A system of internal control refers to the process by which
organizations maintain environments that encourage incorruptibility and
deter fraudulent activities by management and employees. An
organization’s components of internal control are evaluated during the
planning phase of an independent financial statement audit. The results
of the evaluation directly influence the auditor’s level of detailed
testing. To reduce detailed testing, and perhaps the audit fee,
organizations implement common features of a proper internal control
system.
Management Integrity
Management
integrity, or the moral character of persons of authority, sets the
overall tone for the organization. Management integrity is communicated
to employees through employee handbooks and procedural manuals. The
Management Library indicates that in addition to communicating
management integrity, policy manuals facilitate training to employees.
However, management’s enforcement of policies is the major indicator of
an organization’s commitment to a successful internal control system.
Competent Personnel
An
organization’s ability to recruit and retain competent personnel
indicates management’s intent to properly record accounting
transactions. In addition, the retention of employees increases the
comparability of financial records from year to year. Furthermore, an
auditor’s confidence in the underlying accounting records increases as
he observes the reliability of the organization’s personnel. This in
turn reduces an auditor’s assessment of the risk of a material
misstatement in the entity’s financial statements.
Related Reading: Internal Controls in Accounting Information Systems
Segregation of Duties
The
University of California at Los Angeles notes that a segregation of
duties is critical to effective internal control because it reduces the
risk of mistakes and inappropriate actions. An effective system of
internal control separates authoritative, accounting and custodial
functions. For instance, one employee opens incoming mail, a second
employee prepares deposit slips for daily receipts, while a third
employee deposits receipts in the bank. The previous example prevents
the opportunity of one employee to misappropriate incoming funds.
Records Maintenance
Maintaining
appropriate records ensures that proper documentation exists for each
business transaction. Records management involves storing, safeguarding
and eventually destroying tangible or electronic records. Also,
appropriate back-up deters an employee or management from creating
phantom transactions in the underlying accounting records. The
Environmental Protection Agency emphasizes that a good records
management program reduces operating costs, improves efficiency and
minimizes the risk of litigation.
Safeguards
Safeguards
prevent unauthorized personnel from accessing valuable company assets.
Safeguards are physical, such as locks on doors, or intangible, such as
computer software passwords. Regardless of the methods, safeguards are a
necessary feature of an organization’s internal control system. Many
business owners instinctively protect inventory, cash and supplies.
However, blank checks, company letterhead and signature stamps are items
that require safeguarding that are commonly overlooked
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