Limitations of Internal Control in Financial Reporting

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  • 0:01 Internal Control Defined
  • 1:00 Human Error
  • 3:04 Cost-Benefit Principle
  • 4:33 Lesson Summary
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Lesson Transcript
Instructor: Rebekiah Hill

Rebekiah has taught college accounting and has a master's in both management and business.

Internal controls are a vital part of the operation of a business. In this lesson, we will discuss what internal controls are and some of the limitations of internal controls.

Internal Control Defined

I love to cook. Every weekend, you can find me in the kitchen with my cookbook open, whipping up new and exciting meals. I follow the recipes most of the time, but sometimes I think that there are changes that just need to be made. For example, my recipe may tell me to mix a cake for three minutes. However, I think that the batter looks good and smooth after two minutes, so I quit mixing. I still expect my final product to look just like the picture in the recipe. And let me tell you, that doesn't always happen.

That reminds me of the concepts that we're going to discuss today: limitations on internal controls. First of all, let's start with defining what exactly internal controls are. Internal controls are procedures that are put in place within an organization to ensure business is carried out in an orderly, effective and accurate manner. Most of the time, these procedures are put into writing so that everyone can clearly see what the internal control protocols are. However, even with the best of plans, there are limitations on internal control.

Human Error

One major factor that is an important part of an internal control system is the human element. Along with that component comes human error. Human error is an undesirable outcome that is the result of a decision made by an individual. There are two types of human error: intentional and unintentional. Intentional human error is human error that is the result of planned actions. Unintentional human error is human error that is the result of honest mistakes and are not planned actions.

For example, let's say that you and I work in a plant nursery. Part of the internal control guidelines states that the windows in the greenhouse must be cleaned daily so that the plants can get the correct amount of sunlight. You may choose to use old newspaper and a vinegar and water based spray, while I may choose to use regular, store-bought cleaner and paper towels. We both cleaned the windows, but we didn't do it in the same way.

Now, here is where we get to talk about the human error part. Your choice to use a simple homemade solution for window cleaning left the windows clean and shiny, but when I washed the windows, they had a filmy look. The film left on the windows kept the plants from getting all the sunlight they needed, and they started turning brown. This is not at all what the internal control protocols called for. As a matter of fact, it's what they were trying to keep from happening. I didn't purposely leave a film on the windows, but my interpretation of the way the windows should be washed did end up causing damage to the plants. This was an unintentional error.

Now, what if I had deliberately planned to use a cleanser that I knew would leave the film on the windows? If that was the case, then the type of error goes from unintentional to intentional. As you can see from this example, unintentional errors are oftentimes the direct result of how internal control guidelines are interpreted by each individual.

Cost-Benefit Principle

Now let's look at another type of limitation that exists for internal controls. It revolves around a concept called the cost-benefit principle. In a nutshell, the cost-benefit principle, in relation to internal control, means that the cost of implementing a certain internal control procedure must not outweigh the benefit that the company receives from the procedure.

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