Q4: What are ‘internal controls’ in a business and how can using subsidiary ledgers support the ‘internal controls’ in a business?

A:

We do have to trust other people, but in business (as in life) we do like to only trust people as much as we have to; particularly when we are trusting individual people who we do not know that well, if at all. This is often the case in business. We can set up some boundaries around the trust we give people in a firm through a range of techniques, including installing closed-circuit TV in a firm’s warehouse and completing police background checks on potential new employees before we employ them. The controls a firm can put in place to protect its assets from theft (particularly by employees) are called, unsurprisingly, internal controls.

Internal controls also seek to ensure management policies are being followed (such as credit policies for customers), to help detect fraud or errors in a firm’s accounts and to help build confidence that the accounting data in a firm is accurate and complete. If the accounting data in a firm is wildly inaccurate for some reason then the whole value and integrity of a firm’s financial statements can be compromised. In Australia, although small-scale fraud and error is common-place in firms, large-scale, significant fraud and error is much less common (though, of course, it does regularly occur but on a relatively rare basis).

We can usually have a high level of confidence that the usefulness of a firm’s accounts is not unduly compromised by fraud or error. However, strong and consistent internal controls by firms are needed to limit and manage this risk. The use of subsidiary ledgers is an example of the sort of internal controls that can be maintained within a firm’s accounting processes.

The use of subsidiary ledger accounts and general ledger control accounts can support the internal controls within a firm. For example, they can do this by separating the Accounts receivable subsidiary ledger accounts for individual customers from the overall total of Accounts receivable for all of a firm’s customers in the Accounts receivable control account in the general ledger.

If a person in a firm is responsible for, and has read-write access to, the subsidiary ledgers for individual customers’ Accounts receivable, there is the risk they could potentially enter into an arrangement with a customer to falsify its Accounts receivable records and thus reduce that customer’s indebtedness to the firm. Such a customer, say, of Coffee Supreme could then potentially have a ready flow of ‘free’ coffee from Coffee Supreme. However, if a different person is responsible for, and has read-write access to, the Accounts receivable control account in the general ledger then by regularly reconciling the subsidiary ledgers with the general ledger control account this could help to detect possible fraud (or error) in the subsidiary ledgers for individual customers’ Accounts receivable (and discourage people from contemplating such fraud in the first place).