Does internal control improve operations and prevent fraud?

• Author: Sinnett, William M.
• Position: Financial Executives Research Foundation - United States. Securities and Exchange Commission - Sarbanes-Oxley Act of 2002 - Foreign Corrupt Practices Act of 1977 - Reprint

During the 1920s, a need arose--that was not well-defined at first--for a carefully created control function in business organizations. With it came a hunger for the objective judgment that only controllers were in a position to contribute to the decision-making process.

The Controllers Institute of America (predecessor to Financial Executives International) was the response to the demand for this control mechanism and objective quality of thought in management, wrote James L. Peirce in 1971, in the introduction to FEI's history, The First Forty Years, by Paul Haase.

The Controllership Foundation (now Financial Executives Research Foundation, known as FERF) was chartered in New York, on Nov. 29, 1944. It was expected to help achieve two of the institute's original objectives: "Assembling facts and information of value to controllers" and "publishing pamphlets, books and reports," Haase wrote.

The search for a better understanding of control and more effective control systems in business, nonprofit and government enterprises has been a constant endeavor over the past century. It's not surprising then, to look over the long history of FERF research and find countless research publications and substantial dollars invested in issues related to control.

Centralization vs. Decentralization

Some of the earliest research studies published by FERF examined how the controller's department should be organized. In his 1954 research study, Centralization vs. Decentralization in Organizing the Controller's Department, Herbert A. Simon wrote: "If that role is restricted largely to accounting and the preparation of figures to be analyzed by others, a relatively centralized organization may operate in a satisfactory manner."

In 1978, Simon was awarded the Nobel Memorial Prize in Economics, for his pioneering research into the decision-making process within economic organizations.

Roland Laing, retired FERF president and chief staff officer from 1983-93, notes that "During the sixties and seventies, companies were expanding and merging, running much more decentralized and diverse structures (some firms became known as conglomerates). Controllers were asking questions on how to get the right information for analysis and reporting and how to maintain good operational controls in these complex organizations."

FERF published what have become two management classics: Divisional Performance and Control (1965), by David Solomons, and Decentralization: Managerial Ambiguity by Design (1979), by Richard Vancil, as well as a study, Financial Control of Multinational Operations (1971), by Bursk, Dearden, Hawkins and Longstreet.

The Foreign Corrupt Practices Act of 1977

The controller's department was also to take on additional responsibilities. During the 1970s, the U.S. Securities and Exchange Commission had uncovered extensive evidence of bribery and related crime. Lay Person's Guide to FCPA, on the U.S. Department of Justice Web site, states:

"Congress enacted the FCPA [Foreign Corrupt Practices Act of 1977] to bring a halt to the bribery of foreign officials and to restore public confidence in the integrity of the American business system."

Besides its anti-bribery provisions, FCPA also requires SEC-listed companies to meet its accounting provisions.

In 1979, following enactment of FCPA, the SEC proposed rules that would have required a company to annually disclose certain information about its internal accounting controls. Because this proposal was criticized for many reasons--including its close correlation with FCPA requirements--the SEC decided to allow the private sector to develop its own initiative.

FERF responded with Internal Control in U.S...