How to Create an Internal Control System for Your Business

Every business has risks, and while some risk is unavoidable, most companies seek to manage risk (and comply with laws and regulations) by implementing internal controls.

Internal controls are the policies, procedures, and practices a business puts in place to ensure the integrity of reporting and accounting information, promote accountability, and prevent fraud. These controls help safeguard assets, ensure the accuracy of financial reporting, and enhance operational efficiency.

So, how do you create an effective internal control system? And once in place, how do you know whether those internal controls work the way they should?
This article explains internal controls and why they’re essential and provides some best practices to help you implement or improve them in your organization.

Why Are Internal Controls Important?

Internal controls are essential for maintaining trust and confidence in a business’s operations and financial reporting. They provide a framework to detect and prevent errors, fraud, and inefficiencies to reduce the risk of financial loss and legal exposure.

Strong internal controls can increase investor confidence and improve overall business performance.

Understanding the Five Components of Internal Controls

A strong system of internal controls is built on five key components, as outlined by the Committee of Sponsoring Organizations (COSO).

Control Environment

The control environment sets the tone for the organization, influencing employee attitudes about internal controls. It encompasses the integrity, ethical values, and competence of the company’s people, management’s philosophy and operating style, the way management assigns authority and responsibility, and the direction provided by the board of directors.

The entity’s board of directors and senior management set a “tone at the top” by establishing a code of conduct that outlines expected behaviors and responsibilities and demonstrating a commitment to integrity and ethical values. Ideally, employees will follow suit.

Risk Assessment

Risk assessment involves identifying and analyzing the risks that could prevent the business from achieving its objectives. This process helps management prioritize risks and determine how to manage or mitigate them.

The company’s risk assessment should identify the company’s objectives and risks that might prevent achieving those objectives.

Risks generally fall into five categories:

1. Inherent risk – the level of risks that exists when the organization has no controls in place whatsoever
2. Control risk – the chance that an internal control fails to work as intended
3. Residual risk – the risk that remains after implementing an internal control
4. Operational risk – unexpected failures in the company’s day-to-day operations caused by people, processes, or external factors
5. Compliance or regulatory risk – the risk of failing to comply with laws or regulations like the Foreign Corrupt Practices Act (FCPA) or the Sarbanes-Oxley Act (SOX)

Control Activities

Control activities are the actions taken to mitigate risks and ensure management’s directives are carried out. Organizations should perform control activities at all levels and various stages within business processes.

An example of a control activity is implementing segregation of duties, where different employees handle different aspects of a financial transaction, such as authorization, recording, and custody of cash or other assets.

Information and Communication

Information and communication systems support identifying, capturing, and exchanging information in a form and timeframe that allows people to carry out their responsibilities.

The company’s information and communication systems should define the processes for communicating information about internal controls to the right people both internally and externally.

Monitoring Activities

Monitoring involves assessing the quality of internal control performance over time. This process can include ongoing evaluations, separate evaluations, or a combination of both. Businesses change over time, and internal controls need to change as well. Monitoring ensures controls continue to operate effectively and are updated as necessary.

Implementing Internal Controls

Now that you better understand what internal controls are, here’s a structured approach for implementing internal controls in your business.

Step 1: Assess Your Current Controls

Begin by evaluating your current internal control environment. Identify existing controls and determine whether they’re effective at mitigating risks. Include all levels of management and staff in the assessment to gain a comprehensive understanding of the business’s operations.

Step 2: Identify Key Risks

Once you understand your current controls, identify your business’s key risks. Consider financial, operational, compliance, and strategic risks. Prioritize these risks based on their potential impact on the business.

Step 3: Design Control Activities

For each identified risk, design control activities to mitigate them. Ensure these controls are practical, cost-effective, and aligned with the business’s goals.

There are two types of internal controls: preventive and detective. Preventive controls aim to keep errors or fraud from happening, while detective controls aim to find errors and problems after mistakes have already occurred.

Some examples of control activities include:

• Segregation of duties. Divide responsibilities to ensure no single person can perform, authorize, and record financial transactions.
• Authorization and approvals. Have a suitable person (or persons) authorize and approve all financial transactions to ensure they’re appropriate and align with organizational goals. For example, you might require management approval for expenditures over a certain dollar amount to prevent unauthorized spending.
• Access controls. Limit physical control of cash, equipment, inventory, checks, and other assets. Restrict access to entering or updating vendor data to a few employees to reduce the risk of accounts payable fraud.
• Reconciliation. Perform monthly reconciliations of transactions to confirm the information reported is accurate and up-to-date. For example, employees should reconcile bank statements monthly to ensure recorded transactions match the actual account balances.
• Audits. Some organizations may have an internal audit department and/or hire an external audit firm to test internal controls and offer suggestions to strengthen them.

Document your company’s internal controls in policies and procedures that are accessible to all employees.

Step 4: Implement and Communicate Controls

Implement the control activities across the organization. Train employees, establish clear lines of communication, and ensure everyone understands their roles and responsibilities.

Step 5: Monitor and Review

Regularly monitor the effectiveness of your internal controls through audits, reviews, and assessments. Update controls as needed to address new risks, changes in people, processes, technology, or the larger business environment. Ongoing monitoring activities help maintain the integrity of the internal control system over time.

Take Control of Your Control Environment with Percipio Business Advisors

A strong internal control system helps protect your business and supports long-term success. If you need help designing or evaluating your internal controls, contact Percipio Business Advisors. We can help you create a customized internal control system tailored to your business’s unique needs and risks.

Connect with us today