Importance of Internal Control for Business Activities

Executive Summary

The concerned study focuses on the functions and importance of internal control on the regular activities of any business. In this regards, the key difference between internal control on financial records and internal control has been identified. The key beneficiaries of public reporting on internal control have been highlighted in the study along with its key benefits. Moreover, discussion has been made if the process is required for the companies of Australia. In addition to this, the effects of public reporting on internal control on the stock price market has also been highlighted so that knowledge can be gathered on the influences of various types of deficiencies identified from the process of internal control.

Section I

Introduction

The risks in any business organisation can be identified and modified with the help of internal control over the financial records of that organisation. For this, it is difficult to understand the right term that can be used for this risk assessment. This is more because of the purpose of risk management can be served by using similar words and terms for solving various issues. In this regard, there is also an issue between the two terms that are internal control over financial reporting and internal control. As internal control is important for any company, there are some beneficiaries of this process in public reporting of the financial records, which can get some primary benefits of this reporting. Moreover, it is crucial to analyse if this process is also required for various Australian companies and its effects on the share price value of the market.

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a. Difference between internal control over financial reporting and internal control

The two terms of internal control over financial reporting and financial control can be differentiated with some key functions that are specific to each of the mentioned terms. The term internal control over financial reporting, which is also known by the abbreviation of ICFR is focused on covering the control that are the key elements of financial documents and reporting (Vovchenko et al., 2017). These include balance sheet of any company, it profit and loss statement and so on. Moreover, this term also include reviewing and checking of various other functions such as procurement of finance for payments, management of human resources, cash orders, inventory management and so on. Through these, ICFR covers various risks that can be detrimental to financial recording and affect financial reporting either directly or indirectly (Abbott et al., 2016). Therefore, it can be said that ICFR is having the function of managing and controlling the financial statements so that reasonable assurance can be made based on the outcomes along with ensuring that the financial records are totally free from any types of material misstatements.

In the words of Bentley-Goode, Newton and Thompson (2017), the term internal control deals with other functions that are associated with only the functions of a business. This process is associated with managing and controlling the business operations so that their effectiveness and efficiency can be ensured in comparison to the industry. As opined by Ge, Koester and McVay (2017), these may include safeguarding the business assets along with ensuring that the business operations are conducted by making compliance with various legal policies. Moreover, internal control is one of the major responsibilities of the functions of operations management (Davidson, Dey and Smith, 2015). This is because it is a crucial part of the regular activities of any business organisation. Therefore, it can be said that internal control is intended towards various business functions and management of business operations to maintain its profitability and market effectiveness.

b. Primary beneficiaries of public reporting and primary benefits

The primary beneficiaries of public reporting that is made with the help of appropriate internal control are the stakeholders that are associated with the activities of any business organisation. Due to the dependence of many stakeholders including investors, employees, creditors, management, shareholders, and so on upon the regular activities, functioning and profitability structure of any company, internal control is important to be included in the auditing functions. As mentioned by Habib and Bhuiyan (2016), proper internal control can help in making the financial records free from any errors and misstatements that can make the reports much reliable and accurate. Based on these results, various financial decisions can be taken over by these stakeholders, for which they can be mentioned as the primary stakeholders of public reporting by internal control.

The primary benefits of this type of reporting are huge as this maintains accuracy in the reports that are made public requirements. In the words of Donelson, Ege and McInnis (2016) as frauds and errors are quite common inside the business activities; performance of proper internal control within regular intervals can detect them so that rectifications can be made in the statements accordingly. Moreover, this is also important for maintaining the value and brand reputation of any company. Some key aspects that require internal control can be mentioned below.

Financial fraud

Various financial frauds can be detected with the help of internal control. It is quite easy for a person, who is dealing with the financial reports in making intentional frauds by making fraudulent adjustments on the financial statements (Alzeban and Sawan, 2015). Therefore, internal control is the key tool in identifying these frauds and making necessary rectifications for the same.

Business loopholes

Loopholes in business may arise due to some backlogs in the business policies in any organisation. Some employees can take advantage of such conditions for their own benefits that can be said to be equivalent to frauds. In this case, regular process of internal control can act as a barrier for sealing these loopholes and making necessary improvements (aicpa.org, 2014).

Procedures and protocols

As opined by Cheng, Goh and Kim (2018), the business procedures and protocols can be maintained with the help of internal control. Through this function, management can establish all the required procedures and protocols for managing the business activities and human resources that will be effective in establishing regular activities of any business.

