Proper accounting controls are the single most important part of your business. Consider the following scenarios:
- Your sales group achieves record performance for the quarter. However, your accounts receivable accountant pilfers several thousand dollars as those accounts are collected.
- As CEO, you successfully execute the merger of your company and a chief rival. However, two quarters after the merger, you find you cannot account for $1.3M in physical assets of the company. It is unclear whether the missing assets are from your historic company or from the merged rival.
- You are in a cash-heavy business. Most of your transactions are handled by a customer-facing staff member who collects the money and records the sale. You suspect embezzlement may be occurring but all the records seem to be accurate.
Josef Stalin once said that it doesn’t matter who does the voting – what matters is who counts the votes. Just so with accounting. The business that harbors an unchecked rogue accountant is a business facing the most serious threat of all.
No fruitful area of the business is safe from such an affliction. Increased sales may mask the problem. Successfully executed business strategies may operate parallel to it. But no measure of real success is possible without proper accounting controls.
Separation of Duties
The most fundamental protection against fraud is the separation of duties. For small and medium-sized businesses that have been victimized by embezzlement, the root cause can typically be traced back to one person who was operating without proper oversight. Perhaps the person who recorded the accounts receivable was the same person who collected the payments. That’s the sort of situation begging for trouble: the record-keeper is also the one handling the money.
A common example is your local movie theater. When you go out to catch a movie, you go to the window and give the cashier money for your ticket. In return, the cashier rings you up and gives you a ticket.
What’s to stop that cashier from giving you a ticket and pocketing your money for themselves? Personal honesty? Perhaps. But to ensure honesty is the rule, something else is added to this dynamic: the usher inside who takes your ticket stub to allow you entry. Typically that usher will tear up that ticket and deposit the stub in a receptacle to be counted later by management. The number of sales should match the number of ticket stubs in the receptacle. If you have more ticket stubs than recorded sales, it’s quite possible someone is pilfering cash transactions.
Can the cashier and the usher work together to subvert this control? Absolutely! This is called collusion. But collusion is more difficult to initiate because it takes coordination between two or more bad actors instead of one person acting alone. The courts frequently punish collusion more harshly – in no small part because the action is clearly premeditated.
Many employees are honest and would never steal from their employer. But the problem is that you can never really know the inner motivations of another person. There are many sad files at the police department full of statements about the employee who “would never steal” robbing their employer blind.
Sarbanes-Oxley and You
In late 2001, a little company named Enron declared for bankruptcy. Billions were lost. It was the largest Chapter 11 bankruptcy to date.
An outcome of Enron, Tyco, and WorldCom was a piece of legislation called Sarbanes-Oxley (or SOX), named after the U.S. congressmen who sponsored it. A key provision of SOX was that the senior management of a publicly-traded company must take individual responsibility to certify the accuracy of financial records in their company.
An independent auditor must also certify the records. Gone are the days where a firm like Arthur Anderson can double-dip as an auditor and a consultant for the same customer.
The law also recommends increased penalties for white-collar crime and conspiracies designed specifically for an unethical CEO or CFO who wants to overstate profits for better stock market performance.
A lot of provisions in the law sound sensible and seem to achieve the aim of more accurate and rigorous financial records. Corporate governance is likely better as well. But SOX is not without a downside. Businesses – particularly those small and middle-of-the-road public businesses – now face an increased financial burden to navigate the new corporate requirements.
There is also the fact that whole 2008 economic meltdown happened even with Sarbanes-Oxley in full effect. This fact should give any neutral observer pause to wonder how well the legislation does to treat the problems it tries to tackle.
Perhaps the main takeaway is that you must be constantly vigilant for possible misdeeds in your business. Human ingenuity has shown itself up to the task to overcome any set of controls, given skill and opportunity. All one can really do is prepare – prepare and research the accounting controls that have been devised. Once aware of those controls, you have the opportunity to apply them and hopefully save your business from disaster.