Internal controls: Overview, definition, and example
What are internal controls?
Internal controls refer to the processes, policies, and procedures put in place by an organization to ensure the integrity of financial and operational activities, safeguard assets, ensure compliance with laws and regulations, and promote efficiency. Internal controls are designed to prevent fraud, errors, and mismanagement, and they help ensure that the organization’s objectives are met. These controls can be preventive (e.g., segregation of duties, approval requirements) or detective (e.g., audits, reconciliations) to monitor and correct any deviations from the set standards.
For example, a company may implement internal controls to ensure that only authorized employees can approve financial transactions, reducing the risk of unauthorized spending or fraud.
Why are internal controls important?
Internal controls are important because they help organizations minimize risk, prevent fraud, and ensure compliance with legal and regulatory requirements. Well-designed internal controls provide assurance that an organization’s financial reporting is accurate, assets are protected, and operational objectives are achieved efficiently. For businesses, internal controls contribute to maintaining financial health, improving decision-making, and fostering trust with investors, regulators, and other stakeholders.
For businesses, strong internal controls can also help improve operational efficiency, reduce the risk of financial misstatements, and demonstrate accountability to stakeholders.
Understanding internal controls through an example
Imagine a company with a policy that all cash payments must be approved by the finance manager before they are made. This control ensures that no employee can make unauthorized payments, protecting the company from internal fraud. Additionally, the company conducts regular audits to verify that all transactions are recorded correctly, further enhancing their internal control system.
In another example, a business has a system in place where two employees must review and sign off on all expense reports before they are processed. This process prevents errors and fraud by ensuring multiple levels of review and accountability.
An example of an internal control clause
Here’s how an internal control clause might look in a contract:
“The Company shall maintain a system of internal controls designed to ensure the integrity of its financial reporting, protect its assets, and promote operational efficiency. This includes, but is not limited to, regular audits, segregation of duties, and the requirement for managerial approval for all financial transactions above [Insert Amount].”
Conclusion
Internal controls are essential for ensuring the accuracy of financial reporting, protecting assets, and maintaining the efficiency and effectiveness of business operations. They help prevent fraud, ensure legal compliance, and improve decision-making by establishing checks and balances within the organization.
For businesses, implementing strong internal controls is a proactive way to manage risk and demonstrate financial accountability to stakeholders, ensuring long-term operational success.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.