Internal controls are established to guard against losses resulting from employees' oversights and fraud. When an entrepreneur starts his business, he/she performs most, if not all of the tasks necessary to generate sales and operate the company. Very often, he is aided by a family member or a good friend who devotes time and energy as a courtesy. As an entrepreneur, you now come to the realization that it is impossible to handle all tasks, duties and functions including performing the work, developing and selling the product or service, managing the business and handling daily administrative and support tasks.
As you grow your company, you probably hire an employee or two, who is an outsider. It is at this point that the employee performs many of the tasks that you did, but this new person leaves you and the company vulnerable to errors, fraud and oversights.
This is when you should begin to think of internal controls and internal control systems. Often entrepreneurs think of internal controls as a requirement for big business. This thought is compounded by the press coverage of corporate bankruptcies that often result from financial fraud and highly leveraged derivative investments. A recent example is the collapse of Drexel Burnham Lambert as a result of too much control and autonomy in the hands of a few executives.
Internal controls are essentially checks and balances within a company. Their objective is to prevent fraud, limit financial losses and reduce errors and omissions on the part of key employees.
Internal controls involve organization, your company's operations to segregate duties and limit any one person's control over an entire area, in particular, the flow of cash.
In larger companies, accounting responsibilities are divided amongst several individuals, i.e., one person opens the mail and lists all of the checks on the deposit slips and a different person enters the cash receipts in the company's financial records.
Another sensitive area is accounts payable: payment to suppliers and vendors should be handled by an individual who does not handle the checkbook and is not responsible for purchasing. As noted above, dividing responsibilities is very different from the sole proprietor who is growing his business and moves from handling almost all of the tasks by himself or with the aid of a family member. The transition from sole proprietor to one trusted employee and then on to several trusted employees, requires the design and implementation of an internal control system.