Internal Control Definition- Internal Control System In Accounting And Auditing

Internal Control definition

Internal control definition refers to the rules, procedures and mechanisms implemented by an organisation to ensure the integrity of accounting and financial information, prevent fraud and promote accountability. 

It not only prevents employees from stealing assets but also improves operational efficiency by working on the timeliness and accuracy of financial reporting. 

In other words, it is a procedural and systematic step affected and designed by people in charge from management, governance and other personnel to assure the accomplishment of the company’s objectives concerning effectiveness, compliance with the applicability of regulations and laws, reliability on financial reporting and efficiency of operations. 

For internal control examples, The Sarbanes-Oxley Act 2002 has enrolled managers lawfully responsible for the accuracy of the company’s financial statements.

• Internal control is implemented to address identified business risks that can threaten the achievement of any company’s objectives.
• It is regarded as a whole system of controls, established by management in the conduct of businesses including internal audits, internal checks and other forms.

Characteristics of Internal Control

The characteristics of internal control are usually abbreviated as CROSSASIA explained as follows: 

Internal Control Objectives 

The internal control objectives are mainly as discussed above which include:

• To ensure the company holds with relevant rules, regulations and laws
• Ensuring the effective functioning of the company continuously
• Minimizing the business risk respectively
• Protection from inefficiency and carelessness
• Moral pressure over staff
• Division of work in such a manner that no transaction remains unrecorded
• Detect frauds and produce adequate reliable accounting information 

However, all internal control objectives direct to the major goal of the company to achieve the company’s mission such as failing to minimize risk or high costs can affect the company’s profits or might be forced to restructure their planning function leading to a disbalance in the internal control.

Types of Internal Control 

• Preventive: This type of internal control is designed to keep irregularities or errors stop from occurring in the first place.
• Corrective: It is designed to alter, correct or edit the errors or irregularities that have been found through deviations or feedback.
• Detective: Referring to this control system, it is planned to detect or find the errors or mistakes that have occurred by setting a standard performance and comparing the results.

Principles of Internal Control 

Internal control is based on a few principles which are discussed as follows;

• Principle of Responsibility: To ensure healthy internal control, the responsibility assigned for performing a job should be stated clearly to leave no scope for confusion or doubt subsequently.
• Principle of Separation: The accounting and financial operations must be separated. So, This explains that the recording of movement and handling of cash thereof must be done by different departments (in the case of large organisations) or persons.
• Rotation: The principle of job rotation related to the transfer of an employee from one job to another must be the inflexible guiding rule.
• Scepticism: This principle of internal control explains there should not be too much confidence pinned on one employee. Moreover, There is research according to which nearly all frauds are committed by trusted individuals or officials.
• Clarification: There must be well-defined and clearly stated rules that are practically followed and laid down concerning the deals of ordering, issuing goods, cash, receiving etc.
• Review: The chronological order or the hierarchy of work must be arranged in such as way that work done by one employee gets checked by another independent employee promptly.
• Documentation: Similar as the scenario discussed above in the review, the documentation principle of the internal control system talks about the arrangement of written work. So, In such a manner that the written records maintained by one employee should pass from several hands for a recheck in a well-defined way.

Internal Cost Advantages

It provides certain benefits to various parties which can be accounted for as follows:

• Internal control gets applied to receipts and payments to safeguard against the misappropriation of cash.
• Helps to implement management policies to achieve corporate objectives and goals.
• Ensures proper sanction of capital expenditure and use of it for the purpose intended.
• Increases reliability and accuracy of financial statements or books of accounts through supervision like a proper recording of transactions of sale or redemption, profit or loss on an investment, additions, income etc.
• Aids to implement and prepare effective plans through factual and correct information.
• Protect the assets of the company from fraud, errors, accidents, theft, misuse etc.
• Helps the auditor in his work by detecting the irregularities committed in the records of book.
• Regulates the work of employees through proper division of authority and responsibility in a scientific manner that makes the daily routine effective.
• Puts moral pressure on the employees to work according to the guidelines or regulations maintained.

Components of Internal Control

There are five interrelated components of the internal control structure identified by the Committee of Sponsoring Organisations mentioned:

Control environment 

Influencing the control consciousness of the people determines the component of a controlled environment that sets the tone of an organisation. It forms the base for all other steps further determining structure and discipline. The following factors comprise the control environment in an organisation:

• Structure
• Human resource practices and policies
• Integrity and ethical values
• Audit Committee and Board of directors 
• Commitment to competence
• Operating cycle and management philosophy
• Assignment of responsibility and authority

Risk assessment 

Management’s risk assessment must count considerations concerning changed circumstances like changes in accounting standards, the rapid growth of the entity, new areas of business, changes in personnel related to reporting functions or information processing and new laws for internal control.  

Information and Communication 

The information system related to objectives or financial reporting including an accounting system of methods and records formed to assemble, classify, identify, analyse, report and record entity transactions is maintained to ensure accountability for relevant liabilities and assets. 

Whereas, communication includes providing a clear picture of individual responsibilities and roles regarding internal control structure over financial reporting.

Control activities 

The step of control activities in the internal control defines the procedures and policies that ensure the directives are carried out properly. So, They determine that necessary measures are taken to find risks in the achievement of the company’s objectives. The control activities apply at various levels and organisations therefore, financial statement audits can be categorized in different ways:

• Application controls
• Document and records
• Segregation of duties
• Performance reviews 
• Information processing controls
• Independent checks

Monitoring 

Monitoring is the process that checks the quality of the internal control structure’s performance over time. So, It includes assessment by the right personnel of operation of controls and design on a suitable basis to know that the management is performing as it requires and modifies for changes in conditions.

