitors' actions or economic conditions can be beyond management's control. Internal control cannot ensure success, or even survival. Internal control can ensure the reliability of financial reporting and compliance with laws and regulations. This belief is also unwarranted. An internal control system, no matter how well conceived and operated, can provide only reasonable--not absolute--assurance to management and the board regarding achievement of an entity's objectives. The likelihood of achievement is affected by limitations inherent in all internal control systems.
These include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the collusion of two or more people, and management has the ability to override the system. Another limiting factor is that the design of an internal control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Thus, while internal control can help an entity achieve its objectives, it is not a panacea.
Everyone in an organization has responsibility for internal control. Management The chief executive officer is ultimately responsible and should assume "ownership" of the system. More than any other individual, the chief executive sets the "tone at the top" that affects integrity and ethics and other factors of a positive control environment. In a large company, the chief executive fulfills this duty by providing leadership and direction to senior managers and reviewing the way they're controlling the business.
Senior managers, in turn, assign responsibility for establishment of more specific internal control policies and procedures to personnel responsible for the unit's functions. In a smaller entity, the influence of the chief executive, often an owner-manager, is usually more direct. In any event, in a cascading responsibility, a manager is effectively a chief executive of his or her sphere of responsibility. Of particular significance are financial officers and their staffs, whose control activities cut across, as well as up and down, the operating and other units of an enterprise.
Management is accountable to the board of directors, which provides governance, guidance and oversight. Effective board members are objective, capable and inquisitive. They also have a knowledge of the entity's activities and environment, and commit the time necessary to fulfill their board responsibilities. Management may be in a position to override controls and ignore or stifle communications from subordinates, enabling a dishonest management which intentionally misrepresents results to cover its tracks.
A strong, active board, particularly when coupled with effective upward communications channels and capable financial, legal and internal audit functions, is often best able to identify and correct such a problem.
Internal auditors play an important role in evaluating the effectiveness of control systems, and contribute to ongoing effectiveness. Because of organizational position and authority in an entity, an internal audit function often plays a significant monitoring role. Other Personnel Internal control is, to some degree, the responsibility of everyone in an organization and therefore should be an explicit or implicit part of everyone's job description. Virtually all employees produce information used in the internal control system or take other actions needed to effect control. Also, all personnel should be responsible for communicating upward problems in operations, noncompliance with the code of conduct, or other policy violations or illegal actions. A number of external parties often contribute to achievement of an entity's objectives.
External auditors, bringing an independent and objective view, contribute directly through the financial statement audit and indirectly by providing information useful to management and the board in carrying out their responsibilities. Others providing information to the entity useful in effecting internal control are legislators and regulators, customers and others transacting business with the enterprise, financial analysts, bond raters and the news media. External parties, however, are not responsible for, nor are they a part of, the entity's internal control system.
This report is in four volumes. The first is this Executive Summary, a high-level overview of the internal control framework directed to the chief executive and other senior executives, board members, legislators and regulators. The second volume, the Framework, defines internal control, describes its components and provides criteria against which managements, boards or others can assess their control systems. The Executive Summary is included.
The third volume, Reporting to External Parties, is a supplemental document providing guidance to those entities that report publicly on internal control over preparation of their published financial statements, or are contemplating doing so. The fourth volume, Evaluation Tools, provides materials that may be useful in conducting an evaluation of an internal control system.
Actions that might be taken as a result of this report depend on the position and role of the parties involved:
Most senior executives who contributed to this study believe they are basically "in control" of their organizations. Many said, however, that there are areas of their company--a division, a department or a control component that cuts across activities--where controls are in early stages of development or otherwise need to be strengthened. They do not like surprises. This study suggests that the chief executive initiate a self-assessment of the control system. Using this framework, a CEO, together with key operating and financial executives, can focus attention where needed.
Under one approach, the chief executive could proceed by bringing together business unit heads and key functional staff to discuss an initial assessment of control. Directives would be provided for those individuals to discuss this report's concepts with their lead personnel, provide oversight of the initial assessment process in their areas of responsibility and report back findings. Another approach might involve an initial review of corporate and business unit policies and internal audit programs. Whatever its form, an initial self-assessment should determine whether there is a need for, and how to proceed with, a broader, more in-depth evaluation. It should also ensure that ongoing monitoring processes are in place. Time spent in evaluating internal control represents an investment, but one with a high return.
Members of the board of directors should discuss with senior management the state of the entity's internal control system and provide oversight as needed. They should seek input from the internal and external auditors.
