The Importance of Internal Controls

Internal controls for a business are similar to checks and balances in the government; they are processes put in place to make sure things stay on the right track. Internal controls are useful for every business but are critical for companies with employees, especially employees who handle valuable assets. Retail businesses in which customers have direct access to small products can also benefit enormously from internal control procedures. While internal controls are crucial for helping you detect dishonesty, they can also help you reduce the risk that simple mistakes will keep you from seeing your company's true financial picture.

As much as you want to think the best of the people working with you and for you, the sad fact is that a lot of people are dishonest. Whether the scale is small or large, that dishonesty can cost your business — and you — a lot of money over time. Any employee can steal from your company, whether a bookkeeper or warehouse manager or the kid sitting behind the cash register. It's not just money that can be stolen (although that does happen a lot); many employees consider it perfectly normal to take home office supplies or small inventory items. That may not seem like a big deal compared to someone embezzling hundreds of thousands of dollars from the bank accounts, but it still can add up to quite a lot in the long run.

Although internal controls can uncover wrongdoing, they're usually set up with the assumption of honesty in the background. To that end, most standard internal control procedures concentrate on preventing and detecting inadvertent errors. Also, when employees know these controls exist, they're less likely to act dishonestly.

Setting up a system of internal controls can keep such problems from getting out of hand. When you have internal controls in place, you're protecting your assets as well as the accuracy of your accounting records. The types of controls to put in place depend largely on the size and nature of your business; for example, a cash-intensive company with thirty employees would require more control measures than would a three-man operation where virtually no cash changes hands in the normal course of business.

Basic Internal Control Principles

The idea behind internal controls is to create an environment where mistakes are less likely and dishonesty is easily caught. Most of these principles will seem like plain old common sense, but you might be surprised at how many small-business owners neglect to use them.

At the most basic level, put some simple physical controls in place. Store cash in a safe; keep your warehouse locked and limit access to the key; make any sensitive computer files password-protected. If you have a lot of employees who work different shifts, get a time clock to track hours worked. If you have a retail shop, you can tag items with anti-theft sensors. Any company with valuable assets should consider an alarm system to deter break-ins.

Internal controls geared specifically toward employees include assigning specific responsibilities, making sure all transactions are immediately documented, and separating related duties. Documents are the evidence that a transaction has occurred, in addition to being necessary for accurate recordkeeping. Typical internal control documents include cash register tapes, signed delivery slips, and prenumbered invoices (so you will know if any are missing). Along those lines, assigning specific tasks to specific employees lets you know whom to question when something unexpected turns up. For example, having only one employee use the cash register at a time lets you know who's handling the cash.

The Importance of Separating Duties

Separating related duties involves making more than one person responsible for related activities, especially those activities that involve an easily pilfered asset. For example, having one person handle all the cash, make all the deposits, do the bookkeeping, and reconcile the bank statement gives that person almost a free hand with your company's cash.

Especially in small companies, it can be tough to separate tasks, and that's how many small companies get raked over the coals. There are two main ways to separate important duties:

  • Assign different people to related tasks

  • Don't have the person in charge of an asset be the same person who keeps the records for that asset

Related tasks include things such as ordering goods and paying vendor invoices. Someone could, for example, order things for personal use and then pay the vendor invoice with company funds. Separating accountability — meaning one employee is in charge of an asset but someone else keeps the records for it — is another way to protect your company. The person in charge of maintaining the inventory, for example, shouldn't also be in charge of counting the inventory.

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