Management and financial information

Apart from all the functions mentioned above, managing and organising the financial data in most efficient way can be done with the application of internal control procedures. The financial as well as business management information can be kept safe and in order by internal control so that business productivity can be increased.

In regards of the functions and importance of internal control over the financial records, it can be said that the entire business community and companies of Australia should introduce this requirement in their business auditing processes. In the words of Kravet, McVay and Weber (2018), this is because the function of internal control is required for identifying the errors, misrepresentations, and misstatements incurred in the financial statements of any Australian companies. Moreover, appropriate internal control can reduce various risks of loss of business assets along with ensuring that the prepared financial plans and information are accurate, reliable and complete. Furthermore, it also ensures if the financial statements are prepared in compliance of the business laws and regulations and legal provisions of the country. In case internal control procedure is quite effective, the key users of the financial reports can be assured that the business plans are successful in achieving the objectives and aims of financial reporting (aicpa.org, 2014). Therefore, the requirement is quite necessary for the companies of Australia as this can help in minimizing the chances of intentional fraud and unintentional errors along with identifying the smallest of errors in the financial records before they tend to create big problems for the companies.

c. Requirement of public reporting on internal control and effects on share prices

In case the companies of Australia apply public reporting on internal control along with having provision for making assurance on that report, then a negative assurance on this report can affect the share price movement of the Australian market. Due to negative assurance of the internal control report, a suspicion would develop on the performance of any Australia company that would make its value and reputation to decrease in the eyes of its stakeholders (Hao, Qi and Wang, 2018). Moreover, this would decrease the trust of the stakeholders of any such company after a negative assurance is made regarding the financial reports of that company. In the words of Kim, Yeung and Zhou (2019), with the decrease of company value, the share market will also start falling for a decrease in the share price of such companies. Moreover, with a decrease in trust, such company may also face decrease in investment aspects from its investors’ sides. Therefore, negative assurance will start decreasing the share prices of the country along with having negative impact on its economic conditions.

Figure 1: Current Share Price Movement in Australia (Source: marketindex.com.au, 2019)

As per the above graph, it can be seen that the current status of the share price of Australia is quite high that had gradually started increasing from 2012 (marketindex.com.au, 2019). In case a negative assurance is received from public reporting regarding internal control, this can tend the currents status of share price to fall steadily. Moreover, this can also affect the regular activities and performance of these companies by reducing the total earnings received from their individual share prices (Kim, Yeung and Zhou, 2019).

The nature of deficiency in the internal control process can make huge differences on the effects of share market prices. This is because deficiency in this process can make huge differences in the rise and fall of the share price of the Australian share market. These deficiencies can also have an adverse impact on the abilities of any company to authorise, initial, record and process various financial information (Chen et al., 2017). As there can be various natures of these deficiencies, these can have diverse effects on the share market prices of any country. In this regards, it can also be mentioned that due to formation of negative impacts of these deficiencies on the business activities of any company, the assets and liabilities of these companies can also get negatively influenced by initiating a decrease in their values (Kim and Zhang, 2016). Moreover, with such decrease, the financial efficiency of the company gets reduced, thus affecting its shareholders and investors. In turn, this tends to decrease the overall value of the stock market price of a country such as Australia.

Among the other forms of deficiencies in the internal control process, four key forms of deficiencies can be identified that can have negative influences on share market price. These deficiencies can be identified below.

Lack of punctuality

Due to lack of punctuality and timeliness in preparing account reconciliation and cash deposits, discrepancies may arise through the process of internal control (Chen et al., 2017). In these cases, the records could not be kept properly due to time lag and therefore, can create hindrances for the process of internal control.

Lack of physical stock and inventory

Lack of physical stock and inventory can create huge problems in continuing internal control process. This is because it can create various discrepancies due to non-recording of physical inventories and stock.

Lack of overdrafts

Due to lack of proper monitoring of the overdraft funds, deficiency can arise in the preparation of internal control. Moreover, this can also create problems while recording about the overdrafts that may create discrepancies with the source of these overdrafts.

Lack of reconciliation and review

Lack of proper reconciliation and review of various departmental expenditures can create serious problems and deficiencies in the internal control process (Kim, Yeung and Zhou, 2019). As in most of the cases, departmental expenses could not be recorded effectively; internal control becomes difficult to be conducted by the higher authorities.

