Internal Controls for Contractors

You often hear the term “internal controls,” but what does this mean to you and your business?

Internal controls are defined as processes designed to provide reasonable assurance regarding the achievement of certain objectives. They are affected by the organization’s management and other personnel. Basically, internal controls are an important step to help safeguard assets against unauthorized acquisition, use or disposition. With all the talk of corporate fraud these days, internal controls can help minimize the risk of employee theft or fraud occurring in your organization.

Internal controls should be communicated to all personnel involved and monitored by management to ensure compliance and to determine if they are working properly or need to be modified. Strong internal controls generally rely on segregation of accounting duties, which prevents a single employee from both perpetrating and concealing fraud. Many small businesses don’t have the appropriate number of personnel to handle such segregation.

Cash

Preparing timely monthly bank reconciliations is a key control over cash. This basic process can help prevent and locate unauthorized uses of cash in a timely matter. If cash is only reconciled once a year, an employee could be stealing for twelve months before it is discovered.

The owner of the business should have the bank statement delivered directly to his residence (or receive it unopened at the office), and open and review the statement and cancelled checks. Cancelled checks should be reviewed for unfamiliar or unauthorized payees, forged signatures and unusually large dollar amounts. If cancelled checks are returned with the bank statement, the business owner should look for evidence of alterations to the checks. The bank statement should also be reviewed for debit memos, credit memos and unusual items.

Consider using a lock box for your business. Lock boxes are provided by most financial institutions today. A separate mailing location is set up to receive all cash receipts directly. This reduces the risk of employees diverting cash receipts and manipulating accounts receivable records by writing off the balances. Since the financial institution receives the money directly, you have immediate access to the cash. In addition, the institution will provide you with a daily cash receipt report which includes a detailed listing of the source of the receipts. Consider bonding employees who handle money to safeguard against losses, as well. 

Consider dual signature requirements on all checks over a pre-set amount. Lower-level management will be authorized to sign checks for routine expenses, but high-dollar cash disbursements will require the signature of the owner. This practice serves two purposes: it increases the difficulty for lower-level employees to commit fraud with high-dollar transactions, and it ensures the small business owner personally reviews large cash disbursement transactions.

Blank checks should not be signed and kept for future use, even if held in a locked environment.

Accounts Receivable

Accounts receivable aging reports should be reviewed monthly by management. Any amounts in the “over 90-day” column should be explained and followed up. If a customer is a slow payer, consider not working with them or waiting until the current job is complete and fully paid before beginning the next job.

Receivable write-offs should be authorized and approved, in writing, by the owner. It would be helpful to keep a record of accounts receivable write-offs and to summarize these write-offs by project manager, billing clerk or other meaningful classifications. A trend may develop that would warrant further investigation by management.

Where possible, use pre-numbered invoices and maintain a log of the invoices. A gap in numerical sequence may indicate a problem.

Consider shifting the responsibility for collecting receivables to the project managers for their jobs. The project manager knows the status of the job and can communicate directly with the customer to speed up the payment process. This will also segregate the accounts receivable duties so that the employee responsible for entering cash receipts is not part of the collection process. The collection agent will discover if cash receipts are being diverted when contacting customers to request payment as the customer’s records will indicate that payment has already occurred.

Accounts Payable 

Purchase orders should be pre-numbered similar to the pre-numbering of sales invoices. All purchase order numbers should be accounted for at all times as either used, voided or still available. Again, a gap in numerical sequence may indicate a problem. SIDEBAR Purchase orders should be pre-numbered, used sequentially and accounted for at all times.

All vendor invoices and other appropriate documentation such as purchase orders, receiving reports, etc., should be approved for payment by appropriate personnel (someone other than the purchasing agent-usually an owner or estimator) and be attached to the check when presented for signature. This will ensure that excessive quantities are not being ordered and/or higher-than-normal prices are not being paid. A careful review may also identify when materials are delivered to a location other than the jobsite, such as an employee’s residence.

