Internal

Control
Dian Kusuma Wardhani 041924253006
Istiqomah 041924253016
 FRAMEWORKS
“A body of guiding principles that form a template against
which organizations can evaluate a multitude of business
practices”

• Internal Control – Integrated Framework, issued by COSO

• Guidance on Control by Canadian Institute of Chartered Accountants• Guidance on Risk Management, Internal Control and Related Financial
(CICA) and Business Reporting by Financial Reporting Council
DEFINITION
• . . . a process, effected by an entity’s board of directors, management, and other personnel, designed to provide reasonable
assurance regarding the achievement of objectives relating to operations, reporting, and compliance. (COSO)
THE OBJECTIVES, COMPONENTS, AND PRINCIPLES OF
INTERNAL CONTROL
 INTERNAL CONTROL ROLES AND RESPONSIBILITIES

Management The CEO assumes primary responsibility for the system of internal controls.
Board of Directors The board of directors oversees management, provides direction regarding
internal control, and ultimately has responsibility for overseeing the system of internal controls.
Internal Auditors While management, under the leadership of the CEO, has ultimate
responsibility for the adequate design and effective operation of the system of internal controls,
internal auditors play a significant role inverifying that management has met its responsibility.
Other Personnel
 LIMITATIONS OF INTERNAL CONTROL
Internal control is implemented to mitigate risks that threaten the achievement of an organization’s
objectives or to enable an organization to successfully pursue opportunities. Internal control
cannot prevent bad judgments or decisions, or external events that can cause an organization to
fail to achieve its operational goals. In other words, even an effective system of internal control
can experience a failure. Limitations may result from the:

■ Suitability of objectives established as a precondition to internal control.

■ Reality that human judgment in decision-making can be faulty and subject to bias.
■ Breakdowns that can occur because of human failures such as simple errors.
■ Ability of management to override internal control.
■ Ability of management, other personnel, and/or third parties to circumvent controls through
collusion.
■ External events beyond the organization’s control.
 Inherent Risk, Controllable Risk, and Residual Risk

Inherent Risk
The combination of internal and external risk factors in their pure, uncontrolled state, or the gross risk
that exists assuming there are no internal controls in place.

Controllable Risk
The portion of inherent risk that management can reduce through day-to-day operations and
management activities.

Residual Risk
The portion of inherent risk that remains after management executes its risk responses (sometimes
referred to as net risk).
 VIEWING INTERNAL CONTROL FROM DIFFERENT
PERSPECTIVES
Management
From management’s perspective, internal control includes a number of activities designed to
mitigate risks or enable opportunities that affect the achievement of an organization’s objectives.

Internal Auditors
Whereas management is responsible for the system of internal controls itself, internal auditors
are charged with independently verifying that theorganization’s controls are designed
adequately and operating effectively as management intends.
Independent Outside Auditors
The primary responsibility of an organization’s independent outside auditors is to attest to the
fairness of the financial statements and, in certain countries, the effectiveness of internal control
over financial reporting.
Other External Parties
External parties that have an interest in an organization’s internal control include legislators,
regulators, investors, and creditors.
 TYPES OF CONTROLS
Entity-Level, Process-Level, and Transaction-Level Controls
Entity-Level Control
Process-Level Control
Transaction-Level Control
Key Controls and Secondary Controls
Key Control
Secondary Control
Compensating Controls
Compensating Control
Preventive and Detective Controls
A preventive control
A detective control
Information Systems (Technology) Controls
General computing controls
Application controls
Internal Control in Accounting Research:
A Review and Future Research Agenda
Chalmers dkk. (2019)
 ANALYSIS OF BACKGROUND

 The purpose
The purpose of this study is to synthesize previous literature related to internal
control published in 2013 - 2016 globally and to fill in the weaknesses of
previous research so that it has implications for policy making, managers,
creditors and auditors.
 Contribution
This research is contributed in several ways. First, it shows research updates
related to internal control published during 2013 - 2016 in the US. Second,
broaden the scope of research related to IC quality in non-US countries. Third,
synthesizing IC literature with a focus on audit results in order to provide
benefits to stakeholders.
 PREVIOUS RESEARCH