Conclusion and Recommendation

As per the entire study regarding internal control, it can be said that this act is extremely important for any companies across the world so that various risks can be identified before they can create any serious problem. In this context, it is mention worthy that as the companies in Australia are not having internal controls included in their business activities; they may face problems in their future years regarding the preparation of financial documents. Without proper implementation of this function, the companies may face the challenges of frauds and errors in their business reports. Moreover, without proper internal control in their activities, the company may also tend to face a decreasing stock market price for their individual stocks and shares. As internal control may also have different types of deficiencies according to the activities, this can create huge pressure on the Australian companies by reducing their value in the market along with reducing their share prices. Therefore, it is recommended for all the companies and business organisation of Australia to adopt internal control procedure in their regular activities. Moreover, the government of the country should also be aware of such situations so that proper legal policies and laws are implemented regarding the application of internal control in the business operations.

Reference List

Journals

1. Abbott, L.J., Daugherty, B., Parker, S. and Peters, G.F., 2016. Internal audit quality and financial reporting quality: The joint importance of independence and competence. Journal of Accounting Research, 54(1), pp.3-40.
2. Alzeban, A. and Sawan, N., 2015. The impact of audit committee characteristics on the implementation of internal audit recommendations. Journal of International Accounting, Auditing and Taxation, 24, pp.61-71.
3. Bentley-Goode, K.A., Newton, N.J. and Thompson, A.M., 2017. Business strategy, internal control over financial reporting, and audit reporting quality. Auditing: A Journal of Practice & Theory, 36(4), pp.49-69.
4. Chen, J., Chan, K.C., Dong, W. and Zhang, F., 2017. Internal control and stock price crash risk: Evidence from China. European Accounting Review, 26(1), pp.125-152.
5. Cheng, Q., Goh, B.W. and Kim, J.B., 2018. Internal control and operational efficiency. Contemporary Accounting Research, 35(2), pp.1102-1139.
6. Davidson, R., Dey, A. and Smith, A., 2015. Executives'“off-the-job” behavior, corporate culture, and financial reporting risk. Journal of Financial Economics, 117(1), pp.5-28.
7. Donelson, D.C., Ege, M.S. and McInnis, J.M., 2016. Internal control weaknesses and financial reporting fraud. Auditing: A Journal of Practice & Theory, 36(3), pp.45-69.
8. Ge, W., Koester, A. and McVay, S., 2017. Benefits and costs of Sarbanes-Oxley Section 404 (b) exemption: Evidence from small firms’ internal control disclosures. Journal of Accounting and Economics, 63(2-3), pp.358-384.
9. Habib, A. and Bhuiyan, M.B.U., 2016. Problem directors on the audit committee and financial reporting quality. Accounting and Business Research, 46(2), pp.121-144.
10. Hao, D., Qi, G. and Wang, J., 2018. Corporate social responsibility, internal controls, and stock price crash risk: The Chinese stock market. Sustainability, 10(5), p.1675.
11. Kim, J.B. and Zhang, L., 2016. Accounting conservatism and stock price crash risk: Firm‐level evidence. Contemporary Accounting Research, 33(1), pp.412-441.
12. Kim, J.B., Yeung, I. and Zhou, J., 2019. Stock price crash risk and internal control weakness: presence vs. disclosure effect. Accounting & Finance, 59(2), pp.1197-1233.
13. Kravet, T.D., McVay, S.E. and Weber, D.P., 2018. Costs and benefits of internal control audits: Evidence from M&A transactions. Review of Accounting Studies, 23(4), pp.1389-1423.
14. Vovchenko, N.G., Holina, M.G., Orobinskiy, A.S. and Sichev, R.A., 2017. Ensuring financial stability of companies on the basis of international experience in construction of risks maps, internal control and audit. European Research Studies Journal, 20(1), pp.350-368.

Websites

1. aicpa.org, 2014. The importance of internal control in financial reporting and safeguarding plan assets. Available at: https://www.aicpa.org/content/dam/aicpa/interestareas/employeebenefitplanauditquality/resources/planadvisories/downloadabledocuments/plan-advisoryinternalcontrol-hires.pdf [Accessed on 12 September 2019]
2. marketindex.com.au, 2019. S&P/ASX 100. Available at: https://www.marketindex.com.au/asx100 [Accessed on 12 September 2019]