Internal Control - Integrated Framework

Executive Summary
Senior executives have long sought ways to better control the enterprises they run. Internal controls
are put in place to keep the company on course toward profitability goals and achievement of its
mission, and to minimize surprises along the way. They enable management to deal with rapidly
changing economic and competitive environments, shifting customer demands and priorities, and
restructuring for future growth. Internal controls promote efficiency, reduce risk of asset loss, and help
ensure the reliability of financial statements and compliance with laws and regulations.
Because internal control serves many important purposes, there are increasing calls for better internal
control systems and report cards on them. Internal control is looked upon more and more as a solution
to a variety of potential problems.
What Internal Control Is
Internal control means different things to different people. This causes confusion among
businesspeople, legislators, regulators and others. esulting miscommunication and different
expectations cause problems within an enterprise. !roblems are compounded when the term, if not
clearly defined, is written into law, regulation or rule.
This report deals with the needs and expectations of management and others. It defines and describes
internal control to"
#stablish a common definition serving the needs of different parties.
!rovide a standard against which business and other entities$$large or small, in the public or
private sector, for profit or not$$can assess their control systems and determine how to
improve them.
Internal control is broadly defined as a process, effected by an entity%s board of directors, management
and other personnel, designed to provide reasonable assurance regarding the achievement of
ob&ectives in the following categories"
#ffectiveness and efficiency of operations.
eliability of financial reporting.
'ompliance with applicable laws and regulations.
The first category addresses an entity%s basic business ob&ectives, including performance and
profitability goals and safeguarding of resources. The second relates to the preparation of reliable
published financial statements, including interim and condensed financial statements and selected
financial data derived from such statements, such as earnings releases, reported publicly. The third
deals with complying with those laws and regulations to which the entity is sub&ect. These distinct but
overlapping categories address different needs and allow a directed focus to meet the separate needs.
Internal control systems operate at different levels of effectiveness. Internal control can be &udged
effective in each of the three categories, respectively, if the board of directors and management have
reasonable assurance that"
They understand the extent to which the entity%s operations ob&ectives are being achieved.
!ublished financial statements are being prepared reliably.
(pplicable laws and regulations are being complied with.
)hile internal control is a process, its effectiveness is a state or condition of the process at one or
more points in time.
Internal control consists of five interrelated components. These are derived from the way management
runs a business, and are integrated with the management process. (lthough the components apply to
all entities, small and mid$size companies may implement them differently than large ones. Its controls
may be less formal and less structured, yet a small company can still have effective internal control.
The components are"
Control Environment
$$The control environment sets the tone of an organization, influencing the control consciousness of its
people. It is the foundation for all other components of internal control, providing discipline and
structure. 'ontrol environment factors include the integrity, ethical values and competence of the
entity%s people* management%s philosophy and operating style* the way management assigns authority
and responsibility, and organizes and develops its people* and the attention and direction provided by
the board of directors.
Risk Assessment
$$#very entity faces a variety of risks from external and internal sources that must be assessed. (
precondition to risk assessment is establishment of ob&ectives, linked at different levels and internally
consistent. isk assessment is the identification and analysis of relevant risks to achievement of the
ob&ectives, forming a basis for determining how the risks should be managed. Because economic,
industry, regulatory and operating conditions will continue to change, mechanisms are needed to
identify and deal with the special risks associated with change.
Control Activities
$$'ontrol activities are the policies and procedures that help ensure management directives are carried
out. They help ensure that necessary actions are taken to address risks to achievement of the entity%s
ob&ectives. 'ontrol activities occur throughout the organization, at all levels and in all functions. They
include a range of activities as diverse as approvals, authorizations, verifications, reconciliations,
reviews of operating performance, security of assets and segregation of duties.
Information and Communication
$$!ertinent information must be identified, captured and communicated in a form and timeframe that
enable people to carry out their responsibilities. Information systems produce reports, containing
operational, financial and compliance$related information, that make it possible to run and control the
business. They deal not only with internally generated data, but also information about external
events, activities and conditions necessary to informed business decision$making and external
reporting. #ffective communication also must occur in a broader sense, flowing down, across and up
the organization. (ll personnel must receive a clear message from top management that control
responsibilities must be taken seriously. They must understand their own role in the internal control
system, as well as how individual activities relate to the work of others. They must have a means of
communicating significant information upstream. There also needs to be effective communication with
external parties, such as customers, suppliers, regulators and shareholders.
onitoring
$$Internal control systems need to be monitored$$a process that assesses the +uality of the system%s
performance over time. This is accomplished through ongoing monitoring activities, separate
evaluations or a combination of the two. ,ngoing monitoring occurs in the course of operations. It
includes regular management and supervisory activities, and other actions personnel take in
performing their duties. The scope and fre+uency of separate evaluations will depend primarily on an
assessment of risks and the effectiveness of ongoing monitoring procedures. Internal control
deficiencies should be reported upstream, with serious matters reported to top management and the
board.
There is synergy and linkage among these components, forming an integrated system that reacts
dynamically to changing conditions. The internal control system is intertwined with the entity%s
operating activities and exists for fundamental business reasons. Internal control is most effective
when controls are built into the entity%s infrastructure and are a part of the essence of the enterprise.
-Built in- controls support +uality and empowerment initiatives, avoid unnecessary costs and enable
+uick response to changing conditions.
There is a direct relationship between the three categories of ob&ectives, which are what an entity
strives to achieve, and components, which represent what is needed to achieve the ob&ectives. (ll
components are relevant to each ob&ectives category. )hen looking at any one category$$the
effectiveness and efficiency of operations, for instance$$all five components must be present and
functioning effectively to conclude that internal control over operations is effective.
The internal control definition$$with its underlying fundamental concepts of a process, effected by
people, providing reasonable assurance$$together with the categorization of ob&ectives and the
components and criteria for effectiveness, and the associated discussions, constitute this internal
control framework.
What Internal Control Can !o
Internal control can help an entity achieve its performance and profitability targets, and prevent loss of
resources. It can help ensure reliable financial reporting. (nd it can help ensure that the enterprise
complies with laws and regulations, avoiding damage to its reputation and other conse+uences. In
sum, it can help an entity get to where it wants to go, and avoid pitfalls and surprises along the way.
What Internal Control Cannot !o
.nfortunately, some people have greater, and unrealistic, expectations. They look for absolutes,
believing that"
Internal control can ensure an entity%s success$$that is, it will ensure achievement of basic
business ob&ectives or will, at the least, ensure survival.
#ven effective internal control can only help an entity achieve these ob&ectives. It can provide
management information about the entity%s progress, or lack of it, toward their achievement. But
internal control cannot change an inherently poor manager into a good one. (nd, shifts in government
policy or programs, competitors% actions or economic conditions can be beyond management%s control.
Internal control cannot ensure success, or even survival.
Internal control can ensure the reliability of financial reporting and compliance with laws and
regulations.
This belief is also unwarranted. (n internal control system, no matter how well conceived and
operated, can provide only reasonable$$not absolute$$assurance to management and the board
regarding achievement of an entity%s ob&ectives. The likelihood of achievement is affected by
limitations inherent in all internal control systems. These include the realities that &udgments in
decision$making can be faulty, and that breakdowns can occur because of simple error or mistake.
(dditionally, controls can be circumvented by the collusion of two or more people, and management
has the ability to override the system. (nother limiting factor is that the design of an internal control
system must reflect the fact that there are resource constraints, and the benefits of controls must be
considered relative to their costs.
Thus, while internal control can help an entity achieve its ob&ectives, it is not a panacea.
Roles and Res"onsi#ilities
#veryone in an organization has responsibility for internal control.
anagement
$$The chief executive officer is ultimately responsible and should assume -ownership- of the system.
/ore than any other individual, the chief executive sets the -tone at the top- that affects integrity and
ethics and other factors of a positive control environment. In a large company, the chief executive
fulfills this duty by providing leadership and direction to senior managers and reviewing the way they%re
controlling the business. Senior managers, in turn, assign responsibility for establishment of more
specific internal control policies and procedures to personnel responsible for the unit%s functions. In a
smaller entity, the influence of the chief executive, often an owner$manager, is usually more direct. In
any event, in a cascading responsibility, a manager is effectively a chief executive of his or her sphere
of responsibility. ,f particular significance are financial officers and their staffs, whose control activities
cut across, as well as up and down, the operating and other units of an enterprise.
$oard of !irectors
$$/anagement is accountable to the board of directors, which provides governance, guidance and
oversight. #ffective board members are ob&ective, capable and in+uisitive. They also have a
knowledge of the entity%s activities and environment, and commit the time necessary to fulfill their
board responsibilities. /anagement may be in a position to override controls and ignore or stifle
communications from subordinates, enabling a dishonest management which intentionally
misrepresents results to cover its tracks. ( strong, active board, particularly when coupled with
effective upward communications channels and capable financial, legal and internal audit functions, is
often best able to identify and correct such a problem.
Internal Auditors
$$Internal auditors play an important role in evaluating the effectiveness of control systems, and
contribute to ongoing effectiveness. Because of organizational position and authority in an entity, an
internal audit function often plays a significant monitoring role.
%ther &ersonnel
$$Internal control is, to some degree, the responsibility of everyone in an organization and therefore
should be an explicit or implicit part of everyone%s &ob description. 0irtually all employees produce
information used in the internal control system or take other actions needed to effect control. (lso, all
personnel should be responsible for communicating upward problems in operations, noncompliance
with the code of conduct, or other policy violations or illegal actions.
( number of external parties often contribute to achievement of an entity%s ob&ectives. #xternal
auditors, bringing an independent and ob&ective view, contribute directly through the financial
statement audit and indirectly by providing information useful to management and the board in
carrying out their responsibilities. ,thers providing information to the entity useful in effecting internal
control are legislators and regulators, customers and others transacting business with the enterprise,
financial analysts, bond raters and the news media. #xternal parties, however, are not responsible for,
nor are they a part of, the entity%s internal control system.
%rgani'ation of this Re"ort
This report is in four volumes. The first is this #xecutive Summary, a high$level overview of the internal
control framework directed to the chief executive and other senior executives, board members,
legislators and regulators.
The second volume, the 1ramework, defines internal control, describes its components and provides
criteria against which managements, boards or others can assess their control systems. The
#xecutive Summary is included.
The third volume, eporting to #xternal !arties, is a supplemental document providing guidance to
those entities that report publicly on internal control over preparation of their published financial
statements, or are contemplating doing so.
The fourth volume, #valuation Tools, provides materials that may be useful in conducting an
evaluation of an internal control system.
What to !o
(ctions that might be taken as a result of this report depend on the position and role of the parties
involved"
Senior anagement
$$/ost senior executives who contributed to this study believe they are basically -in control- of their
organizations. /any said, however, that there are areas of their company$$a division, a department or
a control component that cuts across activities$$where controls are in early stages of development or
otherwise need to be strengthened. They do not like surprises. This study suggests that the chief
executive initiate a self$assessment of the control system. .sing this framework, a '#,, together with
key operating and financial executives, can focus attention where needed. .nder one approach, the
chief executive could proceed by bringing together business unit heads and key functional staff to
discuss an initial assessment of control. 2irectives would be provided for those individuals to discuss
this report%s concepts with their lead personnel, provide oversight of the initial assessment process in
their areas of responsibility and report back findings. (nother approach might involve an initial review
of corporate and business unit policies and internal audit programs. )hatever its form, an initial self$
assessment should determine whether there is a need for, and how to proceed with, a broader, more
in$depth evaluation. It should also ensure that ongoing monitoring processes are in place. Time spent
in evaluating internal control represents an investment, but one with a high return.
$oard em#ers
$$/embers of the board of directors should discuss with senior management the state of the entity%s
internal control system and provide oversight as needed. They should seek input from the internal and
external auditors.
%ther &ersonnel
$$/anagers and other personnel should consider how their control responsibilities are being conducted
in light of this framework, and discuss with more senior personnel ideas for strengthening control.
Internal auditors should consider the breadth of their focus on the internal control system, and may
wish to compare their evaluation materials to the evaluation tools.
(egislators and Regulators
$$3overnment officials who write or enforce laws recognize that there can be misconceptions and
different expectations about virtually any issue. #xpectations for internal control vary widely in two
respects. 1irst, they differ regarding what control systems can accomplish. (s noted, some observers
believe internal control systems will, or should, prevent economic loss, or at least prevent companies
from going out of business. Second, even when there is agreement about what internal control
systems can and can%t do, and about the validity of the -reasonable assurance- concept, there can be
disparate views of what that concept means and how it will be applied. 'orporate executives have
expressed concern regarding how regulators might construe public reports asserting -reasonable
assurance- in hindsight after an alleged control failure has occurred. Before legislation or regulation
dealing with management reporting on internal control is acted upon, there should be agreement on a
common internal control framework, including limitations of internal control. This framework should be
helpful in reaching such agreement.
&rofessional %rgani'ations
$$ule$making and other professional organizations providing guidance on financial management,
auditing and related topics should consider their standards and guidance in light of this framework. To
the extent diversity in concept and terminology is eliminated, all parties will benefit.
Educators
$$This framework should be the sub&ect of academic research and analysis, to see where future
enhancements can be made. )ith the presumption that this report becomes accepted as a common
ground for understanding, its concepts and terms should find their way into university curricula.
)e believe this report offers a number of benefits. )ith this foundation for mutual understanding, all
parties will be able to speak a common language and communicate more effectively. Business
executives will be positioned to assess control systems against a standard, and strengthen the
systems and move their enterprises toward established goals. 1uture research can be leveraged off
an established base. 4egislators and regulators will be able to gain an increased understanding of
internal control, its benefits and limitations. )ith all parties utilizing a common internal control
framework, these benefits will be realized.
&urchasing Information
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Internal Control Issues in Derivatives Usage-An Information Tool, !roduct number <<99=9