Internal Controls: 5 key elements

John Velasco
March 30, 2022

Internal controls are all around is from traffic signals to parking meters. They are implemented by businesses as a means to limit the behavior of managers, employees and customers. Controls in accounting systems also assure users that the information in financial statements is reliable. In short, internal controls provide reasonable assurance that assets are safeguarded, information is accurate and conforms to generally accepted accounting principles (GAAP), and involved parties comply with the laws and regulations.

According to the Association of Fraud Examiners, it is estimated 5% of annual revenues worldwide, amounting to $3.5 trillion is lost to fraud committed by employees. This can be done by an employee in charge of cash receipts that accepts cash payments and simply pocketing the cash and not recording the sale. Another way is for employees to bill their employers for personal items. This outlines the importance of internal controls as a means to prevent fraud.

To achieve the objectives of internal control, 5 key elements are applied:

  • Control environment
  • Risk assessment
  • Control procedures
  • Monitoring
  • Information and communication

These elements help protect a business from threats to controls. The control environment involves management's operational style, organizational structure, policies. How a business might approach and emphasize the importance of internal control depends on management. For example, the personnel policies may adopt a stricter standard to ensure employees have integrity, honesty and competence. Risk assessment involves assessing the risks of changes in the business environment and should be analyzed. Control procedures are an important element which provide a high degree of assurance that the goals of the business are achieved. One is to prevent fraud through practices such as having a rotation of duties, separation of responsibilities within operations, separating operations, and having a custody of assets and accounting. Proofs such as authorization documents and security measures to safeguard assets such as access codes, locked safes are basic necessities for businesses.

Monitoring is another key element that often involves observing behavior of employees and the accounting system for problems. What are some warning signs? Abrupt changes in lifestyle, refusal to take vacations may be indicative of a problem for employees. Missing documents, gaps in transaction numbers, differences between dally cash receipts and bank deposits, unusual amount of refunds from customers can warning signs from the accounting system. Internal auditors often evaluate controls after changes in management or operations. Lastly, information and communication is essential to internal control. Information is gathered about the control environment, risk assessment, control procedures and monitoring to guide management in operations and strengthening compliance.

However, there are some limitations to internal controls. The human element is always present, as these controls are administered by humans. Management override of internal controls can cause invalid data. Errors can result from fatigue, incompetency. There is also the possibility of collusion to commit a fraudulent act. Nevertheless, internal controls are essential to any organization and these five elements are needed for effectiveness.

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Thanks for reading,

John Velasco


2014 Report to the Nation on Occupational Fraud and Abuse, Association of Fraud Examiners