Types of Internal Controls Used for Financial Accounting

Organizations are expected to maintain accurate financial records and correct any discrepancies to benefit their business, employees and customers. Internal controls put procedures in place to quickly detect any mistakes and stop fraudulent activity. Although the accounting department is in charge of implementing and monitoring internal controls, all employees are responsible for understanding and maintaining the policies and procedures that make up their organization's controls.

In this article, we explain internal controls, share the types of internal controls used by most organizations and answer frequently asked questions regarding internal controls.

What are internal controls?

Internal controls are the accounting policies and procedures that businesses use to ensure financial stability and integrity. Internal controls safeguard the reliability of accounting practices within a company. Internal controls also make up the ongoing process of protecting an organization and its assets from fraud. Accountants, auditors and financial controllers use internal controls to maintain accurate financial reporting inside their organization.

Internal controls are useful for the following with a business:

• Maintaining accurate financial reporting

• Eliminating fraud

• Helping inform financial decisions

• Ensuring compliance with financial regulations

• Increasing accountability

• Enabling risk assessment

• Outlining clear policy guidelines for all staff

• Monitoring accounting records

• Detecting mistakes early

• Creating an audit trail for financial reporting

• Giving auditors a process to follow and check

Read more: Internal Controls: Definition, Advantages, Disadvantages and Examples

Types of internal controls

Internal controls exist within the two main categories of preventative and detective controls. The function of a preventative control is to stop any financial accounting problems or issues before they happen. A detective control reviews financial information after a transaction has occurred to identify problems that may already exist. Here's a breakdown of each type of internal control:

Preventative

Here are the types of preventative controls used by organizations:

Approval authority

This type of internal control requires specific leaders within an organization to approve financial transactions of employees before they are processed by the accounting department. Managers will analyze transactions and large purchases before they can be approved to check for errors, fraud or unscrupulous business practices.

Separation of duties:

When individual employees have control over one part of the overall financial assets of an organization, the possibility of fraud declines. This is why companies split the duties within an accounting department between multiple employees.

Access controls

Limiting access to certain systems is another strategy companies use to safeguard their financial assets. Employees use passwords for protected access to digital accounting tools or physical codes for safes and areas of locked access for physical property. Companies can also use digital passcodes to track errors back to a specific user to correct and account for errors.

Standardized documentation

Another way to protect financial assets is by requiring all staff members to use the same forms to document monetary transactions or physical inventory.

Detective

Here are the detective controls organizations use:

Periodic reconciliations

Routine accounting inspections called reconciliations help balance accounts both with internal financial transactions and external vendors and clients. This may involve checking bank statements to ensure that both parties show the same fiscal data or reviewing purchases through a vendor.

Physical audits

Many companies do a yearly check of their physical assets through an inventory check. Using this method, a business accounts for all materials that make up its physical holdings. In retail stores, this means counting everything in stock on shelves or in warehouses. Non-retail businesses may use this to account for company property used by staff. All companies may also conduct physical audits by hand-counting cash.

Trial balances

Daily, bi-weekly or weekly balance checks in accounting systems can help detect mistakes in accounts. Some companies employ double-entry systems to mitigate errors as well. This control is used to help correct balance discrepancies as quickly as possible.

Common procedures for internal controls

Common procedures that are part of internal controls include the following:

Performing procedural updates

To maintain effective internal controls, management assesses and reviews procedures for controls. They are responsible for communicating any changes with staff regarding how controls are functioning and how they are implemented.

Periodically reviewing processes

Another common procedure is for organizations to periodically analyze the effectiveness of their internal control systems. They often use reports generated by trial balances, audits and reconciliations to assess the amount of quality control within the organization.

Assessing risks

Risk management is one of the outcomes of internal controls. Routine evaluations on the areas most likely to be affected by fraud or errors helps decrease the possibility of loss. The greater the risk, the greater level of controls needed.

Creating the right atmosphere

Since internal controls rely on processes and people, one important factor in protecting financial accounting is to foster an environment of integrity and trust among employees of all levels. If organizational leaders set a tone of honesty and transparency at the top, employees are more likely to follow internal controls and maintain the integrity of the company's assets without extra scrutiny.

Related: What Is an Accounting Information System? Your Guide to AIS

FAQs about internal controls

Here are some of the commonly asked questions regarding internal controls:

Can internal controls eliminate all accounting discrepancies?

Although internal controls help decrease the risk of fraud and balance mistakes when it comes to financial practices, there is no one way to eliminate all accounting errors.

What is a controller and how are they involved in internal controls?

A controller is a financial professional who is responsible for all accounting activities within an organization. They are in charge of regulatory reporting and compliance as well as budgeting, preparing tax documents and developing accounting policies. Controllers act as a manager to oversee that all internal controls are both effective and followed by all staff. They are responsible for updating internal controls and communicating any changes to employees.

Related: What Is a Financial Controller?

What are some ways employees comply with internal controls?

Employees can comply with internal controls in the following ways:

• Adhering to all of an organization's policies and procedures

• Taking reasonable steps to stop loss, waste, misappropriation and unauthorized use of assets

• Monitoring their own work for correctness and limiting errors in their processes

• Meeting all duties and job requirements as outlined in their job description

• Working to meet all performance standards

• Attending continuing education and professional development sessions

• Reporting concerns or known errors to appropriate leaders

How can management encourage adherence to internal controls?

Managers and organizational leaders can encourage adherence to internal controls through the following methods:

• Maintaining a positive atmosphere where honesty and integrity are encouraged

• Modeling truthful behavior that promotes a positive and transparent environment

• Routinely testing internal controls to ensure they are performing effectively as safeguards for company assets

• Documenting all policies and procedures that relate to internal controls

• Communicating success when internal controls are functioning effectively and alerting employees when their help is needed for corrective action such as reconciliation

• Understanding how internal controls can impact work functions

How are internal controls used by auditors?

Auditors use internal controls to assess the accounting procedures of an organization. After testing their effectiveness, an external auditor will give an opinion as to how accurately a business maintains their internal controls. This contributes to an external auditor's overall assessment of an organization's financial systems.

Internal auditors work within an organization to monitor the ongoing effectiveness of their internal controls. They conduct periodic reviews of the processes in place within the company.