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01.14.19

Critical Questions to Ask About Internal Controls
Kenneth Tornheim

When fraud strikes manufacturers, the effects can be devastating. The median fraud loss in the manufacturing sector was $240,000, according to the 2018 Report to the Nations published by the Association of Certified Fraud Examiners (ACFE). That is almost double the median fraud loss for all industries ($130,000).

Internal controls are a company’s first line of defense in preventing and detecting fraudulent activity. How do your controls measure up? Management can ask the following proactive questions to evaluate whether their control systems are strong enough to help protect against theft or misstatement.

Is access to assets restricted?

Start by examining your company’s restrictions on physical access to assets. Employees should be able to access only those assets that are necessary to perform their jobs. Locks, security cameras and radio-frequency identification tags can safeguard inventory in the warehouse. Encryption software and passwords can limit access to the accounting system and sensitive employee and customer data.

To help define who has access to what, conduct interviews and review formal job descriptions to determine if they are available and accurate. In addition to outlining the scope of employees’ responsibilities, job descriptions should address the separation and duplication of sensitive duties.

For example, billing schemes are especially common among manufacturers. So, the person who is responsible for billing customers should not also deposit customer payments and reconcile the accounts. When limited staff makes segregation of duties difficult, supervision is particularly important.

Are accounts reviewed by management?

Signs of strong controls are regular reconciliation and analysis of key accounts. Your company should not wait until year end to reconcile and analyze account balances.

Monthly bank reconciliations and periodic inventory counts may be appropriate. Strong internal control systems require management to review employees’ work via test counts, recalculating mathematical computations or replicating tasks. Management should also analyze account balances using variance analysis, common-sizing and breakdowns of sales by territory or product line to identify unusual trends.

Is your system protected from management overrides?

Frauds perpetrated by executives are the costliest. According to the latest ACFE report, these frauds produce a median loss of $850,000, which is nearly six times larger than the median loss caused by accounting managers, and 17 times higher than the median loss caused by low-level employees.

To help prevent fraud in the executive suite, hiring policies should include background checks and possibly supplemental screening, such as drug testing or psychological evaluations, on new hires. Executive expense reimbursement requests also warrant scrutiny. Often, fraud perpetrators use falsified expense reports to test internal controls. If successful in expense report fraud, they may graduate to bolder, costlier scams.

Are your financial statements audited?

Audits can help catch problems early, thereby minimizing fraud losses. Many manufacturers hire external accounting professionals to audit their financial statements.

Keep in mind that external audits can unearth material irregularities and deter corruption, but they will not necessarily detect immaterial frauds. In fact, no type of audit provides an absolute guarantee against dishonest employee behavior.

Are controls a priority?

For internal controls to be effective, your company needs to publicize them. For example, offer training classes or publish articles in the employee newsletter to let everyone know that internal controls are a priority and that serious consequences await perpetrators.

Management should also communicate fraud reporting mechanisms, such as anonymous hotlines. In addition, consider training accounting managers and staff to recognize possible red flags, including unusual journal entries and employees living beyond their means.

Lessons learned

Monitoring controls is a continuous improvement project to ensure that they remain adequate and effective. The trick to preventing fraud is to stay one step ahead of potential threats.

Manufacturers with proactive controls, including thorough physical controls over assets, management review, account reconciliation and monitoring, can reduce the duration of schemes and their fraud losses. Contact a forensic accounting expert to investigate suspicious activity or reinforce your controls in order to prevent fraud from happening in the first place.

For more information, contact Ken Tornheim at ktornheim@orba.com or 312.670.7444. Visit ORBA.com to learn more about our Manufacturing and Distribution Group.
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