One of the often cited – and often ignored – measures of internal control is separation of duties. This is especially true for smaller businesses who have fewer people involved in their operation. Over time it’s easy to let responsibilities flux and change, but it can result in huge losses. Let’s consider the following scenario:
An entrepreneur has a great idea for a new business. In the beginning the business owner does it all themselves, and it’s back-breaking work. They market the business, track the sales, fulfill orders for products and services, invoice the customers, collect payments, handle the banking, and pay all the bills. They’re super human!
At some point, the business owner realizes they can’t keep up with everything. Their phone notifications are constantly buzzing, their email inbox is perpetually stuffed, and things start to fall through the cracks. They decide to hire help to respond to customer inquiries. The new customer service rep helps so much the business owner hands off the task of invoicing all the customers too, but they continue to do the rest of the bookkeeping themselves.
After awhile the business owner decides the data entry isn’t worth their time and energy to maintain, so they cross-train their trusty customer service representative to take over entering customer payments and putting together the bank deposits. “Just make sure you invoice all the completed sales orders at the end of the day and everything will run like clock work!” It’s what the business owner has done hundreds of times before and they trust their highly competent assistant will probably do it even better than they did.
Relieved to finally have more time to devote to sales, the business owner charges ahead with all the leads they didn’t have time to pursue when they were bogged down with invoicing and banking. Revenue soars and everyone is happy.
Since handing off the invoicing task worked out so well, the owner decides to finally let go of trying to keep track of all the bills that have to be paid. The paperwork is pouring in now that sales have increased and trying to keep up is draining all the owner’s time and energy.
The seasoned customer service rep gets a promotion to “office manager” and trains on entering bills. The promotion comes with a generous raise and all kinds of praise and thanks for being willing to step up to the challenge and be a team player.
Time passes and both business owner and office manager settle into their routines. The business owner starts taking business trips out of town which often double as weekends away with their significant other. The office manager starts to feel chained to their desk and underappreciated.
Then the office manager makes a mistake.
The business owner overreacts and doesn’t apologize for the outburst. They disregard any claims that the workload is too much and they refuse to make any changes that might make the system more efficient. “I did it just fine for all that time before I handed it off to you. You just have to be more careful!” the business owner asserts. The owner continues on with their same routine without regard to why the mistake might have happened. And the office manager doesn’t forget.
Then the office manager makes a mistake… and the business owner doesn’t notice. Instead of bringing it to the owner’s attention they just make an adjustment to the account. It avoids the confrontation, the outburst, and the humiliation. “What they don’t know won’t kill them,” the manager justifies.
Over time it becomes obvious that the business owner really isn’t paying attention to the financial details. The manager decides to test the theory. A new customer places and order and pays with cash while the owner is out of the office. Instead of advising the customer that cash isn’t accepted, the manager takes the cash, logs the payment in the system, and gives the customer a receipt.
Before the owner returns, the manager deletes the payment from the system. Then they delete the invoice. Finally, they shred the sales order. As far as anyone can tell, the order never existed. The manager pockets the cash, sure that the business owner will never find out. They justify the decision based on the way their treated, the feeling that they’re underappreciated, and the thought that the raise they got was pathetic compared to how much more work they do.
On it goes until the office manager becomes over-confident or slips-up in their new scheme and the owner discovers the manager’s secret cash-skimming habit. The business owner fires the office manager immediately with no way to prove how much money was actually stolen.
The 2018 Association of Certified Fraud Examiners (ACFE) Report To The Nations claimed that internal control weaknesses were responsible for nearly half of all reported occupational frauds. Also, 42% of the cases reported throughout the world occurred in private companies and small businesses with less than 100 employees. The median loss reported in small businesses was $200,000.
Source: https://s3-us-west-2.amazonaws.com/acfepublic/2018-report-to-the-nations.pdf
The scenario above painted a picture of just one way the lack of separation of duties can result in fraud. If you’re looking to hire someone, by all means hire someone to fill the need; however, you’ll be much better off hiring a second person (or bookkeeping firm!) to cover your accounting tasks when you’re ready. Don’t put it all on just one person.
Pages 76-77 of the report mentioned above includes a fraud prevention checklist which I highly recommend using for your own business self-assessment.
Also, consider implementing one of the 18 fraud controls studied by the ACFE. In every case, the presence of one of these controls reduced the company’s potential losses:
- Code of conduct
- Proactive data monitoring/analysis
- Surprise audits
- External audit of internal controls over financial reporting
- Management review
- Hotline
- Anti-fraud policy
- Internal audit department
- Management certification of financial statements
- Fraud training for employees
- Formal fraud risk assessments
- Employee support programs
- Fraud training for managers/executives
- Dedicated fraud department, function, or team
- External audit of financial statements
- Job rotation/mandatory vacation
- Independent audit committee
- Rewards for whistleblowers
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