Accounting controls are methods and procedures that prevent, detect, and correct misstatements that occur within the financial accounting process until the formation of the financial statements. They are one type of a larger set of internal controls that every business should follow. When we talk about accounting controls, we’re referring to controls within the accounting cycle, such as preparing journal entries, posting in the general ledger, and gathering source documents.
We’ll discuss the specific preventive, detective, and corrective controls for the accounting department with a small business setup in mind.
1. Preventive Controls
A preventive accounting control prevents a misstatement from entering the accounting system. It’s the first line of defense, and misstatements spotted here are considered before the fact. An effective preventive control can spot misstated transactions easily at the input level. Below are the four common preventive controls:
Objective: Managers or business owners must authorize or approve a transaction before it is performed and entered into the accounting system.
Accounting Controls Examples for Authorization
- Expenses above $5,000 must be authorized and approved by the small business owner.
- Expenses below $500 can be approved by the line manager or supervisor.
- The small business owner and/or business manager must review payroll calculations and authorize payment before disbursing amounts to employee bank accounts.
Objective: Accounting responsibilities pertaining to authorization, recording, and custody must not belong to one person.
Accounting Controls Examples for Segregation of Duties
- The person handling accounts receivable must not handle cash receipts or accept check payments.
- The person authorizing expenses must not handle the disbursement of cash for such expenses.
- The person handling the business’ cash and checking accounts must not be in charge of reconciling the accounts.
Objective: The small business owner or manager must limit employee access to certain aspects of the business.
Accounting Controls Examples for Employee Access and Exposure
- Establish annual job rotation programs so that employees don’t stay in a single position for a long time, such as switching accounts receivable (A/R) and accounts payable (A/P) roles.
- Install electronic access systems like biometric identification systems, one-time passwords, card access, or radio-frequency identification (RFID) systems to limit area or application access.
Objective: The employees hired for accounting positions must have the necessary competency, educational requirements, and experience. The small business owner must also be proactive in promoting continuing education and professional development of their accounting employees.
Accounting Controls Examples for Employee Hiring and Training
- Specify the required work or audit experience, college degree, or certification for the position in the accounting job posting.
- Conduct background checks through past employer references or ask for relevant documentation such as a diploma, academic transcript, or police clearance.
- Give examinations or sample tasks to assess the applicant’s practical knowledge.
- Require psychological assessments if necessary.
- Sponsor employee’s continuing professional development by paying full or half of the price.
- Hire resource speakers to conduct one-day trainings, workshops, or symposiums regarding developments in emerging technologies.
Possible Risks Matrix
Below we list down the possible risks of fraud that preventive controls can deter. For each risk, we assign a specific preventive control and explain how this control can reduce or eliminate the risk.
| Possible Risk | What Happens | Best Detective Control | Action Item |
|---|---|---|---|
| Employee Collusion | Several employees work together to circumvent the controls. | Segregation of Duties, Authorization | Ensure that incompatible duties are not assigned to a specific individual and that appropriate levels of approvals are in place to reduce the possibility of collusion. |
| Management Override | Managers approve transactions without going through the approval process. | Authorization, Employee Hiring & Training | Establish clear approval hierarchies to prevent managers from overriding processes. The business should also be strict in hiring for managerial roles. |
| Poor Access Controls | Unauthorized individuals can access physical and digital assets. | Employee Access & Exposure | Implement strict physical access controls (e.g., digital locks, RFID-based access) and application access controls (e.g., password-protected devices and files) to prevent unauthorized access. |
| Inadequate Monitoring | Errors and fraudulent transactions proliferate in the system. | Employee Access & Exposure, Authorization | Use automated systems and workflows to reduce manual work and alert responsible parties for transactions that might require a higher level of authorization. |
| Insufficient Training | Employees can’t fully perform their job responsibilities if they don’t know how things work. | Employee Hiring & Training | Conduct training to help employees understand business processes and workflows. Proper oversight must be in place as well to prevent fraud and error from proliferating in the system. |
| Employee Attitude and Behavior | Some employees have a high risk of performing fraud due to their attitude and behavior. | Employee Hiring & Training | The hiring team should rigorously evaluate and assess candidates' competencies and ethical standards to ensure the integrity of the workforce. |
2. Detective Controls
A detective accounting control uncovers misstatements that have entered the accounting system. These misstatements are considered after the fact, and it’s up to the company’s detective controls to spot where these misstatements lie. Detective controls are your business’ second line of defense because they catch misstatements that slip through the preventive controls.
Objective: The small business must ensure that all accounting transactions have proper documentation to support the existence of assets, liabilities, and equity. An established document trail must be in place to enable the small business owner, internal auditor, or external auditor to examine past transactions.
Accounting Controls Examples for Documentation and Documentary Trails
- All printed and electronic copies of business documents, such as invoices, bills, contracts, and purchase orders (POs) must be stored for at least five years before deletion unless a longer or shorter period is necessary.
- Only authorized personnel’s signatures must appear in the document unless another person has been authorized to countersign on behalf of the authorized personnel.
- The person approving the cash disbursement must sign the check and stamp it as Paid.
- All requests for payment must be submitted in a voucher package containing the approved requisition form, approved purchase order, sales invoice from the supplier, and a receiving report detailing the quality and quantity of goods received.
