Notes

In financial reporting, Internal Controls are the measures that an organization implements to conduct business in a precise, and effective manner. See the limits of internal controls in the effects of human error on the system, and the cost-benefit principle used in business.
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.

Look back at the nursery example from above. Since I cleaned the windows of the greenhouses and left a filmy covering on them, I caused the company to lose several plants due to lack of 100% light saturation. In an attempt to keep this from happening again, the owner of the nursery, Mr. Treewillow, decides to hire a professional window cleaning crew to come in and clean the windows every day. He figures that by adding this internal control procedure, it will help eliminate the loss of plants in the greenhouses. The cost of this service is $500 a week. In a year, that cost will a total of $26,000.

If the plants that are being started in the greenhouses end up bringing in an average of $25,000 per year, does it make sense for Mr. Treewillow to hire the professional crew? Absolutely not. A better idea would be for him to rewrite the specific window washing guideline and specify what cleaner is to be used and the manner in which the windows should be cleaned. This is a more cost-effective way to attempt to ensure that the plants are getting the light they need to grow.

Lesson Summary
Internal controls are procedures that are put into place within an organization to ensure business is carried out in an orderly, effective and accurate manner. No matter how well a business owner thinks that the internal controls in place in his business are effective, there are always limitations to what they can do.

Two specific limitations are human error and the cost-benefit principle. Human error, which is simply defined as an undesirable outcome that is the result of a decision made by an individual, comes in two forms: 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.

The cost-benefit principle refers to the idea that the cost of implementing a certain internal control procedure must not outweigh the benefit that the company receives from that procedure. If the cost does outweigh the benefit, then there is no point in implementing that internal control procedure. There's no doubt that internal controls are significant, necessary and important parts of a business. Even so, you must always keep in mind that no matter how well-designed an internal control system may be, there will always be limitations on how well that system performs.