Principles of Control Activities - Online Tutor, Practice Problems & Exam Prep

The COSO framework outlines essential principles of internal control activities, crucial for effective management. Key principles include the establishment of responsibility, ensuring one person is accountable for tasks, and separation of duties to mitigate fraud risks. Documentation procedures, physical controls, independent internal verification, and human resource controls, such as bonding and mandatory vacations, further enhance security. These measures collectively aim to prevent fraud and ensure accurate financial reporting, aligning with accounting standards and practices.

Principles of Control Activities

The COSO framework also defines principles of control activities. The control activities, remember that's one of the components of internal controls. Well, this is the big chunk. This is where most of our stuff happens for internal controls. These are the procedures we put in place, the policies. This is where we're actually having our internal controls function. Let's check this out in a little more detail. So remember, the control activities, these are the foundation of the internal control efforts of the company. Right? So let's talk about the 6 principles that the COSO framework, the framework that defines how to make effective internal controls. Well, let's discuss what those principles are.

The first one is the establishment of responsibility. Okay. So for any task, there should only be one person responsible for a given task. Okay? That way we know who was responsible. It can't be like, oh, you know, who counted the cash in that register? Well, there was one person who was responsible for that task, right? They were assigned that task, they were supposed to count the cash, so if there is any misstatement in that cash register, we know whose responsibility it was. Okay? So that one's pretty easy. Let's go on to the next one, the separation of duties. Separation of duties, this is one of the biggest topics in internal controls that they love to talk about, and this is to make sure that more than one person is necessary to complete a task, right? So notice that the establishment of responsibility is that each person has their own specific job, right?

But when we think of a whole big task like purchasing inventory or something, right, each little portion of that big idea of purchasing inventory, well each of those needs to be separated to a different person, okay? So let's think about an example here. There's going to be 1 employee who purchases goods, not purchases, orders the goods, sorry. There's one employee that orders the goods, verifies the receipt of the goods, and pays the supplier. So think of a situation where there's a company that has one person that does all of these tasks, okay? They call a supplier and order the goods, they get the goods, they verify that they got there and then they pay the supplier as well.

This is a huge risk in internal controls, let's see why. So what could be possible fraud? Well, when the employee makes the orders, right, the employee could order from a particular supplier because they are friends. Right? He might just pick hey, you know, me and this guy go way back, I'm going to order from him, you know, regardless of the price or the quality. Right? When we think about the company, the company would be very objective and pick the best supplier for them based on price and quality factors such as that, not just like oh, we're on friendly terms with this guy. I'm gonna order from him anyway. So that's not good, right? That's not making the best decision for the company.

How about another one? Well, the company may pay false or inaccurate invoices because the invoices are not verified outside of this person, right? So this person could just order, you know, fake goods, they could just write up an inventory, they're the ones who verify the receipt. They could say, yeah, that stuff got here, right? Yeah, yeah, yeah, and they can pay basically themselves. They can make an account, a fake invoice in the system, and pay themselves, right, because there's nobody outside verifying this information or the employee could just steal straight-up. The employee could just steal the goods from the company, right? They're in charge of all of the processes related to inventory. There's nobody who is going to be able to stop them. Okay? So what's a possible solution? Well, we have obviously separation of duties, right? Separation of duties. Okay? And to do that, we hire 3 employees, or we have 3 employees, each one responsible for one of these tasks, right? So we would have one employee who orders the goods, right? So to be able to place that order they would have to have the verification that this is the supplier we want to order from and then there's another separate employee who's receiving the goods and that separate employee makes sure that the order matches with the received goods, right? So now they have a they're separate from the first person, so the first person couldn't just fake an order, right, because there's another person who's going to verify that order and then there's the last person who's paying the supplier, right? So notice how there's all this separation that makes sure that one person can't just steal from the company. Right? So the separation of duties, that's a huge part of our internal controls.

So let's go on to the rest of these principles of our control activities. They're all pretty simple, so we can kind of just go on pretty quickly. Documentation procedures. So we might have talked about this already about using pre-numbered documents, right, to make sure that all documents are accounted for. So a very good example, this is using checks that are numbered, so you might have check 101, 102, 103, 104, 105, right? So if you look in your checkbook and you see or you look in the records and you see and maybe that was a voided check, right, what could have been the issue with check 103, or maybe the accountant, right, wrote the check to his own personal bank account and then didn't put it in the records, but this pre-numbered make sure that our records are complete. Right? So pretty simple documentation procedures.

