UPI Study › Courses › Principles of Management › Free lessons › Lesson 12.7 Free with a free account
Keeping the Numbers Honest: Financial Controls in Organizations
Principles of Management · Chapter 12: Communication and Financial ControlSection 12.7 · lesson 79 of 11714 min · free with a free account
Free preview
Create a free account to keep watching
It takes a minute and costs nothing. Your free account unlocks all of Chapter 1 and 3 more lessons of Principles of Management.
Lesson complete
Earn the 3 college credits for Principles of Management
Enrolling adds a quiz after each lesson, the graded work and the official transcript. Recommended for credit by NCCRS.
Next lesson: Budgeting Methods Compared: Top-Down, Bottom-Up, Zero-Based, and Flexible →← When Outsiders Step In: Mediation and ArbitrationNext lesson: Budgeting Methods Compared: Top-Down, Bottom-Up, Zero-Based, and Flexible →
In this lesson
The control cycle applied to money, and the mechanisms that make it work.
- Explain financial control and its control cycle
- Describe the principal financial control mechanisms
- Tell profit from cash, and match units to measures
- Identify the control weakness in a described situation
Transcript
Everything said in the video, section by section (1,845 words). Read along, or search it.
Communication and Financial Control
Keeping the Numbers Honest: Financial Controls in Organizations
Every organization runs on money, and someone has to make sure the money goes where it's meant to go. That's the job of financial control, the subject of this section. We'll define it, and see how the familiar control cycle applies to finance. We'll cover the mechanisms that put it into practice. One of them gets special attention, because it's widely regarded as the most important routine control. We'll name the three financial statements, and see why profit and cash are not the same thing. We'll look at responsibility centers, audits, and the ratios managers watch. And we'll finish with the side effects. Financial controls change behavior, and not always for the better.
Financial Control, Defined
Controlling, Applied to Money
Financial control is a set of processes. They ensure an organization's financial resources are obtained, and used, as intended. They also ensure that the financial information the organization reports is accurate. This is the controlling function from Subchapter two point one, applied specifically to money. The logic is the same. Set a standard, measure against it, and act on the variance. Only the subject has changed, from operational performance in general to the organization's finances. Financial control serves three distinct purposes. The first is safeguarding assets. That means protecting cash, property, and other resources from loss, theft, or misuse. The second is ensuring accurate reporting. The financial information the organization produces, internally and externally, has to reflect what actually happened. The third is enabling management decisions. Decision-makers need financial information that's reliable enough to actually be used. That connects directly to the quantitative decision support covered in Subchapter five point two.
Figure 12.7.1
The Financial Control Cycle
Financial control follows the same four-step cycle Subchapter two point one set out for controlling in general. Figure twelve point seven point one draws it as a loop. First, set the standard, through budget and policy. That establishes, in advance, what spending, revenue, and financial behavior are expected to look like. Second, measure actual results, through the organization's accounting records. Third, compare those results against the standard the budget and policy established. Fourth, act on the variance. Investigate and correct wherever results diverge meaningfully from the plan. The figure marks a weakness at that last stage. A fictional department's response to an unfavorable variance was delayed for several months. That single weak stage undermines the entire cycle. A variance that's well measured and well compared, but never acted on, is in practice no better than one never measured at all. The cycle is only as strong as its weakest stage.
The Control Mechanisms
6 Ways Financial Control Is Implemented
At a management level, six specific mechanisms put financial control into practice. Authorization limits and delegated authority define who may approve what level of financial commitment. That connects to the centralization and delegation covered in Subchapter seven point two. Segregation of duties ensures that no single person controls a transaction from start to finish. We'll come back to it. Reconciliation compares two independent records of the same activity, to catch discrepancies. For instance, a bank statement can be checked against the internal cash records. Physical controls protect resources from unauthorized access directly. Think locked storage, restricted access, and inventory counts. Documentation requirements create a record supporting every financial transaction. That way, any transaction can later be traced, and justified. And independent review has someone who wasn't involved in a transaction examine it, after the fact. That person can catch errors or irregularities the original participants might miss. Or, in rare cases, irregularities they might have deliberately concealed.
