Financial Controls

What Are Financial Controls?

Starting with controls, it's simply power or limit on something or someone to direct in a certain way. Here, the management function involves identifying and checking actions for errors.

When errors are circled, they are to be fixed with appropriate measures. The relevant actions taken will depend upon the type of error. Some of the main controls implemented by various corporations can be:

• The organization can implement preventive controls, the type of control that prevents undesired events from happening. It means that employing preventive controls will defend the system from the effects of unfavorable circumstances.
• That doesn't mean the organization or the system is bulletproof. It might still have some loopholes. Here, the organization can deploy directive controls complementary to preventive controls. Less expensive and less complicated than preventive controls.
• A company can also implement Financial Controls to start developing and deploying methods, policies, procedures, and measures to protect and optimize financial resources.
• Internal Controls ensure that financial statements are free from material misstatements and errors and compliance with GAAP over financial reporting to provide greater transparency and governance over financial, operational, and other risks.

Initially, controls were for the events that had already occurred. A past event. When errors are already made, authorities in modern management have more foreseeing responsibilities.

These risks impede the achievement of the organizational goals and objectives.

For successful businesses, part of managing risk effectively lies in developing and enforcing adequate financial controls.

These controls help protect a company's financial assets and ensure staff complies with policy, procedure, and the law.

Understanding what financial controls are, and investing in tools that can help you create and implement them, will give your company a decisive advantage in:

• Reducing risk
• Ensuring financial responsibility
• Making smart & strategic spending decisions

Understanding Financial Controls

Financial Controls means the procedures and policies by which the management monitors and controls the direction, allocation, and usage of its financial resources"- Law Insider. These are used in strategic management planning.

Different strategies and policies are adopted. According to the guidelines, the resources are divided and allocated. This paves the way for effective and efficient scarce resource allocation.

Financial controls are regular checks of financial statements and processes. These checks ease robust analysis and assessment of the firms' financial system.

The financial statements are examined to identify losses and areas of potential losses and to reduce extravagant expenses. It is essential for cash management, budgeting, and prevention of any fraud or theft. Hence, aiding in monitoring and tracking financial activities to grow and flourish.

It helps a great deal for companies. They ensure compliance with:

• Fiduciary duties
• Corporate governance 
• Due diligence

Financial Controls also assist in mitigating financial risks and meeting financial objectives.

To record, document, report, and analyze the transactions, an organization needs a formal framework, that in financial controls is an essential element and necessary to implement.

Its absence could lead to unfavorable impacts on the budgets, financial statements, operations, and performances.

In another definition, financial controls refer to:

"The systems implemented in place to trace the directed resources of an organization with timely monitoring and measurement."

Financial controls:

• Ensure effective financial management
• To make sure that everyone is aware of the procedures to follow
• Confirm that there is a better understanding of each one's responsibility
• They state those tools and techniques adopted by a concern to control its various finan­cial matters

With the meaning and definition of Financial Controls understood, it's evident that any financial performance is meaningless without the proper means to control and check it.

If a strategy isn't laid out and defined to control the financial performance, management can expect:

• Losses
• Errors
• Misrepresentation
• Misinterpretation
• Frauds

It's important to note that errors point out the competence of the employees. , But misrepresentation and frauds point toward the integrity and dignity of employees and management.

Objectives of Financial Controls

Every measure and technique has a purpose and an objective to fulfill. So, for example, financial control dreams aren't limited to regulated financial performances and records. But also to regulate non-financial activities in the firm.

Such controls are designed and placed effectively and efficiently in the firm at various functions. This installation results in a wide range of benefits. To name a few, improved profitability, productivity, and better utilization of resources.

1. Use of resources

As per the definition of controls under finance, they also aid in coordination. Therefore, coordinating economic and financial activities is a prerequisite for the firm's success.

The aspect where there should be effective and efficient utilization of resources is that these controls come to the rescue.

The firm may have resources in both forms. Tangible and Intangible. Actual being cash, machinery, plants, and equipment. In short, all the assets.

A firm's resources will never be misused with proper bookkeeping, periodic reconciliation, and planning. Since these resources can be subjected to alteration or manipulation.

