Open Access Research Article
UNDERSTANDING INTERNAL CONTROL MECHANISMS IN INDIAN CORPORATIONS: -
Published Paper
Article Details
UNDERSTANDING INTERNAL CONTROL
MECHANISMS IN INDIAN CORPORATIONS: -
AUTHORED BY - NIRDHAR NAPHADE &
NIPUN NAPHADE
Abstract
In the past
decade, a number of countries passed laws governing financial reporting
controls in response to significant global financial frauds like Enron and
Worldcom. They required the board of directors, senior executives, and the
auditors of the financial statements to assess and report on the adequacy and
success of an organization’s internal control structure. Resultantly,
questions such as reasons for oversight of unlawful activities, failure to
report violations in compliance practices, and incompetent managerial control
over financial decisions were highlighted. The focus of shareholders and
management was diverted from profit maximisation to stakeholder value
maximisation, at the forefront of which was the commitment to be legally and
morally compliant to socio-economic standards. To avoid unnecessary
interference of the state in private organisations, the Indian government
directed corporate leadership to implement internal checks and balances, to
prevent unlawful activities at the first stage itself. This paper delves into
the methods of internal control, the effects it has on organisations, and the
level of efficiency each one reaches in the Indian economy. It adopts a
theoretical approach and analyses secondary data in the light of certain research
questions. The questions in turn provide an outline and direction to the
analysis, which is converted into logical conclusion and suggestions.
Key words: Internal control system, Corporate governance,
preventive controls, corrective measures, financial frauds.
I.
Introduction
to internal control mechanisms
India as a growing economy of the
world sees a more diverse set of commercial entities, wherein the companies can
be divided on the basis of their ownership structures, eg:- one person company,
sole proprietorship, limited liability partnership, partnership firm, or
limited company. Internal Control of an organization refers to the mechanisms
put in place by the entity to internally manage risk. Following significant
global financial frauds like Enron and Worldcom, several nations passed laws
governing financial reporting controls that require the board of directors,
senior management, and the auditors of the financial statements to evaluate and
report on the sufficiency and effectiveness of an organization’s internal
control over financial reporting[1]. The goal
of these laws is to strengthen the existing corporate governance framework.
1.
Literature Review:
2.
Research on the Internal Control of Small and Medium
Manufacturing Enterprises under Comprehensive Risk Management (Chen Xiaofang).
This paper has combed the research
results on internal control of small and medium manufacturing enterprises of
domestic and foreign scholars. Combined with the status analysis of internal
control and risk management of small and medium manufacturing enterprises, this
paper built the internal control framework of small and medium manufacturing
enterprises based on comprehensive risk management in order to improve the
system of internal control theory and provide reference to small and medium
manufacturing enterprises in China. However, the paper does not mention the
risks, advantages, disadvantages or types of internal control systems.
3.
On the Efficiency of Internal and External Corporate Control
Mechanisms[2](James
P. Walsh and James K. Seward).
After reviewing the related work in
organization theory and financial economics, this paper articulates the
strengths and shortcomings of both types of control mechanisms; it also
identifies a variety of managerial entrenchment practices that managers can use
to compromise these mechanisms. A theoretical framework is developed next that
explicates the interrelationships between and among these corporate control
mechanisms. A number of research opportunities that span the disciplines of
organization theory and financial economics are identified. However, this paper
does not explain the intricacies of internal control systems and their
disadvantages or challenges.
a.
Legal environment of
India:
The Companies Act, 2013[3] (“Act”)
was enacted in 2013, which was a significant step in India in achieving this
goal. The Institute of Chartered Accountants of India (ICAI) recently updated
its “Guidance Note on Audit of Internal Financial Controls over Financial
Reporting” (the “Guidance Note”)[4], which was
published in September 2015. The Guidance Note toughens the requirements in The
Companies Act by substantively involving the external auditor in the compliance
process. An organization’s internal controls, including its corporate
governance and accounting procedures, are assessed via internal audits. By
recognising issues and making corrections before they are found in an external
audit, they help to preserve operational efficiency and assure compliance with
laws and regulations, accurate and timely financial reporting, and data
collecting. Since the Sarbanes-Oxley Act[5]
of 2002 rendered managers liable for the accuracy of the company’s financial
statements, internal audits are essential to a company’s operations and
corporate governance.
