Importance of Internal Control Systems
In different times, the world has seen many companies falling and closing operations. This could have been prevented if effective internal control systems existed in the companies. An internal control system ensures that directors, operating officers, and employees perform their duties according to company guidelines laws of incorporation. The system ensures that proper business operations are conducted within a company. The board of directors can act as an internal control system of an organization. When the board fails to function effectively as an internal control system, the company is bound to collapse. This paper critically discusses how the board of directors should function under an effective internal control system and conditions under which the board can fail due to failure of internal control systems.
How the Board of Directors Should Function under Effective Control Systems
The board of directors, among its various roles, establishes accountability for the company management as well as assuring rational internal controls via independent third-party evaluations of a company. While boards should look for members who can offer a variety of competent views according to their expertise and experience, members must be conversant in accounting and finance (Stehnei et al., 2017, pp.216). This knowledge is critical to ensure that auditing is done right. An internal control system is a system that ensures directors, operating officers, and employees perform their responsibilities according to laws of incorporation (Alam et al., 2019). The system ensures that proper business operations are conducted within a company.
In an effective internal control system, the board governing an organization strengthens a company management to prepare for risks concerning management as well as oversee the performance of duties by executive managers. This means that the board, as an internal control system, functions to ensure that laws and regulations are followed in every activity in the company (Admati, 2021, pp.680). If a company compensates employees in the company, it is proper that laws, regulations, and the Articles of Incorporation are followed. If that does not happen, then the internal control system has failed (Wang, 2019). The board can fail by allowing activities in a company that is not according to the laws, regulations, and the Articles of Incorporation.
Examples of Failure of Internal Control System
Controls in a company refer to the guidelines as well as procedures determined by management to guarantee that risks recognized during risk evaluation procedure are prevented or handled to an ideal level. When internal controls fail, it results in issues like misuse of company assets, embezzlement, and business interruption, according to Blythe (2021, p.875). Detection controls refers to a type of internal controls that help prevent issues like misusing company funds. The system is created in a manner that any transaction is recorded and can be reviewed later. So, if such a system does not function well or is manipulated by individuals to commit fraud, then it is said that the internal controls have failed to deliver on their duty. For instance, a chief executive officer can manipulate the system to award compensation package that is more than allowed.
Fraud in an organization happens when there are limitations in the audit, which can lead to the board of directors’ failure as an internal control system, for example, in Refco. Auditors are responsible for evaluating an organization’s fiscal reports (Kamil & Ahmed, 2020). Many of the audit processes are targeted towards material facts as well as correcting material faults. Materiality refers to a flaw in internal controls over fiscal statements that impact decisions as well as stakeholders’ profitability. Therefore, auditing detects trades plus controls at the material phase.
Insufficiency in volatility during auditing leads to the board of directors’ failure as an internal control system, for example, in Hypo Real Estate. The auditors are known for maintaining consistency in the methods they use. They focus on particular thresholds of controls as well as the transactions happening. This makes the process predictable as employees usually know the scope of the audit and the present loopholes. Even though the addition of surprise is an excellent way of detecting fraud, auditors seldom use it.
The board of directors fails when the sampling is insufficient to capture the entirety of the situation. Sampling is extensively utilized for checking issues with transactions during auditing (Abidin, 2017). The individuals responsible gather transaction data to check whether they were accurately documented and the availability of internal controls (Monks & Minow, 2016). An inherent limitation of the process is that every transaction is not tested. Thus, coming up with a high possibility that fraud is not noticed in the data and thus goes unnoticed. Auditors must utilize sufficient sampling in capturing their activities.
Cyber security attacks that affect organizations lead the board of directors to fail as an internal control system. The attacks lead to the loss of information that is crucial in understanding the operations going on in the organization Vergne et al. (2018, p. 810). The loss ensures that the board has little or limited information to positively affect the organization. For instance, the case of an executive manager receiving too much compensation can fail to be prevented if the detection controls fails to record the transaction. To avoid such issues in the future, organizations must empower the Information Technology (I.T) Security departments to ensure that an organization’s data assets are protected.
Examples of Large Corporations
In the history of business, there are many large corporations that collapsed as a result of the board of directors failing to control them, for example, the notable cases being the Enron, Arthur Andersen, and Lehman brothers. In 2001, Enron was discovered to report one hundred billion dollars in revenue via systematic and institutional accounting scam (Brickley et al., 2016). After the scandal, Andersen’s performance as well as alleged involvement as an auditor came under immense scrutiny Silvia & Ramona (2019, p. 155). The Powers Committee concluded that the proof presented to them shows that Andersen failed to fulfil its professional duties in relation to the audit of Enron’s financial reports, or its duty to bring to present to the company’s board worries concerning the company’s internal contracts over the associated-party dealings.
Andersen, in the middle of 2002, was convicted for obstructing justice after proof was found of shredding documents that contained information connected to the audit of Enron. Even though the court overturned the conviction, the effect of the scandal plus the discovery of criminal involvement eventually destroyed the company Blythe (2021, p.876). Nancy Temple and David Duncan were found responsible in this controversy as they worked as managers in the legal and account departments respectively and ordered employees below them to shred paper documents.
