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January 2010
Locks Have Their Limits
By John Blair and Steve Johnston

     Employees are one of the most important factors to your business’s success. Without competent and motivated employees your businesses would not exist. Essentially, this requires you to believe that your employees are individuals of integrity who are inherently truthful and honest.

     Luckily most people are hard-working individuals who deserve your trust and it goes without saying that you would not deliberately hire an employee who was dishonest.

     But the adage, “Locks are meant to keep honest people honest,” captures a significant dilemma associated with employees—establishing the appropriate mix of oversight and trust.

     The Association of Certified Fraud Examiners’ 2004 Report to the Nation on Occupational Fraud and Abuse estimated that the average organization loses about 6 percent of annual revenues to occupational fraud, which translates into approximately $660 billion in annual fraud losses, if multiplied by the 2003 U.S. Gross Domestic Product.

     The Association identified three types of occupational fraud and abuse. The first type is asset misappropriation (theft or misuse of assets), i.e. theft of cash, inventory and other assets, submitting false invoices, abuse of leave.

     The second type is corruption, where an employee wrongfully uses influence in a business transaction to procure some benefit for himself or herself or another, contrary to their duty to their employer (includes conflicts of interest, bribery, and economic extortion).

     The final type of fraud and abuse is fraudulent financial reporting.

     Additionally, studies have identified three elements that are usually present when an employee commits fraud: the individual perpetrating a fraud has an incentive or is experiencing actual or perceived pressure to commit it, he or she is presented with the opportunity to commit it, and he or she adopts an attitude rationalizing it.

     It is possible then, given current economic conditions, that an increased number of employees could be experiencing actual or perceived pressures that motivate them to justify “dipping into the till.”

     So, instituting reasonable measures to ensure that your employees perform their tasks in accordance with policies and procedures that assure your company’s success are necessary and prudent.

     Internal controls are those activities meant to ensure your business operates efficiently and effectively, safeguards its assets, produces reliable financial reporting and complies with applicable laws and regulations. Studies have determined that maintaining strong internal controls is the best deterrent to employment fraud.

     However, establishing the specific type or number of controls to implement to safeguard your company’s assets, unfortunately, is as much art as science.

     A few controls are self evident. For example, you would not leave substantial amounts of cash unattended on your desk when, a simple but effective control for cash is to limit access to it by storing it in safe to which one or two individuals have the combination.

     Of course if you wanted to make it more secure, you could encase the cash in a block of concrete and drop it in the Marianas Trench in the Pacific Ocean. Understandably, not many people would go to the trouble of retrieving the cash. Yet it would be equally difficult for you to use that cash in your business.

     The art of internal controls then is selecting those controls that provide reasonable protection of your assets while allowing you to carry on your business.

     Fortunately, you don’t have to start from scratch in designing internal controls. An integrated framework has been developed for establishing internal controls for your business by the Committee of Sponsoring Organizations (COSO), a voluntary private-sector organization.

     In addition, most CPA firms have a thorough understanding of this framework and also have the expertise to help you develop an appropriate system of internal controls for your business.

     It is important to note that the COSO framework emphasizes the importance of creating a control environment based on the integrity, ethical standards and competence of the business owner; it points out that doing so sets the tone of your organization, influences the control consciousness of your people, and is the  foundation for all other components of internal control.

     Rarely do employees receive guidance as to what is expectable at work exclusively from a policies and procedures manual. Most often, the conduct of others and especially the business owner influence an employee’s conduct while on the job.

     So, be mindful that your ethical standards disproportionately influence your employees’ behavior and accordingly being an ethical individual is important to the success of your business; because locks have their limits.

     Steve J. Johnston is an assurance partner and John D. Blair Sr. is a managing partner at Blair Bohlé & Whitsitt, PLLC., a CPA firm that provides accounting, assurance, tax compliance and planning services, strategic planning and tax minimization strategies to privately held business in addition to assurance and consulting services to governmental and nonprofit entities. Contact them at 704-841-9800 or visit www.bbwpllc.com.

John D. Blair Sr. is a managing partner and Steve Johnston is an assurance partner at Blair, Bohle & Whitsitt, PLLC.
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