- Disposal of fixed assets must have proper documentation that shows how the fixed asset was disposed of, such as sale and retirement, the proceeds of the sale, and other relevant details.
- Foot debits and credits for equality.
Objectives: The accountant or bookkeeper must perform reconciliations of accounts to ensure the accuracy and existence of accounting records.
Accounting Controls Examples for Reconciliations
- Monthly bank reconciliations
- Monthly customer and vendor account reconciliations
- Annual or semi-annual inventory physical counts to reconcile inventory account balances and inventory aging report
- Annual count of all business assets to determine the physical existence of asset records in the books
Objective: The small business owner or a third-party accounting professional must perform cut-off testing to determine if all transactions of the current period are recorded in the current period.
Accounting Controls Examples for Cut-off Testing
- Receiving reports dated as of the current accounting period must be recorded as current-period purchases
- Goods shipped (sold) with the term FOB Destination, goods held (sold) on consignment, and goods purchased (sold) on a repurchase agreement must not be reported as current period purchases (sales)
- Delivery receipts dated as of the current accounting period must be recorded in the books as current-period sales
- Inventory purchased (sold) with term FOB shipping point but is still in transit must be included (excluded) in the physical count
Possible Risks Matrix
Below we list down the possible risks of fraud that detective controls can deter. For each risk, we assign a specific detective control and explain how this control can reduce or eliminate the risk.
| Possible Risk | What Happens | Best Detective Control | Action Item |
|---|---|---|---|
| Incomplete, Omitted, or Falsified Documentation | Submitted documents are incomplete, missing, or intentionally altered without approval. | Documentation & Documentary Trails | Ensure all transactions are documented and can be traced back to their source. Employees must also be keen on reviewing submitted documents (e.g., verifying the calculations, and reading the details). |
| Cut-off Date Manipulation | Document dates are intentionally altered to affect. | Cut-off Testing | Instruct responsible personnel to test cut-off dates to ensure that all transactions are recorded as of the cut-off date below that date. |
| Proliferation of Errors | Errors from previous periods remain uncorrected to date. | Reconciliations, Cut-off Testing | Regularly reconcile accounts to detect errors that have entered the accounting system. Moreover, cut-off testing can also prevent errors from proliferating if they are caught right away. |
| Misfiled and Unorganized Documentation | Documents are not archived in a logical manner (e.g., by fiscal year, by account, etc.) | Documentation & Documentary Trails | Establish proper documentation that will make it easier for employees to access old files. Using document management systems and software can also help in organizing and accessing digital files. |
3. Corrective Controls
Corrective accounting controls are directives that aim to resolve weaknesses in preventive and detective controls and correct misstatements. Corrective controls aren’t common in the accounting department since improvements in preventive and detective controls can resolve weaknesses in accounting controls. But for the sake of explaining this concept, here are some examples of corrective controls:
- Updating the accounting manual of the business to modify or correct processes that are susceptible to fraud or error
- Updating the accounting software regularly to solve software errors in the old version
- Releasing memorandums to instruct accounting employees for minor updates and remedies
- Subjecting poorly performing accounting staff to appropriate disciplinary action in worse cases
Here are some ways on how you can correct erroneous transactions:
- Entering a corrective journal entry that will reverse the error
- Making a single-line correction for simple errors, such as:
- Transposition errors (e.g., $157 instead of $175)
- Slide errors (e.g., $10.25 instead of $102.50)
- Mathematical errors
- Deleting invoices or bills that are exact duplicates
- Revising the financial statements if the error is so material
- Striking errors in source documents to emphasize the error and placing the correct amount either above or beside the erroneous information
Role of Compensating Controls in a Small Business Setup
A compensating control is an alternative control put in place to satisfy the requirements of a good internal control system when traditional controls are impossible. It exists in small businesses because it’s often impractical to follow optimal controls when there are only a few employees (fewer than 10) handling administrative and accounting functions.
This limitation makes it difficult to comply with the segregation of incompatible duties because it’s possible that one or two employees might handle several custody, authorizations, and recording functions. In small business bookkeeping, the owner might only hire one to two accounting staff to record daily transactions, reconcile customer or vendor accounts, or even handle assets.
Due to the limitation, compensating controls must be in place to solve any deficiencies. For small businesses, the best compensating control is the participation of the small business owner in the accounting process. The owner must take an active role by supervising and monitoring accounting activities, and they may delegate minor tasks to managers or supervisors to filter out issues that are material to the small business.
Frequently Asked Questions (FAQs)
What are the five elements of internal control?
The five elements are as follows: Control Environment, Risk Assessment, Control Activities, Information and Communication, and Monitoring. Each element determines the effectiveness of controls, especially in its ability to prevent, detect, and correct misstatements.
What is the biggest threat to internal controls?
Human intervention will remain to be the biggest threat to internal controls. Collusion and management override can beat internal controls even if it was designed exceptionally.
Bottom Line
Accounting controls are necessary, even for a small business. They help owners monitor business transactions and ensure that every transaction has been properly recorded in the books. Without controls, you risk your business losing assets or having unreliable financial information that could lead to over or underpaying taxes.
