The Essence of Internal Control

THE ESSENCE OF INTERNAL CONTROL

By

 Charles L. Kern, BS/MBA/CPA/CVA/CFA/ABV/CFF/AEP/FCPA

For most of us the thought of our business growing is very appealing. But sometimes that may not be a blessing. Your business can grow too fast! Even if individual transactions are profitable, the cost of funding the growth can hit you before you realize the cash from previous sales. Yes, you can grow yourself right into bankruptcy! If the cash flow is not a problem in your growth, just the increased number of transactions and paperwork can be overwhelming. The problem is control, or rather, the lack thereof. You are losing control of what is going on around you. In the accounting world, we refer to this notion of control as “internal control”.

Let’s talk briefly about the concept and meaning of internal control. Of course, it refers to things like theft and fraud. But I think that is a rather negative view of the world and that internal control has a friendlier and more important meaning. Not that theft and fraud are not important, but let’s set them aside for a moment. Internal control really has to do with the avoidance and minimization of errors, mistakes, and waste. Now isn’t that what really concerns you the most as your business grows? So internal control is not just an accounting issue. It has to do with all of your rules and policies—from sales, to purchasing, to manufacturing, to assembly, to delivery, to personnel, to accounting, etc., etc. The question now is, what to do about it?

First, let me share with you my favorite definition of internal control. It is, I believe, the best definition that I have ever found even though some of the terminology is a bit dated (“dated” as from my college days—and that is “dated”!!!). A key notion in this definition is that internal control is more than an accounting issue:

            “When considering internal control, an organization’s objectives include safeguarding assets and providing reliable financial information. But internal control extends beyond the accounting and financial functions; its scope is companywide and touches all activities of the organization. It includes the methods by which top management delegates authority and assigns responsibility for such functions as selling, purchasing, accounting, and production. Internal control also includes the program for preparing, verifying, and distributing to various levels of management those current reports and analyses that enable executives to maintain control over the variety of activities and functions that constitute a corporate enterprise. The use of budgetary techniques, production standards, inspection laboratories, time and motion studies, and employee training programs involve engineers and many others far removed from the accounting and financial activities; yet all of these devices are part of the mechanism referred to as an internal control structure.”  (See Note)

If you are growing and growing too fast, you have probably exceeded what is called your “span of control”. In other words, you have got a lot more on your plate than one person can reasonably handle. There are too many people asking you questions. Every little thing seems to require your attention. You are making money, but working too many endless hours and days, and you have absolutely no time for the family, let alone yourself. Then to make matters worse, when your accountant does give you the financial results, they just don’t look right to you. Knowing what you know about the business, the bottom line is crazy! You need help to bring things under control and the question is, again, what to do about it, where to begin?

You can hire some help and/or delegate some of the work among your current staff. In either case, the thing to keep in mind here is that you really must delegate and give people authority. A person cannot be held responsible for something if they don’t have the authority to do anything about the issue. If you delegate, you must empower those persons. You must also give them some guidance—the goals, the time frame, the resources, the limitations. You must allow these people to set policy, make changes, and to establish procedures. The goals are especially important. There are overall (your) company goals and their individual segment goals. It is sometimes tough to make sure that all of these goals point or will point in the same direction. You must also be open-minded. These people will do things differently from you. It may be better or worse or more or less efficient, but it will be different. But try to be loose—different may well be better and you just cannot do it all yourself.

Your staff must report to and be accountable to you, and that reporting system has to be carefully designed. You don’t need all of the detail; you need to be aware of significant exceptions. Remember my comment earlier about goals needing to mesh? Well, reporting is very important here. A person will perform according to how they are measured! So if you reward them based on the reporting scheme, the reporting scheme had better be pointing them in the right direction—the direction where all of the goals mesh. There are all kinds of reporting to explore. There is sales reporting, production reporting, branch reporting, daily settlements, and more, all of which can be tailored to meet your needs, your business, and to properly motivate your staff.

 

The next question is what to do if all of these reports indicate those things just aren’t going too well or the way that you would like. If the problems are internal to your business and systemic, your accountant can probably help. They can help to assure that the system is documented so that everybody is reading from the same sheet of music. They can help to assure that the system generates a trail by which to track down problems. In other words, they can do what we accountants call operational audits. Are things operating as they should, within tolerable limits? That is the question!

Note—Principles of Auditing 9th Edition; Meigs, Whittington, Pany, and Meigs; 1989.