Internal Controls

Quality of Employees

A business is only as good as the people it employs. Cheap labor is not a bargain if the employees are incompetent. Employees should be properly trained. In fact, they should be trained to perform a variety of tasks. The ability of employees to substitute for one another prevents disruptions when co-workers are absent because of illnesses, vacations, or other commitments. The capacity to rotate jobs also relieves boredom and increases respect for the contributions of other employees. Every business should strive to maximize the productivity of every employee. Ongoing training programs are essential to a strong system of internal control.

Limitations

A system of internal controls is designed to prevent or detect errors and fraud. However, no control system is foolproof. Internal controls can be circumvented by collusion among employees. Two or more employees working together can hide embezzlement by covering for each other. For example, if an embezzler goes on vacation, fraud will not be reported by a replacement who is in collusion with the embezzler. No system can prevent all fraud. However, a good system of internal controls minimizes illegal or unethical activities by reducing temptation and increasing the likelihood of early detection.

Procedures Manual

Appropriate accounting procedures should be documented in a procedures manual. The manual should be routinely updated. Periodic reviews should be conducted to ensure that employees are following the procedures outlined in the manual.

Performance Evaluations

Because few people can evaluate their own performance objectively, internal controls should include independent verification of employee performance. For example, someone other than the person who has control over inventory should take a physical count of inventory. Internal and external audits serve as independent verification of performance. Auditors should evaluate the effectiveness of the internal control system as well as verify the accuracy of the accounting records. In addition, the external auditors attest to the company's use of generally accepted accounting principles in the financial statements.

Authority and Responsibility

Employees are motivated by clear lines of authority and responsibility. They work harder when they have the authority to use their own judgment and they exercise reasonable caution when they are held responsible for their actions. Businesses should prepare an authority manual that establishes a definitive chain of command. The authority manual should guide both specific and general authorizations. Specific authorizations apply to specific positions within the organization. For example, investment decisions are authorized at the division level while hiring decisions are authorized at the departmental level. In contrast, general authority applies across different levels of management. For example, employees at all levels may be required to fly economy class or to make purchases from specific vendors.

Required Absences

Employees should be required to take regular vacations and their duties should be rotated periodically. Employees may be able to cover up fraudulent activities if they are always present at work. Consider the case of a parking meter collection agent who covered the same route for several years with no vacation. When the agent became sick, a substitute collected more money each day than the regular reader usually reported. Management checked past records and found that the ill meter reader had been understating the cash receipts and pocketing the difference. If management had required vacations or rotated the routes, the embezzlement would have been discovered much earlier.

Physical Control

Employees walk away with billions of dollars of business assets each year. To limit losses, companies should establish adequate physical control over valuable assets. For example, inventory should be kept in a storeroom and not released without proper authorization. Serial numbers on equipment should be recorded along with the name of the individual who is responsible for the equipment. Unannounced physical counts should be conducted randomly to verify the presence of company-owned equipment. Certificates of deposit and marketable securities should be kept in fireproof vaults. Access to these vaults should be limited to authorized personnel. These procedures protect the documents from fire and limit access to only those individuals who have the appropriate security clearance to handle the documents.In addition to safeguarding assets, there should be physical control over the accounting records. The accounting journals, ledgers, and supporting documents should be kept in a fireproof safe. Only personnel responsible for recording transactions in the journals should have access to them. With limited access, there is less chance that someone will change the records to conceal fraud or embezzlement.

Prenumbered Documents

How would you know if a check were stolen from your check book? If you keep a record of your check numbers, the missing number would tip you off immediately. Businesses also use prenumbered checks to avoid the unauthorized use of their bank accounts. In fact, prenumbered forms are used for all important documents such as purchase orders, receiving reports, invoices, and checks. To reduce errors, prenumbered forms should be as simple and easy to use as possible. Also, the documents should allow for authorized signatures. For example, credit sales slips should be signed by the customer to clearly establish who made the purchase, reducing the likelihood of unauthorized transactions.

Bonded Employees

The best way to ensure employee honesty is to hire individuals with high levels of personal integrity.Employers should screen job applicants using interviews, background checks, and recommendations from prior employers or educators. Even so, screening programs may fail to identify character weaknesses. Further, unusual circumstances may cause honest employees to go astray. Therefore, employees in positions of trust should be bonded. A fidelity bond provides insurance that protects a company from losses caused by employee dishonesty.

Separation of Duties

The likelihood of fraud or theft is reduced if employees must work together to accomplish it. Clear separation of duties is frequently used as a deterrent to corruption. When duties are separated, the work of one employee can act as a check on the work of another employee. For example, a person selling seats to a movie may be tempted to steal money received from customers who enter the theater. This temptation is reduced if the person staffing the box office is required to issue tickets that a second employee collects as people enter the theater. If ticket stubs collected by the second employee are compared with the cash receipts from ticket sales, any cash shortages would become apparent. Furthermore, friends and relatives of the ticket agent could not easily enter the theater without paying. Theft or unauthorized entry would require collusion between the ticket agent and the usher who collects the tickets. Both individuals would have to be dishonest enough to steal, yet trustworthy enough to convince each other they would keep the embezzlement secret. Whenever possible, the functions of authorization, recording, and custody of assetsshould be performed by separate individuals.