2. Budget preparation

Budget preparation is an activity that is well-coordinated from the top and executed at every level.

Every department has its budget. All these departments should communicate their goal and objectives to each other to ensure goal congruence.

A formal and strict communication system between these departments acts as a feedback and monitoring tool. The budget also paves the way for performance evaluation through Variance Analysis.

It's a technique that compares the actual results from the budgeted/standard performances.

3. Capital Maintenance

Controls aid the management in making decisions in favor of internal and external stakeholders.

When the goal is to satisfy the shareholder's needs and maximize their wealth, controls help the management to take projects that will optimize the firm's overall ROI and ROR.

Direct, divide, manage, and use financial resources per needs, resulting in increased performance and income.

4. Profit Maximization

When the financial controls are installed in good faith and intention to secure the financial resources and their optimization, the profits are meant to maximize.

This is possible when suitable sources are identified and funds are procured from all the certified sources. And finally, when applied to all the growing ways will maximize profits.

Boost productivity and profitability by streamlining processes across all areas and departments of the business.

5. Business Survival

A sound control system facilitates the optimal use of resources, ensuring a thriving and growing business. In this competitive world, it's not enough to generate profits or even maximize them. The need of the present world is survival and growth.

6. Minimizing the Cost of Capital

Selecting suitable sources of finance will reduce the overall cost of raising capital and additional capital. This will ease the pressure on management to reach the threshold.

7. Ensuring Compliance

A successful company isn't only limited to generating vast amounts of profits and satisfying its financial covenants. A successful and great company also operates under the limits set by respective:

• Federal Laws
• Company and Corporate Laws
• Laws of district and state
• Bylaws
• Article of Incorporation
• Accounting standards and policies
• Financial Reporting standards
• Auditing Standards

Conduct frequent audits and report accurate financial data to guarantee the balance sheet, cash flow statement, and income statement are all free of errors.

8. Detecting Errors and Frauds

The controls should be implemented at all levels of management and operations. This is to protect organizations from the results of irresponsible and unethical acts.

Controls are in place to protect the company from unethical behavior, fraud, and erroneous outcomes. Meet production targets, cut costs, and prevent invoice fraud through on-budget, on-target expenditure. Here are some of the best practices related to Financial Controls. 

Importance of Financial Controls

The importance and need for such controls are:

1. Financial Discipline

Control is placed in departments such as account receivables, accounts payables, purchasing, and sales.

The Board of Directors and the stakeholders can expect order and rule in the areas of:

• Record-keeping
• Authorization
• Custody
• Reporting
• Reconciliation 

2. Communication and Coordination

Just like the strategies and budgeted needs are to be communicated at all levels of management, the control procedures and policies should be displayed and toned at the top.

They are restricting any activity against the interest of the firm. When the commands are communicated, they are to be carried out in coordination for them to be successfully implemented.

Establishing a culture that stands for actual work. With such harmonious relations throughout the organization, the natural fruits of the controls can be observed.

3. Creditworthiness

There are 2 aspects of creditworthiness.

1. One, through an established control structure and policies, a strict collections and receivables environment is assured. When such activities are executed at the correct times, liquidity and solvency positions improve the intended direction. It was given that the controls don't have any loopholes and can address deficiencies.
2. Two, with improved and secure activities/transactions, the confidence of stakeholders increases. This acts as a boost in creditworthiness.

4. Ensuring Fair Return

Optimized operations, cycles, and functions improve the organization's overall profitability position.

All the possibilities of where the resources could have been depleted due to errors or fraud are closed. Such savings can contribute favorably to the firm.

5. Reduction in wastage

Linking back to the part where an organization will be able to utilize resources effectively and efficiently with the presence of a sound control system.

This points us toward the fold that this might be able to evade the wastage of scarce resources. Be it capital resources or assets resources.

6. The Cash flow maintenance

Cash is the lifeline of businesses. Therefore, effective and efficient controls in the cash flows will contribute significantly to the firms.

Once a detailed understanding of the cash flow process is done, the overall cash inflows and outflows are monitored with the right approach and controls installed. It is bound to produce efficient operations.

