How To Identify Internal Control Weaknesses

A company’s employees, shareholders, senior management, and board of directors expect the company to conduct its business reliably, efficiently, and securely – especially its financial transactions.

A company’s internal controls are the mechanisms to ensure that its business processes meet those expectations. To keep that system of internal controls running smoothly year after year, you must identify the internal control weaknesses in those systems.

An internal control weakness is a failure in your internal activities that bad actors can exploit. Identifying and mitigating weak internal controls helps strengthen your company’s operations before malicious actors take undue advantage.

What Are Internal Controls?

Internal controls are the rules, mechanisms, and procedures you use to safeguard your financial information, promote accountability, and prevent and detect fraud. Internal controls help you comply with laws and regulations and are crucial to fraud prevention and asset security.

Publicly traded companies must implement data security controls to protect their financial data, per the audit requirements of Section 404 of the Sarbanes-Oxley Act (SOX). Section 404 holds executives liable for inaccurate or false financial reporting and requires them to maintain strong internal controls and the documentation needed to prove compliance.

Internal controls have become an essential business function for every U.S. company since the accounting scandals of the early 2000s. An effective data governance model, rigorous risk management, and compliance software controls can heavily monitor, measure, and fill control gaps.

Type of Internal Controls: Preventive, Detective, Corrective

Internal controls include authorization, documentation, reconciliation, security, and the segregation of duties. Three types of internal controls exist preventive, detective, and corrective.

• Preventive controls aim to prevent errors or fraud. They include thorough documentation and authorization practices. For example, segregation of duties assures that no person is in a position to authorize, record, and maintain a financial transaction and its corresponding asset. 
• Detective controls are procedures that aim to uncover anomalous events after those incidents have occurred. Detective controls provide evidence that a material misstatement or loss has occurred, but they don’t prevent such occurrences from happening. Reviews, analyses, and inventory are all detective controls.
• Corrective controls are usually implemented after detective controls uncover an issue. Examples of these controls include disciplinary action, software patches or modifications, and new policies that prohibit certain practices.

What are internal control weaknesses?

Internal control weaknesses are lapses in your internal processes, categorized into two categories for severity: material weaknesses and significant deficiencies.

• A material weakness is a severe control weakness that the company’s financial statements cannot be relied upon, or the company could violate regulatory compliance obligations. A material defect is a significant problem that needs prompt attention from the board and senior management.
• A significant deficiency is less severe than a material weakness. It will not likely lead to a material misstatement of financial results or a compliance violation. However, it still warrants attention from senior management to resolve the weakness.

A significant deficiency is typically reported to the company’s board by its outside audit firm or internal management. Several significant flaws could also constitute a material weakness.

Examples of internal control weaknesses

Understanding internal control weaknesses is vital for mitigating risks and strengthening your organization’s integrity. Here are some examples of common internal control weaknesses:

• Insufficient Segregation of Duties:

Weakness: When a single employee has both authorization and access to financial transactions, it creates a vulnerability. For instance, an employee who can approve and process payments may be more likely to engage in fraudulent activities since there’s no independent oversight.

• Lack of Documentation:

Weakness: Inadequate financial reporting on transactions and authorizations can lead to problems. For example, without proper documentation, verifying the legitimacy of transactions is complex, making it easier for errors or fraud to occur undetected.

• Ineffective Inventory Management:

Weakness: Poor control over inventory movement can result in issues. For instance, if inventory levels aren’t accurately tracked, it can lead to losses through shrinkage or theft, which may go unnoticed due to inadequate management.

Five Major Internal Control Weaknesses

Five significant internal control deficiencies put your company assets at risk.

Technical control weaknesses

Technical security control focuses on hardware and software changes that might not have been configured or maintained with all necessary controls to secure access and usage.

Architectural control weaknesses

Architectural control helps you build a resilient IT architecture that allows your company to operate effectively. Any areas for improvement in setting up and maintaining this architecture can result in a loss of business and reputation.

Operational control weaknesses

Operational control weaknesses often result from a lapse in executing company-mandated operations and standards, which might result in unplanned incidents that disrupt the operating model. For example, someone might only perform the required scans of third-party software after installing that code, and the code introduces a vulnerability or virus into your operating system.

Administrative control weaknesses

Administrative controls protect your company’s IP and assets and help your workforce handle sensitive information. In addition, running highly available systems is vital to helping your organization recover from IT incidents, so any weaknesses inflicting downtime on your IT systems can be fatal to your business.

Financial control weaknesses

Financial controls protect your company’s cash flow and financial operations. Any weakness in your financial controls leaves the door open for outside attackers or malicious internal actors to exploit. For example, inadequate approval processes within your internal control over financial reporting might lead to vulnerabilities, such as falling victim to a business email compromise or inadvertently issuing payments to bogus vendors. 

How To Identify Internal Control Weaknesses

Here are the steps to help you identify internal control weaknesses: 

Conduct a thorough risk assessment

You should conduct thorough, regular (say, once a year) risk assessments for all your internal control procedures. Identify the most probable incident-prone parts in your company.

When you examine each risk, add columns to indicate which new risks could arise from material weaknesses or significant IT deficiencies, who is in charge of that particular process, who inspected it, solutions, and when the responsible person took action.

Document and analyze internal control procedures

Catalog all the necessary operating procedures in your company that might affect your business model. These procedures include cash reconciliation, accounts payable, and stock and asset inventories. For example, your accounts payable analysis will ensure that your organization’s payments to your suppliers are accurate when reconciled externally with bank statements and receipts.

Conduct regular audits

Risk assessments are often created by the individuals executing the internal controls, and you can never guarantee that those people act objectively or competently. Hence, it’s essential to have an independent third party occasionally audit your controls to assess whether they are appropriately designed and working effectively.

Listen to stakeholder feedback

Examine customer and stakeholder feedback to determine whether they have common complaints, such as internal control breaches. For example, if customers identify the exact product failure, such as a button that’s not working correctly, you can work backward through your organization’s processes to uncover the issue.

How to correct internal control weaknesses

Managing internal control weaknesses is essential for safeguarding your company’s integrity and assets. Fortunately, you can implement continuous control monitoring, blended with machine learning techniques, to provide real-time insights into new vulnerabilities. Here are some steps to correct identified weaknesses:

1. Strengthen Preventive Controls: Focus on bolstering preventive controls like thorough documentation, authorization practices, and segregation of duties. For example, ensure no single person has the authority to authorize, record, and maintain a financial transaction and its corresponding assets.
2. Audit Procedures: You must integrate internal audit procedures into your ongoing activities. Integrating these detective, preventive, and corrective measures helps your internal control review the effectiveness of your internal controls on a timely basis.
3. Implement Corrective Measures: When detective controls reveal an issue, take swift corrective action. This might involve disciplinary actions, software patches or modifications, or the establishment of new policies to prevent similar occurrences in the future.

Managing internal control weaknesses is a dynamic process that requires continuous improvement and adaptation to evolving threats. You can fortify your company’s defenses against potential risks by addressing weaknesses promptly and effectively.

Manage Internal Control Weaknesses with ZenRisk

Identifying and rectifying internal control weaknesses can seem overwhelming. ZenRisk, with its comprehensive platform for risk management, can make it easy to stay on top of your internal controls.

The ZenRisk Platform allows for a single source of truth for all your internal controls, risk assessments, remediation of weak internal controls, tests of controls, and so forth. That evidence becomes invaluable as you seek to improve your internal control system or want to pass an external audit as efficiently as possible.

To understand how to put a rigorous risk management solution for your internal controls in place for your organization, schedule a demo with ZenRisk today.