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25. Discuss management’s incentives for establishing and maintaining strong ‘internal control’.
Before we start answer this question, let us understand what the definition of internal control is. Internal control is designed and implemented by an entity’s management, those charge with governance of the entity, and other personnel to provide reasonable assurance regarding the achievement of objectives. In addition, internal control is also can be refer to a process wherein the structure of the organization, the information system and authority are designed in such a way that it can helps the organization achieve its objectives and goals. (Bhattacharyya, August 2010) Internal control plays an important role in how management meets its stewardship or agency responsibilities. For example, internal control for a bank is the systems, policies, procedures, and processes effected by the board of directors, management, and other personnel to safeguard bank assets, limit or control risks, and achieve a bank’s objectives (Internal Control Comptroller’s Handbook January 2001). A system of strong internal control is the backbone of an association’s management program. Strong internal control may helps a company to meet their objectives and goals, and to maintain a healthy, successful operations.For a bank, Good internal control can help a bank to avoid surprises and achieve its objectives.
After we understand the internal control, let us see the management’s incentives for establishing and maintaining strong ‘internal control’. There are few management incentives such as provide safeguard of assets and company records, effectiveness and efficiency of operations, prevention and detection of fraud and error, compliance with applicable law and regulation, avoid wastage of resources, risk management systems are effective and decreased risk of damage to the association’s reputation.
First, the management’s incentive for establishing and maintaining strong ‘internal control’ is to ensure company records and assets can be properly safeguard. A strong internal control can ensure that asset was not been stolen and certificates or company records are proper keeping. Then, a proper safeguard of company records and assets can generate reliable information for the company because the records will not easily be manipulated. Besides, Management also needs reliable information to ensure the fairness of financial report. It can reduce the problem between the principal and agent. So, what is mean by principal and agent? Actually, principal is referring to absentee owner such as shareholder and agent refers to manger who is working in company. The problem is information asymmetry and conflicts of interest are occurring between themselves. This is because manager has more information about “true” financial position than shareholder. Moreover, they are different objectives in sometimes, so it will lead to conflict of interest. For example, the goal of shareholder is to obtain higher dividend from the company which they invest. However, the goal of manager is to maximum the profit of the company. Therefore, they will be a conflict such as whether using the excess earning to maximum the dividend for each of the shareholder or increase their market share by increases the advertising. It will lead to the problem between shareholder and manager, because the shareholder did not know whether the manager has done a correct or win-win decision. Then, they did not know the financial statement have incurred error or fraud or not. However, a strong internal control may ensure a safeguard of company’s records and assets and it will increase the trustiness to the company. Then, decrease the problem between agent and principals. Besides this, reliable information is important to make a good decision to a company. If the information system does not provide reliable information, management may be unable to make quick and informed decisions such as product pricing, profit information and cost of production. It is important that the top management is generated with accuracy information, as they rely on these data to make important and critical decisions. Therefore, a strong internal control is necessary in order to make financial information transparent and accessible to the managers or decision makers.
Second, the management’s incentive for establishing and maintaining strong ‘internal control’ is to have an effectiveness and efficiency of operations in a company. Effective of internal controls can be sure that all duties are being completed according to standards, rules and all quotas are being met. However, efficiency of internal control is very important to the achievement of sustainable competitive advantage and the maximization of profitability. Operational procedures, best-practice and performance reviews are effective internal controls of efficiency. (Ingram, eHow Contributing Writer) A strong internal control increases the effectiveness and efficiency of operations, reduces the risk of asset loss, and helps to ensure compliance with laws and regulations.
Third, the management’s incentive for establishing and maintaining strong ‘internal control’ is to prevent and detect of fraud and error in company. Error is unintentional misstatements make by staff or manager such as making mistakes in gathering or processing financial data used to prepare financial statements. Then, fraud is intentional misstatements make by staff or manager such as manipulation, falsification, or alteration of accounting records or supporting documents used to prepare financial statements. Therefore, a strong internal control can prevent and detect the error and fraud. For example, segregation duty between record shipping inventory and calculate inventory physically can prevent theft or stolen of inventory occur. Besides, a proper accounting information system can prevent the error or fraud, such as sales clerk only can access and key in the information about the sales and account receivables only. Therefore, the sales clerk can’t access to cash account in order to create a fictitious customer. Moreover, monthly bank reconciliation can check the mathematical accuracy of the bank reconciliation working paper and agree the balance per the books to general ledger to detect the error or fraud in account bank.
Next, the management’s incentive for establishing and maintaining strong ‘internal control’ is to compliance with applicable law and regulation. Following law and regulation set by government require huge investments, especially that of time. Therefore, a strong internal control is necessary in order to avoiding legal consequences by follow the rule and regulation. That mean, it can reduces or avoid the costs which may have to occur if the company don’t follow rules.
Then, the management’s incentive for establishing and maintaining strong ‘internal control’ is to avoid wastage of resources. A strong internal control can helps company avoiding wastage of precious resources, besides increasing efficiency. It is because maximize the profits or income by utilization the resources is one of the method of efficiency. Strong internal controls can avoiding wastage of resources like an effective accounting information system can ensure the reliability and appropriate of the information for avoid to making an inefficiency and inaccurate decision and wasted asset of the company in investment in that decision such as wasted cash or establish a useless debt for an ineffective investment.
The management’s incentive for establishing and maintaining strong ‘internal control’ is to making risk management systems effective. An entity’s risk assessment process is its process of identifying, evaluating, and responding to the identified business risk. For example, mobile phone company such as Nokia always facing business risk not because of its competitive environment only but rapid changing technology is also a main reason. To suit for the customer trend and favourite, Nokia facing business risks that are always need to make investment in Research and Development Department to design a new model and rapid upgrade their product. However, not all the mobile phone produce by Nokia will be the favourite of the customer and making a profit, so a strong internal control is important to assess the business risk and reduce the business risk to an acceptable level.
The last management’s incentive for establishing and maintaining strong ‘internal control’ is decreased risk of damage to the association’s reputation. It is because a strong internal control can produce a reliable financial statement, making operating procedures more effective and efficiency, prevent and detect the error or fraud and compliance with applicable laws and regulations. Therefore, the financial report will be more credibility and decreased risk of damage to the association’s reputation.
Last but not least, after we review the management’s incentive for establishing and maintaining strong ‘internal control’, we can conclude that a strong internal control is very important to every company to achieve their business’s goal, such as provide a safeguard of records and assets or making an effectiveness and efficiency of operations. Therefore, a strong internal control is one of the factors that ensure the company may successful also.
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