The Board of Directors of a company
is responsible for the effective implementation of the Internal Control
Mechanisms. Internal controls can help increase operational efficiency by
enhancing the accuracy and timeliness of financial reporting, in while also
assisting organization comply with laws and regulations and stop employees from
stealing property or committing fraud. It includes rules, procedures, reports,
code of conduct, etc and helps to maintain a professional culture in the
organization.
b.
Socio-economic factors
Without Internal Control Mechanisms,
like a whistleblower policy, many scams like the Worldcom scam, or other scams
continue to take place if there is no proper procedure of reporting. India has
seen a lot of scams, like the Harshad Mehta scam, DHFL scam, NiravModi scam,
Kingfisher scam, Ketan Parekh scam, etc[6].
A detailed study of scams suggests that a lack of internal control mechanisms
facilitates these scams because it is always something that starts small and
insignificant and ends up being the scam of the decade.
If studied properly, everything that
goes wrong in a company can be traced down to a failure in the internal
controls mechanism in the corporate. Thus we can concur that the Internal
Controls Mechanism in a company is the root of all safeguards and failsafes
that a company contains or requires. In their book “The Philosophy of
Auditing”, R.K. Mautz and Hussein Sharaf mention that ‘The existence of a
satisfactory system of internal control eliminates the probability of irregularities’[7]. In this
paper, we will take a close look at the importance of Internal Controls
Mechanism and various types of internal controls. We will also study the
important advantages and disadvantages of the internal controls system. In the
end, the researcher shall offer suggestions to overcome a few of the
disadvantages of the internal control mechanisms.
2.
Methods of Internal Control:
There are five interrelated
components of an internal control framework. They provide the entity with the
procedure of following internal control mechanisms. These are usually
implemented by corporations with some variations. They include control
environment, risk assessment, control activities, information and
communication, and monitoring.
a.
Control environment:
An example of control environment can
be the code of conduct of a company. It usually governs conduct of employees
with other employees and management.
b.
Risk assessment:
An example of this can be the risk
register of a company. It helps to anticipate the future risks and keep
provisions ready for them.
c.
Control activities:
Examples of this can be internal
audits or secretarial audits. It is the job of such audits to check the
failsafe and countermeasures of the company.
d.
Information
communication:
This entails being
transparent/translucent in the affairs of the company. It can include
optimizing communication with the stakeholders of the company. It emphasizes on
the importance of accountability.
e.
Monitoring:
This requires daily or periodically
checking all the complaints and concerns of the stakeholders. Effective
Corporate Governance includes responsiveness and that can only be achieved by
constant and efficient monitoring of the company.
3.
Types of Internal control
mechanisms:
Internal control mechanisms are a
part of every company. They can be implemented formally or informally. It is
imperative for an organization to have internal control mechanisms so as to
avoid any wrong-doing, error or malpractice. Security, division of
responsibility, authorisation, documentation, reconciliation, and other
such control procedures are frequently included in these. They could also
be broadly categorised as detective and preventive actions, followed by
corrective actions.
a.
Preventive control
operations
They aim to avoid errors or fraud in
the first place, including thorough documentation and permission procedures[8]. Examples
of preventive controls include:
Segregation of duties is an
essential internal control that aims to lower the likelihood of errors or fraud
by ensuring that no one employee has the ability to both commit and cover up
errors or fraud during the course of their duties. One instance of segregation
of jobs is having one employee draft the checks and another employee approve
the payments. In general, the responsibilities that should ideally be separated
include: Transaction, Authorization, Reconciliation, Asset custodianship, etc.
ii.
