Question

Whats the importance of internal control in regards to accounting? With some examples.

Answer 1

Internal controls refer to the plan, policies and procedures that a company has in place to detect, prevent and correct any misstatements in the books of accounts. After getting to know frauds like the Enron case it was very clear for everyone that there was an urgent need for internal controls in the accounting world to reduce the number of frauds. The importance of internal controls in regards to accounting can be further explained with the help of below points:

1. Helpful in Risk assessment:

Internal controls are extremely helpful in risk assessment. They help in obtaining an understanding of the accounting process and in identifying and mitigating the risks.

2. Safegaurds assets:

Another important advantage of internal controls is that it safeguards the assets in various ways such as ensuring segregation of duties etc.

3. Detect, prevent and correct frauds:

The main purpose of introducing internal controls was to detect, prevent and correct frauds. This is done by implementing authorization process at each and every stage of each processes.

4. Preventing material misstatements in the books of accounts/financial statements:

This is the most important advantage from both an accounting as well as from an audit perspective. It prevents incorrect numbers from being entered in the books of accounts.

A few examples explaining the importance of internal controls are as follows:

-->> For the first example let's consider 2 companies, A & B. In company A let's say there is a control that the debtor aging policy is prepared by an associate in the finance team and reviewed by the Finance head after which the adjustment entry is posted in the books. Whereas in Company B there's no such control and the associate in finance team both prepares and passes the adjustment entry in the books of accounts.

Now let's say the associate for both companies make the same mistake, let's say they take the wrong percentage while calculating the provision for doubtful debts. Now in case of Company A this mistake will be detected by the Finance Head and hence he will be able to correct the same and pass the correct entry in books. On the other hand since no one is reviewing the associate's work in Company B an incorrect entry will be passed in the books.

-->> For the second example let's assume Mr. A is the associate in finance team which is handling the Fixed Assets area including all the entries related to purchase, depreciation and sale etc. Now if Mr. A will also be the person responsible for physically handling the assets it will be much easier for him to conduct a fraud by recording a purchase of fixed assets whereas physically no asset would be purchased.

Hence internal controls play a major role here by ensuring that there is segregation of duties among such processes. It means that no single person should be responsible for the same process which reduces the risk of fraud.