How to Prevent Accounting Fraud

Bad accounting habits seem to be cropping up everywhere these days. New information surfaces almost daily about Enron, Adelphia, WorldCom, ImClone and other companies accused of fraud or cooking the books. You may even read accounts in your local newspaper about a bookkeeper stealing money.

Poorly advised or dishonest people in large companies can find numerous ways to misrepresent the financial condition of a business, including accounting for stock options, pension plans, derivatives and more. Just because small businesses such as screen printing or embroidery shops don't face these technical accounting challenges doesn't mean there's no potential for fraud. With this in mind, it's a good time to ask yourself, "What's protecting my business?"

Systems Check

You can protect your business from both innocent error and intentional fraud by documenting fundamental disbursement and revenue procedures and identifying the number of people that have to be involved for a loss to occur.

First, the CEO and auditor of your business should review documentation of how your accounting systems work, and identify what controls are in place and who has responsibility to exercise those controls.

A simple audit verifies all the assets and liabilities. Inventory is counted. Accounts receivable are confirmed with customers. Cash is counted, and all liabilities are confirmed. The difference between assets and liabilities is stockholders' equity and capital stock. Any increase or decrease in the equity since the last audit is profit or loss.

This is an easy way to account for profitability, but doesn't protect against fraud or innocent mistakes. The balance sheet audit approach simply tells you the company's financial condition after the fraud or innocent error has occurred. Many small business audits are conducted using this method because the company does not have systems controls in place, and because this audit method is inexpensive.

A systems approach requires documenting the company's revenue and disbursement procedures, and the separation of duties or other procedures such that collusion would be required for an error or embezzlement to occur. People do make mistakes that can cost an organization substantial amounts if the errors aren't caught. That's what makes the systems approach essential.

Spending Habits

When an organization spends money, the quantity, description, price and authorization for expenditure should be documented (usually via a purchase order). In large organizations, the person preparing the purchase order and the person authorizing the expenditure are different people. Industry statistics show, however, that 85% of screen printing and embroidery businesses employ 10 or fewer people. In such cases, the owner alone should authorize all expenditures.

For capital expenditures (purchasing expensive equipment or entering a long-term financial commitment such as bank financing or leases), large organizations should have rules in place requiring the approval of higher management or the board of directors. Perhaps outside counsel such as an accountant or lawyer should be consulted.

The levels of approval required are determined by how much impact the decision could have on the company's profitability. The more money at risk, the more care should be taken that the right decision is being made.

Capital expenditures in large companies require close scrutiny such as payback analysis and discounted cash flow analysis. These techniques, which can be explained by your accountant, measure how fast the business will recover the investment in the form of profits earned from the assets being acquired. This is simply the due diligence wise business leaders exercise to conserve and grow their assets.

Shipping Strategies

If a vendor ships upon receiving your purchase order, the vendor accepts your terms and prices, regardless of what they are. If the price you entered on the purchase order isn't correct, the vendor is obligated to get a corrected purchase order before shipping. Once the vendor ships, there has been offer and acceptance, and a contract has been completed.

On your purchase order you might want to specify the method of shipment to minimize your shipping cost. If you know UPS is less expensive than other options, specify UPS. If you want Next Day Air, specify the early morning, standard or economy option to control your disbursement of funds. If employees are authorized to disburse company funds, then rules should be established for when to select each option.

Never select "Best Way" as the shipping method when making a purchase; that's like handing the vendor a blank check. Did you know that about 80% of your vendors charge more for shipping than their cost? Conserve cash by noting on all purchase orders that you will reimburse the vendor for his cost. When the package arrives, weigh it and look up the cost to ship the same package to the vendor. Pay no more than that amount. When you exercise this control, you will be shocked to find out how many companies have established shipping as a profit center.

One way to protect your business in the freight cost area is to have vendors ship on your UPS account rather than on theirs. If shipping by common carrier, you can save money by specifying the company (if you have a volume discount arrangement with a carrier) and the class of shipment.

