How to Prevent Accounting Fraud

Preventing Fraud

The newspapers and television are full of reports of Enron, Adelphia, WorldCom,
ImClone and other companies accused of fraud or “cooking the books.”  In
your local newspaper you may notice accounts from time to time about the bookkeeper
that stole money.  What protects your business?

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 does not protect against
fraud or innocent mistake occurring.  The balance sheet audit approach
simply tells you the financial condition of the company after the fraud or
innocent error has occurred.  Many audits of small businesses are conducted
using this method, because the system controls are not in place, and this method
of audit is inexpensive.

A systems approach requires documenting the revenue and disbursement procedures
of a company, and the separation of duties or other procedures such that collusion
would be required for an innocent error or defalcation to occur.  People
do make lots of mistakes that can cost an organization substantial dollars,
if the errors are not caught.  So the systems approach is essential.

Disbursement Procedures  When an organization spends money, the
quantity, description, price and authorization for expenditure should be documented,
such as on a purchase order.  In larger organizations, the person preparing
the purchase order and the person authorizing the expenditure are different
people.   Industry statistics show that 85% of screen printing and
embroidery businesses have 10 or fewer people.  So the owner alone should
be authorizing all expenditures.

 If the expenditure is a capital expense, such as for expensive equipment,
or a long term financial commitment like a bank financing or lease, then rules
should be in place to require the approval of higher management in a larger
organization or the Board of Directors.  Perhaps outside counsel like
the accountant or lawyer should be consulted.   The level of approval
is established by how much impact the decision could have on the profitability
of the company.  When more money is at risk, then more care should be
taken that the right decision is being made.

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

If a vendor ships based on receiving your purchase order, the vendor accepts
your terms and prices, regardless of what they are.  If the price you
have entered on the purchase order is not correct, then the vendor is obligated
to get a corrected purchase order before shipping.  Once the vendor ships,
there has been offer and acceptance, and a contact has been completed.

 So 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 whether
early a.m., standard or the economy option to control your disbursement of
funds.  If employees are authorized to disburse company funds, then decision
rules should be established guiding them when to select each option. 

Never enter “Best Way” as the method of shipping, because that
is a blank check.  Did you know that about 80% of your vendors charge
more for shipping than their cost?  You can conserve cash by including
on all purchase orders that you are responsible to reimburse the vendor for
his cost.  Then 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 at how many companies have established
shipping as a profit center.

A great way to protect your business in the freight cost area is to have vendors
ship on your UPS account rather than their account.  If shipping by common
carrier, specify your trucker, if you have a volume discount arrangement with
the carrier, and the class of shipment to save money.

Once the product is received, a copy of the purchase order should be used
to receive the merchandise.  The items should be counted, and the counts
compared to the quantities ordered.  The quantity received should be noted,
and differences verified.  This is also the time to inspect to make sure
the products received match the specification, such as colors, sizes, quality,
and so forth.

Larger businesses log in all receipts and assign a sequential number to the
log with the same number posted to the receiving documents in the event there
is ever a question about merchandise being received.  Never receive on
a packing list provided by the vendor.  If the vendor entered the order
incorrectly, then the packing list will be wrong.  The packing list should
be attached to the purchase order copy to assist identifying the source of
errors.

The paperwork goes to Accounts Payable.  Here evidence of something ordered
(purchase order) is matched to evidence of something received (receiving report
or P.O. copy) and the vendor’s invoice of money due.  These documents
were prepared by different people.  If they all match, then payment is
authorized.  The probability of all three people making the same innocent
error is remote.  Fraud can only occur up to this point when the three
conspire against the interests of the owners of the business.

Accounts Payable prepares the check.  The person who signs should be
different, and should make sure the P.O., receiving report and invoice match
and appear reasonable.  Later that check will clear the bank and be returned
to the company for bank reconciliation.  Those checks should not be available
to Accounts Payable.  In a small business, the checks should go to the
home of the owner.  As part of the bank reconciliation process, the signatures
should be checked.  An owner of a small business would spot a phantom
vendor created by a dishonest bookkeeper or a forgery right away.  All
employees should be covered by an insurance bond as well.

This disbursement system can be flow charted with notations added identifying
the controls ownership is relying on to protect against loss.  The flowchart
could be as simple as columnar paper with the names of the people involved
at the head of each column, and a list of the duties of each person as the
document passes from one person to the next.

Revenue Procedures  The prices you charge should be documented
so that employees charge the approved prices.  If sales orders are hand
written, then these orders should at a minimum be checked against the approved
list of prices to make sure the correct price was selected and numbers were
not transposed.  If prices are on a computer, the opportunity for innocent
error is reduced.

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

Most shops require 50% down with order, and the balance when the customer
picks up the order.  If you ship without payment, then you will waste
time collecting money and be deprived of a key asset required to run your business
- cash.  Be careful about extending credit, because some large companies
purposely pay slowly so the money is earning interest in their account.  Schools
and government can be slow at paying.  You need the cash to pay your invoices
and should work out with the customer when the order is placed how you will
be paid at time of delivery.

In our business we photocopy all checks which go into a cash receipts binder
along with credit card slips and itemized deposit slips.  That cash binder
is then agreed to the bank statement and entries in the general ledger to make
sure the money was posted to our accounting records and bank correctly.  Again,
we want to avoid innocent error and be sure we do not have a silent partner
in the business.

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

Documenting disbursement and revenue procedures does not guarantee an organization
will be profitable.  The effort does protect against unintended loss.  To
be sure a company is profitable, the revenue and cost of every transaction
must be measured.  Some of the costs are incurred solely for the purpose
of earning the revenue, and are therefore easy to measure and document.  The
overhead, or period charges, like rent, power, insurance, and even salaries
are more difficult.  That is the subject of another article.

How Did the Fraud Occur?  The companies we have been reading about
that are now under investigation for fraud did not manipulate the disbursement
or revenue procedures as presented above.  However, the procedures above
are critical to the success of your business.

When commentators talk about “cooking the books,” they are referring
to a variety of methods to overstate revenue.  For example, disbursements
normally classified as an expense that is an offset to revenue might be recorded
as an asset.  That produces revenue or income in the current accounting
period without the expense being recorded.  Later those companies “write
down” their assets and typically show  losses later.  A variation
on this theme is to transfer those “assets” to another company
so what is really a liability does not appear on statements creditors and investors
review.  Outside independent auditors should be checking those transactions
and independently confirming the market value of all assets and liabilities.

Frequently assets in fraud situations are over valued.  When the season
is over, inventory loses value and should be marked down at retail and equally
in the inventory cost records.  Old accounts receivables should be written
off, even though management may still be trying to collect.  All the equipment
or other property assets should be in use and have the commercial value as
stated in the records, or be written off and removed from the business.

Poorly advised and dishonest people find other ways in large companies to
misrepresent the financial condition of a business, such as the accounting
for stock options, pension plans, derivatives and more.  However, these
technical accounting areas are not confronted by people in small businesses,
and therefore not a risk to a screen printer or embroidery shop owner.

Conclusion  Your business will be protected from innocent error
and fraud by documenting fundamental disbursement and revenue procedures and
identifying the multiple of people that have to be involved for a loss to occur.