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Dishonesty made easy: the importance of internal controls.

A bakery driver found that selling bread stolen from his employer was a profitable sideline. Shift supervisors at a small manufacturer of portion control meat products, in collusion with driver-salesmen, made off with $90,000 a year by pocketing cash from sales made on various routes.

Over my 30 years of professional experience as a certified business management consultant and public accountant, my calling has been to administer to sick companies on the verge of bankruptcy--caused mainly by lack of effective internal controls.

Any business can get ripped off. If it does, the culprits probably are close by. Based on my auditing experience, losses primarily are caused by employees. The biggest peril is from trusted people.

Small companies can be easy prey. Their accounting systems usually lack tight controls because of the extra expense involved. A few employees normally do a number of critical jobs, weakening the first line of defense against employee dishonesty: segregating duties. The bookkeeper who makes bank deposits, opens the mail and draws checks for someone else's signature can divert receipts or forge checks and docter the books to hide the loss.

Simple Precautions

A basic precaution a company can take is to check out people before hiring them. In Pittsburgh, one firm charges from $50 to $100 for a simple background check and more than $350 for a probe going back at least ten years.

Some simple precautions can make larceny difficult. Segregation of duties is the biggest single deterrent. For example, the person who makes accounts receivable entries shouldn't be the one who opens the mail or receives checks, because that person could divert the checks and cover up by juggling the records. One juggling method is to credit customer accounts for fictitious returns of goods or price adjustments.

One person should make accounts receivable entries and another should open the mail, list, endorse and total incoming checks and perhaps make up a bank deposit. If the latter person diverts checks, receivables won't be adjusted to hide the fraud and eventually the customers will complain about being billed for sums they have already paid. Complaints about statement balances from customers can signal something wrong: bookkeeping may be sloppy, someone may be embezzling or both.

Improving Documentation

Sloppy recordkeeping invites cheating, for employees know money can disappear without immediate detection. Good controls mean that nothing moves in or out of inventory without documents such as purchase orders, receiving tickets, bills of lading, invoices, sales orders and shipping tickets. Different people should process forms to act as a check on one another. Fraud can then only be covered up by collusion of two or more employees.

A common safeguard is a system of documents to control purchasing, sales, shipping, receiving, billing and collections. Sequential numbering is essential. A missing number should be taken as evidence of a possible problem. However, controls can only work if they are maintained and monitored. As was previously pointed out, it is risky to entrust several bookkeeping functions to one person. Someone in charge of both billing customers and accounting for collections can divert money and cover up the fraud by altering records of accounts receivable and cash receipts. Sometimes owners don't realize they are making dishonesty easy.

Cash creates the most temptation and usually is under the tightest controls. But a company has to check periodically to see if the controls are working. Such a check might have caught a manager at a busy branch office of a fast-copying service where $200 and $300 jobs were common. He had a receipt book of his own. To steal cash he simply gave customers a receipt from his book instead of one of the company's numbered forms. His cheating was spotted by an undercover investigator posing as a customer.

Paperwork should tie into the books. For instance, bills should be paid only when the amount tallies with a valid purchase order, receiving ticket and invoice. The person who issues purchase orders shouldn't be authorized to approve the receipt of goods because such dual authority provides the opportunity to cheat.

Remember: The person trusted the most often is the one who can steal with the least effort. You shouldn't put all your trust in one person because when temptation is there, many people will take it.

Methods Used to Embezzle Money

The ways in which employees may misappropriate money or other property of their employers are limited only by their ingenuity. Such thefts may range from the simple pocketing of an expensive tool to the most intricate accounting manipulation. Following are some of the more common methods of embezzling money:

* Issuing checks in payment of bills of fictitious suppliers and cashing them through a dummy or by faked endorsements.

* Invoicing goods below established prices and getting cash kick-backs from the purchasers.

* Raising the amount of checks, invoices and vouchers after they have been officially approved.

* Issuing and cashing checks for returned purchases not actually returned.

* Pocketing the proceeds of cash sales and not recording the transaction.

* Pocketing collections made on presumably uncollectible accounts.

* "Lapping," i.e., pocketing small amounts from incoming payments and applying subsequent remittances on other items to cover the shortages.

* Forging checks and destroying them when returned by the bank, then concealing the transactions by forcing footings in the cash books or by raising the amounts of legitimate checks.

* Padding payrolls as to rates, time, production or number of employees.

* Paying creditors' invoices twice and appropriating the second check.

* Stealing from the cash register and tampering with the tape.

* Misappropriating cash and charging the amounts taken to fictitious customers' accounts.

* Increasing the amounts of creditors' invoices and pocketing the excess or splitting with the creditors.

* Pocketing unclaimed wages or dividends.

* Pocketing portions of collections made from customers and off-setting them on the books by improper credits for allowances or discounts.

According to a report published in the Wall Street Journal by the National Association of Certified Fraud Examiners, "Half of those |employees involved in fraud~ caught are nabbed by accident; tips snare one-third and audits the rest."

Louis A. Orlando, MBA, served as internal auditor on the controller's staff of Youngstown Sheet & Tube Company before opening his own office 12 years ago. He recently completed a four-year term as a member of the Pennsylvania State Board of Accountancy.
COPYRIGHT 1993 National Society of Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Orlando, Louis A.
Publication:The National Public Accountant
Date:Sep 1, 1993
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