Use a copy of the purchase order during the receiving process. Count the items and compare the counts to the quantities ordered. Note the quantity received and verify any differences. Make sure the products received match specifications, such as colors, sizes and quality.

Large businesses log in all receipts and assign a sequential number to the log. The same number is posted to the receiving documents in the event a question arises about merchandise being received. Never check merchandise received against the vendor-provided packing list. If the vendor entered the order incorrectly, the packing list will be wrong. The packing list should be attached to the purchase order copy to help identify the source of errors.

Send the paperwork to accounts payable. Here evidence of something ordered (a purchase order) is matched to evidence of something received (a receiving report or a copy of the purchase order) and the vendor's invoice. These documents were prepared by different people and if they all match, payment can be authorized. The probability of all three people making the same innocent error is remote. At this point, fraud can only occur if all three conspire against the owners' interests.

Someone in accounts payable will prepare the check. Someone else should sign and make sure the purchase order, receiving report and invoice match and appear reasonable. Later that check will clear the bank and be returned to the company for reconciliation. Those checks should not be available to the accounts payable department. In a small business, the checks should go to the owner's home. Signatures should be checked as part of the bank statement reconciliation process. A small business owner would spot a phantom vendor created by a dishonest bookkeeper or a forgery right away.

This disbursement system can be documented on a flow chart with notations added identifying the controls ownership is relying on to protect against loss. This can be as simple as recording the process on paper with the names of the people involved at the head of each column next to a list of the duties each performs as the document moves down the chain.

Revenue Procedures

Create a price list so employees charge the approved rates. Handwritten sales orders should, at a minimum, be checked against approved price lists to make sure the correct price was selected and numbers were not transposed. Storing prices in a read-only computer file reduces the opportunity for innocent error.

Many screen printing and embroidery businesses require the customer to sign off on a proof of the artwork. This is also an excellent time to have the customer sign verifying other conditions of the order, such as quantity by size, color, style, art charges, expediting charges or any other term that affects revenue. Otherwise, customers may later deny they requested you disburse the funds on their behalf and try to not compensate you.

Most shops require a 50% down payment with the balance due when a customer picks up the order. If you ship without payment you will waste time collecting money and be deprived of a key asset required to run your business?cash.

Be careful about extending credit; some large companies purposely pay slowly so the money continues to earn interest in their bank account. Schools and other government entities can also be slow to pay. You need the cash to pay your invoices. How you will be paid at delivery time is something you should work out when the order is placed.

Photocopy all checks and place them into a cash receipts binder along with credit card slips and itemized deposit slips. Reconcile the binder's contents to the bank statement and entries in the general ledger to make sure the money was posted to both the accounting records and bank account correctly. Such processes will help avoid innocent error and detect intentional error.

Assign the reconciliation process to a person not involved in the disbursement or revenue procedures. In a small business, that probably means the owner will be reconciling cash at home at night. The volume of work can be reduced by issuing paychecks from a separate account funded with the total amount of all paychecks to be disbursed. Each pay period the account will be reduced to a safety amount such as $100 to cover bank charges.

Documenting disbursement and revenue procedures does not guarantee profitability. These actions do, however, protect against unintended loss. To be sure a company is profitable, the revenue and cost of every transaction must be measured. Some costs are incurred solely for the purpose of earning revenue, and are therefore easy to measure and document. Overhead, or period charges, such as rent, power, insurance and even salaries are more difficult to work with.

Protecting your business from fraud is time-consuming and requires in-depth thought about the way your operation is structured. However, as more revelations of shady book-keeping practices come to light, it's obvious that the time it takes to put even the most basic safeguards in place is time well spent.

Roger Jennings is president of R Jennings Mfg. Jennings has written numerous technical and business articles for IMPRESSIONS and been a seminar speaker at the Imprinted Sportswear Shows for 20 years. Contact him at (518) 798-2277 or e-mail roger@rjennings.com.