Once signed, checks should not be returned to the employee responsible for the preparation of checks. This prevents the opportunity for fraudulent modification to a signed check.

Consider where invoices are sent, such as the office or jobsite. If invoices are lying around the jobsite, payment can be delayed, which could hold up the job and your subsequent payment for the job.

Certain employees may be permitted to carry corporate credit cards to allow them to purchase small items without delay. Management should require credit card receipts and detailed vendor invoices for all such items as employees may attempt to pass personal purchases through to the company.

Payroll/Human Resource Functions

Consider background checks and/or drug testing on all employees. This could turn up valuable information as to their integrity and ethics. It is especially important to screen employees who will have access to cash and other assets that can be easily stolen.

Handing out paychecks at the jobsite to the actual employee can help find fictitious employees. One employee will not be able to collect more than one paycheck without detection. Any payroll checks which were not distributed to an employee should be returned to the corporate offices.

All overtime should be approved by the appropriate personnel.

Payroll journals should be reviewed by an owner or upper-level management in a timely manner. This will ensure that employees are being paid reasonable amounts and are being paid in accordance with the payroll schedule (monthly, bi-weekly, etc.) In the case of hourly employees, such a review will identify an unusually high number of hours worked or pay rate.

Management should enforce mandatory vacations. Many fraud situations are dependent on the employee being at work to continue the theft cover-up. Forcing the employee to take vacations may result in another employee discovering the inappropriate activity. SIDEBAR Mandatory vacations help prevent employee theft. SIDEBAR END

Pre-Project Meetings

Hold a meeting between the project manager, project engineer, IT personnel and owner to discuss internal controls, job communication, etc. Assign responsibility for authorization of approval of invoices, billing, etc. This will tighten control over the approval process by restricting authorization to specific personnel. Determine how often invoices will be delivered from the jobsite to the office and who is responsible for this procedure.

Budgets and Job Costs

Budgets (job and company level) should be prepared annually and compared to actual results throughout the year. Large or unexpected variances should be researched and documented on a regular basis to ensure timely identification of unusual operating or job results.

Maintain procedures for bidding and estimating a job. Management should review and approve bids, estimated job costs and updated estimates as the job progresses.

Change orders should be approved by at least one, if not two, authorized personnel.

Gross profits should be analyzed on a job-by-job basis for unauthorized costs and to determine if costs are being shifted to other jobs. Particular attention should be paid to costs being included in the results of a job with significant profit fade or one which will likely generate a loss upon completion. Likewise, a job which is enjoying unexpected profit should have its costs compared to the original or updated job budget to identify the specific areas of increased billing or decreased costs. SIDEBAR Job results should be reviewed frequently to identify unusual profit fades or gains. SIDEBAR END

Management should perform surprise jobsite visits to ensure procedures are being followed, locate unrecorded invoices and make sure the job is on track. Jobsite equipment and materials should be secured when there are no employees present to protect these assets from theft.

Subcontractor Qualification

• Require proof of insurance from your subcontractors and monitor the expiration of such insurance.
• Consider the number of jobs the subcontractor is working on, and determine if they have the capacity to handle your job.
• Obtain references on new subcontractors and check them! Don’t give another job to a new subcontractor until they’ve satisfactorily completed the first job.
• Perform credit checks on your subcontractors and consider reviewing financial statements of subcontractors for the ability to pay for and complete the job.

One of the benefits of strong internal controls is to help strengthen an organization’s record keeping, which in turn, helps detect and prevent embezzlement and fraud. Owners and managers can help deter fraud by incorporating some or all of the above internal controls. By implementing and vigorously enforcing internal controls, management is displaying an active interest in the business’s overall operating results, individual job results, budget-to-actual comparisons and daily transactions. Inquiring about any transaction, whether routine or unusual, sends a clear message to employees that management is closely monitoring the business’s activities. Ultimately, strong internal controls keep the business’s profits where it belongs-with the business!

Construction Business Owners, August 2006