Posted on Aug 18, 2015

‘Internal controls’ – accountants love to throw the phrase around and tell you just how important it is to have them.  They’ll tell you that without them your financial information will be inaccurate, your accounting practices inefficient, and in all likelihood your employees will steal from you. Hearing this may worry you, and in all honesty, it should. Accountants don’t just say these things to scare you. In our experience, it is absolutely the truth.

Accordingly, the accounting profession will gladly help you create procedures to reduce your risk. One of the most basic of these procedures is to make sure that you have one person create invoices for customers, another collects payments and creates deposits, another person take them to the bank, and a third person reconcile the accounts. By using this structure, each person’s work is verified by another person, which drastically reduces the likelihood of errors or theft. The same process works for vendor payments: you can have one person enter invoices, another person processes the payments, and yet another approves the payments.

Easy, right? Actually, the methods are quite simple. However, if you own or manage a business with less than five or six people in just your accounting department, this setup is all but useless. Many, if not most of you reading this have one or less dedicated accounting staff, much less an entire dedicated team. Fortunately, a very large segment of the accounting profession is dedicated to small and medium sized business that have been developing processes that can be tailored to your needs.

Let’s take the first example, which involves invoicing clients, collecting payments, and getting their payments into the bank. The reason the profession tries to separate these duties is that, in theory, an unscrupulous employee could create an invoice, receive the payment, then route the funds to his or her accounts rather than the business. Then, the invoice is deleted from the system, and no one ever notices.

For a small business, the combination of technology and management and owner oversight can effectively combat this scenario. Most modern accounting software packages can create warnings when an invoice number is missing or out of sequence. There are also several solutions available for making deposits. First, you can request your customers pay you electronically using a credit card or an online service provider. Additionally, you can use an electronic check reader from your bank to electronically deposit all checks immediately upon receipt, rather than taking any of them to the bank. For those in cash heavy industries, many banks will provide you with on-site lockboxes in which the cash can be immediately inserted and deposited. The bank then makes this cash available to you and will periodically come by to pick up the funds from your location.

The final step involves oversight from either the owner, a supervisor, a third party, or a combination of those parties. Any one of those individuals must be able to check the system warnings for invoice numbers that are out of sequence. They can then review the accounts receivable aging reports to confirm customer balances. Finally, the bank account should be reconciled by one of these individuals. By utilizing this streamlined process, a small business or medium size business can protect itself with the same policies and procedures as a large accounting department.

One very important idea should be sticking out to you while reading this; the internal control system described above still requires the people (or person) in your organization to do their job honestly and effectively. That is why the last step – oversight – is crucial to the power of the control system. Without it, people can simply skip steps or worse, work together to circumvent the controls.

That means the supervisor must be someone that understands what the end result should be. In this example, he or she should be able to quickly scan an invoice listing noting anything out of sequence. This person should also be able to trace a customer’s transaction from the invoice to collecting payment and depositing it into the bank. It should also be someone that does not have an incentive to circumvent the system.

The owner is a somewhat obvious choice for the supervisor role. The trade-off for the owner performing this duty is the loss of time and energy available to grow the business. If, however, it is not in the business’ best interest for the owner to supervise this duty, another person must be chosen. This could be a separate executive level employee within the organization. An outside party such as your external CPA could step in to perform this function at the end of each month as he or she works with you and your accounting staff to close the books.

There is a definite need for strong internal controls for businesses of all sizes. We have only explored an accounts receivable and deposits scenario today, but we will continue to explore different examples in the future. All businesses – big and small – need effective internal controls. Continue checking in with us, as we’ll continue providing real life solutions custom tailored for small and medium businesses.