General principles of internal control - Objectives of inter...

Learning Outcomes

After studying this article, you will be able to explain the main objectives of internal control systems in an entity. You will recognise the key aims that internal controls are designed to achieve, distinguish between core categories of controls, and discuss why even strong controls have built-in limitations. You will also understand why both management and auditors value effective internal controls.

ACCA Foundations in Audit (FAU) Syllabus

For ACCA Foundations in Audit (FAU), you are required to understand the general principles governing internal control. Your revision should focus on:

• The primary objectives of a system of internal control
• The categories and examples of internal controls (including control activities)
• The importance of internal control to both management and auditors
• The inherent limitations of internal control systems and their practical implications

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which of the following is NOT a key objective of internal control in an organisation?
   1. Safeguarding assets
   2. Preventing all employee errors
   3. Ensuring the accuracy of records
   4. Encouraging adherence to company policies

2. State two categories of control activities commonly found in effective internal control systems.

3. Briefly explain why internal control systems cannot guarantee the prevention of fraud.

4. Complete the statement: Internal controls should ensure that all transactions are **__** and **__** recorded.

Introduction

Internal control systems are essential to the effective management and accurate reporting within any business. They exist to provide reasonable confidence that the organisation achieves its objectives around accurate financial reporting, operational effectiveness, safeguarding of assets, and compliance with laws and policies. Both management and auditors must understand what such controls aim to accomplish and where their limitations lie.

OBJECTIVES OF INTERNAL CONTROL

Internal controls are designed to help an entity meet certain essential aims.

Key Term: internal control
Policies and procedures implemented by management to help achieve organisational objectives over reporting reliability, operational efficiency, safeguarding assets, and compliance.

The main objectives of internal control are:

• Reliability of Financial Reporting: Assist management in producing records and statements that are complete, accurate, and trustworthy.
• Operational Efficiency and Effectiveness: Enable orderly and efficient business operations and optimal use of resources.
• Compliance: Support adherence to laws, regulations, and internal policies.
• Asset Protection: Prevent loss or unauthorised use of company assets.
• Error and Irregularity Prevention/Detection: Reduce risk of both accidental errors and deliberate fraud, and allow prompt detection when issues occur.

Controls do not remove risk entirely, but reduce it to an acceptable level.

Key Term: control objective
A specific aim or result that an internal control system seeks to achieve, such as preventing unauthorised payments or ensuring completeness of sales recording.

TYPES AND EXAMPLES OF CONTROL ACTIVITIES

Control activities are practical measures or processes targeted at these objectives. Common types include:

• Authorisation and Approval: Ensuring transactions are permitted by appropriate personnel before processing.
• Segregation of Duties: Dividing responsibilities so that no one individual can both initiate and finalise a transaction (for example, separating custody of assets from accounting for them).
• Physical Controls: Protecting assets by physical means, such as locks or restricted access.
• Reconciliations: Regularly comparing data from different sources and following up differences.
• Verifications: Checking accuracy, such as comparing invoices to goods received notes.
• Supervision and Review: Oversight and checks by management or supervisors.

Key Term: control activity
Specific policies or procedures—such as authorisations, reconciliations, or physical safeguards—implemented to achieve control objectives.

IMPORTANCE OF INTERNAL CONTROL TO MANAGEMENT AND AUDITORS

For management, robust internal controls support them in monitoring performance, ensuring operations are efficient, and that company assets are adequately protected. For auditors, understanding the quality of internal controls is essential in assessing audit risk and designing appropriate audit procedures. Strong controls can justify reducing the extent of substantive audit testing.

Worked Example 1.1

Question: A company's payroll system has procedures to authorise new employees and require supervisors to approve timesheets before payment. Which control objectives are being supported here, and which control activities are involved?

Answer:

• Objectives supported: Ensuring only legitimate employees are paid (asset protection), paying correct amounts (accuracy of financial reporting), and following company policies (compliance).
• Control activities involved: Authorisation/approval of hires and timesheets, segregation of duties (separate HR and payroll), and supervision.

INHERENT LIMITATIONS OF INTERNAL CONTROL

While internal controls greatly reduce the risk of errors and fraud, no system is foolproof.

Key Term: inherent limitation
The unavoidable practical weaknesses in any control system that prevent it from providing absolute assurance.

Typical limitations include:

• Human Error: Mistakes can still happen through oversight, misunderstanding, or carelessness.
• Collusion: Two or more employees working together can circumvent even well-designed controls.
• Management Override: Senior staff may be able to bypass controls if so inclined.
• Unusual Transactions: Controls for routine transactions may not be adequate for rare or non-recurring events.
• Cost-Benefit Restrictions: It is not always feasible to control every risk, as the cost of some controls would outweigh their benefits.
• System Changes: Controls can become outdated if not kept up-to-date with business changes.

Worked Example 1.2

Question: A company discovered that a manager bypassed supplier payment approval limits to authorise payments to a fake company. Which inherent limitation does this scenario illustrate?

Answer:

• Management override: The manager used their senior position to circumvent approval controls, demonstrating that managerial authority can sometimes bypass designed safeguards.

Exam Warning

A common misconception is that internal controls can eliminate fraud and error entirely. Remember, controls offer reasonable—not absolute—assurance.

Summary

Internal control systems are implemented to help organisations meet key goals around accuracy of reporting, effective operations, asset security, and compliance. While different types of controls exist, no system is without weaknesses. Understanding both objectives and limitations is essential for both management and auditors.

Key Point Checklist

This article has covered the following key knowledge points:

• The main objectives of internal control: accurate records, operational effectiveness, compliance, and asset protection
• Typical types of control activities (authorisation, segregation, physical, reconciliation, etc.)
• The importance of internal control to management and auditors
• Recognition that all internal control systems have inherent limitations and cannot provide absolute assurance
• Examples of how controls aim to achieve objectives in real business processes

Key Terms and Concepts

• internal control
• control objective
• control activity
• inherent limitation