Merriam-Webster defines internal control as, “a system or plan of accounting and financial organization within a business comprising of the methods and measures necessary for safeguarding its assets, checking the accuracy of its accounting data or otherwise substantiating its financial statements, and policing previously adopted rules, procedures, and policies as to compliance and effectiveness.”
Internal controls are essential to any organization, and crucial to its ability to drive operations and measure success. Internal controls are the key policies, rules, and procedures that establish and promote:
- accurate financial reporting
- operational effectiveness and efficiency
Proper controls help organizations to both detect and prevent from a negative occurrence that may risk the protection of its assets. Five key components make up the framework for strong and effective internal controls – control environment, risk assessment, control activities, information and communication, and monitoring.
The control activities are at the heart of proper policies and procedures that prevent and protect the organization from errors, issues, and fraud:
- Separation of duties – Separation of duties helps to reduce the likelihood of errors and lower the risk for an occurrence of fraud by dividing accounting processes and tasks when it comes to bookkeeping, authorizations, deposits, and more. Effective separation of duties divides certain actions or steps within a key process among two or more individuals.
- Authorization – Proper authorization practices prevent invalid transactions from occurring. Approval for various transactions is a necessary control to help ensure that all business activities adhere to established guidelines and objectives, and to prevent fraud or theft. Requiring specific individuals to authorize certain types of transactions provides internal record that an activity has been seen, reviewed, and approved by appropriate authority before it can be processed or paid.
- Documentation – Documentation is a crucial component to maintaining internal controls. Documented processes clearly establish accounting procedures and the process steps, associated rules, and ownership within them. They provide an internal record for what actions need to take place, by whom, and in what order they should be taken, ensuring consistency in the completeness and accuracy of activities. Processes to document should span all those related to expenses, revenues, inventory, personnel, and other types of organizational transactions.
Learn more about the best practices around the five key components of internal controls and control activities within our guide, Internal Controls for Nonprofits.