Internal Controls And The Five Senses

Large scale corporate malfeasance over the past decade was a call to action for the executive and legislative branches of our government. They responded (as only our government can) with a massive piece of legislation called the Sarbanes-Oxley act. The act contained a myriad of new laws aimed at strengthening the internal control and reporting standards for public companies. All of this came with a hefty cost to American companies, and ultimately the taxpayers to whom they pass along their costs. And just what is the cost? A study by the law firm of Foley and Lardner found the Act increased costs for publicly held companies by 130 percent!

Money is often a solution for problems; and fraud is no different. With enough money, companies can implement processes and standards to prevent or reduce fraud. But small businesses are not covered under the Sarbanes-Oxley umbrella, which is actually a good thing since it would cost more than the typical small business could bear. While many small businesses are plagued by deficient internal controls, protecting the business from fraud does not have to be an expensive endeavor. To a degree, sufficient internal controls are as simple as the five senses: sight, hearing, touch, taste and smell.

We’ll start with sight. When a small business finds itself the victim of employee fraud, I’ve found the business owner typically does not even look at the basic accounting documents. I was involved in a case in which the bookkeeper pocketed every single bit of cash received from customers for almost three years. During this time, only checks were deposited at the bank–never any cash. This company’s cash sales were small in comparison to the check side of the business. However, the missing cash added up to about $300,000 over the relevant time frame. This fraud could have been prevented, or caught very early on by using the sense of sight. If the business owner simply looked at the prepared deposit tickets, or the deposit receipt validated by the bank, he would have seen rather quickly that cash was not being deposited. As it turns out, however, nobody other than the bookkeeper ever saw the deposit tickets.

The topic of sight reminds me of another case. The victim this time was an ophthalmologist. There were virtually no segregation of duties within the office; the office manager pretty much handled everything. And in this case, “everything” included stealing a healthy chunk of cash receipts. The company’s monthly financial statements were compiled by a local certified public accountant. As such, the office manager knew that if the bank deposits did not match the computerized sales records, she would be discovered. So to cover her tracks, she created phony refund transactions commensurate with the amount of cash she was stealing. The first year during which she perpetrated the fraud, the company’s refunds grew from around two percent of revenue to eight percent. This aberration was clearly shown in both dollar and percentage terms on the second line of the company’s income statement. The business owner never even looked at the statements. Apparently, the accountant didn’t either. But for the most extreme circumstances, refunds should never be so high for a professional practice. If only the owner had used the sense of sight and looked at the statements early in the life of the scheme!

The next sense is hearing. Small business owners should listen carefully to what they hear. I once evaluated a case where the company’s office manager was stealing money using various methods. She racked up over a quarter-of-a-million dollars in ill-gotten gains. Her scheme was ultimately detected only by happenstance. When I interviewed the business owner, he recalled a time when he heard this employee talking about the new lake house, jet skis and other goodies that she and her husband were enjoying. Knowing what he paid his officer manager, he admitted that hindsight was 20/20. However, business owners need to turn hindsight into foresight. To do so, small business owners must listen carefully to what they hear in the office.

It is also important that the would-be perpetrator hear certain things. During the hiring process, employees should hear that the company has a zero tolerance policy for theft, and the company will prosecute any wrong-doers. If the business carries fidelity (a/k/a employee dishonesty) insurance, employees must hear about it. They need to be aware that some insurance policies require the company to report the incident to law enforcement. They also need to understand that the insurance company will pursue dishonest employees with civil action.

Touch is another one of the senses. This one is pretty straightforward. Business owners simply need to be a part of the accounting process. They do not have to serve an active role, per se. Rather, employees just have to believe that the owners are active in the process. For instance, if a business owner insists on being the person that opens the monthly bank statements, employees will think the owner is reading these statements. He or she does not actually have to read them. Also, if the business owner insists on having a copy of the daily deposit ticket, employees will believe he or she is reviewing the deposits. I could go on and on. These suggestions on touching documents center around what is known as “the threat of detection,” which is a major fraud deterrent. If the business owner physically touches certain documents, employees will feel as though they are watched, and are less likely to venture down the fraud path.

We have discussed three of the five senses, which leaves smell and taste. For the purpose of internal controls, these senses are related. Our sense of smell and taste are often accompanied by expectations. We expect a glass of orange juice to taste a certain way. Likewise, we have a pretty good idea of what, smoke, smells like. When things “taste” or “smell” different than we expect, we have cause for alarm. The same should hold true with small businesses. When something in the business does not smell or taste right, there is likely a problem.

I once worked with a dental practice that grew its patient base approximately 30 percent from one year to the next. However, the owner of the practice, a dentist, actually made less money. Had she thought about it, she would have known something didn’t smell or taste right with that scenario. That something was a bookkeeper who was siphoning cash out of the practice by paying for her extravagant lifestyle with company checks.

Accountants often talk about giving the records the “sniff test,” which is a clever way of saying whether or not the records meet our expectations. Accountants are not alone. There’s been many a cop movie in which a detective is on the verge of breaking a case, when moments before he or she stated “this really smells.” Business owners need to pay attention to things that just don’t seem right. The dentist who made less money in the face of a significant increase in business should have had the same reaction as sniffing a three-week-old carton of milk.

Who needs expensive government mandates to prevent fraud? If they are willing, small business owners can see, touch, hear, smell and taste their way into fraud prevention.

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