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Kezia Farnham

Senior Manager

5 components of internal controls: What they are and why they’re important

March 7, 2023

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0 min read

Internal controls are an important yet challenging part of any organization. In a survey from the Association of Chartered Certified Accountants:

• 41% of respondents said that technological advances made it difficult to maintain existing controls
• 32% reported that lack of emphasis on internal controls only compounded the difficulty of internal controls management

Focusing on the five components of internal controls can help. While internal controls ensure good governance, the internal control components provide a framework for the accounting system. Both accountants and audit teams should incorporate these components when they design and review the accounting system.

The five components of internal controls are:

1. Control Environment
2. Risk Assessment
3. Control Activities
4. Information and Communication
5. Monitoring

What Are the Components of Internal Control?

1. Control Environment

The control environment refers to the overall culture of compliance. In other words, it’s how both executives and employees buy into internal controls. The more seriously the organization views internal controls, the stronger the system will be.

If executive and management teams disregard existing controls, employees will likely follow suit. Over time, this can create vulnerabilities across the system. Compliance can also happen from the bottom up since audit teams can use their data to make a business case for cyber risk management.

2. Risk Assessment

To effectively manage risk, organizations need to identify their potential risks, then implement internal controls to mitigate them. Accounting teams should have an always-on approach to monitoring since new risks can surface without warning. The teams should then deliver audit reports to the board to surface any new risks.

This is especially important if a business’s products or services frequently evolve since changes in the organization’s infrastructure will also impact its system of internal controls.

3. Control Activities

'Control activities' means ensuring that the proper controls are in place and using accounting systems and automation to verify that controls are functioning as intended. This can include regular controls testing or inventory audits, all of which should follow an internal audit strategy.

4. Information and Communication

Knowledge is power. Communicating with management about any lapses in internal controls is the best way to mitigate risks quickly. Though audit teams likely have hundreds or even thousands of data points, taking a proactive approach to enterprise risk management is essential.

Audit teams can likely tackle minor breaches independently, but they should inform executives of any major vulnerabilities. Communicate precisely the information the person needs to know, whether that’s a well-versed Chief Audit Executive or a board member who’s more of a layperson in the components of internal controls.

5. Monitoring

Audit teams should monitor internal controls on an ongoing basis. Doing so ensures that they’ll be able to identify when internal controls are functioning properly and when there are potential lapses in the internal controls system.

That’s what makes this one of the key components of internal controls, since monitoring is how teams identify failures and make improvements. Without monitoring, vulnerabilities may go unchecked, turning minor issues into major breaches.

Future-Proof Internal Audit With Internal Controls

The five components of internal controls may seem like they’re the business of only the accounting and audit teams. In reality, every member of an organization should understand and support the internal controls system. Without internal controls and the teams supporting them, organizations could face major breaches, compromising their reputation and bottom line.

Understanding the components of internal control opens up an opportunity to future-proof internal audit. Audit teams can prove the internal audit function’s value through the internal controls system. They can automate processes, analyze data and deliver insights, all of which can make them an invaluable strategic partner to the board. Download the ebook from Diligent to learn more.

Controlling is one of the most basic functions of management. It involves several important steps that play a big role in effective management. In order to meet their targets according to plans, managers must have a good control system at disposal. This system requires certain basic elements for it to fulfil its functions.

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Elements of a good Control System

Every decent control system must possess certain basic elements. Since they all play a major role, the absence of any one of them can make the whole system weak. Hence, managers must ensure that their control systems contain the following basic elements and considerations.

1) Feedback

Feedback is the backbone of all control systems. This feedback is nothing but the information that managers use to correct their organization’s actual performance.

The aim of feedback is basically to adjust future actions using previous experiences. Managers use the information they receive from feedbacks to implement corrective measures. Such measures generally help in bridging the gap between the actual performance of the organization and its goals.

Feedback may be either formal or informal. Formal feedback consists of sources like financial statements, statistics, reports, other written communication, etc. On the other hand, informal feedback includes personal opinions, informal discussions and an individual’s observations.

2) Control must be objective

The second essential requirement of a good control system is that it must always be objective. A subjective criterion should never be the basis of evaluating actual performances.

For example, evaluation of an employee’s performance should comprise of standards like working hours, productivity, efficiency, etc. Managers should not evaluate employees using subjective prejudices.

3) Prompt reporting of deviations

This element of the controlling system basically requires quick reporting of deviations and discrepancies. If some work is not going according to plans, relevant managers must take notice of this immediately. This is because any delay in reporting problems and taking corrective measures can lead to financial losses for a business.

4) Control should be forward-looking

Control systems can often suffer from the defect of delays in reporting of deviations and taking of corrective measures. As we saw above, this problem can lead to financial losses for a business.

Hence, managers must ensure that their control systems are forward-looking. This will help in predicting deviations in advance as well as giving adequate time for course correction.

5) Flexible controls

A rigid control system can often make it ineffective in extraordinary and unpredictable situations. It should, thus, be flexible and open to changes. Managers must be able to adapt their control measures as per the requirements of every possible scenario.

6) Hierarchical suitability

Almost all business organizations possess management hierarchies comprising of managers at various positions and levels. Since each manager performs controlling functions at his level, the system itself must suit his organization’s hierarchy. Every manager must have adequate powers for this purpose and the flow of information for evaluation should be effective.

(source – Utah ATV) 

7) Economical control

Every good controlling system has to be economical when it comes to its implementation and maintenance. In other words, its benefits should outweigh its costs. An organization must be able to afford it and also derive all possible advantages from it.

8) Strategic control points

Not all deviations require the same level of attention and importance. For example, if an infrastructure company loses one government tender for constructing roads, it can work on other projects.

However, if the government blacklists it altogether due to its financial irregularities, this can be a huge issue.

A good control system must be able to deal with every deviation as per its seriousness. No organization can afford to accord equal importance to each and every problem. This is basically the whole aim of strategic control points.

9) Control must be simple to understand

Sophisticated policies can often make elements of control systems difficult to understand and implement. A good system, however, is always simple to comprehend and work on.

Thus, before launching controlling measures, managers should first check whether their employees will be able to understand them. They should also try to resolve any ambiguities and confusion that may arise later.

10) Control should focus on workers

Good control systems always focus on workers instead of the work itself. Since it is workers who implement these systems, everybody should be able to work with them effectively.

Solved examples for you

Question: Name the missing word in the following sentences. 

(1) __________ helps managers collect information for taking corrective action.

(2) __________ feedback includes personal opinions and informal discussions.

(3) Control systems should focus on __________ and not the work itself.

(4) Since managers at all levels perform controlling, its systems should suit every organization’s __________.

Answers:          (1) feedback          (2) informal          (3) workers          (4) hierarchy

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