What are the Best Practices for Internal Controls and the Warning Signs of Embezzlement?

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Published in Corporate Compliance Insights

President Ronald Reagan once said, “Trust, but verify,” echoing a Russian proverb to describe the relationship moving forward with the Soviet Union. The saying loosely translates into proceeding cautiously when someone is supposed to do what they say.

These words of wisdom not only apply to working with foreign powers, but also, when employers entrust their employees with specific job roles, particularly when those duties pertain to handling and overseeing company funds.  

In the military, trust is everything. At war, betrayal by a fellow solider could lead to injury or death. Betrayal by a fellow employee, especially when it involves embezzlement or theft, could lead to the death of a business, or at the least, a devastating blow to your operating finances.

Embezzlement – the misappropriation of funds by someone entrusted with money – can take place in multiple ways and by employees in various roles. Funds are often transferred into an account controlled by the employee. Check or deposit amounts are altered. A similar-sounding business is started under a similar name as a well-known vendor, such as “Professional Roofing Inc.” vs. “Professional Roofing Co.” Small amounts of monies are withdrawn to add up to a lump sum over time. Employees use the company credit card for unauthorized expenses.

Implementing robust internal controls can mitigate risks. Here are the best practices for employers:

Best Practices to Implement Robust Internal Controls

• Segregate duties: Ensure that no single person has complete control over financial transactions - separate duties such as authorization, recording, and custody of assets, and implement added security measures, such as management approval for wire transfers. Ensure that sure the person who signs the checks is different than the person who does the bank reconciliation, or whoever pays the bills never signs the checks. 
• Perform regular audits: In the military, we call them Pre-Combat Checks (PCCs) or Pre-Combat Inspections (PCIs). Conduct audits, including unannounced inspections, to identify discrepancies and weaknesses in your financial systems. Hire an external auditor.
• Purchase insurance: Buy specific fidelity insurance to cover your employees.
• Install robust accounting systems: Use reliable accounting software and maintain accurate financial records. Implement strong password protection and access controls.
• Develop clear policies: Develop comprehensive policies and procedures for financial transactions, expense reimbursements, and other high-risk areas. Implement strict expense reporting policies, including detailed receipts and approval processes.
• Train employees on fraud prevention: Educate employees about fraud prevention, ethical conduct, and the company’s internal control policies. Inform employees that those who are caught cheating the company out of money will be fired immediately, and fully prosecuted, criminally, and through civil charges.
• Implement anonymous reporting system: Establish a confidential reporting system for employees to report suspected fraud or misconduct without fear of retaliation.
• Review vendor relationships: Review vendor relationships, payment processes, and invoices to detect irregularities. Also, be mindful of “kickbacks” from vendors who then overcharge the company, so competitive bidding may catch that concern.

Warning Signs of Embezzlement

Nine out of ten occupational fraudsters are first-time offenders and have never been charged or convicted of a fraud-related offense, according to the Association of Certified Fraud Examiners. Here are common red flags that can help stop internal theft before it’s too late:

• Unexpected financial discrepancies and transactions: Unexplained shortages in cash, inventory, or assets; large or frequent cash withdrawals, suspicious payments, or altered documents; missing receipts, invoices, or other supporting documentation.
• Vendor and customer complaints: Vendors claiming they haven't been paid or have received partial payments. Customers claim to have already paid the bill.
• Employee lifestyle changes: Employees live beyond their means, such as purchasing luxury items; employees experiencing financial difficulties; excessive overtime or weekend work without a clear reason; and refusal to take vacation.
• Resistance to external checks and audits: Watch out for employees’ reluctance to cooperate with audits or reviews of financial records; and employees becoming defensive or overly protective about their work and computer.

Conclusion

As employers, it is important to demonstrate a commitment to strong leadership that upholds a culture of integrity, ethical conduct, and prevention of any kind of fraud, theft, and embezzlement. Create a culture of open communication where employees feel comfortable raising concerns, and reward employees for ethical behavior and reporting suspected misconduct.

Remember that no system is completely foolproof, but implementing robust internal controls, being aware of warning signs of embezzlement, and displaying ongoing vigilance and participation in your company’s daily activities, can mitigate most risks.

You don’t have to micromanage, but you do to have manage. “Trust, but verify.”

About Our Authors

Richard Carmody has practiced for close to 50 years in commercial restructuring and bankruptcy. He served eight years in the Army Field Artillery, including two Vietnam tours. Richard is the first lawyer in Alabama certified as a specialist in Business Bankruptcy by the American Board of Certification. Richard is an American College of Bankruptcy Fellow and was recognized as the ABI’s Outstanding Committee Member of the Year. Richard works with the ABI to improve veterans’ disability benefits under the Bankruptcy Code. He also belongs to the ABI Task Force on Veterans and Servicemembers Affairs.

John Woods is a member of the Adams and Reese Litigation Practice Group, and a former infantry officer in the U.S. Army National Guard. He is a co-founder of the Adams and Reese “Vets to Ventures” series. Practicing in the firm’s Memphis office, John represents corporate clients in commercial litigation, business disputes, and insurance defense litigation that encompasses professional liability claims, mostly in health care and real estate. He is an experienced trial and appellate attorney.

Adams and Reese Vets to Ventures Series

For Our Veterans, by Our Veterans - Adams and Reese is proud to feature a monthly series of informative articles addressing hot topics of legal interest for service members
transitioning back to the private sector.

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• “Remembering Our Fallen Heroes: Significance of Memorial Day”
• “Employer-Employee Considerations and Tips for Veteran Business Owners”
• “Succession Planning for Veteran-Owned Businesses with Federal Certification”
• “From Battlefield to Boardroom: Applying Military Principles to the Business World”
• “Operation Litigation: Top Tips if Your Business is Threatened with a Lawsuit”
• “Forming an LLC or Corporation: Which Business Entity is Right for You?”
• “Legal Intel for Veteran Entrepreneurs”