Pre-approval of actions
and transactions
In a company where actions are
reimbursed by the company or travel or purchase is paid for by the company, a
pre-approval process should be adopted so as to ensure avoidance of fraud or
scams[9]. An
example of this can be travel authorization wherein an employee who has to
travel to another site in the course of his or her employment, should provide
details and estimated expense of such mode of travel.
iii.
Access controls (such as
passwords and Gatorlink authentication)
Who or what has access to company
assets, including IT systems, is controlled by access controls. These
safeguards are essential security ideas that lessen danger to the business or
organisation[10]. Access
to sites, buildings, offices, and other IT assets is restricted via physical
access control. To implement physical access control, security guards may be
used to validate IDs or access key cards. Connections to computer networks,
system files, and data are limited by logical access control. According to the
information security guideline known as the principle of the least privilege
(PoLP), users should only have access to system functions and data that are
required for them to perform their job.
b.
Detective controls
They are backup measures intended to
identify things or situations that the first line of defence may have
overlooked. Detective controls are designed to find errors[11]
or problems after the transaction has occurred. Detective controls are
crucial because they offer both a chance to find abnormalities after the fact
and proof that preventive controls are working as intended. Examples of
detective controls include:
i.
Review organizational
performance
Under this measure, the performance
of an organization is evaluated by keeping multiple checks and balances. The
different parts of the organization are evaluated separately and jointly and
then their respective scores are evaluated to find out which area requires
improvement and which is self-sufficient.
ii.
Monthly reconciliations
of departmental transactions
This measure is more related to
financial transactions. It is known that in large companies, there are multiple
branches and organs within the company which work autonomously in some
functions and are co-dependent on others for other functions[12].
Naturally, they carry out transactions within and without the company. Such
transactions need to be reconciled with the company’s books of accounts because
although they are made by the particular branch of the company, they represent
the company as a whole and therefore need to be checked and verified by the
Board of Directors or other relevant personnel. Therefore, monthly
reconciliation of departmental transactions should be done to avoid discrepancy
and confusion.
c.
Corrective measures:
Given that the abovementioned
measures are implemented and perform properly, errors and malpractices will
ideally be detected by the company officials. Therefore, the company should
have some corrective measures or procedures in place to negate the detected
effect. These are called as corrective measures and these vary for each company
depending on internal and external factors.
i.
Patch Management:
Examples of patch management can be
software update. When a software company finds any flaw or error or bug in the
software after it is sold or published, then the company uses this process to
remove or remedy such flaws[13]. This
also prevents data breach or security breach and therefore makes the software
safer to use.
ii.
Updated policies:
When a company updates its user
policy or procedure, it is usually does so to avoid any legal action or any
breach of privacy or security after it finds some flaw in its previous/original
policy. Such updates are also part of the corrective measures of internal
control.
iii.
Disciplinary actions:
When the wrongdoing of any employee
is brought to light, the company has to take disciplinary action to avoid such
occurrence in the future. The event has already occurred and the harm has
already been done, but the action proves to be a detriment for other actors in
the future.
2.
Advantages of internal
controls:
The advantages of internal controls
are wide and important. They include detection of errors and identification of
frauds, time saving, very little scope for frauds and scams, operational
efficiency.
a.
Identification of frauds:
Good corporate governance requires
good implementation of internal control mechanisms. They ensure that scams are
identified and avoided. Identification of scams at an early stage and
introduction of changes in management policies helps avoid and punish scams and
is essential for the survival of a company[14].
Thus, Internal Control Mechanisms are the only way to ensure that such scams do
not occur by keeping proper measures to root out such scams at the grassroots.
Transparency is reflected through the Internal Control Mechanisms of a company.
If company policies allow for easy access to company management, maintenance of
a risk register, complaints register and efficient grievance redressal, then
the company can be said to be transparent. This is a good practice and promotes
good governance in the corporate sector.
b.
