As a business owner, how much confidence do you have on your financial reports’ numbers? Does the net income represent a successful business operation? Alternatively, does the net loss indeed expose all the weaknesses of your business? Are you sure the amount of inventory sitting in your warehouse is the number showing in the balance sheet? Alternatively, is the accounts payable amount honestly all the money you owe to your suppliers? Internal controls of each primary business function must be approved to be necessary and enough to let your accounting numbers tell you the accurate information about your business. The core theory of internal control is that, with the consideration of cost-benefits tradeoff, the structure of an organization and the assignment of job duties should be designed to segregate specific functions within its environment. To explain how to develop and implement an efficient and effective internal control, we will talk about 1) segregation of duties, 2) organizational hierarchy, and 3) internal controls on five primary accounting cycles in an organization.
Segregation of duties
Usually, the employees who oversee receiving cash payments from customers are not allowed to make journal entries because they can easily steal the money by keeping the money for themselves without booking it and letting the account become “uncollectable.” If you agree, then you understand the concept of “segregation of duties”: for any given transaction, separate individuals in different parts of the organization should perform three preferable functions – authorization of transactions, recording transactions, and custody of the assets associated with the operation. It’s common for some small-sized organizations to assign several jobs to one employee to maximize the use of their limited resources, but it is essential to make sure that no employee performs more than one of those three functions.
For medium or large-sized organizations, separating the responsibilities according to the following orders can achieve adequate segregation of duties:
- Operations: Sales, warehouse, receiving, shipping, production, and purchasing
- Accounting: accounts receivable, billing, accounts payable, general ledger, inventory control, cost accounting, and payroll
- CFO/treasurer: cash receipts, cash disbursements, and credit
- Administration: mail room
- Human resources: HR
In general, five accounting cycles can describe the accounting process of an organization that sales products to customers:
- Sales-Receivable cycle
- Cash-Receipts cycle
- Purchase-Payable cycle
- Cash-Payment cycle
- Payroll cycle
Except for the payroll cycle, we will discuss all other four accounting cycles in the next paragraphs. Remember, what we consider, and present is a very simplified model. The business owner who is willing to adopt these models should make appropriate adjustments based on the real conditions of their business, and the field of industry their business in so that they can better design and implement internal control in their business effectively and efficiently.
There are eight, separately-grouped, related parties/departments involved in a complete sales-receivable cycle:
- Authorization: Customer who initiates a purchase, sales, credit, billing
- Custody: Shipping, warehouse
- Recording: Inventory control, accounts receivable, and general ledger
When the sales department receives a customer order from a customer for merchandise, they prepare a sales order and forward it to Credit. In here, sequentially numbered sales orders are recommended for better periodically reconciliation purposes. Credit performs a credit check on the customer. If the customer is creditworthy, Credit will approve the sales order. It is essential for an organization to have a separate person to confirm sales orders by checking the customer’s credit file because it helps to ensure that goods are shipped only to the actual customer and that the account is unlikely to become delinquent. Credit then sends the approved sales order to Sales, Warehouse, Shipping, Billing and Inventory Control. Upon receipt of an approved sales order, Sales sends an acknowledgment to the customer. Upon arrival of an approved sales order, Warehouse pulls the merchandise, prepares a packing slip, and forwards both to Shipping. Shipping verifies that the goods received from Warehouse match the approved sales order and makes a bill of lading and sends the shipment to the customer. Then Shipping forwards the packing slip and bill of lading to Inventory Control and Billing. Upon receipt, Inventory Control matches them with the approved sales order and updates the inventory system. In here, the Inventory Control ensures that inventory unit counts are updated once the goods have been shipped. Updating inventory and GL files separately provides additional accounting control when they are periodically reconciled. Upon receipt of the packing slip and bill of lading, Billing matches them with the approved sales order, prepares an invoice, and sends it to the customer. If the invoice is paper-based, a remittance advice is included for use in the cash receipts cycle. The Sales Department receives the invoice from Billing and updates the sales order file. Accounts Receivable receives the invoice from Billing and posts a journal entry to the AR file. Accounts Receivable prepares a summary of all invoices for the day and forwards it to General Ledge for posting of the total to the GL file. Updating AR and GL files separately provides an additional accounting control when they are periodically reconciled