Physical controls are pretty easy as well. So physical controls, this is literally locking the door. Locking the door. Having a safe for cash, right? A password. Anything that's physically keeping people out, right? Okay. So pretty easy. Independent internal verification. So this is basically some sort of internal auditing procedure where a separate employee periodically checks another employee's work, right, just to make sure that everything is going all right and usually you want to do this kind of like on a surprise basis, right, where they just like, okay, today's your check, They walk in and they check your stuff, so you can't really prepare or hide stuff if you were committing fraud. Right? So remember, all of these activities, everything we're talking about is to help prevent fraud.

And last is human resource controls, right? So the HR department could also have controls like bonding. So bonding employees, this isn't some sort of fetish thing, no. Bonding, this has to do with insuring employees who handle cash. Okay. So any employee who handles cash, you get insurance for them just in case they steal cash, well you're insured against it. Another benefit of this bonding is that the insurance company is going to do some sort of background check to make sure that the employee is, you know, worth insuring for them. So that gives a little extra security. Next, this one's really interesting is mandatory vacations. This is a really cool one. Mandatory vacations are good because it's usually when an employee is on vacation that fraud is discovered. Think about it, they're at work all the time and they're committing fraud, maybe they're siphoning money out of the company's bank account. Well, nobody's really checking on what they're doing until they leave on vacation and someone does their job for them, right? Now someone comes in and does their job and they're like, hey, something looks weird here and they get caught out. It's actually very true that a lot of fraud gets discovered while the employee is on vacation, so a mandatory vacation that's going to help discover fraud. Last is background checks, right? Obviously, there's an obvious advantage to doing a background check before you hire an employee. You're going to hire more honest people when they have a clean record. Cool? Alright. So that's about it here. Let's go ahead and move on to the next video.

Here’s what students ask on this topic:

What are the six principles of control activities according to the COSO framework?

The six principles of control activities according to the COSO framework are:

1. Establishment of Responsibility: Assigning specific tasks to individual employees to ensure accountability.

2. Separation of Duties: Dividing responsibilities among different employees to reduce the risk of errors and fraud.

3. Documentation Procedures: Using pre-numbered documents and maintaining proper records to ensure all transactions are accounted for.

4. Physical Controls: Implementing physical measures like locks, safes, and passwords to protect assets.

5. Independent Internal Verification: Periodically checking the work of employees by an independent person to ensure accuracy and compliance.

6. Human Resource Controls: Implementing HR policies like bonding, mandatory vacations, and background checks to ensure the integrity of employees.

Why is the separation of duties important in internal controls?

Separation of duties is crucial in internal controls because it helps to prevent fraud and errors. By dividing responsibilities among different employees, no single person has control over all aspects of a critical task. For example, in purchasing inventory, one employee orders the goods, another verifies receipt, and a third pays the supplier. This division ensures that one person cannot manipulate the process for personal gain, such as ordering from a friend or creating fake invoices. It also makes it easier to detect discrepancies and hold individuals accountable for their specific roles.

How do documentation procedures enhance internal controls?

Documentation procedures enhance internal controls by ensuring that all transactions are properly recorded and accounted for. Using pre-numbered documents, such as checks, helps track each transaction and identify any missing or unauthorized entries. This systematic approach makes it easier to detect errors, prevent fraud, and maintain accurate financial records. Proper documentation also provides a clear audit trail, which is essential for verifying the accuracy and completeness of financial statements.

What role do physical controls play in internal control activities?

Physical controls play a vital role in internal control activities by safeguarding assets and sensitive information. These controls include measures like locking doors, using safes for cash, and implementing password protection for computer systems. By restricting physical access to assets and data, physical controls help prevent unauthorized use, theft, and damage. They are a fundamental aspect of a company's overall security strategy, ensuring that only authorized personnel can access critical resources.

What is the purpose of independent internal verification in internal controls?

Independent internal verification aims to ensure the accuracy and reliability of a company's financial records. This process involves having an independent person periodically review and verify the work of other employees. By conducting these checks, often on a surprise basis, companies can detect and correct errors, prevent fraud, and ensure compliance with policies and procedures. Independent internal verification adds an extra layer of oversight, enhancing the overall effectiveness of the internal control system.