Improves process
performance:
It has to be noted that compliance
and internal control mechanisms is a process and not a one-step function. It
requires continuous compliance with laws and regulations, proper standards and
measures and implementation of the required internal control systems in order
to be efficient, transparent, accountable and responsible. Management can
decide if a process is working as it is being implemented or if it requires
further attention by continuously reviewing its efficacy. The accuracy of
financial reporting, upon which management depends to make efficient
company decisions or judgements, increases as systems are improved[15]. An
example of the above can be if a company’s revenue went down by 30% because of
a reduction of in-store traffic, then the management would decide to focus on
the company’s website to increase web traffic and boost online sales.
c.
Time saving:
Complying with the applicable laws
and regulations is always efficient and time saving than risking a penalty.
This means that when a company starts functioning, the management has to decide
whether to carry out proper compliances or to commit illegal acts by not
following regulations. At the outset, the company may feel that compliance is time
consuming and tedious and non-compliance is more beneficial and time saving.
However, in the long run, the company’s survival may be endangered if proper
compliance is not followed[16]. The
penalties, court proceedings, show-cause notices, etc will always prove to be
more time consuming and expensive. Hence, compliance is cheaper and time saving
than penalty. Proper utilization of Internal Control systems will ensure proper
compliance.
d.
Operational efficiency:
Internal Control does not just entail
a few papers to be signed or a few forms to be filled. It needs a special
department or a person making sure that all the laws, regulations, standards,
rules, and notifications are followed and the company is compliant of all such
norms. The company has to understand that this process is for the betterment
and progress of the company and it only safeguards its interests. When a
company does not have proper internal control mechanisms; or does not have
proper implementation of such mechanisms, then it leads to disorder in the
company as there is no defined hierarchy, there is no defined roles of
employees, there is no provision for any future risks, the stakeholders do not
trust the management of the company and hence can cause multiple interventions.
A company operates smoother and better with good internal control mechanisms in
place since everyone knows their roles and functions. The stakeholders trust
the management as they can see that there are control mechanisms in place to
avoid frauds and that their concerns and issues are addressed and resolved in
time. By eliminating redundant or superfluous stages from a process, internal
controls can increase the effectiveness of operations[17].
This could involve integrating functions efficiently or automating manual
controls. The management may now receive timely information to confirm that
present activities are accomplishing the goals of the organisation owing to
increased operational efficiency.
e.
Other advantages include:
•
Identification
of potential operating process opportunities
•
Updated
formal, centralized, and managed internal financial controls documentation for
the company
•
Enhanced
support to CEO/CFO certifications
•
Enhanced
control environment, thereby mitigating risk
•
Better
understanding of inherent and residual control risks in internal controls
•
Helps
in business process redesigning to plug revenue leakages & cost
•
Containment
opportunities
•
Helps
in rationalizing the number of controls across organization - moving to smart
and automated controls
•
Helps
in standardizing policies and procedures for multi-location/multi-business
companies
•
Fosters
a control conscious work culture for people behind controls
•
Provides
assurance to the CEO/ CFO as well as improves business performance
•
In
some instances, also serves as a base for blue print of optimal procedures
while thinking about ERP.
3.
Disadvantages of
implementing control mechanisms:
However, there are also some
disadvantages to the internal control mechanisms currently in place and
practice in India. These include the cost of the process, human error, chance
of misuse of power, follow up hassles, other problems with respect to the
organizations and their unique structures.
a.
Costly process:
As discussed earlier, the company
management could be of the opinion that it would be costlier and more time
consuming to carry out all the compliances than to just ignore them and avoid
state interference in the short run. It may initially seem to be costly because
of the compliance cost as it seems like an avoidable cost. Initially when the
company is new, the entire process may appear to be a tedious responsibility.
But if the management appoints the qualified staff to ensure healthy
compliance, then in the long run, it becomes common practice to follow the
compliances and the laws and regulations. Then it becomes easier, time saving
and convenient. As for the cost, if the authorities detect non-compliance with
proper laws and regulations, repercussions may include imposition of heavy
monetary penalty, with extreme cases being punished with imprisonment of
involved personnel. Thus, although compliance appears to attract higher costs
than avoidance of preventive mechanisms, it is always cheaper than a penalty.
b.
