The impact of weak internal controls on profits

Executive summary

Good internal controls are not just a cost, but an investment that protects profits and the company in the long term. Weak controls lead to direct losses (thefts, fraud, accounting errors) and indirect losses (decreased operational efficiency, loss of customers, regulatory fines, and increased cost of capital). Addressing weaknesses quickly reduces profit leakage and turns control into a competitive advantage.

What is meant by 'weak internal controls'?

Weak internal controls mean the absence or inadequacy of policies, procedures, or technical and governance controls aimed at protecting assets, ensuring the reliability of financial information, and compliance with laws. Examples: unclear division of duties, lack of approvals for payments, incomplete manual records, or weak access controls to ERP systems.

How does weak internal control directly affect profits?

1. Thefts and financial fraud

   • Cash thefts, fictitious expenses, and forged invoices lead to direct financial losses that drain net profit.

2. Accounting errors and profit distortion

   • Recording revenue or expenses in the wrong period or failing to allocate expenses leads to inaccurate profit reporting, misleading management and investors, and resulting in poor decisions.

3. Revenue leakage

   • Billing errors, unissued invoices, unrecorded discounts, or transactions with related parties without disclosure—all of this reduces actual revenue.

4. Unjustified expenses or cost inflation

   • The absence of approvals and a purchasing system allows for uncontrolled spending and increased operational costs that pressure profitability.

5. Poor inventory management (Shrinkage / obsolescence)

   • Thefts, damage, or incorrect inventory recording lead to higher cost of goods sold and lower profit margins.

Indirect effects on profitability

1. Decreased operational efficiency

   • Poorly organized operations mean longer work time, duplicate data entries, and delays in delivery— which increases costs and reduces potential revenue.

2. Loss of trust and reputation

   • Revealing cases of manipulation/public errors affects the trust of customers, suppliers, and investors, which may translate into lost contracts or worse credit terms.

3. Fines and legal enforcement

   • Tax or regulatory non-compliance can lead to significant fines and legal expenses that are deducted from profits.

4. Higher cost of capital

   • Investors and lenders demand a risk premium if they consider controls to be weak — which increases the cost of financing and pressures net profit.

5. Wrong management decisions

   • Strategic decisions (pricing, investment, expansion) based on distorted data lead to missed profit opportunities.

Operational indicators to measure impact

• Inventory loss ratio = Inventory losses ÷ Total inventory value.

• Billing error rate = Number of invoices with adjustments ÷ Total invoices.

• Processing time for payments and average cost per financial transaction (reflects the efficiency of controls).

• Annual fraud cost as a percentage of revenue.

• Rework rate (transactions reworked) and its impact on cost.

• Discrepancy rate between internal reports and audited reports (number of adjustments/size of adjustments).

(Aggregating these metrics through quarterly reports provides a quantitative view of profit leakage).

A simplified numerical example (illustrative)

If a company generates revenue of 10,000,000 annually and an expected net profit margin of 10% = 1,000,000.

• A slight revenue loss of 1% due to missing invoices = 100,000 direct loss.

• Theft/fraud and unjustified financing of 0.5% = 50,000.

• Increased operational costs of 0.5% due to inefficiency = 50,000.

  Total = 200,000 additional loss — a decrease in profit margin from 10% to 8% (1,000,000 → 800,000).

  (The numbers are for illustration; actual measurement requires company data).

How do you identify the root causes of the problem and assess the losses?

1. Value chain review: from sales to receipt, analyzing exposure points.

2. Control tests: sampling models for payments, invoices, and inventory operations.

3. Data analysis: extracting abnormal patterns (duplicate invoices, inactive suppliers).

4. Fraud/imbalance loss report: aggregating incidents and estimating them financially.

5. Comparison with the previous period/industry: identifying performance deviations.

Practical steps to strengthen controls and reduce the impact on profits.

1. Segregation of Duties: do not allow the same person to prepare, sign, and approve payments.

2. Formal approvals for payments and purchases with clear thresholds.

3. Digitizing invoicing and automated matching between purchase orders, invoices, and receipt documents.

4. Periodic and automated bank reconciliation to monitor discrepancies as they occur.

5. Access controls for accounting systems and recording user activity (audit trail).

6. Monitoring Key Performance Indicators (KPIs) and generating alerts for anomalies.

7. Awareness and training program for finance and procurement staff on policies.

8. Independent internal audit and scheduling of external audits as needed.

9. Reporting issues to the board/audit committee immediately and documenting corrective actions.

Quick checklist for management (Immediate actions)

• Is there a basic segregation of duties for each financial function? Yes / No

• Is the bank reconciled monthly by an independent person? Yes / No

• Are invoices automatically compared to purchase orders? Yes / No

• Do we have a clear policy for service providers/emergency payments? Yes / No

• Are changes to accounting systems reviewed and who has the authority to make modifications? Yes / No