Segregation of Duties
The Most Important Routine Control
Segregation of duties gets its own treatment, because it's widely regarded as the single most important routine financial control. The principle is simple to state. No single individual should control a transaction all the way from start to finish. A transaction has distinct functions. Initiating it, authorizing it, recording it, and holding custody of the related asset. Segregation divides those functions among different people. Here's why that works. Fraud, or a serious error, would then need collusion between several people to succeed. One person, acting alone, could no longer manage it. That substantially raises the practical barrier against either one occurring. Getting several people to cooperate in wrongdoing is far harder than one person acting alone.
When Staff Are Few
Compensating Controls
Segregation of duties has a notable limitation. Most small organizations can't fully achieve it. An organization with only a handful of staff often lacks enough distinct people to divide the functions cleanly. The same one or two people may handle several functions at once, simply because no one else is available. Where full segregation is genuinely impossible, compensating controls become necessary. There are three to know. First, more frequent independent review. Second, owner-level oversight of transactions above a defined threshold. Third, mandatory reconciliation by someone outside the transaction entirely. Each one substitutes for the protection that full segregation would otherwise have provided. The substitution is imperfect. But it's meaningful.
The 3 Financial Statements
What Each One Shows
Three financial statements matter here. We'll name them by what each one shows, without the full mechanics. The income statement shows performance over a period. It covers revenue earned and expenses incurred, across a month, a quarter, or a year. Those net to a profit, or a loss, for that period. The balance sheet shows position at a single point in time. What the organization owns, what it owes, and the resulting net worth, as of one specific date. So one statement covers a stretch of time, and the other captures a single moment. The cash flow statement shows the actual movement of cash, into and out of the organization, over a period. That's distinct from the income statement, which measures performance on an accrual basis. And the gap between those two carries a consequence important enough for its own slide.
Profit Is Not Cash
Profitable, and Still Unable to Pay
Here's the consequence, stated directly. Profit and cash are not the same thing. A profitable organization can still fail, if it runs out of cash. How is that possible? Because profit is measured on an accrual basis. Profit can include revenue that hasn't actually been collected yet. The sale counts toward profit, but the money hasn't arrived. And profit can exclude cash that has really been spent. Debt repayment and asset purchases use real cash. Yet they don't appear on the income statement as an expense at all. Put those together, and the gap can be wide. An organization can report a genuinely healthy profit, while lacking the cash on hand to pay its bills as they come due. That's why the cash flow statement matters. It answers a different question from the income statement.
Table 12.7.1
Responsibility Centers and Their Distortions
A responsibility center is a unit held accountable for a defined set of financial results. Different units should be measured differently, depending on what they actually control. A cost center is measured only on its costs. It suits a unit with no direct control over revenue. A revenue center is measured only on revenue. It suits a unit with limited control over the costs behind what it sells. A profit center is measured on its own revenue minus its own costs. It suits a unit that genuinely controls both. An investment center is measured on profit relative to the capital invested in producing it. That suits a unit that controls its own capital allocation, as well as its revenue and costs. Table twelve point seven point one adds the distortion each measure can produce. A cost center may cut costs even where the cut damages quality or capacity that isn't separately measured. A revenue center may chase volume, regardless of the cost or margin behind it. A profit center may defer necessary but non-urgent costs, to protect this period's profit figure. And an investment center may avoid a genuinely good investment, because it would temporarily lower the measured return. The governing principle, from Subchapter seven point six, is to measure a manager only on what she actually controls. Holding her accountable for factors outside her authority creates a mismatch. Subchapter three point five called it a design flaw. It isn't a genuine performance signal.
Audit and Ratios
Independent Checks and Warning Lights
Two kinds of audit check the system independently. Internal audit is an independent function within the organization. It reviews controls, processes, and compliance on an ongoing basis. It typically reports to senior leadership, or a governing board, rather than to the operations it reviews. External audit is an independent review conducted by an outside firm. It typically gives an opinion on whether the financial statements fairly represent the organization's actual position. Its main audience is outside. Investors, lenders, and regulators, who can't verify the finances directly themselves. Financial ratios work as control indicators. Here we name what each one signals, rather than computing them. A liquidity ratio signals whether the organization can meet its near-term obligations as they come due. A profitability ratio signals how efficiently revenue converts into actual profit. An efficiency ratio signals how effectively assets are being used to generate revenue. And a leverage ratio signals how much of the organization's resources are financed by debt, relative to its own equity. That shows how exposed it is to debt obligations, regardless of how operations are performing.
