IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities.  Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses. The following blog article has been provided by Eric Moore of Accounting Solution Partners (www.asp-nw.com):

Internal Controls Mitigate Risk & Problems for Entrepreneurs

Business leaders understand it is essential to have accurate financial data to drive operations and measure success.  However, without the proper controls in place errors, fraud, and other issues can occur, hindering operational efficiency and growth.  While some small business owners assume internal control systems are only designed for larger organizations, these functions are crucial for companies of all sizes in all industries.

Internal control accounting systems are the policies and procedures used to ensure accuracy and reliability across accounting reports to:

• Prevent fraud
• Control risk
• Proactively identify financial issues
• Protect resources (both tangible and intangible) from theft and waste
• Operate efficiently
• Generate timely, reliable reporting
• Measure progress towards business objectives and goals
• Comply with applicable laws and regulations
• Secure outside funding
• Reassure investors

Controls can either be preventative, deterring fraud and mistakes, or detective, identifying issues after they have happened. Working in unison they can remedy existing problems and help to avoid future ones to strengthen ongoing business activities.

The most common types of  internal accounting controls include:

1. Separation of DutiesAssigning specific duties to each employee that divides accounting responsibilities is a basic control system to ensure that the people responsible for financial reporting are separate from the people tasked with making cash deposits and asset purchases. Similarly, anyone conducting audits should be as far removed from financial duties as possible to ensure impartiality. The further apart these functions are in an organization, the lower the risk for fraud associated with each.In small companies where there are not enough employees to separate duties completely, peer review can serve a similar “checks and balances” function to mitigate risk. While complacence and collusion can still result in erroneous reporting, requiring peer sign-off on reports and job functions can eliminate simple opportunistic theft.

   Because fraud can occur at any level of an organization separation of duties is crucial at not just the top, among executive leadership, but at every step of the organizational hierarchy. In large organizations, rotating assignments among employees with the same job functions helps to isolate discrepancies and conduct thorough analyses of root causes.

2. Access ControlsAccess controls keep people out to keep value in the organization.Setting permission levels to safeguard data and physical assets is one of the most routine controls businesses use because they are so easy to implement. In password-protected areas, secure passwords and two-step authentication procedures make it difficult for employees to use others’ login credentials. Additionally, changing passwords frequently enables access controls to remain steadfast over time.

   Access logs and usage history reports are automated features that can be used to regularly audit software systems to find discrepancies. They can also serve as evidence in identifying culprits when errors occur, or fraud is present.

   Access controls can also be physical in nature allowing for more effective management of tangible assets, such as restricting badge access to employees who should not be allowed in certain areas. Other types of physical access controls include safes for cash or other valuables.

3. Required ApprovalsDesignating managers to be responsible for transaction authorizations is an internal control function that funnels purchase decisions through the most trusted employees. Authorizations may be required for large payments, unusual expenses, and unexpected cost increases.In larger organizations required approvals may follow a hierarchy, necessitating multiple layers of agreement before being finalized. The aim with this approach is to weed out unnecessary expenses at every level to minimize waste and reduce incidence of fraud.
4. Asset AuditsAuditing is the most widely used internal accounting control.Financial audits like cash reconciliations are performed regularly to verify that actual balances match accounting balances. Differences can be analyzed and investigated, where necessary, to result in accurate financial reports.

   However, asset audits are not simply electronic in nature – they also include physical audits. Any time a cash drawer is tallied, or raw material counts are verified, an asset audit is being performed. These on-site audits should be performed regularly to ensure financial accuracy. Counting cash should be done hourly or daily, while physical asset tracking is typically done quarterly or annually. Manually counting assets in this manner is crucial because fraud can occur off the books to bypass financial report audits.

   In addition to these routine checks, detective asset audits should be performed as well. Utilizing surprise or random cash counts, for instance, helps to keep employees honest and focused on performing work fastidiously.

5. TemplatesStandardizing financial documents creates consistency, which makes it easier during the auditing process. While some reports like a balance sheet or P&L statement have a standard format, other documents can vary substantially between business teams. Creating and using the same templates for estimates, invoices, purchase orders, funding requests, receipts, and expense reports creates comparability across like items during an audit. Streamlining these items is an important internal accounting control that businesses tend to overlook in the rush to implement more obvious control systems.
6. Trial BalancesDouble-entry accounting ensures that the books are always balanced. However, errors can fraud can still exist in a double-entry accounting system, which is why trial balances should be used in conjunction with this method. Trial balances are a form of accounting control that infuse additional reliability into the system by keeping an internal record of credits and debits to allow businesses to identify issues early on.
7. ReconciliationsBank, supplier statement, and credit card reconciliations can factor into other accounting control systems, however conducting these reconciliations is an internal control in and of itself as well. Understanding which items have cleared, are in-transit, or have not yet posted allows businesses to uncover errors and fraud. Furthermore, performing regular reconciliations informs strategic business decisions and day-to-day operations.
8. Data BackupsData backups are the most forgotten internal accounting control system. Because accurate financial data requires technological interaction between platforms, loss of financial inputs can skew reporting and muddle audits. When technology fails, past reports and vital data can go missing, delaying reporting and impairing essential accounting functions.Backing up computer files to the cloud safeguards data from loss when computers become corrupted or servers fail.

Implementing the proper accounting controls is meaningless unless employees are equipped to act when they notice a problem or detect suspicious activity. Formal policies must be created to educate employees on how to respond when issues arise. All employees should know who they can tell when there is suspicion of error or malicious intent and what kind of response to expect. Furthermore, their anonymity needs to be protected after doing so.

If you have questions relating to internal controls or the content of this article, Eric Moore of Accounting Solutions Partners would welcome the opportunity to answer them.  Mr. Moore can be reached at (425) 492-1901 or moore@asp-nw.com.

IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, and mergers & acquisitions community on subjects relevant to the purchase & sale of privately held companies and family owned businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.