The Failings of Internal Controls
Accounting controls are the means by which we gain a reasonable assurance that a business will operate as planned, that its financial results are fairly reported, and that it complies with laws and regulations. They are usually constructed to be an additional set of activities that overlay or are directly integrated into the basic operations of a business.
A well-constructed system of internal controls can certainly be of considerable assistance to a business, but controls suffer from several conceptual failings. They are:
- Assured profitability. No control system on the planet can assure a business of earning a profit. Controls may be able to detect or even avoid some losses, but if a business is inherently unprofitable, there is nothing that a control system can do to repair the situation. Profitability is, to a large extent, based on product quality, marketplace positioning, price points, and other factors that are not related to control systems.
- Fair financial reporting. A good control system can go a long ways toward the production of financial statements that fairly present the financial results and position of a business, but this is by no means guaranteed. There will always be outlier or low probability events that will evade the best control system, or there may be employees who conspire to evade the control system.
- Judgment basis. Manual controls rely upon the judgment of the people operating them. If a person engages in a control activity and makes the wrong judgment call (such as a bad decision to extend credit to a customer), then the control may have functioned but the outcome was still a failure. Thus, controls can fail if the judgment of the people operating them is poor.
- Determined fraudulent behavior. Controls are typically designed to catch fraudulent behavior by an individual who is acting alone. They are much less effective when the management team itself overrides controls, or when several employees collude to engage in fraud. In these cases, it is quite possible to skirt completely around the control system.
Thus, the owners, managers, and employees of a business should view its controls not as an absolute failsafe that will protect the business, but rather as something designed to increase the likelihood that operational goals will be achieved, its financial reports can be relied upon, and that it is complying with the relevant laws and regulations.
This article is an excerpt from Steven Bragg's Book The Accounting Controls Guidebook .