Human error:
In the process of complying with the
requisite norms, laws, regulations, rules and proper practices, it becomes
tedious and repetitive. Also, since it is carried out by the employees of the
firm who may be inexperienced, it may involve errors of compliance and this can
lead to a penalty or even worse, imprisonment[18].
Therefore, it should be noted that the advantage mentioned earlier about the
process being time saving and cost saving, turns out to be erroneous. Such
human errors are unavoidable. This can cause distrust in the entire process of
internal controls mechanism and its daily practice.
c.
Misuse of power:
During the process of internal
control mechanisms[19], there
are various people who are given the power and responsibility to carry out such
compliances. There is a hierarchy among these people and that can lead to
concentration of power if it is not implemented correctly. Centralisation of
auditory power may lead to misuse of the power given to the individual if he
tries to control all the variables in the process. This will lead to incomplete
corporate governance and can also lead to scams and frauds and cause loss to
the company and the stakeholders.
d.
Follow up hassles:
During the entire process of the
internal control mechanism, the management of the company has to keep a check
on the persons responsible and make sure that the compliances are done in
accordance with the law[20]. As
mentioned above, the management also has to make sure that there is no misuse
of power and no concentration of such power. This follow up becomes very
tedious and repititive as it has to be done periodically and has to be done to
ensure proper functioning of the internal control mechanisms and the compliance
procedures. The company has to hire an officer to ensure all these compliances
and follow ups and has to make sure that they are legally secure and compliant[21]. As this
all requires time, manpower and money, the internal control mechanisms are
wrongly considered to be a waste of time, money and effort.
e.
Size of the
Organization:
Small organizations have very low levels of internal control, which
are almost negligible due to more interference by owners and management. This
can cause financial frauds or other such offences. This is not the case when it
comes to larger organisations. They have to follow stricter levels of internal
control as the owners and the managers are different and they do not frequently
interfere with the control systems. However, in larger companies, compliance of
internal control would be difficult as they have to follow stricter levels of
internal control.
f.
Obsolescence:
Control system may become redundant with passage of
time if not updated with change in the size and nature of business. Thus the
persons in charge of the internal control mechanisms have to be up to date and
have to keep updating the system with time and development. They cannot let the
process become obsolete and redundant.
4.
Legal Requirements:
As per[22]section
134 of the companies act, 2013, all listed companies shall publish a
Director’s Responsibility Statement which shall mention the internal financial
control mechanisms implemented by the Company.As per section 143 of the Act,
the Auditor’s report must state that there are effective internal control
mechanisms in place and they are operating properly. Similarly, Clause
49(V)(c) of the Listing Agreement puts the responsibility on the CFO
and the CEO to check the implementation of internal control systems. Section
149 of the Companies Act states that it is the duty of the Independent
Director to oversee that the integrity of financial information and the
internal systems is proper and safe. Section 177 of the Act requires the
audit committee of a company to evaluate the internal controls and the risks
present internally and to ensure proper checks and balances are in place. Thus,
the persons responsible for checking and maintaining and reporting on internal
control systems include the External Auditors, Internal Auditors, Directors,
Independent Directors, CEO, CFO, etc.In the case of Tri-Sure India Ltd. vs A.F.
Ferguson And Co. And Others[23],
the Bombay High Court held that it was the auditor’s responsibility to ensure
that there were adequate internal control mechanisms in place in a company and
that he or she should mention the same in the Auditor’s report.
In USA, the SOX Act, also
known as the Sarbanes-Oxley Act, 2002 was passed after the infamous Enron scam.
