Private organizations and public companies have experienced complex and multifaceted growth in recent times. Each year new challenges emerge in management as stakeholders and investors become more aware about operations of their companies. With these complexities, reporting about overall performance of a big company can be protracted hence fail to reveal true image of the company. Internal controls come as part of the policies and procedures guiding financial and business undertakings of organizations. They are aimed at protecting companies from waste, fraud, and inefficiency, especially when it comes to financial reporting. As carriers of public interest, organizations have to comply with rules and regulations either internal or external to ensure that rules of business are adhered to and that interests of stakeholders and investors are protected. Internal control works to compel organizations to comply with these policies and regulations. This paper discusses internal controls and how they affect financial reporting in organizations. It also discusses the Sarbanes-Oxley Act of 2002 and how this Act affects use of internal controls in companies.
As companies continue to operate in a dynamic environment, it is important to use limited resources efficiently. Internal controls are systems and mechanism employed by the management of a company to ensure that operations in the company meet expectations of stakeholders. They also ensure that integrity and honesty are maintained when it comes to financial reporting to investors. Finally, they ensure that the company functions in accordance to laws and regulations that govern the industry (Graham, 2007). In essence, internal controls are aimed at ensuring that organization’s properties are utilized well and that accountability is upheld by the management.
Internal controls are mechanisms that are put in place to safeguard interests of investors and stakeholders of a business organization. They are ethical business practices that are aimed at preventing fraud, waste, and inefficiency in terms of financial reporting and operation evaluation by chief executive officers (CEOs) and chief financial officers (CFOs). Moeller (2008) observes that being a control mechanism, internal control helps the management of an organization to control the use of organizations’ resources, guarantee accurate and reliable financial reports, ensure compliance with rules and regulations, and finally evaluate performance of different departments within an organization.
Graham (2007) notes that being a control mechanism, internal controls function by controlling business environment, assessing the risk posed to the organization, and supporting information and communication systems within an organization. In addition, internal controls provide policies and procedures so that management of the company could have a greater control over activities of the organization. Besides, Graham (2007) explains that internal control systems will be useless if the quality of internal control performance is assessed only from time to time.
Sarbanes-Oxley Act and Internal Controls
According to Moeller (2008), Sarbanes-Oxley Act of 2002 introduced new standards of corporate accountability. It also introduced new penalties in management of organizations and companies. As the custodian of investors, the Act sought to improve accuracy and reliability of corporate management during reporting about the performance of an organization. Being a regulation, Sarbanes-Oxley Act compelled managers to report about financial standing of a company, including reporting about internal controls that were put in place. The aim was to show that reports were not only accurate but that the company also had confidence in them.
Moeller (2008) observes that Sarbanes-Oxley Act of 2002 affected internal controls systems that were in place prior to its passing. For instance, company’s definition of internal controls was expanded to include a control system which was to assess how reliable and effective internal control systems were. Additionally, the Act implied that auditing firms were to ascertain the reliability of controls used by the company or organization to prepare a financial report.
According to Moeller (2008), this Act led on enhancement of internal controls in public organizations as it required that any report from the organization concerning finances of the company should be accompanied by evidence of internal controls used. This has forced many mangers to go back to the drawing board and evaluate their management styles to ensure they were corresponding to provisions of Sarbanes-Oxley Act of 2002.
Since the Act has made stakeholders and investors concerned with operations of companies, it has become vivid that any activity of the company will be scrutinized keenly. As a yardstick of efficient management of companies, investors are likely to take advantage of effectiveness of internal controls in their organization to measure their level of success. Announcement of the inefficiency of management will be an indicator of the inaccuracy and unreliability of the company, which is an important factor that determines if an investor is going to invest in a company (Moeller, 2008).
Limitations of Internal Controls
According to Buchanan Publishing LLC (2011), internal control systems like any other systems have limitations which can be either internal or caused by human error. Being a control system, internal control is subjected to the operation by human beings, who may sometimes be stressed or fatigued, thus causing errors to occur. Another challenge to internal controls is the subdivision of activities, which is likely to increase maintenance costs. Increased costs will imply that even though the company reports are reliable and accurate, it fails to meet its business objectives and may, therefore, fail to sustain itself in a competitive environment.
Buchanan Publishing LLC (2011) has indicated another challenge being the designing and establishing of an effective and reliable system with little errors and risks. The source notes that implementing an internal control system requires expertise to ensure that benefits are maximized. In essence, the cost of implementing internal control systems should not exceed benefits accrued from the control. However, this is not the case as many companies do not have expertise in management of internal controls in their countries. Internal controls may also not be able to eliminate external challenges that businesses face. Such challenges as competition and technological change are still able to make the company experience great losses and, therefore, must be watched for.
In conclusion, internal control is essential for all companies. It ensured that responsibilities regarding company’s operations are subdivided and segregated according to roles of each employee in an organization. Therefore, it allows the company to be in line with internal control principles, which outline responsibilities using physical, mechanical, and electronic controls. It also allows to establish independent internal verification procedures. Being management mechanisms, internal controls are packed with legal procedures and policies that allow the company to improve the accuracy of management of its resources.