Entity Level Controls - Research Paper Example

 Entity Level Controls Introduction Entity-level controls are a significant element of internal controls, essentially required in modern organizational settings. Entity-level controls aim to prevent various risks associated with internal as well as external levels of organization. A well designed entity-level control system would help an organization to achieve its strategic and business objectives by minimizing diverse threats associated with its daily business transactions. This study will discuss different levels of controls in an organization and essential factors to be considered for adopting the most suitable method. Even well designed entity-level controls may fail to achieve its exact goal, if it is operated in an inefficient way. The following case study mainly deals with widely publicized financial failures happened due to entity-level controls breakdown. Entity-level controls A large volume of operations and increased accountability force the organizations across the world to adopt some internal controls. Entity level controls or firm level controls are some of the best fitted instruments to strengthen internal controls by assisting the companies to reduce risks associated with various business operations. The major purpose of entity level controls is to prevent the intentional mistakes (frauds) and unintentional mistakes (errors). In addition to this, entity level controls also aims at evaluating the performance level of all organizational units. Generally frauds and errors are identified and reported to the management normally through ‘final audit’ conducted at the end of every financial year. The net profit obtained by the firm cannot be improved unless these mistakes are found at the earlier stages. Hence the identification of frauds and errors at the year’s end is of little use to the management. Therefore entity level measures have been ‘enacted by Australia, Canada, China, the member countries of European Union, India, Japan, South Africa, the United States and other countries’ (Ernst & Young 1). Internal control elements and its impact on entity level control The internal control system established in organizations includes different levels based on the size of the organization concerned. The management has the authority to take decisions regarding size and type of internal control measures to be adopted. Entity level control is the second level approach to minimize the risks and to enhance the overall organizational performance. In order to evaluate the effectiveness of the established entity level control system, it is necessary to assess whether five elements of COSO (Committee of Sponsoring Organizations of the Treadway Commission) are presently functioning or not. The five elements of COSO associated with entity level controls are described below. Control environment: it includes various control measures adopted by the management over the employees in order to promote a code of discipline in the organization. At the same time, they encourage healthy competition among the employees in order to ensure their maximum effort. Risk assessment: the management takes into account all possible risks associated with various changes such as technological changes, accounting standard changes or operational changes in the organizational environment. Control activities: it refers to ‘policies and procedures’ which help the top level management to ensure that management directives are carried out properly. Information and communication: it emphasizes up and down communication in the organizational structure. By the efficient application of a well developed communication strategy, management gets sufficient information about various organizational affairs from time to time. Monitoring: the management needs to know the effectiveness of the internal control system persisting in the organization. So monitoring includes auditing, direct testing and self judgment by the management (Kansas State University). Causes of some globally publicized financial failures On 2 December, 2001 Enron Corporation, an American corporate business got filed for bankruptcy as a result of its exceeding debt and faulty investments in some risky ventures. Inflated earnings ware one of the important primary causes for the Enron’s collapse. In addition to this, the management was allowed to infringe the code of conduct and to serve in special purpose entities without any constraints from the part of board of directors. As stated by Mehta & Srivastavaare (n.d.), despite its code of conduct and ‘corporate social responsibility task force’ there was lack of compliance to all of those provisions. For instance, the auditors failed to check improper accounting procedures and took no effort to examine the special purpose entity transactions (Mehta & Srivastavaare, n. p.). Furthermore, the American telecommunications giant, WorldCom also plunged into bankruptcy subsequent to huge accounting frauds committed by the CEO Bernie Ebbers. He falsified the company’s account for an amount of $11 billion by booking revenue expenditure as capital expenditure. Some fruitless business strategies of Ebbers led the company to bankruptcy. Ebbers mainly concentrated on acquisitions to achieve further growth of the organization. In order to handle and run the newly acquired companies in a proper way, the management needed more time. In contrast, Ebbers failed to manage the situation well that gradually paved way for the collapse of WorldCom. Ebbers had to alter the books of accounts of WorldCom in order to conceal debts conceived by the company and thereby satisfy the shareholders’ interests. According to Stefano “Another major factor driving this fraud was Ebbers’ very apparent desire to build and protect his personal financial condition” (Stefano, 2005). Clarke (187) describes the fall of Parmalat SpA, the Italian diary products company which had become a global concern within a short period of time. The management of the Parmalat inflated its revenues by fictitious sales to dealers in order to justify its huge amount of loans from global banks. They manipulated the company’s accounts so as to remove some of its debts from the financial statements using three Caribbean based shell companies. In addition to this, the management built up a network of 260 international speculative entities with intent to make the debts concealed. The Parmalat SpA filed for administration ‘when the Bank of America denied the authenticity of the existence of 3.9 billion euros’ (Clarke 2007: 187). Barings Bank was the oldest merchant bank in the U.K Lesson, the trader based at the Singapore branch of the bank, indulged in excessive risk taking ventures with regard to the bank. Lack of accountability and inadequate flow of information also accelerated the disaster of the bank since management could not take timely appropriate decisions. According to Bhalla, (1995), ‘the absence of appropriate mechanisms of control and supervision’ also accelerated the company’s collapse (Bhalla, n.p.). From the above case studies, it is clear that the deficiency of internal controls or entity level control systems was the major cause of these failures. Even though the persons at the helm of affairs had been the convicts in the case of Enron Corporation and WorldCom, an effectively performed entity level control system might have minimized the intensity of the disaster. If they had modified the system of entity level controls that existed in Enron, the management would not have caused to violate company’s code of conduct. Similarly, in the case of WorldCom, the unnecessary acquisitions by the CEO could be avoided to some extent if there were well established Entity level controls. On the other hand, the collapse of Parmalat SpA and Barings Bank happened simply as a result of absence of a better control system. The Parmalat SpA recorded fictitious transactions in order to exaggerate its actual revenues and thereby obtained huge loans from global banks. It precisely shows the entity level control breakdowns. It is better for the company to fix suitable strategies regarding maximum amount of loan to be borrowed which will save the company from indebtedness. Similarly excessive risk taking, lack of accounting and inadequate accounting led the England’s Barings Bank to a disastrous end which would be disregarded with an efficient entity level control system. Proper supervision and control over employees must be exercised in order to control the organizational environment and to achieve the basic objectives of a firm. The application of a basically accepted accounting system helps to eliminate the errors and frauds associated with increased accountability. Likewise apposite communication strategies should be adopted in order to enhance the communication between management and employees. Thorough scrutiny of the above mentioned accounting failures teach us the lesson that business would not come to a tragic end if entrepreneurs functioned entity level control systems effectively. Works Cited “Entity Level Controls: Strengthening Internal Control Through More Effective and Efficient Entity-Level Controls”. Ernst & Young. EYGM Limitted, 2007. Web. “Internal Controls”. Kansas State University. n.d. Web. 6 Nov 2010 Mehta, Shruti & Srivastavaare, Rachana. “Reasons for Corporate Governance failures”. Skyline Institute of Engineering & Technology. n. d., Web. 6 Nov 2010. Stefano, Theodore F. di. “WorldCom’s Failure: Why Did It Happen?” E-Commerce Times, 19 Aug 2005. Web. 6 Nov 2010. Clerke, Thomas. International corporate governance: a comparative approach. Abingdon, Roultedge, 2007. Print. Bhalla, A. S. “Collapse of Barings Bank Case of Market Failure”. Economic and Political Weekly, 1995. Web. 6 Nov 2010 Read More