Internal control can be defined as the process put into effect by the management and other personnel in an organization that has been designed to provide an assurance concerning the reliability of financial records, effectiveness of operations and compliance with the regulations. Internal controls in an organization are very important as they provide a level of confidence in their financial reports and information. This is because they limit the individual’s accessibility in manipulating and misrepresenting financial records and are, therefore, very critical in the organization and especially in the accounting department (Herrera, 2010).
Limitations of internal control systems
Lack of employee training and communication is one major limitation for the internal control procedures. This can be attributed to the fact that employees, who do not understand the importance of the procedures to be followed, limit its effectiveness. Through training and communication of the purpose of the incorporating internal controls, the staff has a responsibility to work towards the purpose and will reduce any problems caused by the lack of internal controls. An improper staff system is usually as product of human error caused by misunderstandings, stress and fatigue, therefore employees are required to motivate workers and give them earned vacations in order to avoid stress and fatigue. This will lead to an efficient internal control system (Fight, 2002).
Lack of reporting fraud is another limitation for internal control systems. This can be attributed to staff that collude to fraud in the company as they manipulate financial data for their own purposes. Falsifying accounting records is very disadvantageous for the company, as it will lose revenues and profits. Policies on fraudulent behavior should be set in order tocreate an efficient control system and those who report fraudulent behavior should also be protected by the law as per the Whistleblower Act.
Management override is another limitation for the efficient internal control systems. High-level personnel in the organization sometimes ignore the prescribed policies and procedures for any purposes mainly for their own advantage (Fight, 2002). This leads to lack of investigation whenever there is a problem with the control system and can make employees take advantage of this fact and enter fraudulent information.
Examples of internal control procedures
Segregation of duties is one example of the internal control procedures. It refers to separating of administrative functions or operational functions that when combined to be harmful to the company’s profits and revenues. This is done by having different employees responsible for recording, maintaining financial information and for the custody of assets. Segregation of duties removes the ability to easily manipulate company information and is an excellent measure of internal control.
Bank reconciliations are examples of internal control procedures, as they make certain that all physical cash transactions have been properly recorded for a specific period. People other than those in charge of the transactions do this action and review cancelled checks to make sure they match the accounting records of the company. This reconciliation statement needs to be prepared monthly, reviewed and signed by the managers of the company. It is an efficient control measure as it identifies omissions and errors in the financial records and is an excellent way to identify fraud within the company (Fight, 2002).
Each control set out by the management should be evaluated based on risk and cost benefit annalysis. The cost of implementation should not outweigh the benefit of controls. The internal controls should also reduce the risks associated with any form of errors.
Symptoms of lack of internal control
With lack of an efficient control system, employees are likely to be inefficient as well creating errors, mistakes and an environment that lacks assurance. This can lead to an increasing rate of employee dissatisfaction and low rates of employee retention, hence employers may spend unnecessary resources in staff recruitment and training. This shows lack of poor management, inefficient use of resources and poor business practices. Lack of an internal control shows that there is poor supervision and care of staff, lack of ethics policy in an organization giving room for errors and missing documentation (Herrera, 2010).
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Various stakeholders creating a negative reputation for the company can question the integrity, reliability and validity of financial information of the company. It is understood that this is not a good thing for the company as customers will begin to notice and it will affect its operations negatively. Lack of internal controls shows the lack of ability to track the company’s performance against set budgets, schedules and forecasts (Herrera, 2010).
Impact of the missing journal entry
The pre-paid insurance was not recorded for the first three months in the financial statements. As the insurance is an expense for the company, is means that the expenses were in fact understated resulting in an overstated net income. This will also imply that current assets were overstated. The errors made in this entry would result in an incorrect ratio analysis and would affect the decisions made by the management as is would be based on the wrong information.