Business, Legal & Accounting Glossary
In accounting and organizational theory, Internal control is defined as a process, effected by an organization’s people and information technology (IT) systems, designed to help the organization accomplish specific goals or objectives. It is a means by which an organization’s resources are directed, monitored, and measured. It plays an important role in preventing and detecting fraud and protecting the organization’s resources, both physical (e.g., machinery and property) and intangible (e.g., reputation or intellectual property such as trademarks). At the organizational level, internal control objectives relate to the reliability of financial reporting, timely feedback on the achievement of operational or strategic goals, and compliance with laws and regulations. At the specific transaction level, internal control refers to the actions taken to achieve a specific objective (e.g., how to ensure the organization’s payments to third parties are for valid services rendered.) Internal control procedures reduce process variation, leading to more predictable outcomes. Internal control is a key element of the Foreign Corrupt Practices Act (FCPA) of 1977 and the Sarbanes-Oxley Act of 2002, which required improvements in internal control in United States public corporations.
There are a variety of definitions of internal control, as it affects the various constituencies (stakeholders) of an organization in various ways and at different levels of aggregation.
Under the COSO Internal Control-Integrated Framework, a widely-used framework in the United States, 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: a) Effectiveness and efficiency of operations; b) Reliability of financial reporting; and c) Compliance with laws and regulations.
COSO defines internal control as having five components:
The COSO definition relates to the aggregate control system of the organization, which is comprised of many individual control procedures.
Discrete control procedures, or controls are defined by the SEC as: “…a specific set of policies, procedures, and activities designed to meet an objective. A control may exist within a designated function or activity in a process. A control’s impact…may be entity-wide or specific to an account balance, class of transactions or application. Controls have unique characteristics – for example, they can be: automated or manual; reconciliations; segregation of duties; review and approval authorizations; safeguarding and accountability of assets; preventing or detecting error or fraud. Controls within a process may consist of financial reporting controls and operational controls (that is, those designed to achieve operational objectives).”
Under the COSO Framework, objective setting is considered a precondition to internal control. By setting objectives, management can then identify risks to the achievement of those objectives. To address these risks, management of organizations may implement specific internal controls. The effectiveness of internal control can then be measured by how well the objectives are achieved and how effectively the risks are addressed.
More generally, setting objectives, budgets, plans and other expectations establish criteria for control. Control itself exists to keep performance or a state of affairs within what is expected, allowed or accepted. Control built within a process is internal in nature. It takes place with a combination of interrelated components – such as social environment affecting the behaviour of employees, information necessary in control, and policies and procedures. Internal control structure is a plan determining how internal control consists of these elements.
The concepts of corporate governance also heavily rely on the necessity of internal controls. Internal controls help ensure that processes operate as designed and that risk responses (risk treatments) in risk management are carried out. In addition, there needs to be in place circumstances ensuring that the aforementioned procedures will be performed as intended: right attitudes, integrity and competence, and monitoring by managers.
According to the COSO Framework, everyone in an organization has responsibility for internal control to some extent. 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. Each major entity in corporate governance has a particular role to play:
Internal control can provide reasonable, not absolute, assurance that the objectives of an organisation will be met. The concept of reasonable assurance implies a high degree of assurance, constrained by the costs and benefits of establishing incremental control procedures.
Effective internal control implies the organization generates reliable financial reporting and substantially complies with the laws and regulations that apply to it. However, whether an organization achieves operational and strategic objectives may depend on factors outside the enterprise, such as competition or technological innovation. These factors are outside the scope of internal control; therefore, effective internal control provides only timely information or feedback on progress towards the achievement of operational and strategic objectives, but cannot guarantee their achievement.
Internal control involves human action, which introduces the possibility of errors in processing or judgment. Internal control can also be overridden by collusion among employees (see separation of duties) or coercion by top management.
Internal controls may be described in terms of: a) the objective they pertain to; and b) the nature of the control activity itself.
Internal control activities are designed to provide reasonable assurance that particular objectives are achieved, or related progress understood. The specific target used to determine whether a control is operating effectively is called the control objective. Control objectives fall under several detailed categories; in financial auditing, they relate to particular financial statement assertions, but broader frameworks are helpful to also capture operational and compliance aspects:
For example, a control objective for an accounts payable function might be: “Payments are only made to authorized vendors for goods or services received.” This is a validity objective. A typical control procedure designed to achieve this objective is: “The accounts payable system compares the purchase order, receiving record, and vendor invoice prior to authorizing payment.”
Management is responsible for implementing appropriate controls that apply to transactions in their areas of responsibility. Internal auditors perform their audits to evaluate whether the controls are designed and implemented effectively to address the relevant objectives.
Control activities may also be described by the type or nature of activity. These include (but are not limited to):
Internal control plays an important role in the prevention and detection of fraud. Under the Sarbanes-Oxley Act, companies are required to perform a fraud risk assessment and assess related controls. This typically involves identifying scenarios in which theft or loss could occur and determining if existing control procedures effectively manage the risk to an acceptable level. The risk that senior management might override important financial controls to manipulate financial reporting is also a key area of focus in fraud risk assessment.
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This glossary post was last updated: 24th April, 2020 | 38 Views.