Importance of Internal Controls
Internal controls are processes and procedures put in place to mitigate risk. All companies need internal controls. For small businesses, implementing internal controls can prove to be challenging but necessary to ensure things run smoothly and prevent fraud. The appropriate level of internal controls to implement can be hard to determine and should be based on your tolerance to risk and the level of effort you are willing to put forth to manage the risk.
How do internal controls help?
Have you ever watched a toddler and learned that as soon as they are up and moving you need some safeguarding around the house to keep them protected? Plugs in the electrical outlets to keep little fingers safe, a baby gate at the top of the stairs to prevent a tumble, and locks on cabinets to keep little explorers out. All these safeguards allow you to rest a little easier as your little one goes through life. It allows your toddler to explore the house without as much risk of injuring themselves.
Internal controls function in the same way as the safeguards you put in place for your toddler. They are protection for your property, employees, and processes. They don’t ensure that nothing bad will happen, but they reduce the probability of it. They help you to manage both external and internal risks to the business.
Types of Internal Controls
There are two types of controls – preventative and detective. Preventative controls stop something from happening. An example of a preventative control is a password on a system. This prevents an unwanted user from gaining access to the system. Many preventative controls revolve around segregation of duties which is the concept of having more than one person required to complete a task to prevent fraud and detect errors.
Detective controls uncover something that has already happened. They don’t stop it from happening, but they provide evidence that it did happen. An example of a detective control is a review of physical inventory. This is when someone independent from the department that purchases or controls the inventory physically counts the inventory and then compares it to the recorded balance for inventory. Any missing items are investigated.
It is important to find the right mix of preventative and detective controls for your business. ESG can help you assess the current design of your internal controls and implement new controls when needed. We can also test the effectiveness of your internal controls.