Topic 8: Internal Controls

Internal Controls

Processes designed to ensure the reliability of financial reporting, safeguard assets, and prevent fraud

Three Types of Financial Statement Problems

Errors, disagreements in judgment, and fraud

Error (in accounting)

An unintentional mistake in recording or posting financial transactions

Disagreement in Judgment

Differing opinions about how to report transactions based on estimates

Fraud

Intentional misstatement or omission of financial information

Purpose of Internal Controls

To reduce risk of errors and fraud, and ensure accurate and reliable financial reporting

Three Elements of an Internal Control Structure

Control environment, accounting systems, control procedures

Control Environment

Overall attitude, awareness, and actions of management regarding internal controls

Accounting Systems

Methods and records used to identify, assemble, analyze, classify, record, and report transactions

Control Procedures

Specific policies and procedures that help ensure management’s directives are carried out

Five Types of Control Procedures

Segregation of duties, authorization procedures, documentation, physical safeguards, independent checks

Segregation of Duties

Separating responsibilities among different employees to reduce risk of error or fraud

Authorization Procedures

Requiring approvals for transactions to ensure legitimacy

Documentation and Records

Keeping written evidence of transactions to support accounting entries

Physical Safeguards

Securing assets and records to prevent unauthorized access or theft

Independent Checks

Reviews and audits conducted to verify that activities are performed correctly

Earnings Management

Intentional influence on financial reporting to meet targets or expectations

Reasons for Earnings Management

Pressure to meet internal goals, external expectations, income smoothing, financing goals

Techniques of Earnings Management

Timing of transactions, changing accounting methods, non-GAAP accounting, fictitious transactions

Sarbanes-Oxley Act (SOX)

U.S. law passed to increase accountability and reduce fraud in financial reporting

Public Company Accounting Oversight Board (PCAOB)

Regulates audits of public companies and sets audit standards

SOX Constraints on Auditors

No non-audit services to audit clients, partner rotation, must report to audit committee

SOX Constraints on Management

CEO/CFO must certify financial statements, mandatory ethics codes, no executive loans

Internal Auditors

Evaluate internal controls, monitor operations, and detect compliance or fraud issues

External Auditors

Independent accountants who verify the fairness and accuracy of financial statements

SEC (Securities and Exchange Commission)

Government agency overseeing securities markets and enforcing financial reporting rule