Week 3: Accounting Controls

Proper accounting controls are the single most important part of your business. Consider the following scenarios:

  1. Your sales group achieves record performance for the quarter. However, your accounts receivable accountant pilfers several thousand dollars as those accounts are collected.
  2. 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.
  3. 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.

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6 thoughts on “Week 3: Accounting Controls

  1. Hi Nick,
    It amazes me how many people who learn a trade and get the degrees and go into business with such great intentions and hopes of having a great job just to fall into the possibility of theft and loose it all. I have heard even in our small town of people that took hundreds of thousand of dollars over a time of years and they for the longest time never got caught. You would think that along the way someone would have seen a red flag.
    This is why I think it is so important that an owner or President know accounting. Maybe not enough to do it all but enough to look at a set of books and say there is a problem here some place.
    Mary

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  2. My father’s company had someone employed for 20 years. Later they found the same problems you are describing. A cash system that “lost” cash slowly and imperceptively. They never figured out why

    There are so many reasons why people can migrate from being trustworthy to deceptive. It’s easy to get into personal financial trouble from accidents, health problems or even gambling. And we know about kids and lying. The first lie is small, then the other lies have to grow to cover up the first until all there are is lies.
    So a dual system is indeed essential.

    I like how you take it out of the individual realm and move it up to the organizational level. I see the same thing in science. Most of the scientific findings are not reproducible because no one is funded to reproduce results. So we end up with findings that “dietary cholesterol is bad” and then later are told, “actually eggs are fine”. Similarly, we were told that fat was bad for us by a bunch of scientists (funded by the sugar industry). 30 years later we are told that actually there is no data that fat is bad and perhaps dietary fat (even potentially saturated fat) is good for us. We need dual systems at all levels.

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  3. Nick,
    Very interesting post. Like Brad, my father’s company had the same issue with a long term employee. As I read about these crimes in the paper I am always amazed that people do not think they will get caught. I know there are many reasons people steal. I would think the penalties would keep people from trying if not for the harm they do to themselves but for the harm they do to their family.
    Cece

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  4. Great Post. Thanks for informing us on this situation and giving us real life examples, like the movie theater. You are right, people should not be allowed to “double-dip” positions, it has a recipe for disaster. We hope that good human nature over comes all obstacles, but sometimes we as humans get in the way of our selves. So, any business owner must stay alert and on top of their records.

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  5. Nick,

    If I have an accounting person it will definitely be someone I really trust and not allowing double dipping. These things can happen and people get taken advantage of, and you have to be cautious and prepare for these situations. I would most likely do all my accounting myself but if I have someone else in charge of numbers and finances it will be my father who has a degree in finance and I know that I could trust him with all my information and he would catch it if something seemed off and could find the source of the problem. It’s important to have a good finance person you can trust in these types of situations.

    Thanks,
    Mackensie

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  6. You really must be careful who you trust to placed in certain positions. When money is involved it is a lot at stake. But, we must trust someone because, we don’t want to spend time in a position when it can be delegate. Likewise, good faith and really do a good background.

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