Internal controls: 3 limitations that your company should anticipate

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Internal controls play an important role in preventing fraud in any company. According to ACFE’s 2014 Global Fraud Study, a lack of internal controls is a major contributing factor to nearly one-third of fraud cases.

As the saying goes, ‘No rose without a thorn,’ even though your company has tried to set the best internal control possible, there are always limitations that would prevent it from working perfectly. Therefore, it is crucial for your company to conduct evaluations from time to time and to monitor the implementation of the internal controls.

Limitations of Internal Controls and Their Impact

A study titled The Impact of Weak Internal Controls on Fraud highlights several limitations of internal controls, three of which are human error, the override of policies and procedures, and collusion. The study was conducted on a Malaysian multinational company using a mixed-methods approach that included interviews and archival analysis.

1. Human Error

The effectiveness of internal controls is inherently limited by human judgment. Individuals may not fully understand how specific control mechanisms work, may misjudge situations, or may make decisions that violate internal control policies. For example, an employee may not know how to report an incident using the whistleblowing system. This limitation can be addressed through proper education and whistleblowing training for employees.

2. Override of Internal Controls

Managers with authority may choose to bypass established policies and procedures. In urgent situations, a manager might act in the company’s interest by ignoring certain rules. However, in some cases, they might override procedures for personal gain, such as intentionally concealing the company’s actual financial condition.

To address this issue, companies must foster a healthy corporate culture. This can be achieved by setting a good example from the top (set the tone from the top), raising awareness, and encouraging open communication across all levels of the organization.

3. Collusion

Even the most sophisticated internal control systems can be compromised through collusion among employees. For instance, staff in procurement, inventory, and finance may conspire to create fictitious purchases. As a result, fraud becomes more difficult to detect using standard internal controls. To mitigate this risk, companies should conduct regular monitoring and continuously improve transaction recording and documentation systems.

Fraud cases highlighting the impact of weak internal controls

1. Wirecard

Wirecard, a German payment processing company, collapsed after it was revealed that €1.9 billion in reported assets did not exist. Notably, weak internal controls and inadequate audits by EY were key factors in the scandal.

2. Cocoon SDA Care

This disability service provider faced a federal investigation after failing to pay rent, leaving three women with disabilities homeless. An independent audit found that the company had nearly $10 million in unpaid taxes and lacked basic financial controls. This case clearly illustrates the dangers of weak internal oversight.

3. Syahrul Yasin Limpo

The former Indonesian Minister of Agriculture was arrested on corruption charges involving contracts with private vendors. He allegedly received around USD 885,000 in bribes through subordinates and misused state funds. This incident underscores how vulnerable internal controls can be without strict oversight and accountability.

Solutions for strengthening internal controls

PT Integrity Indonesia offers a range of services to help businesses enhance their internal controls and reduce fraud risk:

Due Diligence
Our due diligence service thoroughly assesses potential business partners, allowing companies to identify risks before entering into agreements.
Whistleblowing System
The Canary® Whistleblowing System enables secure and anonymous reporting of misconduct, supporting a transparent and compliant workplace. Consequently, employees feel safer reporting unethical behavior.
Pre-Employment Background Screening
Verification of candidate information to ensure integrity and reliability before hiring. Through early detection, companies can prevent risks before they enter the organization.

A robust internal control system is vital for fraud prevention and business integrity. By understanding potential limitations and taking proactive measures, organizations can minimize risks and strengthen trust among stakeholders.

Also Read:

Fraud Prevention: 7 Acts of Internal Control for Small Businesses

3 Types of Fraud Commonly Occurring in P2P Businesses

Image by Werner Herbert from Pixabay