Disadvantages of Internal Control

No matter how well the internal control structure is designed, they can only give reasonable assurance that the goals have been achieved. Therefore, there are a few limitations in all internal control systems which are inherent as follows:

Breakdowns 

The staff sometimes simply makes mistakes or misunderstands the instructions. Therefore, even well designed internal control structure may break down. Moreover, irregularities might also occur from the complexity of computerized information systems and new technology.

Judgement 

So, efficiency and effectiveness affect by decisions made with the human judgement under pressure based on information in hand to conduct business.

Collusion 

Control systems might be circumvented by staff collusion. So, Individuals working in groups can edit the other management information or financial data. In a manner, that identifies the internal control in control systems.

Management override 

Higher-level personnel may override the prescribed procedures and policies for personal advantage or gain. However, this act must not mix up with management intervention. Which depicts management actions to depart from procedures and policies for legitimate purposes.

Unusual transactions 

A limitation of internal control is that they generally structure to handle the normal or daily routine activities in a business. However, there is a possibility that an unusual transaction may occur out of the box of normal routine, in which the standard controls do not fit. Hence, errors are from unusual transactions or situations.

Costs v/s benefits

The cost lastly, the cost of the company’s internal control structure might exceed the benefits that becomes expected to be ensured.

What is Internal Control in Accounting? 

Moreover, To give a brief of what internal control in accounting explains the applicability of the accounting system to achieve the objectives mentioned below:

• To safeguard the assets in adherence to the management procedure and policy
• Detection or prevention of fraud and mistakes
• Orderly and effective conduct of accounting transactions
• To ensure completeness, timely preparation, accuracy and reliability of accounting data

While for non-accounting areas, administrative control seeks to achieve the aim of orderly conduct of transactions and management inefficient.

For internal control examples, in a manufacturing system, the internal control system establishes to ensure control over wastages, check of security system, ABC control over raw materials, supply of management information system and quality control.

Also, If the accounting system is not strong, the auditor might pursue a detailed checking of events in the financial statements. While good internal control puts greater reliance on financial data leading to test checks of only selected items.

For internal control examples, an auditor before certifying the valuation of stocks might refer to the reports of consumption patterns if he feels material discrepancy in the physical quantity of stocks prepared by the manufacturing department to administration.

What is Internal Control System?

The internal control or check-in an integral part of what is the internal control system. Therefore, what is internal control system explains by collaborating all the functions under one roof of internal control definition that manages by a system. 

The internal control system however is a need along with the expansion of business, requiring recruitment of employees and officers. Which further widens the scope of business. 

It differs from one business to another depending upon the size and the nature of the business accordingly. 

As a result, the internal control system or structure highlights achieving the objective of business with appropriate execution of activities keeping in mind the prevailing laws and socio-economic conditions (external environment) of the country. 

Also, 3 elements of the internal control system gives a clear picture:

• Environment control: The work zeal and alertness of managers, shareholders and director reflects by environment control.
• Control procedure: It takes into account the additional procedures and policies adopted by the company authority for ensuring the accomplishment of a specific goal. So, The control procedures are segregation of responsibility, adopting security measures to protect the properties, proper delegation of power, and preparation of documents.
• Accounting system: It states the recordings with which identification, classification of business transactions, summarization, preparation of statements and analysis for the presentation of correct information. 

Internal Control System in Auditing 

The key responsibility of auditing is to certify the authenticity and fairness of the accounts in a business. To do so, an auditor expects to perform his duties in such a manner that it would reveal the actual state of affairs.

However, an efficient internal control system in auditing can make the work convenient and easy. Also, The auditor relieves from the detailed checking of the transactions. But to what extent an auditor must be dependent on the internal control system in auditing is solely his matter of discretion.

Moreover, the auditor has to trust the internal control system in auditing since it becomes practically impossible to conduct a check on thousand of transactions maintained.

Review of internal control system

Before happening of the star audit, the internal control system in auditing must review as follows:

• Frauds, mistakes or errors must be located
• Reliability of reports, certificates and records that are presentable by the management
• Frame audit program concerning to present circumstances 
• Review the efficiency of the internal control system in auditing and check the internal audit program
• System of accounting entries, whether it records according to the accounting standards or not
• Keep a check on the possibility of improvement in the existing internal control system in auditing

Note: To improve the understanding of the internal control structure, documentation is required in all components while auditing. The documentation may take the form of the following in a computerized accounting system:                                                                                      Flowcharts                                                                                                                                        Questionnaires                                                                                                                                      Narrative memoranda                                                                                                                                  Decision tables

Conclusion 

Therefore, from the above study, we concluded that the internal control definition explains a process of systematic look after. By the management on the rules, regulations and policies to avoid errors and irregularities. In addition, if we consider the environment it refers as an internal control system. Also, The internal check has a key role in accounting and auditing terms to achieve the objectives of the organisation.

Frequently Asked Questions (FAQs)

What is internal control definition?

Internal control definition defines the policies and procedures implemented by an organization to ensure their financial reports are reliable, operations are efficient, and activities are compliant with applicable laws and regulations.

what is internal control?

Internal control is a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance: That information is reliable, accurate and timely. Of compliance with applicable laws, regulations, contracts, policies and procedures.

What is the internal audit definition?

Internal auditing definition defines an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations.

What are the 5 internal controls?

Five Interrelated Components

• Control Environment. The control environment sets the tone of an organization, influencing the control consciousness of its people. …
• Risk Assessment. …
• Control Activities. …
• Information and Communication. …
• Monitoring.

What Is internal control meaning?

Internal control is a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance.