The Need to Implement and Respect Basic Internal Controls

The founders and other senior executives of emerging companies often think that implementation of a comprehensive system of internal controls is a luxury they cannot afford and instead focus their time and money on initiatives of more immediacy to the survival of the company such as new product development, marketing and advertising programs and improvement of manufacturing facilities.  Internal controls are deferred under the rationale that they are only necessary when the company reaches the size and sophistication of more established competitors.  Unfortunately, experience shows this attitude to be shortsighted and surveys find that a significant percentage of the failure rate for small companies, regardless of the talent and management experience of their founders and senior executives, can be attributed to inadequate internal controls.

There are a number of different definitions of internal controls and the concept has changed dramatically over the years in response to various events such as Enron.  For our purposes, however, it is useful to define internal control as a process—implemented by the company’s board of directors, management, and other trained personnel—designed to provide reasonable assurance regarding the achievement of objectives with respect to reliability of financial reporting; effectiveness and efficiency of operations; and compliance with applicable laws and regulations.  For start up companies, the biggest concern for the founders is simply making sure that adding new employees does not cause them to lose touch with the details of how scarce resources, including cash, are used.  In fact, when the company is first launched the most important control may well be signature approvals and it is recommended that founders and/or designated senior managers maintain the right to review and approve all key documents such as checks, credit memos, payroll journals, bank reconciliations, other journal entries, and contracts.  In addition, smaller companies can deploy simple rules to segregate responsibilities for day-to-day activities that may be sensitive from an internal controls perspective.  For example, a receptionist may be tasked with opening the mail, making a list of checks received and restrictively endorsing those checks while another employee has responsibility for preparing the daily deposit slip.  The totals on the list and deposit slip should then be reviewed and compared by a senior manager before a deposit is made.

Other controls which are basic to most businesses include:

  • Direct receipt of bank statements so that they can be reviewed for unusual transactions that might indicate that funds have been misappropriated or that account balances have been manipulated;
  • Periodic count and reconciliation of the petty cash fund
  • Comparison of amounts reflect in the financial statements to cash balance on the bank reconciliation, total accounts receivable listing, and total accounts payable listing;
  • Approval of pricing policy and each exception to the policy;
  • Approval of credit policy and each exception to the policy;
  • If perpetual inventory records are maintained, periodic test counts;
  • Review of recorded scrap sales for reasonableness;
  • Accounting for numbers of pre-numbered documents such as purchase orders, receiving tickets, sales invoices and checks;
  • Review of salesperson’s commission accounts;
  • Review of purchase orders to verify that purchases are being made only from approved vendors;
  • Occasional inspections of shipping and receiving areas in search of unauthorized goods;
  • Periodic review of paid vendors’ invoices to determine whether they been properly mutilated to avoid reprocessing;
  • Review of miscellaneous income and expense;
  • Periodic review of employees’ expense reports;
  • Review of computations of gross and net pay for select employees; and
  • Distribution of all payroll checks.

In our next post we will discuss the basic records and reports that should be created and maintained for start-up companies.

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