The Southbourne Tax Group Strengthening Internal Controls to Prevent Fraud

Fraud is often not detected until after the crime has been committed. According to the Association of Certified Fraud Examiners (ACFE), the average time it takes to identify fraud is 18 months after the fact. Furthermore, roughly 58% of fraud cases have no recovery whatsoever. 1 This statistic is chilling, as it indicates that many organizations fall victim to significant loss with slight hope of financial repossession, regardless of fraud detection and response measures. Many times, business owners decide to accept the risk as they don’t want to pump additional resources into additional staff or other control-related activities (such as additional internal audits). However, it’s important to understand what you do have control over along with some relatively simple, yet critical controls to implement.

Who Typically Commits the Crimes?

You might be surprised by the most common fraudster – the trusted employee. ACFE reports that 53% of employees committing fraud have been with the organization for more than five years and more than half of fraud schemes are perpetrated by an employee between the ages of 41 and 60. If fraud is occurring in your dealership, it is likely that the perpetrator is a trusted employee with access to account numbers, passwords, financials, etc. Unfortunately, it is common for good people to make poor decisions based on circumstance.

Internal fraud often happens when an employee finds himself/herself in an ill-fated personal situation (i.e., divorce, medical expenses, financial difficulties, etc.). In fact, the “fraud triangle” – which is comprised of the three elements of rationalization, opportunity, and pressure – applies to most cases of employee/occupational fraud. If a dealership employee is in a personal bind (which would line up with the pressure element), and either rationalization or opportunity presents itself, the gateway to committing fraud opens up. Therefore, when considering the fraud triangle, the only element the dealership has control over is the opportunity for someone to commit fraud (whereas the rationalization and pressure is typically outside the control of the business owner).

A good first step in making fraud prevention measures a top priority is for dealers to understand that trust is not a control.

A Good Starting Point

While there are many means of fraud prevention, a good place to start is tightening up your internal controls. For example, many dealers fall into the trap of either “smoothing” earnings throughout the year, holding on to “rainy day” accruals, or reclassifying certain income lines items to make their numbers look better for their peers in their 20 groups. This practice makes it even tougher to analyze monthly financials and may cloud the ability to detect anomalies. As such, accurate, up-to-date financial information of your dealership is a primary element of a strong internal controls function and may help you detect fraud early so that you don’t fall within the 18-month statistic.

Dealerships often lack a sophisticated internal controls system, as many dealers’ budgetary priorities and time do not accommodate its implementation. However, the benefits often outweigh its cost, as the expenses associated with fraud response measures (not to mention the dollars lost from the fraudulent act itself) are damaging.

What Does My Internal Control System Look Like?

While a thorough internal controls assessment may be a good idea, regardless of how well you think everything is running, there are several signs you can look for that indicate weaknesses. Key indicators may include, but are not limited to:

Lack of segregation of duties, specifically around high-value assets or assets easy to get “legs” such as cash and parts
Lack of a timely reconciliation process and review on key accounts
Outdated computer/software systems
An accounting department that doesn’t post daily transactions (including new/used vehicle sales, cash receipts, repair orders, invoices, etc.)
An accounting department that consistently produces balance sheets and income statements late
Inconsistencies in journal entries or frequently adjusted entries
No real-time access to checkbook balances and accounting information effective as of the prior day’s close of business
An accounting department that doesn’t timely reconcile intercompany or related party transactions

What Can I Do Today?

Fortunately, there are a number of immediate action items you can take to strengthen internal controls within your dealership to help stave off fraud.

Segregation of Duties. Avoid the blurring of roles. Specifically, do not allow employees who record and reconcile transactions to have access to reconciled assets. Reconciliation should be prepared by someone who is not involved in banking duties and does not have access to accounting records. There are steps you can take without adding additional resources, such as owner involvement. The best way to prevent and detect fraud is for the owner to be involved in the financial statement process. It should be noted, however, that segregation of duties does not work well with close friends, so consider the effect of relationships here.
Reconciliation Process. It is imperative to have a recurring, formal reconciliation process of all the key accounts with a review. Informing employees that accounts will be reviewed and reconciled, and that differences will be investigated can be a preventative measure
Checks and Balances. Mark in your calendar a few random days throughout the year to perform inventory counts. Remember not to let the individual performing the inventory have an inventory listing or reconcile back to the accounting records.
Electronic Transfer Review. As wire transfers leave no paper trail, they are a favored method of fraud. As such, you should review these transactions regularly and make sure the payments are supported by some form of documentation.
Journal Entry Review. Make sure you review general journal entries each month. Be on the lookout for large and unusual amounts, such as entries to parts inventory, cash entries, anything that affects profit and loss accounts. It’s always good practice to limit the manual journal entries that post to the general journal.
Review Canceled Checks. Review the front and back of the checks and let employees know you are doing this.
Testing and Check Ups on Controls. This is highly effective when performed unannounced.
Data Analytics. Consider performing analytics on disbursement files and vendor files.
Fraud Hotline. This can be a cost-efficient control that allows employees to report incidents in a safe environment.
Tone from the Top. This is a phrase that indicates management’s leadership and commitment towards honesty and integrity. Furthermore, it is among the most important components of a control environment. It has a trickle-down effect, meaning most employees will uphold the same values as those demonstrated by leadership. Beyond leading by example, make sure you clearly communicate your ethics and values throughout all areas of the dealership. Communicate them informally through daily interactions and formally by way of written codes of conduct, staff meetings, memos, etc. You will also want to create a path for employees who witness fraud to be able to confidentially and safely report the unethical behavior.

Consider Objective Input

While the above self-regulated action items come strongly recommended, including an internal audit in your controls routine performed by an objective, experienced third party advisor can be extremely beneficial in analyzing your internal controls and accounting records. There are a variety of reviews and procedures an auditor can thoroughly perform to spot any anomalies and help you implement preventative measures against fraudulent acts, including, but not limited to:

Preparing surprise bank account reconciliations
Periodically, physically hand out paychecks or paystubs for those on direct deposit
Assessing part inventory activity
Reviewing cancelled checks
Performing physical inventories

While you may need to rearrange your budget to accommodate an internal audit, the fee to implement a solid set of internal controls is far less than the financial loss and high remediation/response costs of fraud detection.