Internal Controls: What Are They & Why You Should Care

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what are internal controls

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 intends to protect 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 report their financials and prove that their procedures ensure effective fraud prevention as well as showing that they have addressed any uncertainty such as stocks.

Why are objectives the first step to creating internal controls?

Many organizations feel that the first step to establishing a protective armor lies in defining the risks it attempts to mitigate. Until your company understands how it wants to position itself, it will remain unable to set appropriate objectives and address the risks inherent in those.

For example, if Iron Man fights Thanos, he needs something to stand up to the villain’s 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 area must explore the internal controls required by the Health Insurance Portability and Accountability Act of 1996 (HIPPA).

If the organization wants to enter the financial arena, then management needs to look at the standards and regulations that govern banks to ensure the appropriate controls.

Once your organization knows the objectives, it can move forward to defining the risks.

How does risk management support internal controls?

Once your company defines its objectives and goals, it can begin to look at the risks tied to those strategic decisions.

The core values of governance, risk, and compliance (GRC) focus on defining risks so that your organization can comply with standards or regulations, while continuously monitoring to ensure the processes work. For example, physical access risks differ from system intrusion risks. Both require controls, but physical access risk needs you to review people while system intrusion reviews firewalls and encryption.

Effective corporate risk management involves creating 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 have resources to help them. The COSO Framework sets out the five types of internal control and offers definitions to help companies.

When the Securities and Exchange Commission established the Committee of Sponsoring Organizations of the Treadway Commission (COSO), they brought auditors and accountants to review fraudulent reporting. In 2013, the commission created the COSO Framework and its five interrelated components.

Control Environment

Internal audit and enterprise risk management professionals define this as the way that the Board of Directors and Senior Management approach the internal control system’s importance within the company by reviewing awareness and actions taken through 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.

Risk Assessment

Reviewing risks not only means identifying them but creating appropriate preventative strategies to mitigate them. Defining risks not only means looking internally but also externally. If your organization outsourced work to vendors, then you need to be protecting against the threats they pose. When an organization limits its liability and creates an inventory that addresses risk and any exemptions made, then

Control Activities

Internal policies, procedures, and mechanisms are examples of control activities. Not only do you need to act, but you need to document the decisions to show your organization’s coverage of risks.

Information and Communication

While management and the Board of Directors communicate when reviewing risks and establishing policies, they need to continue those conversations during the monitoring phase. Internally generated reports providing timely information to external auditors and shareholders proves the commitment to documenting and sharing information. Moreover, implementation of segregation of duties, such as separating human resources and payroll responsibilities, and creation of multiple communication channels, such as whistle-blower policies, demonstrate a commitment to communicating within the organization. Finally, communication must be appropriate to employee authority level.

Monitoring

Monitoring internal controls requires integrating internal audit as well as ongoing activities to ensure that the organization embedded procedures within normal operations. These detective measures help internal analysts review effectiveness. The audit committee needs to regularly update the Board of Directors by providing reports and reviews.

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 design 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 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 AS 5 can help 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. Moreover, you can create a more streamlined audit process by communicating early and often with your external auditor. The documentation needed for an auditor to prove 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, the 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 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 make your audit committee’s job easier and ensure a better audit outcome when the external auditor interviews your Board.

Finally, by using a SaaS platform like ZenGRC, you can gather your documentation quickly to provide your internal and external auditors with the information needed to review your control systems. With all the information housed in a single cloud 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 established their armor. For more information about how ZenGRC can help your organization be Iron Man, schedule a demo today.