Establishing an Internal Control System to Prevent Embezzlement

Any small business is a potential target for embezzlement. You can fall victim to this crime when there are no internal controls to ensure all monies are accounted for. Key to stopping embezzlement is implementing a dual control system on accounting functions.

A dual control system requires the authorization or approval of two individuals to complete a transaction. It’s that simple. One individual should not be responsible for an entire financial transaction from beginning to finish. Many small companies fall into the trap of having one bookkeeper handle all accounts payable and accounts receivable and write, sign, and deliver the checks. The dual control system puts a second set of eyes on transactions, greatly lessening the risk of embezzlement.

Preventing fraud and embezzlement in business requires diligence on the part of the manager and the owner. There are four areas to which business owners should pay special attention:

• Accounting books/reconciliation: The first thing a business needs is good financial books. The business needs to track where money is coming from and where it is going. Books need to be current, and the manager needs to look at the income statement, balance sheet, accounts payable, and accounts receivable on a monthly, if not weekly, basis. Knowing where every penny and inventory item is in your company is vital. Your books need to be audited by an outside firm at least once every year. Your bank accounts need to be reconciled with the books and with themselves on a monthly basis, and if at all possible, that reconciliation should not be performed by the bookkeeper. Your bookkeeper should take a full, uninterrupted annual vacation of at least two weeks if possible. This permits transactions under the bookkeeper’s control to clear properly in his or her absence.
• Check signing and disbursement: The bookkeeper should not sign checks. The business head or owner should sign every check that goes out of the company. Each check should be looked at, and if you do not know what it is for, ask questions. All checks should require two signatures.
• Inventory: A common way of committing fraud in a company is to place orders to fictitious companies for materials that are never delivered but are paid for. Reconciling orders to inventory on a periodic basis can catch this problem. In many small businesses, employee theft of inventory is a real problem (particularly in small restaurants). Taking partial inventory on a random basis will help detect and dissuade employee theft.
• Cash: If your business is a cash business, you have another set of problems. As an example, a small chain of coffee shops in Seattle was having financial problems. Each of the shops was unprofitable, but each seemed to be generating enough customer flow to make money. The owner started working in each of the coffee shops on a periodic basis and quickly determined that they did generate enough cash to be profitable. The problem was the employees were pocketing the cash from some of the coffee sales. The owner then established a dual control system where he took an inventory of cups and reconciled it to the daily dollar sales and quickly determined where the problems were. Reconciling cash to inventory is key in many cash businesses.

John C. Shovic is a partner in Coeur d'Alene, Idaho–based MiloCreek Consulting.