Due to the US Securities and Exchange Commission’s refusal to accept audits by convicted individuals, the company agreed to surrender its CPA licenses as well as rights to work to the SEC two months later. This meant that the company could no longer be in business. By this time, it had begun reducing its operations in the US after indictment as well as many of its employees applied to work with other companies. The company sold majority of its operations to Deloitte & Touche, KPMG and Grant Thornton LLP. The impact of the scandal to the reputation of the company was felt in the company’s global operations.
In the 2001 scandal of Enron, it is important to note a few points as to how it came to being. The leadership of the company fooled the regulators with false holdings as well as off-the-books accounting activities. Apart from that, the company utilized special purpose entities or the special purposes vehicles to keep the huge debts it was experiencing as a secret from the investors and creditors Silvia & Ramona (2019, p. 157). The price of its shares went from ninety dollars and seventy-five cents at its peak to twenty-six cents at bankruptcy. It paid its creditors more than twenty one billion dollars from 2004 to 2011. Failure by the board of directors in the organization to handle operations resulted in this scandal that is remembered as one of the worst in the history of financing. Many schools are even teaching using the company as a cases study.
In 2008, the Lehman Brothers was faced with bankruptcy and was widely viewed as the climax of mortgage crisis. After the company was informed about a pending credit downgrade because of its heavy position in subprime mortgages, several banks were summoned to discuss funding its reorganization. The negotiations did not succeed, and Lehman filed for bankruptcy which caused four and a half percent single-day depreciation in the Dow Jones Industrial Average. It indicated a limitation in the government’s capacity to manage the crisis as well as prompted an overall panic (Banks, 2004). One of the key sources of credit, money market mutual funds, saw many withdrawal demands to escape losses as well as the interbank lending market became tighter. This threatened the state of banks all over the country as they feared impending failure.
Five Consequences of Overpaying C.E.O.s
Overpaying chief executive officers can lead to much debt on the part of the company. For instance, in the paper, we had seen that some companies failed land stopped operations or existed as before because the C.E.O.s in the companies received excessive compensation. An example of such a company is Hypo Real Estate in Germany (MacDonald & Hughes, 2017). The debts keep on increasing to the point that the company can no longer operate normally. Employees have to seek jobs elsewhere because they cannot receive payment for their work at the organization.
Another consequence is the bad vibes created due to the salary imbalance between top managers and people who work for them. One of the reasons Schlecker Retail Company failed is the decreasing talent pool in the organization (Edmans et al., 2017). The most experienced employees felt that they deserved more than what they were getting. The company’s top managers received more compensation at the employees’ expense, which made them leave. After the departure of several key employees at the different departments, auditing became an issue, and the company collapsed.
Another consequence of overpaying C.E.O.s is bringing up leaders in an organization focused on occupying the top positions for the wrong ideas. Any individual in the organization is supposed to focus on the company’s goals and how they can help the company take another step. Huge compensation clouds many from realizing that their priority at work should be the company, leading to decreased profits, such as the Banco Espírito Santo in 2014.
Overpayment of the C.E.O.s in large corporations also creates a bad reputation. In recent times, the world has experienced a pandemic that has led to many individuals losing their jobs while many others are experiencing economic hardships (Picone et al., 2021). The number of homeless people around the world has increased. So, the idea of some individuals receiving huge compensations while people who work for them or those who sell their products suffer does not sit well with many (Jiang et al., 2021, pp.1032). This is not good for the companies since it impacts how people also perceive their products in the market (Schulz & Flickinger, 2020, pp.911. Like Microsoft, most of the big companies’ top managers in the U.S. had to re-evaluate their payments over the years. Apart from a bad reputation, overpayment of C.E.O.s can also lead to companies failing to adequately impress the shareholders (Constantinescu and Kaptein, 2019, pp.125). For instance, the excessive money paid can be given to shareholders. An issue like that can make the shareholders decide to cut short their partnership with the company, for example, in the case of Refco.
Meaning of Excessive Compensation
Identifying how much salary or compensation should be deemed excessive is not easy. However, according to (Aguinis et al., 2018), compensation should be deemed excessive if it is twenty percent above the national average chief executive officer salary. There is an upward trend in the U.S. to recruit and retain corporate chief executive officers by providing exaggerated pay packages. The trend has led to changing the relationship between stakeholders and the C.E.O.s (Aguinis et al., 2018). Whereas the free market society can avail reasonable facts for the rise in wages, the vast majority of information concludes that the effect on society is unfavourable. It is one of the reasons why the C.E.O.s are recording more cases of corruption.
In the paper, the meaning of internal control systems is evident and how the board governing an organization can act as one and ensure the proper running of a company. Through the use of practical examples, I have shared how in different times, companies have collapsed because the board in those companies failed to function effectively to provide internal controls against occurrences such as fraud, overpayment of executive managers, misappropriation of company assets, and embezzlement. I have also looked at the issue of overpayment since it impacts many companies even now in the United States. Many companies are still overpaying chief executive officers in an attempt to retain their services, which has an impact on the performance of those companies and society. While the C.E.O.s receives huge paydays, the common employees receive much less regardless of experience in the company, which causes disgruntlement in the company.
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