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Lester Bahr CPA, LLC
(484) 707-5934
Allentown, Pennsylvania

Don't let your business become a victim of theft. Implement proper internal controls.

Internal control encompasses the systems, procedures and policies employed by an enterprise to help assure that its transactions are properly authorized and appropriately executed and recorded. We will take a narrowed focus on the aspects of internal control that are pertinent to small businesses, specifically, controls to guard against employee theft.

The fact is that probably most small businesses experience some kind of employee theft or fraud from time to time, its just a matter of magnitude and frequency. Most business owners tend to associate theft with the taking of "cash" and therefore think it would be easy to discover should it happen.

However, theft is probably more likely to involve taking inventory and equipment because it is usually easier to gain undetected access to as compared to cash. However, theft can also be of lesser degree. For example, it may involve excessive employee personal long-distance telephone usage, using the company's postage meter for personal mail or inflating of expense and mileage reports. These latter examples are more likely to persist unnoticed over a long period of time just because most business owners are far too busy with other aspects of their business and do not scrutinize telephone bills and expense reports. However, it is because this type of employee theft can go on for so long without notice that the total dollars can become very significant to the business over time. 

What makes small businesses particularly vulnerable to employee theft is the fact that they usually don't have the resources or internal controls in place to prevent it. The employee is probably also well aware of this fact. For example, a small businesses often has to rely on one person to perform many of the accounting transactions that would otherwise be segregated in a larger company. Often in a small business it is not uncommon to find a single person who is opening the mail, posting payments to accounts, making the deposits, in charge of entering customer "adjustments" and controlling petty cash. Granted, although most employees will handle these tasks honestly, the business owner must recognize the potential risks of this kind of unrestricted access. 

Employee theft and dishonesty costs businesses billions of dollars each year. In severe cases it can have a material impact on the profitability of the business and drain cash flow resulting in higher borrowing costs etc. In the worst case scenario it can put a small company out of business. Therefore, it is important for business owners to arm themselves with some basic knowledge of what to look for and devise some effective controls where potential exposures exist.

Step 1 - Determine where your company's weaknesses are by answering these questions:

1. Does your bookkeeper or other employee in charge of finances directly receive the bank statements and cancelled checks? Does that same person also have responsibility for reconciling the bank account and making any adjustments in the accounting system? If so, that person has both custody of assets and record keeping access, the two primary components to perpetuate theft and cover the trail.

2. Are all checks and other transactions documents pre-numbered and always accounted for in sequential order? Does the person in charge of finances and reconciling the bank statement also have check signing authorization? You do reconcile your bank statement on a monthly basis - don't you? Again, this is almost an invitation for theft.

3. Do you have a detailed, computerized perpetual inventory system for your business? Due to the expense of setting up and maintaining such a system effectively, many small businesses are very lax when it comes to inventory management. In fact, many don't have any idea how to track their inventory. At year end, often just a "guestimate" of the physical inventory on hand is provided to the accountant who then simply makes a journal entry to adjust inventory on the balance sheet to this figure. The obvious problem with this is that with no way to track what was bought versus what was sold, there is no way to ascertain what the "shrinkage" number really was or what accounted for it.

4. If your company is small and you have no choice but place all these tasks with one individual, do you require that person to take a vacation every year? Do you ever get resistance from the employee in not wanting to do so? If so, the reason may not be out of dedication. Rather, it may be out of concern that another person filling in will discover the fraud being perpetrated.

5. Do you have an independent accountant from the outside come in to audit your books? Although this may increase the chance of theft being discovered, be advised that an audit makes no guarantee to discover fraud.

6. Do you ever receive customer complaints claiming that their account was not credited with a payment? Or, notice that the account was credited late? Also, is the same financial person responsible for accounts receivable monitoring and collection procedures?

7. Is a paper shredder readily accessible? Don't make it easy to dispose of documents.

8. Are employees permitted to take home customer lists or other confidential documents or computer files to work on from home? Remember, when the information leaves your office premises, you the business owner loose complete control over it and how it is used.

9. Speaking of computer files, is your computer system password protected with the appropriate restrictions in place as to who can access and copy certain directories or files? Also, do you allow employees to login to your network from the outside using communication software? Computer files are just too easy to freely and quickly transfer and copy without being noticed.

10. In regard to hiring practices do you check references and run background checks? These are very inexpensive peace of mind procedures.

11. Do you have fidelity bonds on key employees? Do you required employees to sign non-disclosure agreements.

12. Do you have strict policies for controlling who has keys to your office?

13. Do you have a means to monitor other business supplies and control who has access to them?

Step 2 - Having identified your weaknesses, it's time to create some effective financial controls:

1. Segregation of duties: The basic concept here is that no single employee should control a financial transaction from beginning to end. This means the person who writes the checks should never also signs the checks. Neither should the person who opens the mail also record the receivables and reconcile the accounts. By separating responsibilities, you make it more difficult for a person to take cash and later doctor up the records to cover it up. 

2. Have your bank statement sent directly to you. That way an employee in a position to embezzle does not have a chance to destroy or remove evidence that might be present in the bank statement. It goes without saying but the bank statement should always be reconciled. Also, each check should be carefully examined for proper payees, signatures and endorsements. Indications of fraud might surface as a result of noticing checks to suppliers you don't know, large checks made out to cash, tampered or forged signatures, missing checks or checks out of order, differences in the payee listed on the check versus what is written in the register.

3. Safeguard you company checks and other documents. Don't be careless with access to company documents. Also, always use pre-numbered forms and be sure you can account for any missing or voided documents. In the case of checks, its also a good idea to require two signatures.

4. Monitor payroll records and personally sign payroll checks. Sometimes, it also helps to maintain a separate payroll checking account so that all payroll related transactions can be isolated within one account. If you deposit the exact amount into the account to cover payroll and related taxes, any extra withdrawals will become evident soon enough.

5. Insist that the bookkeeper take vacations. Often times an embezzlement effort involves a continuous process to perpetuate the concealing process. Many business owners have discovered that someone who appeared very loyal, never took vacations or sick time were actually involved in a complicated scheme of covering the paper trail of theft. By having another person take over the duties for a period of time breaks the pattern that the employee was able to benefit by.

6Conduct an unscheduled audit from an outside accountant. By not knowing when or if the company will be audited makes it more difficult for an employee to cover his or her actions. 

7Be interested in understanding the books. Often time the business owner is more interested in other aspects of the business such as sales or production and views the bookkeeping aspects as drudgery. However, an environment ripe for embezzlement can occur when the owner seems disinterested or the bookkeeping system itself is sloppy and/or unsupervised. The business owner needs to be familiar with the bookkeeping system. But, if you just don't have the interest or the time, then have an accountant from the outside provide periodic oversight. Also, if you use bookkeeping software, make sure that both the computer and the application have the appropriate password restrictions.

8. Be careful when disposing of confidential records. Don't just throw away sensitive information in the trash. This may include things such as financial statements, customer information, receipts and invoices etc. Rather, make sure they are first shredded.

9. Check employee references and background before hiring. Also, consider obtaining fidelity bonding insurance on any employee involved with financial responsibilities. Some bonding companies will also check an employee's background which can also help to identify a potential problem employee.

How to Protect Your Business Through Proper Internal Controls