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Why Private Companies Need Better Internal Controls

Public companies are heavily monitored, private companies need to step up

24Sep

The degree of regulation faced by firms has increased dramatically in response to a number of corporate accounting scandals. As such, proper internal controls are more important than ever. Public companies in particular now face an unprecedented level of scrutiny, primarily as a result of section 404 of the Sarbanes-Oxley Act, under which companies are required to submit annual reports in which chief executives and chief financial officers attest to ‘the effectiveness of the internal control structure and procedures of the issuer for financial reporting.’ For smaller public organizations, this has proved a source of much contention, hitting their bottom line by adding significant costs that they often struggle with.

Private companies, while not subject to Sarbanes-Oxley (SOX), also face an existential threat as a result of poor internal controls. A recent paper by PWC revealed that a poor control environment is the greatest risk a private company can face, and could result in potentially substantial financial consequences. These range from the risk of encouraging unethical behaviour, and the fines levied as a result, to basic accounting mistakes that arise from overly complex spreadsheets, which could lead to exaggerated profits or losses and overpayment of taxes. Lack of controls over transactions can result in inappropriate recording of revenue, theft of inventory and cash, and excess inventory purchases, among other hazards.

In order to avoid these potential pitfalls, companies must be seen to promote ethical behavior - implementing a written code of conduct, an ethics hot line, or an advisory board in an oversight role. There must be a control-focused culture, with senior management actively engaged in encouraging integrity and concern for the business.

Many private companies are also voluntarily abiding by Sarbanes Oxley. There are a number of benefits to doing this. Over 50% of respondents to a survey conducted by Reed, Buchman, and Wobbekind said that the possible benefits of voluntary compliance included establishing stronger business credit, the potential for better major financing options and enhancing credibility with key stakeholders. It is particularly important to private companies looking to go public, as it makes them more appealing acquisition candidates, especially if the acquisition is material to the public company, which will be responsible for the adequacy of the acquired company's financial controls after it is purchased.

Another advantage is that good financial and governance guidelines and practices are less subject to litigation. The standards by which their practices are judged increasingly follow the requirements of SOX and other established ‘best practices,’ so they are more likely to prevail if they’re sued.

While not obliged to follow SOX, it is often advisable for private companies seeking better internal controls. The costs that come from the changes to accounting practices may not seem worthwhile at the time, but are likely the preferable option compared to any costs incurred if controls fail.

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