Strong internal controls are a must for any size or type of business as they help a business achieve overall objectives by doing the following:
• Minimize errors
• Safeguard assets
• Promote operational efficiency leading to higher profits
• Produce more reliable financial data
Adherence to Procedures
Although internal controls require (rather than requesting or asking) employees to adhere to the established procedures, this does not mean that the controls will be followed all the time. Many times, it is much easier to establish procedures rather than to actually implement them and have employees follow them. Obviously, a business establishes certain procedures for reasons that they believe will enhance operating efficiency leading to higher net profit.
However, to achieve the business objectives, a business cannot assume that procedures will be followed consistently by all employees. Therefore, there must be controls in place to ensure compliance.
Preventive Controls
Preventive controls are actually a form of proactive controls to ensure systems are in place to assist in the efficient operation of a business. They help to:
• Standardize procedures
• Safeguard assets
• Attempt to reduce errors and irregularities
An example of preventive control is the segregation of duties which means having different employees involved in related functions rather than one employee handling all procedures related to the same function. An example would be having a check writer and check signer be different employees.
Another example of preventive controls would be having an approval system where certain types of transactions must be approved or verified by another employee or someone in management. Approving new contracts, new vendors, or new credit customers would be an example of preventive controls in the approval area. Needing approval before an account receivable is written off as a bad debt would be another example of this type of preventive control.
There could also be preventive controls to safeguard assets such as cash, equipment, inventory, supplies, etc. by having restricted access, various tangible controls, or periodic counting and inspection of physical assets.
Detective Controls
Detective controls are a check system for preventive controls. A business might have preventive controls written or assumed, but there must be “detective” controls to:
• Ensure compliance
• Find errors or problems if and when they occur
An example of detective controls would be operational performance reviews
that would compare current performance to expected performance. These controls could identify irregularities, unexpected results, or other out-of-ordinary outcomes that might require corrective action or future follow-up.
Another type of detective control would be in the area of reconciliations comparing various data sets to ensure accounts and records are correct and consistent. A typical example of this type of detective control is reconciling monthly bank statements with the bank accounts on the balance sheet of a business.
Taking a physical count of inventory and comparing that figure with the inventory figure on the balance sheet ensures that the physical inventory and book inventory figure agree is still another example of detective control. Financial statement adjustments and, possibly, corrective action could be taken after this type of detective control is implemented.
Areas of Control
All major areas in a business should have certain procedures in place and controls to ensure compliance. It is important to remember that internal control is not about making sure that every procedure is followed to the letter or that every asset is 100% safeguarded. It is about requiring that all employees adhere to established procedures in order to minimize errors, safeguard assets, and produce more reliable financial data.
Strong internal controls simultaneously increase operational efficiency and reduce detrimental effects on net profit. This can only happen when control measures are in place and followed consistently by all employees in all areas of a business.