Personnel Managers and other personnel should consider how their control responsibilities are being conducted in light of this framework, and discuss with more senior personnel ideas for strengthening control. Internal auditors should consider the breadth of their focus on the internal control system, and may wish to compare their evaluation materials to the evaluation tools.
Government officials who write or enforce laws recognize that there can be misconceptions and different expectations about virtually any issue. Expectations for internal control vary widely in two respects. First, they differ regarding what control systems can accomplish.
As noted, some observers believe internal control systems will, or should, prevent economic loss, or at least prevent companies from going out of business. Second, even when there is agreement about what internal control systems can and can't do, and about the validity of the "reasonable assurance" concept, there can be disparate views of what that concept means and how it will be applied. Corporate executives have expressed concern regarding how regulators might construe public reports asserting "reasonable assurance" in hindsight after an alleged control failure has occurred. Before legislation or regulation dealing with management reporting on internal control is acted upon, there should be agreement on a common internal control framework, including limitations of internal control.
This framework should be helpful in reaching such agreement.
Rule-making and other professional organizations providing guidance on financial management, auditing and related topics should consider their standards and guidance in light of this framework. To the extent diversity in concept and terminology is eliminated, all parties will benefit.
This framework should be the subject of academic research and analysis, to see where future enhancements can be made. With the presumption that this report becomes accepted as a common ground for understanding, its concepts and terms should find their way into university curricula.
We believe this report offers a number of benefits. With this foundation for mutual understanding, all parties will be able to speak a common language and communicate more effectively. Business executives will be positioned to assess control systems against a standard, and strengthen the systems and move their enterprises toward established goals. Future research can be leveraged off an established base. Legislators and regulators will be able to gain an increased understanding of internal control, its benefits and limitations. With all parties utilizing a common internal control framework, these benefits will be realized.
The agency theory explains the existence of mechanism in resolving problems that exist in principal-agent relationships. Internal controls are predominantly operational tools institutions make use of in addressing the principal-agency problem (Jensen and Payne, 2003). The tools and organs used in addressing agency issues include audit committees, external auditing, financial reporting, and budgeting. But studies have shown that agency costs can be reduced by effective internal controls (see; Abdel-khalik 1993; Barefield et al. 1993).Agency theory suggests that the firm can be viewed as a nexus of contracts between resource holders. An agency relationship arises whenever one or more individuals, called principals, hire one or more other individuals, called agents, to perform some service and then delegate decision making authority to the agents (Shankman, 1999). The primary agency relationships in business are those between stockholders and managers and secondly between debt holders and stockholders. These relationships are not necessarily harmonious. Indeed, agency theory is concerned with the so called agency conflicts, or conflicts of interests between agents and principals. This has implications for, among other things, corporate governance and business ethics (Shankman, 1999).The relationship between internal controls and financial performance has been extensively discussed in the literature. Notable theories regarding this relationship are the agency theory and the contingency theory.
The agency theory explains the existence of mechanism in resolving problems that exist in principal-agent relationships. This theory contends that internal audit helps in maintaining cost-efficient contract between owners and management just like other intervention mechanisms such as financial reporting and external auditing. As suggested by Adams (1994), the agency theory provides richer and more meaningful research in the area of internal audit. The responsibility for ensuring that internal control is established in the organization lies within management. The internal audit is supposed to be the custodian of internal control by providing assurance to the management that the organization has put in place adequate and effective internal control system, and must not hesitate to draw management's attention to lapses observed in the control. A good and viable internal control system increases operational efficiency, thereby making it more difficult for the preparation of fraud (Mayo, 1993).Internal control is a management tool used to provide reasonable assurance that the organization's objectives are being achieved.
The responsibility for the adequacy and effectiveness of internal controls rests with management to ensure that there are adequate and effective internal controls in the organizations they manage. Accounting officers and/ or management are expected to establish and maintain a control environment as the foundation for all other components of internal control. They must ensure that proper internal controls are introduced, reviewed, and updated to keep them effective (Joel, 2013)Contingency theory focuses on the behavioral aspect of an organization in explaining how contingent factors such as culture, technology, and external environment have an influence in organizations designing and functioning. It is assumed by the contingency theory that no single type of organization's structure is equally applicable to all organizations. Rather, the effectiveness of an organization depends heavily on the type of technology, the size of the organization, environmental volatility, the features of the organization's structure and the system of information that it is using.