After this, the Chief Financial Officer or the Chief Executive Officer of the
Company has to give an annual or quarterly report to certify that the company
follows proper internal control mechanisms and guidelines. The auditors also
have to attach a management report which certifies the effectiveness of the
internal controls of the company. The COSO framework of 2013[24]
gives the definition and legal requirement of companies to follow internal
control. It gave the definition of Internal Control as
‘A process designed by, or under the supervision of, the
registrant’s principal executive and principal financial officers, or persons
performing similar functions, and effected by the registrant’s board of
directors, management and other
personnel, to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for external
purposes in accordance with generally accepted accounting principles and
includes those policies and procedures that:
1)
Pertain to the
maintenance of records that in reasonable detail accurately and fairly reflect
the transactions and dispositions of the assets of the registrant;
2)
Provide reasonable
assurance that transactions are recorded as necessary to permit preparation of
financial statements in accordance with generally accepted accounting
principles, and that receipts and expenditures of the registrant are being made
only in accordance with authorizations of management and directors of the
registrant; and
3)
Provide reasonable
assurance regarding prevention or timely detection of unauthorized acquisition,
use or disposition of the registrant’s assets that could have a material effect
on the financial statements’
In the United Kingdoms, the Cadbury
Committee report in 1991 spoke about the responsibility of directors to report
on the effectiveness of companies’ internal control[25].
This report also includes the recommendations on the roles of auditors,
directors, non-executive directors, etc. It is a report on importance and
implementation of good corporate governance in UK.
The Turnbull Committee report of
1999, informed directors of their obligation under the Combined Code with
respect to keeping good internal controls in the company and having audits and
checks to assure themselves of the quality of reporting in the company.
5.
Conclusion:
There are multiple reports of
committees that advocate for an internal controls mechanism inside the company.
The Cadbury Committee report in the United Kingdom mentioned that every company
should have an internal control mechanism and the Director of the company
should provide a report to mention such mechanism and ensure its smooth
functioning. Similarly the clause 49 of the listing agreement in India
specifies that the Internal Audit committee of a company should file a compliance
certificate which ensures that there are certain statutory mandated internal
controls which the company complies to. If either of these reports/certificates
is wrong or untrue, then there can be penal provisions imposed on the director
(in United Kingdom) or the Audit Committee (in India).As seen above, internal
controls are integral to the smooth and long term functioning of a company.
They do entail challenges, but internal control systems are efficient and time
tested methods to avoid scams and frauds and therefore, violation of internal
control system, or absence of any such system should ideally attract penalty.
6.
Suggestions:
In the Indian context, good corporate
governance practice is a comparatively recent term. A company that is
responsive, transparent, efficient, accountable, fair, legally compliant and
also profitable, not only earns money, but also earns goodwill and loyalty. The
disadvantages as mentioned above including corporate governance being costly,
some employee entrusted with the power ending up misusing power and follow up
hassles can be overcome if the advantages are explained properly. The cost of
penalty for non-compliance is always more than that of the compliance cost
because it also entails harm to the goodwill of the company. If the hierarchy
in the persons entrusted with the function of carrying out the internal control
mechanism is properly set and implemented and if the roles of each person are
explained to them properly, then there would be no place for any scam or fraud
or misuse of any power. The follow up hassles, however, prove to be true and
may cause some redundancy in the complying nature of a corporate. But if
continued for the right amount of time, then the compliance becomes a part of
the work life and is followed without any hassles or problems, then the follow
up hassle can be proved to be wrong and untrue. To ensure that the companies
maintain good corporate governance practice and proper internal control
mechanisms, the Government should levy some penalty on non-compliance or
absence of internal controls. This should only be done to act as a deterrent
against non-compliance.
The Government can also, on the other
hand, publish reports which announce companies which have greater standards of
internal control mechanisms. This would act as an incentive for the companies
as it would result in positive publicity of the companies and would result in a
possibility for more investments. For the public at large, it would assure the
masses of the good corporate governance practices followed by the companies and
would encourage them to invest in such companies which have a robust internal
control system.
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Article Information
UNDERSTANDING INTERNAL CONTROL MECHANISMS IN INDIAN CORPORATIONS: -
Authors: NIRDHAR NAPHADE, NIPUN NAPHADE
- Journal IJLRA
- ISSN 2582-6433
- Published 2024/02/23
- Issue 7
About Journal
International Journal for Legal Research and Analysis
- Abbreviation IJLRA
- ISSN 2582-6433
- Access Open Access
- License CC 4.0
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