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Internal Control Systems

to lend money to their best customers. While the prime will receive a gain. If market interest rates increase, the
rate is not usually available to consumers, some consumer investor will receive a loss on the value of the investment.
loans (such as mortgage lines of credit) are priced at
SEE ALSO Finance; Investments
“prime + 2 percent”; that is, a consumer will pay 2 percent
over the prime rate to borrow money. When the Federal
Reserve raises the discount rate, typically banks raise the Henry H. Davis
prime rate and consumers pay higher interest rates.
Individuals lend money by investing in debt instru-
ments, such as Treasury bills and bonds. In this scenario,
the investor receives periodic payments (annuity pay- INTERNAL CONTROL
ments) and a lump sum when the debt instrument SYSTEMS
matures. This stream of cash flows is valued as follows:
Internal control can be described as any action taken by
market value = annuity payment ¥ an organization to help enhance the likelihood that the
objectives of the organization will be achieved. The defi-
annuity factor i,n + maturity value ¥
nition of internal control has evolved as different internal
present value factor i,n [4]
control models have been developed. This article will
where: describe these models, present the definitions of internal
control they provide, and indicate the components of
market value = value of the debt instrument
internal control. Various parties responsible for and
annuity payment = amount of the payment that is
affected by internal control will also be discussed.
made each period; it is equal to the interest rate
stated on the debt instrument multiplied by the
THE COSO MODEL
face value of the debt instrument
In the United States many organizations have adopted the
annuity factor = a number obtained from an ordi-
internal control concepts presented in the report of the
nary annuity table that is determined by the
Committee of Sponsoring Organizations of the Treadway
interest rate (i) and the number of annuity pay- Commission (COSO). Published in 1992, the COSO
ments (n)
report defines internal control as:
maturity value = amount received by the investor
when the instrument matures, also known as the a process, effected by an entity’s board of direc-
face value of the debt instrument tors, management and other personnel, designed
to provide reasonable assurance regarding the
present value factor = a number obtained from a achievement of objectives in the following cate-
present value table that is determined by the gories:
interest rate (i) and the number periods until
maturity (n). • effectiveness and efficiency of operations
• reliability of financial reporting
When an investor purchases a debt instrument, the
following factors are “fixed”: (1) the amount of each annu- • compliance with applicable laws and regulations
ity payment, (2) the amount of the maturity value, and
COSO describes internal control as consisting of five
(3) the number of periods until maturity (this is also the essential components. These components, which are sub-
number of annuity payments that will be received in the divided into seventeen factors, include:
future). As interest rates increase, the market value of the
investment will decrease; that is, the price of debt securi- 1. The control environment
ties is inversely related to the market rate of interest. This
2. Risk assessment
is shown in Table 2.
The investors who keep the investment until the debt 3. Control activities
instrument matures will receive the market rate of interest 4. Information and communication
on their investment from the date of purchase. The
5. Monitoring
investor who sells their investment prior to maturity will
receive the market rate of interest on the investment until The COSO model is depicted as a pyramid, with the
it is sold. At that time, this investor will also receive either control environment forming a base for control activities,
a gain or a loss due to changes in the market value of this risk assessment, and monitoring. Information and com-
investment. If market interest rates decrease, the investor munication link the different levels of the pyramid. As the

ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 403