The contingency theory in effect explains the relationship that exists in the effectiveness of internal control structure given varying contexts as well as organizational performance such as reliability. Simply put, the type and usage of control systems is contingent upon the context of the organizational setting in which these controls work (Fisher, 1998). Internal control variables including control environment, risk assessment, control activities, information and communication and monitoring have remained operational tools through which organizations achieve varying organizational goals predominantly income generations and or survival (COSO2013). Cohen et al. (2000) emphasized on the relevance of control environment following findings from a survey which suggests that management's leadership and commitment towards integrity and ethical behaviour and their implications on employees behavior remains the most important element for effective control. In situations where the tone set by management is weak, fraudulent financial reporting tends to be frequent since the control environment begins with directors and management who implement organizational policies, behaviors and effective governance (Rittenberg et al. 2005)
Empirical literature reviewDefinition of Internal controls COSO, 2013 defined internal controls as process affected by entity's board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives relating to operations, reporting and compliance.Turnbull Report from 1999 was created by London's stock exchange. It was later revised and updated by Turnbull Review Group established by Financial Reporting Council (FRC). They defined internal control as an internal control system that encompasses the policies, processes, tasks, behaviors and other aspects of a company that when taken together facilitate its effective and efficient operation by enabling it to respond appropriately to significant business, operational, financial, compliance and other risks to achieving the company's objectives. This includes the safeguarding of assets from inappropriate use of from loss and fraud, and ensuring that liabilities are identified and managed. It also helps ensure the quality of internal and external reporting. This requires the maintenance of proper records and processes that generate a flow of timely, relevant and reliable information within and outside the organization. Lastly it helps ensure compliance with applicable laws and regulations, and also with internal policies with respect to the conduct of business. (Chambers and Rand, 2010).
McGraw (2008) defined internal control as a process designed to provide reasonable assurance that the organization produces reliable financial reports, complies with applicable laws and regulations, and conducts operations in an effective manner.In 2008, Hightower defined internal controls as program of activities established to catch and monitor a potential exposure that could result in a significant error, omission, misstatement, or a fraud.Risks in local authoritiesAccording to Redja (2008), there is no single definition of risk however it has traditionally been viewed as a condition or uncertainty leading to loss, misfortune or an adverse deviation from a desired outcome that is expected or hoped for (Redja, 2008). According to Nexis (2012) risk is inherent in the operating environment within any entity functions, since the outcome of events cannot always be predicted with accuracy, and a certain degree of uncertainty in the environment with regards to the future in respect of economy, markets, products and consumer trends is inevitable. Furthermore, entities are exposed to risks arising from unexpected events such as fraud, errors, natural disasters and accidents. A good set of internal control procedures is vital to avoid compliance risks. Compliance risks involve the organisation breaking local or federal laws or policies for example when they are issuing tenders, procurement procedures, and obtaining quotations from suppliers. Compliance risks can cause misleading information within the organisation's financial statements, and problems between the organisation and the Internal Revenue Service. To avoid this high risk, an organisation need to take preventative measures. Avoid compliance issues by having knowledgeable, honest employees, and keeping up with all laws and regulations. Fraud is a common risk in an internal control system.
Preventing fraud involves developing a good system that separates each employee's duties. Employees who accept payments should be separated from employees making deposits and also an employee who inputs checking transactions should not also reconcile the checking accounts. Also according to the city of Tampa a system of appropriate documentation is vital to avoid fraud, all transactions should be traceable to their origination point. Fraud risk can also be detected through unusual occurrences.Employees who appear to live beyond their means is often a symptom of fraud, as are missing or altered documents. Transactions that can't be traced are also a symptom that could be fraud-related. Previous studies (Ziegenfuss 2001) have documented that fraud is a concern in state and local governments, and that management and control systems were not well equipped to deal with it. However, a KPMG survey found that lax controls were the most significant reason for fraud in government (Wade, 2007).A lack of employee monitoring is a risk often associated with internal controls.
Even with an effective internal control system, risks can occur if employees aren't periodically monitored. Regular reviews and evaluations should be part of an internal control system. This includes spot-checking transactions to determine if they comply with regulations and company policies. Managers must also keep a close eye on financial reporting, always looking for discrepancies or irregular activity. Managers can also perform surprise cash and asset counts, holding employees responsible for any discrepancies.Effectiveness of internal controls in local authorities Effectiveness was proposed by Etzioni, et al, (1985);Mardiasmo (2002) that define effectiveness as the level of success of the organization in an effort to achieve the objectives and goals. Effectiveness focuses on outcomes (results), programs, or activities that are considered effective if the resulting output can meet the desired objectives. Based on the effectiveness of some sense it can be concluded that the effectiveness of an organization is successful in achieving the desired objectives or outcomes with a comparison between the output, Devas (1989);(Mahmudi, 2005).
