Internal Control

Abstract

Internal Control is a system designed to promote efficiency, assure the implementation of policy, safeguard assets and avoid fraud. Internal Control is very important in a company because it not only ensures that everyone is operating ethically and efficiently, it also protects the organization's resources. Internal Control does not only apply to employees, but most importantly its senior level executives. In recent years there have been a number of companies that went under due to fraud and lack of internal control; Enron, WorldCom, Arthur Anderson, etc. Since then Congress has created the Sarbanes Oxley Act of 2002 to help ensure that scandals like these will never happen again. In this paper I will discuss how the lack of internal controls played a major role in these scandals and how the Sarbanes Oxley Act of 2002 protects companies and shareholders from future fraudulent activities.

Internal control is a term typically heard in a business setting and is extensive in scope. Internal control can include many different aspects of a business and is meant as a way to secure the business from wrongdoing. The purpose of an internal control in a business is to keep the company running smoothly without any unlawful activity by its employees. The activity may be intentional or unintentional, but having steps in place to catch mistakes can help a company save money, inventory, time and even its reputation. Internal control means that there are safe guards that the company leaders have put in place to watch for incorrect procedures. The employees of the company are the control.

Internal control can be placed anywhere in a company. You will find most of the control where the money is. Whether it is in accounting or inventory areas, corporate leaders want to make sure they are not losing money. They will create an internal control to ensure that theft of any type is very difficult. Other controls fall into categories of quality to ensure the product is meeting company expectations, customer service to make sure employees are treating customers in the manner required, and safety to ensure that employees are not injured.

An example of an accounting control might be a separate employee signing the checks than the one that printed them. Also, most companies will have more than one person sign a check that is over a certain amount of money. Payroll might be processed by one employee and another may look at the reports. A company might even bring in auditors from a different location to look at the overall books to ensure there is no wrongdoing. Inventory controls will make sure that all products are counted correctly. This not only keeps someone from walking off with product, but also insures that the inventory is correct for reporting on financial statements. One inventory control is the inventory count. Some do this only once a year while others will do it monthly.

There are many benefits of internal. From making sure that the company does not lose money because of different types of theft to making sure that employees are safe and unharmed, internal control can save a company a lot of headache, cost and time in the long run.

This paper will focus on the importance of accounting controls in a company. I will discuss the scandals of companies such as Enron and WorldCom, the passing of Sarbanes Oxley and the role internal control or the lack of played in their downfall.

The Enron scandal, exposed in October 2001, ultimately led to the bankruptcy of the Enron Corporation, an American energy company based in Houston, TX, and the termination of Arthur Andersen, which was one of the five largest audit and accountancy partnerships in the world. Enron was formed in 1985 by Kenneth Lay after merging Houston Natural Gas and InterNorth. Jeffrey Skilling, hired several years later, developed a staff of executives that hid billions of dollars in debt from failed deals and projects through the use of accounting loopholes, special purpose entities, and poor financial reporting. Not only did Chief Financial Officer Andrew Fastow and other executives mislead Enron's Board of Directors and audit committee on high risk accounting practices, but they also pressured Anderson to ignore the issues.

Shareholders lost just about $11 billion when Enron's stock price, which hit a high of US $90 per share in mid-2000, plunged to less than $1 by the end of November 2001. The U.S. Securities and Exchange Commission (SEC) began an investigation, and Houston rival company, Dynegy offered to purchase the company at an extremely discounted price. The deal fell through, and Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code on December 2, 2001. Enron's $63.4 billion in assets made it the largest corporate bankruptcy in U.S. history until WorldCom's bankruptcy the following year.

WorldCom, which used to be known as MCI WorldCom, was founded in 1963 and grew to be the second largest long-distance provider in the United States. In 1998, the telecommunications industry began to slow down and WorldCom's stock was declining. Bernard Ebbers, CEO, came under increasing pressure from banks to cover margin calls on his WorldCom stock that was used to finance his other businesses endeavors (timber, yachting, etc.). The company's profitability took another hit when it was forced to abandon its proposed merger with Sprint in late 2000. During 2001, Ebbers persuaded WorldCom's board of directors to provide him corporate loans and guarantees totaling more than $400 million. Ebbers wanted to cover the margin calls, but this strategy ultimately failed and Ebbers was ousted as CEO in April 2002.

In the middle of Ebbers failed strategies, WorldCom, under the direction of Scott Sullivan (CFO), David Myers (Controller) and Buford Yates (Director of General Accounting) used shady accounting methods to mask its declining financial condition by falsely professing financial growth and profitability to increase the price of WorldCom's stock. The fraud was accomplished in two main ways. First, WorldCom's accounting department underreported 'line costs' (interconnection expenses with other telecommunication companies) by capitalizing these costs on the balance sheet rather than properly expensing them. Second, the company inflated revenues with bogus accounting entries from "corporate unallocated revenue accounts".

The first discovery of possible illegal activity was by WorldCom's own internal audit department who uncovered approximately $3.8 billion of the fraud in June 2002. The company's audit committee and board of directors were notified of the fraud and acted swiftly: Sullivan was fired, Myers resigned,

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