Internal controls are the policies and procedures that a firm uses to safeguard its assets, insure the accuracy of financial reporting, and prevent fraud. Insuring the accuracy of accounting information can involve something as simple as designing transaction registers and journals that minimize the mis-recording of transactions. Other common sense policies involve purchasing reliable accounting software and hiring well-qualified bookkeeping personnel to handle basic accounting tasks.
There are several widely used internal control procedures to prevent employee theft. Three of the most important controls are employee bonding, segregation and rotation of duties, and budgeting. Bonding is a form of commercial insurance that indemnifies a firm against employee theft. Usually, a background check is required to obtain bonding for any particular employee. Many umbrella commercial insurance policies include blanket employee theft coverage that does not require specific background checks.
Segregation of duties ensures that employees who handle cash or other assets do not also have access to accounting records. This prevents employees with access to both assets and accounting records from covering up their thefts.
Another control involves shifting personnel into different job functions on a periodic basis or forcing employees to take vacations and having someone else perform their job functions for a certain period of time. The logic of this internal control is that certain frauds, such as lapping schemes, require the fraudster to maintain continuous control over a certain accounting function. Here is an example involving a lapping scheme.
Budgeting is the process of predicting the operating revenues and expenses for the next accounting period. This process serves as an internal control when owners regularly compare current actual revenue and expense with budgeted amounts. Failure of actual results to fall within a reasonable range of budgeted amounts should cause the owners to investigate the reason for the variance.
Failures to Implement Internal Controls
Most frauds occur in small firms because their financial statements are rarely audited and they often lack the resources to implement proper internal controls. Many small firms cannot afford the cost of hiring enough staff to implement proper segregation of duties. Another more subtle reason why internal controls are not effectively implemented stems from human psychology.
The premise of internal controls is that people are susceptible to dishonesty and that special efforts must be implemented to protect a firm from its own employees. This is an easy premise to accept when thinking about human beings in the abstract. However, it is more difficult to think of your employees as potentially dishonest. When you work closely with another person over any period of time, it is natural for trust to develop. The conscientious implementation of internal controls in a small business may send a subtle message that there is a lack of this natural trust.
On the other hand, it is precisely the tendency to trust that gets many small business owners into trouble. They do not make the effort to implement the needed controls, because the burden of mistrusting their own employees is too great. In fact, the shock and anguish of employers who have been betrayed by trusted employees who have acted dishonestly, is often more painful than the monetary loss (which is often insured).
A good source for fraud prevention visit www.acfe.com
(Association of Certified Fraud Examiners) You can download for free Fraud Prevention Check-Up.