Cash Receipts cycle
There are four related parties/departments involved in a complete cash receipts cycle. They are listed here separated into the three functions we mentioned before:
- Authorization: Customer, bank (both are not a department)
- Custody: Mailroom, cash receipts
- Recording: Accounts receivables, general ledger
The first step in the process is for the mail room to open customer mail. Two clerks should always be present to reduce the risk of misappropriation by a single employee. Customer checks are immediately endorsed “For Deposit Only.” Remittance advices are then separated. Mail Room prepares a remittance listing of all checks received during the day and forwards it with the payments to Cash Receipts. In here, remittance listing provides a control total for later reconciliation. Cash Receipts prepares a deposit slip and deposit checks in the bank. The bank validates the deposit slip. In here, the bank provides independent evidence of the deposit. Upon receipts of the validated deposit slip, Cash Receipts posts a journal entry to the cash receipts journal. Mail Room also sends the remittance listing to General Ledger for posting of the total to the GL file. Mail Room also sends remittance listing and remittance advices to Accounts Receivable for updating of customer accounts. The Accounts Receivables department periodically sends account statements to customers showing all sales and payment activity.
There are six related parties/departments involved in to complete a purchase-payable cycle. They are listed here by separately grouped into the three functions we mentioned before:
- Authorization: Inventory Control, Purchasing
- Custody: Vendor, Receiving, Warehouse
- Recording: Accounts payables, General Ledger
Inventory Control prepares a purchase requisition when inventory approaches the reorder point and sends it to Purchasing and Accounts Payable. Purchasing locates an authorized vendor in the vendor file, prepares a purchase order, and updates the purchase order file. Using sequentially numbered purchase orders helps ensure that they are legitimate. Purchasing sends the purchase order to Vendor, Receiving, and Accounts Payable. In here, Vendor prepares merchandise to ship, Receiving is put on notice to expect shipment, and Accounts Payable notes that liability to this vendor is about to increase. Account Payable then prepares a summary of all purchase orders issued that day and forwards it to General Ledger for posting of the total to the GL file. Goods arrive at Receiving with a packing slip. Receiving prepares a receiving report and forwards it with the products to Warehouse. Warehouse verifies that products received match those listed on the receiving report. Receiving sends the receiving report and packing slip to Inventory Control and Accounts Payable for pairing with the purchase requisition and updating of inventory records and updating of the AP file.
Cash payments cycle
There are four related parties/departments involved in to complete a cash payments cycle. They are listed here by separately grouped into the three functions we mentioned before:
- Authorization: Vendor, Purchasing
- Custody: Cash Payments
- Recording: Accounts Payable, General Ledger
Purchasing receives a vendor invoice and remittance advice. The remittance advice is separated and filed. The invoice is matched with the purchase order and approved for payment. They mark purchase order as closed and forwards the approval to Accounts Payable. Accounts Payable matches the approved vendor invoice with the AP file and issues a payment voucher to Cash Payments. Upon receipt of a payment voucher with an approved vendor invoice, Cash Payments issues a check and forwards it to Purchasing. Purchasing sends the remittance advice with the check to the vendor. Cash Payments prepares a check register of all checks issued during the day and posts a journal entry to the cash payment journal. They also forward the record to General Ledger for posting of the total to the GL file.
It may seem complicated, even impossible, for some companies to adopt this internal control framework. Appropriate customization is necessary due to various attributes of different business and industry. However, don’t override the central concept of segregation of duties, and proper internal control implementation for risk control purpose. If you would like to have someone who is qualified and full of experiences to advise your internal controls based on your business situation, or if you want to learn more about internal controls, contact us at 417-823-7171 or www.abacuscpas.com. The Abacus audit team is here to give you better guidance so that you can make smarter decisions.
Wa Gao, CPA, CIA