7. Management Of Resources

Capital resources and human resources are both scarce. And unique in their meaning. Their allocation and use will determine if the organization can go further. Inappropriate allocation/unnecessary allocation will deplete these valuable resources, affecting the organization unfavorably.

The use of resources and not wasting/exploiting them should be the center of focus. Financial control measures are crucial to managing all other resources too. An effective and efficient control system will do so.

8. Operational Efficiency

The primary goal of the control mechanism is to ensure smooth operations, free from human errors, even from intentional manipulation.

When strict controls provide security at various operational levels, right from the stage of data entry to report preparation. It means the organization is producing confident results.

Confident results that are free from errors, misrepresentations, and manipulations affecting the quality of financial reports.

9. Improved Profitability

With improved processes and increased productivity, the firm is bound to produce positive results. Productive operations in functions and departments will contribute positively to efficiency at the organizational level.

Establishing effective control measures ensures improved profitability. Examine budgets, balance sheets, and financial statements for irregularities and take corrective measures.

10. Preventing Fraud

Among many controls available to the management. These are preventive controls against fraudulent activities in an organization.

It's the nature of preventive controls to prevent an illicit/unethical activity from happening by taking appropriate measures. These undesirable events can take place in the form of:

• Online theft
• Employee fraud
• Collaboration among employees
• Collaboration between employees and outsiders

Required Processes for Financial Controls

The process and steps required for it are:

1. Setting standards

Standards are the expected performance, price, cost, or quantity level a firm expects. The first step is setting standards for all the financial activities to measure them against.

Standards help in assessing the performances. These standards can be for revenue, costs, and capital as well.

Standard costs(revenue): "How much an operation/service should cost (generate)?" or, they are "costs entity expects to incur (make), assuming all goes planned, under expected normal time/capacity.

2. Assess current performances

The current sales, costs, cash, and other sources of investments and finances should be assessed. Leaving alone the historical performances for comparison, it's important to note how the firm is performing now.

Present performances observed from the income statement, balance sheet, and statement of cash flows are to be documented proactively.

3. Detecting anomalies and outliers

Setting a system of standards and assessing actual performances help the management to identify unusual observations. Anomalies in:

• Financial reports
• Budgets
• Balance sheets
• Cash flow statement

Are detected that could prevent the company from achieving its goals?

4. Periodic updating of documents

Updating the financial reports and statements at regular intervals provides management with updated figures and numbers.

With this, the management can enforce and direct control where there is a priority and maintain places where they operate at satisfactory levels. Regular updating is recommended.

5. Analyze operational policies and scenarios

Once new controls, policies, and procedures are in place. The management should closely monitor them. Managers should ask questions such as:

• "Which areas do the new controls focus on?"
• "In which aspects do the previous controls lag?"
• "What are the benefits expected to be received from the new control system?"
  And, finally, even quantify the changes.

6. Variance analysis

Going back to step 1, the standards help the organization compare the actual performances with the budgeted ones.

Variance analysis is just not limited to understanding the deviations from the standard. It will also aid a great deal in understanding the possible causes for deviations.

Example: Any layman would say the production department is responsible when Direct Material Price Variance is unfavorable.

But, if we dig deep, we can make out that it could be the Purchasing department's fault for accepting a price higher than the budget. It's also to ascertain if the variance is significant or not. When it is, it should be reported to the concerned authorities.

7. Forecasting and Projecting

Estimates should be made based on the changes made in the control policies and procedures. Forecasting the sales, cost of goods sold, operating expense, net income, and operating income as well.

The level of assets required to fulfill the sales level and finances needed should also be projected.

8. Make recommendations

Recommendations should be made, irrespective of how well the organization is performing at all levels.

The negative gaps between the budgeted performance and actual performance should be minimized. However, if there are positive gaps (in revenues) should be analyzed too, to maintain good performance.

Researched and authored by Farooq Azam Khan,CMA | LinkedIn

Reviewed and Edited by Savan Sabu | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Beta Coefficient
• Black Swan Event
• Bond Tranches
• Break-even Point (BEP)
• Bullet Loan