 Schneider, Gramling, Hermanson & Ye (2009) conducted observations in the US during 2005 - mid 2009 and
showed that weaker ICs were associated with smaller, riskier and more complex firms. Weaker ICs were also
associated with independence, weaker board and audit committee expertise, increased financial costs, less accurate
revenue estimates, and higher audit fees.
 Kinney, Martin & Shephardson (2013) examined how internal control inspection requirements affect audit
results.
 Asare, Fitzgerald, Graham, Joe, Negangard & Wolfe (2013) suggest auditors to do more testing when the client
has deficiencies in IC with manifestations in higher audit costs and delays.
 Bedard and Graham (2014), conducted observations in Canada, the Netherlands and Japan. Their results suggest
that IC-related problems are more likely to occur in smaller, financially challenged firms. Their findings also
suggest that auditor affiliation and audit quality affect IC quality and reporting, and that effective IC is associated
with lower capital costs.
 Coates and Srinivasan (2015) reviewed a decade of post-SOX US literature on IC from accounting, finance and
legal disciplines and concluded that SOX has provided financial reporting benefits, but the contribution of research
on social practice remains inconclusive.
 DATA ANALYSIS

Researchers synthesized 60 US articles published during 2013-2016 and 34 non-US articles. Based on
the review of 94, the researchers managed to find:
• the theoretical underpinnings of IC research;
• the main proxies and approaches used in the accounting and auditing literature to measure IC quality;
• a summary of the main empirical findings;
• and some problems to be investigated in future research.

In discussing these points, this study categorizes articles into two categories, namely determinants and
consequences of IC quality. the first category focuses on the characteristics of board and board
subcommittees, ownership structure, internal audit characteristics, other corporate structural
characteristics, external audit-related variables, national culture, and the regulatory and market
environment. The second category discusses the impact of IC quality on the decisions of managers,
creditors, investors, auditors, financial analysts and other stakeholders.
 RESEARCH RESULTS AND DISCUSSION
Category 1 Determinants: Internal
• Board characteristics
Consistent with previous research, IC quality is positively related to board composition consistent with good
governance practices. The results of research on audit committees and IC are also consistent, and support the
view that positive aspects of audit committees (such as expertise or independence) are associated with higher
IC quality. The literature on CEO characteristics is more diverse as is the emerging literature on the influence
of female directors on IC quality.
• Ownership structure
They document that ownership concentration has a negative effect on this disclosure. The general evidence is
that ownership concentration is associated with weaker IC quality, whereas results of family ownership are
mixed.
• Internal auditors
They document that improved internal audit quality is associated with decreased IC failure and persistence of
deficiency and thus higher IC quality. That better internal audit is associated with better IC quality.
• Other company structural variables
Chen & Keung (2016) show that firm diversification is positively related to the possibility of IC weakness.
Ekternal
a. Audit-related variables
The overall results generally support a relationship between higher audit quality and IC quality. Higher
IC quality is associated with proximity, tenure, IT expertise.
b. Financial analyst
Mao and Yu, 2015 documented that after cash flow forecasts made by company analysts reported less IC
weakness under SOX 404 implying that company management was motivated to improve the quality of
their ICs in order to attract investors.
c. National culture
Managers operating in countries with high levels of individualism are more concerned with their own
interests than shareholder wealth and stakeholder requirements, and they are more likely to use
discretionary measures to serve their own interests. Hooghiemstra, Hermes, & Emanuels (2015) found
that individualism (uncertainty avoidance) has a positive (negative) effect on voluntary IC disclosure.
d. Regulation and markets
When examining the moderating effect of state ownership, they provide evidence that such an
association remains significant only for companies that are not state-owned. Thus, the theoretical and
empirical relationships between market product competition and IC quality, and the factors that mitigate
this relationship, remain open to further research.
 Category 2 Economic consequences of IC quality
1. IC quality and management decisions
IC quality can influence management behavior through the magnitude of discretionary accruals, earnings conservatism, and the accuracy of
management forecasts. The existence of material deficiencies in the company's IC system implies inadequate control over financial reporting which
translates into a significant risk of intentional and / or unintentional material anomalies in the financial statements (AICPA, 1995; Doyle, Ge, &
McVay, 2007a).
2. IC quality
change of management and executive compensation Lower IC quality can adversely affect management status within the firm through higher
turnover (e.g., Johnstone, Li, & Rupley, 2011; Li et al., 2010) and reduced compensation (e.g., Hoitash, Hoitash, & Johnstone , 2012; Hsu & Liao,
2012).
3. IC quality and debt market
Low IC quality can also have a negative impact on creditors' lending decisions. Schneider & Church (2008) posits that the adverse opinion on IC
indicates concerns about the reliability of financial data and increases the uncertainty associated with loan applicants, thus impacting credit risk
assessments.
4. IC quality and equity market
The quality of IC is also believed to affect investors' perceptions of risk. For example, when a company's IC system has weaknesses, the quality and
accuracy of its accounting signals is compromised (Ashbaugh-Skaife, Collins, Kinney, & LaFond, 2009).
5. Quality of IC and auditors
IC quality is expected to affect the performance of external auditors as indicated by the audit fees and audit report delays. IC deficiency detection
heightens audit risk, requiring more audit testing through an approach that strengthens and enhances the scope and effort of the audit.
6. Quality of IC and financial analysts
Financial analysts rely heavily on corporate financial information to form their earnings estimates (Clinton, Pinello, & AshbaughSkaife, 2014; Xu
& Tang, 2012). Low IC quality can jeopardize the reliability of financial information through noise recognition, because lack of proper supervision,
or proper documentation increases the likelihood of unintentional errors in the accounting cycle that bias earnings quality (Clinton et al., 2014).
7. Quality of IC and other stakeholders
Customers represent important stakeholders with whom the company has an implicit contract (Su, Zhao, & Zhou, 2014). The willingness of
customers to buy from the company is influenced by their perceptions of the company's ability and incentives to fulfill implied commitments
(Maksimovic & Titman, 1991).
 LIMITATION OF PREVIOUS RESEARCH

