Building Strong Internal Controls to Stop Fraud

I was scrolling through a business chat room this morning when a story jumped out at me.

So there is an IT company run by two friends, let's call them Joe and Bill (not their real names).

Joe, a talented programmer, enjoyed handling operational and technical aspects. He disliked being involved in finance and business development, so Bill, the other partner, took care of these tasks.

They had a bookkeeper, but Joe, trusting Bill as a friend, never reviewed the finances in detail. The business generated millions in revenue but remained cash-flow negative with very little profit.

Until one day, Joe seeks help from an accountant after reviewing some financial reports he couldn't understand.

The discovery was devastating!

The company credit cards were never reconciled and carried significant balances. Bill had been charging hundreds of thousands of dollars in personal expenses as business costs for years.

On top of that, the company had unknowingly sent money to fake vendors Bill made up. The total damage amounted to nearly a million dollars.

Joe is now working tirelessly to rebuild the business while facing a lengthy lawsuit against Bill. While recovering the lost funds remains uncertain, at least there's a chance the company can survive.

This story reminds me of something they told us a lot in business school – the "fraud triangle."

What is the Fraud Triangle?

The Fraud Triangle is a model to explain why individuals commit fraud. The triangle consists of three key elements that, when combined, can lead to fraudulent behavior:

1. Pressure/Motivation: It is the "WHY" people commit frauds. This could be personal financial pressure or non-financial pressures.

2. Opportunity: This is the gateway for fraud. It could be weak internal controls or lack of oversight that provides a chance for someone to commit fraud without being detected.

3. Rationalization: This is the self-justification that makes the fraud seem acceptable.

Understanding these elements is crucial because it helps us put in place measures to prevent fraud.

What could break this triangle and have prevented this situation?

       ➤  Strong internal controls.

       ➤  Adequate accounting policies.

If Joe had implemented a few of the following practical internal controls, it may have helped to prevent Bill's fraudulent behavior:

Practical Internal Controls to Prevent Fraud:

1. Implement Approval Hierarchies:

   • Establish spending limits for Bill without requiring Joe's approval.
   • Require Joe's approval for anything above the limit or for specific categories.
   • Consider a three-way approval process for very large expenses or high-risk vendors.

2.  Vendor Verification Procedure:  This policy ensures the legitimacy of vendors before payments are made.  Verifying new vendors' contact information, licenses, and references could have helped identify the fake vendors Bill created.

3. Regular Account Reconciliations: This policy ensures all financial accounts (bank statements, credit cards) are compared to the company's records regularly.  Joe's lack of involvement in reviewing finances likely meant credit card statements weren't reconciled, allowing Bill's fraudulent charges to go unnoticed.

4. Encourage a Culture of Awareness:

   • Train all employees, including the bookkeeper, to recognize potential red flags for fraud (e.g., missing receipts, duplicate invoices).

5. Consider External Verification:

   • Mandate periodic reviews by an independent accountant, focusing on high-risk areas like credit card statements and vendor payments.
   • Utilize bank positive pay controls, where the bank verifies the legitimacy of each check before payment.

6. Mitigate Risk from Bookkeeping Errors:

   • Random internal audits to check the bookkeeper's work.
   • Periodic review financial support documents directly by Joe.

As a CEO or small business owner, you wear many hats. But prioritizing strong internal controls shouldn't be an afterthought. It's the shield that protects your hard-earned success from fraud and errors.

As President Reagan wisely said, "Trust but verify."

Don't let blind trust put your business at risk. We can help you establish strong internal controls and sound accounting policies.

Schedule a free consultation and learn how we can protect your company's financial future.

#InternalControls  #FraudPrevention #SmallBusinessFraud