Internal Controls: What Are They & Why You Should CarePublished February 6, 2018 by Karen Walsh • 5 min read
Internal controls act as the protective armor for an organization. Much the way that Tony Stark’s Iron Man suits protect him from the dangers inherent in battling supervillains, internal controls protect your business from the risks that can compromise an information technology environment.
Understanding the Importance of Internal Controls & What They Are
What is a system of internal controls?
A system of internal controls protects your organization from financial, strategic, and reputational risks. In auditing and accounting terms, internal controls assure that your business basics remain operationally effective and efficient.
These processes protect your organization by providing the reliable financial reporting required by various regulations and industry standards that track investment, capital, and credit risks. For example, section 404 of the Sarbanes-Oxley Act of 2002 (SOX), intended to protect investors, requires annual proof that companies accurately report their financials, prove that their procedures effectively prevent fraud, and show that they have addressed any uncertainty such as stocks.
Why are objectives the first step to creating internal controls?
The first step to establishing protective armor lies in defining the risks you are guarding against. Until your company understands how it wants to position itself, it will remain unable to set appropriate objectives and mitigate the inherent risks.
For example, if Iron Man fights Dr. Strange, he needs something to stand up to his powerful magic. However, when fighting against Hulk, his armor needs to withstand the green rage monster’s strength.
Determining business objectives drives the risks your organization faces the same way. If you want to enter the healthcare services space, you need to think about the risks to electronic personal health information (ePHI). An organization that wants to engage in the healthcare arena must explore the requirements of the Health Insurance Portability and Accountability Act of 1996 (HIPAA).
If the organization wants to enter the financial industry, then management needs to look at the standards and regulations that govern banks to ensure they provide the appropriate controls.
Once your organization knows its objectives, it can move forward to defining the risks.
How does risk management depend on internal controls?
Once your company defines its objectives and goals, it can begin to identify the risks tied to those strategic decisions.
The core values of governance, risk, and compliance (GRC) focus on addressing risks so that your organization can comply with standards or regulations, while continuously monitoring to ensure the processes work. Controls are the specific measures put in place within those processes. For example, physical access risks differ from system intrusion risks. Both require controls, but physical access risk controls limit people with system access, while system intrusion controls include measures like firewalls and encryption.
Effective corporate risk management requires a structure to support the procedures that protect resources and assets.
What are the five internal controls?
When creating a system of internal controls, organizations should utilize available guidance. The COSO Framework identifies five types of internal control and offers definitions to help companies.
The Committee of Sponsoring Organizations of the Treadway Commission (COSO) convened expert auditor and accountant organizations to develop resources that would deter fraud. In 2013, the commission updated the COSO Framework and its five interrelated components.
Internal audit and enterprise risk management professionals define this as the standards, infrastructure, and processes that form the basis of the internal control system. These foundational structures establish the expectations for and importance of integrity within the company’s corporate culture. Management and Directors evidence their values through operating styles and organizational structure.
For example, formalizing segregation of duties shows that management not only acts appropriately but holds itself accountable.
Assessing risks means not only identifying them but also creating appropriate preventative strategies to mitigate them. To appropriately define risks, an organization must look both internally and externally. If your organization outsourced work to vendors, then you need to be protecting against the threats they pose. When an organization limits its exposure and creates an inventory that addresses risk and any exemptions made, it develops a strategy to manage threats to the achievement of objectives.
Internal policies, procedures, and mechanisms are examples of control activities. These actions are the manifestations of the organization’s risk management strategies. They can work to identify, prevent, or monitor risks; control activities must be embedded throughout a program’s life cycle.
Not only does an organization need to act, but it also must document its control activities to demonstrate its management of risks.
Information and Communication
Communication underpins the entire GRC program. Management and the Board of Directors communicate expectations to an organization’s employees. Staff must share information upward, so that reviews of risks and policy formulation processes inform corporate decision-making. During the monitoring phase, internally-generated reports provide timely information to external auditors and other stakeholders. As information is gathered and disseminated, it must flow up, down, and across the organization.
Monitoring internal controls ensures that control activities have been embedded within normal operations. Ongoing measurement, evaluation, and audits are necessary to regularly update the Board of Directors by providing reports and reviews. Controlling risk is an iterative process, and to continuously improve controls, an organization must evaluate control effectiveness and learn from its own implementation efforts.
How do you design internal controls?
When designing controls, your company needs to determine how business processes relate to the integration of financial reporting and your information systems.
Organizations need to establish procedures regarding the initiation, recording, processing, correcting, transferring, and reporting of electronic and cash transactions. Then, these processes should be coordinated with your financial statements’ information.
Moreover, control design needs to explain how your information systems record events and conditions outside the financial statement realm. For example, a breach impacts your financial performance because the losses affect your income and reserves. Thus, you need controls that document your breach responses.
Finally, when designing internal controls, your company needs to review the financial reporting process and the way you record non-standard transactions. While the internal control design process focuses on financial reporting and financial controls, organizations need to remember that modern-day solutions involve both software and hardware. Unlike the days of hand-written ledgers, modern businesses use digital tools to track their general ledger information, which is how internal control design connects to your IT environment.
What does an internal control audit require?
The Public Company Accounting Oversight Board (PCAOB) defines the standard of review for internal controls in Auditing Standard No. 5 (AS5) An Audit of Internal Control Over Financial Reporting That is Integrated with An Audit of Financial Statements. Since your auditor is likely a certified public accountant (CPA), understanding the terms and concepts within AS5 can help you be prepared.
The Section 404 audit will require you to provide documentation proving the coordination of internal control audit with your current financial statement audit. Auditors want proof of the evaluation process. Gathering this documentation in advance can ease the process during the audit itself. Moreover, you can streamline the audit process by communicating early and often with your external auditor. The documentation needed to demonstrate to an auditor reasonable assurance of compliance sometimes feels overwhelming.
How does automation ease the pain of internal control development and monitoring?
Between risk assessments, procedures, reporting, and communication, paperwork is the one thing that all internal control designs share. Small companies may begin working with spreadsheets to try to track their controls, but as they scale their business, their internal and external stakeholders increase in number. Thus, budgeting for a sleeker solution can save time and money long term.
More people interacting with the controls leads to potential errors when you use the confined authorization of shared documents. SaaS solutions like ZenGRC offer individual access controls, which means that your administrator can set appropriate authorizations for reviewing and editing to keep your information protected.
Additionally, with ZenGRC, you can create easy-to-read reports that give your Board of Directors the insights they need to monitor the control environment appropriately. Managing reports in one place makes your audit committee’s job easier and contributes to a better outcome when the external auditor interviews your Board.
Finally, by using a SaaS platform like ZenGRC, you can quickly gather your documentation to provide your internal and external auditors the information needed to review your control systems. With all the information housed in a single cloud-based repository, you can manage your audit requests more efficiently and cost-effectively. When your IT department spends less time gathering audit trail documents, they spend more time protecting you from threats.
Organizations need controls to protect them from threats, but they also need the supplementary systems to help them prove that they correctly assembled their armor. For more information about how ZenGRC can help your organization be Iron Man, schedule a demo today.