• Previous studies have often measured IC quality as a dichotomous variable with 1 being the disclosure of IC
deficiency and 0 otherwise. According to Oh et al. (2014, p. 413) "This approach does not fully address the effect
of the level of regulation on the quality of accounting information, and only produces partial evidence of the
benefits of having strong internal controls on the quality of accounting information".
• The use of the disclosure index (content analysis) to measure the disclosure / quality of IC also experiences
limitations.
• Survey methodology has also been used in IC accounting research, especially in developing countries where data
on IC are limited. Surveys of internal auditors or external auditors (Mazza & Azzali, 2015a; Khlif & Samaha,
2014; Khlif & Samaha, 2016) have also been the target of criticism. For example, Bloomfield, Nelson, & Soltes
(2016) state that the responses generated from surveys can be biased by the selection of the sample as well as the
self-selection of respondents to participate.
 IMPLICATIONS

• This research has implications for the accounting and auditing literature in several ways. First, reviews are
informative for policy makers, managers, and researchers. For policymakers, this research sheds light on the
advances in knowledge made possible by new regulated disclosures. In particular, SOX disclosure has led to
evidence-based assessments of the role of the audit committee in improving IC quality. Disclosure under SOX has
resulted in improved decision making due to reduced opacity of information regarding financial reporting quality.
This could inform policymakers outside the US, who may consider or reassess their approach to requiring board
and auditor oversight of IC systems to increase the credibility of corporate reporting policies.
• For managers, this study shows that lower IC quality increases audit delay, which in turn increases reporting delay
and audit costs. Thus, improving IC can improve timely disclosure and reduce audit costs. It is also relevant for
investors, creditors and financial analysts by demonstrating the influence of IC on the cost of finance and the
accuracy of revenue forecasts.
• For researchers, this review is a comprehensive compilation of the IC literature, identifies the direction the IC
literature has taken (eg, the influence of gender on IC quality), and includes suggestions for future research.
 CONCLUSION

The documentation, synthesis, and evaluation of IC accounting research with this

research review offers three main insights. First, there is a mixed effect finding regarding
the relationship between board characteristics (e.g., CEO duality, gender), ownership
structure (e.g., family ownership), and IC quality, while empirical evidence regarding the
effect of audit committee characteristics (financial expertise, number of meetings) on
quality IC supports positive and significant relationships. Second, the existing literature
on the economic consequences of IC quality shows that IC quality can have a significant
influence on the decisions and behavior of management, investors, creditors and auditors.
Third, US studies are predominantly in this research domain. This is expected given the
availability of data in accordance with the enactment of laws that require disclosure of IC
quality.
What are the shortcomings of the article?
Narrative reviews generally have weaknesses related to the results of their generalizations
(Ahmed and Courtis, 1999).

What are the strengths of the article?

This study recommends consolidating the evidence reported in the literature review by
conducting a meta-analysis regarding the determinants and economic consequences of IC
quality when sufficient studies are available using similar proxies in their empirical analysis.

What is the follow-up research topic associated with the article?

Future research could explore the possible interactions between disclosure policy (voluntary
disclosure, timely disclosure, earnings quality) and IC quality in shaping the cost of debt and
the cost of equity capital. In addition, for countries that have adopted IFRS, future empirical
questions may focus on the effect of IC quality on IFRS compliance.
Thank you.