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Management Letter Fix-it Guide:  Segregation of Duties
by Jenea Smith, CPA, Manager
February 2, 2012

Organizations that have their financial statements audited may have received management letters related to the entity’s internal controls.  Auditors have been given guidance by the American Institute of Certified Public Accountants (AICPA) Auditing Standards Board, which formalized the communication of internal control matters with management.  One common area where internal control weaknesses are identified is in the improper segregation of duties related to the performance of day-to-day administration and recordkeeping.

What Does Segregation of Duties Mean?

Simply said, separate people should be responsible for performing the steps in processing accounting transactions.  Separating the approval, accounting, reconciling and asset custody functions by having different individuals assigned to each is good segregation of duties.

What do Auditors Look For?

During the performance of the audit, auditors gain an understanding of the entity’s control environment.  This includes looking at who is performing what task for any incompatible activities that may arise in the crossover of recordkeeping or authorization.  When this crossover is identified, there is cause for concern in safeguarding against any misuse of an organization’s assets. 

What can Management Do?

When a management letter points out an issue related to segregation of duties in the entity’s internal controls, management should take a look at the processing of that function and come up with a the structure that does not give too many responsibilities to one individual. 

Common scenarios:

Cash - It is not uncommon for the person charged with taking deposits to the bank to also be the person who processes accounts receivable and performs the reconciliation of the bank statements.  In this case, there is the opportunity for the theft of a deposit, since the person who took the deposit could hide the stolen funds in the accounting records by making adjustments to the customer accounts and the bank reconciliation.  By having a different individual reconcile the bank statement, there is another set of eyes involved that can compare deposit documentation to cash receipt records to ensure the cash is being properly handled.

Accounts Receivable - The person who processes cash receipts often-times is also the one who maintains the delinquency reports.  This usually means that the same individual sends out the billing, collects the cash, posts this activity to the general ledger, tracks delinquencies and handles outside complaints.  If the person in charge of these activities has a relationship with a customer, employer or member, unauthorized credits could be given, which, in turn, results in the organization not receiving the income it is due.  To alleviate this scenario, management should assign the activities listed above to different people.

Payroll - Frequently there is only one person in charge of all aspects of processing payroll:  hiring the employees, reviewing the timecards, preparing the payroll calculation, distributing the checks, maintaining the payroll reports and reconciling the cash in the payroll accounts.  This provides the perfect opportunity for theft, as unauthorized increases in wages may be issued or unauthorized bonuses may be paid if nobody is monitoring the payroll processing and records.  In this case, the auditor might recommend that the payroll reports be reviewed by an individual who is separate from the payroll processor in order to ensure that all items used to calculate the amount paid are accurate.  To further strengthen the controls, one individual should calculate the timecards, another individual should perform the payroll calculation and another individual should print the paychecks. 

Take it to the Top

Management should devise some form of a daily monitoring process to ensure that the procedures are being performed as designed by the assigned and/or authorized individuals.  Lastly, top-level review by the Board during meetings and by the audit committee members on a periodic basis also lends to good controls.  This top-level review should include the:

  • Analysis of reports on the organization’s performance relative to established objectives.
  • Periodic comparisons of actual cash receipts/disbursements to budgeted cash receipts/disbursements and following through on investigating any significant differences.

Its Importance

Overall, the proper segregation of duties in the administration and recordkeeping of an entity helps management deter fraud and reduce errors in financial reporting.  Monitoring of the daily activities and top-level reviews are good compensating controls.  However, how the department functions are set up, with the proper segregation of duties in mind, is a key to controlling the entity’s assets and financial records.

Look forward to future articles in our Management Letter Fix-It Guide series, addressing expenses, controls over financial reporting and items specific to not-for-profit organizations.

Jenea Smith, CPA, is a manager in the certified audit department of Lindquist LLP.  She has more than 15 years of experience providing audit, accounting, tax and consulting services, including nine years of specialized experience with employee benefit plans and not-for profit organizations. She is a member of the California Society of Certified Public Accountants, American Institute of Certified Public Accountants, International Foundation of Employee Benefit Plans and Western Pension and Benefits Conference.  Jenea also serves on, and lends her accounting experience to, the board of trustees of an international non-profit organization.

 

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