Academic journal article Review of Business

The Internal Control Paradox: What Every Manager Should Know

Academic journal article Review of Business

The Internal Control Paradox: What Every Manager Should Know

Article excerpt

How extensive should my company's internal control system be? In today's environment, this is a difficult question to answer. The reason for the confusion is that some current business, legal, and social trends suggest that companies need to increase their emphasis on internal control, while other trends indicate just the opposite. The purpose of this article is to explore these conflicting trends and to offer a balanced view of internal control systems in the 1990s. This balanced view recognizes that there are costs of having too much control in a company and costs of having too little control. The key is to try to minimize your company's total costs of control by picking controls that are appropriate for the risks your company faces.

What is Internal Control?

A control is "any action taken by management to enhance the likelihood that established objectives and goals will be achieved" [Institute of Internal Auditors, 1993]. In other words, controls are designed to ensure that organizations conform to standards or plans. Examples of controls include the use of sales or expense budgets, computer passwords, or even padlocks on warehouses.

An internal control system is a collection of controls designed to provide reasonable assurance that the company meets the following objectives: (1) reliability and integrity of information, (2) compliance with policies, plans, and laws, (3) safeguarding of assets, (4) efficient use of resources, and (5) accomplishment of goals [Institute of Internal Auditors, 1993]. The major risk that companies face is that these five objectives will not be met. Therefore, the internal control system is the company's defense against risk.

An internal control system consists of three elements - the control environment, the accounting system, and the individual control procedures. The control environment includes the company's organizational structure, management's operating style, the personnel practices used, and the methods of assigning authority and responsibility to employees. The accounting system is designed to accurately identify, record, and report the company's transactions. Control procedures are detailed policies and rules, such as authorization of transactions, segregation of duties, documentation, physical controls over assets, and independent checks on performance. The debate over internal control primarily relates to finding the "right" level of control procedures.

Trends Toward Internal Control

Several trends suggest that companies should increase their emphasis on control procedures. First, companies today face substantial liability from several sources, including environmental fines, sexual harassment suits, and worker safety fines. For example, Chevron Chemical recently was fined $17 million for environmental violations [Begley, 1993]. A recent survey found that 25% of the nation's largest companies had been sued repeatedly for sexual harassment and that these companies spent an average of $6.7 million per year on costs related to sexual harassment [Moskal, 1991]. OSHA violations recently cost Cargill, Inc. nearly $1 million in fines [Garland, 1991]. It is possible that these companies' losses could have been prevented if the companies had implemented internal controls designed to prevent the environmental, harassment, and safety violations.

Second, in addition to preventing violations, internal controls also are important in calculating the fines charged to companies whose employees violate federal laws. The Federal Sentencing Guidelines of 1991 hold your company responsible if an employee violates a federal law. The fines imposed on companies can be as high as $290 million, depending on the seriousness of the crime and the control systems the company had in place to prevent the violation [Golden, 1993]. For example, assume that Company A and Company B each have employees who violate the same federal law. Company A had a good control system in place, but the system failed on one occasion. …

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