Effective internal control system refers to the effective control measures established by an organization with the aim of safeguarding their assets, ensure the reliability of records both financial and non-financial as well as compliance with relevant policies and procedure that will ensure the achievement of organizational objective. The quality of an organization's internal control system has significant impact on the accuracy of management guidance, likewise organisation's that disclose ineffective internal controls system have larger tendency of experiencing management errors in their operation than those organisations that report effective internal controls system (Feng, Li ; McVay, 2009). Therefore, it is the responsibility of management of an organization to ensure that effective internal control system is put in place that will ensure the achievement of organizational established objectives. This is because establishment and supervision of effective internal control systems are the responsibility of management, not auditors (Changchit et al, 2001).As an organization the following components that is the control environment, control activities, information and communication, risk assessment and monitoring are taken into account as they determine how effective the internal control system will be. The control environment sets the tone of an organization influencing the control consciousness of its people. It is the foundation for all other components of internal control, providing discipline and structure.
Control environment factors include the integrity, ethical values and competence of the entity's people; management's philosophy and operating style; the way management assigns authority and responsibility, and organizes and develops its people; and the attention and direction provided by the management.It has influence over organization goals achievement (Aldridge ; Colbert, 1994). However, it is the foundation for the other components of internal control and providing structure (Sudsomboon ; Ussahawanitchakit, 2009). Control environment assist toward reducing the level fraudulent activities within organizational operation also the quality of an entity's internal controls system depend on the function and quality of their control environment (Amudo & Inanga, 2009). Therefore, providing a proper control environment for a local government is very essential to the effectiveness of their operation.Control activities are the policies and procedures that help ensure management directives are carried out. (Aikins, 2011; Rezaee, Elam & Sharbatoghlie, 2001) They help ensure that necessary actions are taken to address risks to the achievement of the entity's objectives. Control activities occur throughout the organization, at all levels and in all functions.
They include a range of activities as diverse as approvals, authorizations, verifications, reconciliations, reviews of operating performance, security of assets and segregation of duties. Proper documentation of policies and procedural guidelines in these aspects help to determine not only how the control activities are to be executed but also provide adequate information for auditors examination of the overall adequacy of control design over financial management practices (Aikins, 2011). These control activities ensure that all necessary actions should be taken with the aim to address risks so that organizational objectives are achieves.Risk assessment is the identification and analysis of relevant risks associated with the achievement of the management objectives (Theofanis, et al 2011), similary (Sudsomboon ; Ussahawanitchakit, 2009) view risk assessment as the process of identifying and analyzing management relevant risks to the preparation of financial statements that would be presented fairly in conformity with general accepted accounting principle. In this situation, management must determine the level of risk carefully to be accepted, and should try to maintain such risk within determined levels.
Therefore, local governments are required to frequently assess the level of risk their experiencing in order to take necessary actions or to put necessary controls in place.Information and communication refers to the process of identifying, capturing, and communicating of relevant information in an appropriate manner and within timeframe in order to accomplish the financial reporting objectives (Aldridre ; Colbert, 1994). However, effective communications should occur in a wider sense with information within the various sections of the organization (Theofanis et al, 2011). Most of the recent literature on internal control system frameworks gave concerns on information and communication as one of the internal control system components, because of their importance in influencing the working relationship within the organization at all levels (Amudo ; Inanga, 2009). Hence, such information must be communicated throughout the entire organization in order to permit personnel to carry out their responsibilities with regard to objective achievement.Internal control systems need to be monitored a process that assesses the quality of the system's performance over time. This is accomplished through ongoing monitoring activities, separate evaluations or a combination of the two.
Ongoing monitoring occurs in the course of operations. It includes regular management and supervisory activities, and other actions personnel take in performing their duties. Monitoring is usually accepted that internal control systems need to be adequate monitored in order to assess the quality and the effectiveness of the system's performance over time. Monitoring provides assurance that the findings of audits and other reviews are promptly determined (Theofanis et al, 2011), also monitoring of operations ensures effective functioning of internal controls system (Amudo ; Inanga, 2009). Hence, monitoring determines whether or not policies and procedures designed and implemented by management are being carried out effectively by employees.
Internal Control. (2016, Oct 13). Retrieved from https://studymoose.com/internal-control-4-essay
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