Behavioral Effects
Controls Change Behavior
Financial controls, like the goals in Subchapter eleven point seven, produce behavioral effects beyond their technical function. Three are worth knowing. The first is the incentive to manage the measure. People subject to a financial control naturally adjust their behavior to look good against that specific measure. Whether the adjustment serves the organization's real interest is a separate question. The second is spending to protect a budget allocation. Remaining budget gets used up before the period closes. The aim is to stop next cycle's allocation being cut, on the assumption that unused budget wasn't needed. This is well documented. And it's a rational response to how budgets are typically used to set future allocations. The third is deferring necessary spending across a period boundary. A genuinely needed cost is delayed until after the reporting period closes, so this period's numbers look better. That trades a short-term improvement in the measure for a real cost, even if it's temporarily invisible.
Case Vignette
A Department Defers Maintenance to Hit Its Number
Here's a composite case, constructed for instruction. A facilities department at a fictional manufacturer was nearing its fiscal year-end, slightly over its annual maintenance budget. The manager knew that exceeding the allocation would draw unwelcome scrutiny. So the manager postponed a scheduled equipment maintenance visit, which wasn't yet urgent, into the following fiscal year. That brought the department's reported spending back within its approved budget. On paper, the department hit its target exactly. The year-end review showed a clean, on-budget result, with no variance requiring explanation. But the maintenance hadn't become unnecessary. It had simply moved to a different reporting period. It would still need to be done. And after the extra months of wear, it would cost somewhat more than on schedule. The control had worked exactly as the behavioral effects predict. A budget measured strictly against a fixed period boundary created an incentive, to push a real cost across that boundary. The reported number improved for one period. The hidden cost fell on the organization's actual equipment reliability. Next, Subchapter twelve point eight turns to how the budget itself gets built. It compares top-down, bottom-up, zero-based, and flexible approaches.
About Principles of Management at UPI Study
Principles of Management (Business 101) is a self-paced online course of 117 video lessons in 17 chapters, from the classical schools and the four management functions to leadership, motivation, change, human resources, strategy and ethics. It carries a NCCRS credit recommendation for 3 semester credits.
Every lesson transcript is free on pages like this one, and the videos are free with a free UPI Study account. Enrolling adds a practice quiz after each lesson, the graded work and final exam that earn the credit, lifetime access, and an official transcript on completion. UPI Study has helped over 130,000 students with college credits. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.
Enroll now → Course details Download the syllabus Every course with PRO →
Why take it here
Why students take Principles of Management with UPI Study
Where the credit goes
Universities that work with NCCRS
Principles of Management carries a NCCRS credit recommendation. These universities work with NCCRS; some are UPI Study's signed partners. ACE and NCCRS have over 2,100 cooperating colleges that will consider accepting credits; the final decision is with the universities.
Thomas Edison State UniversitySigned partner
University of the PeopleSigned partner
Charter Oak State CollegeSigned partner
Strayer UniversitySigned partner
Columbia Southern UniversitySigned partner
Indiana TechSigned partner
Penn StateWorks with NCCRS
Southern New Hampshire UniversityWorks with NCCRS
SUNYWorks with NCCRS
+many more cooperating universitiesFind my college →Find my college → Not listed? Ask Athena in the corner of this page, or book a 15-minute call.
FAQ
Questions students ask us
About Keeping the Numbers Honest: Financial Controls in Organizations
What is segregation of duties in financial control?
How can a profitable company run out of cash?
What is the difference between internal audit and external audit?
What unintended behaviors can financial controls and budgets cause?
About the Principles of Management course
How many college credits is Principles of Management?
How much does Principles of Management cost and what is included?
Which universities accept UPI Study credits?
How long does Principles of Management take?
How are the exams done?
How do my credits reach my college?
Ready for the full course? Earn 3 credits in Principles of Management.
117 video lessons, a quiz after each one, and the graded work that earns the credit. Recommended for credit by NCCRS.
3 credits · NCCRSEnroll →