Internal Accounting Control

From Labyrinth Inc.
Internal accounting control is a series of procedures designed to promote and protect sound management practices, both general and financial. Following internal accounting control procedures will significantly increase the likelihood that:

• financial information is reliable, so that managers and the board can depend on accurate information to make programmatic and other decisions
• assets and records of the organization are not stolen, misused, or accidentally destroyed
• the organization s policies are followed
• government regulations are met.

Developing an Internal Accounting Control System
The first step in developing an effective internal accounting control system is to identify those areas where abuses or errors are likely to occur. Many accountants can provide you with a checklist of areas and questions to consider when you are planning your system. Price Waterhouse's booklet, Effective Internal Accounting Control for Nonprofit Organizations: A Guide for Directors and Management, includes the following areas and objectives in developing an effective internal accounting control system:

• Cash receipts
  To ensure that all cash intended for the organization is received, promptly deposited, properly recorded, reconciled, and kept under adequate security.
• Cash disbursements
  To ensure that cash is disbursed only upon proper authorization of management, for valid business purposes, and that all disbursements are properly recorded.
• Petty cash
  To ensure that petty cash and other working funds are disbursed only for proper purposes, are adequately safeguarded, and properly recorded.
• Payroll
  To ensure that payroll disbursements are made only upon proper authorization to bona fide employees, that payroll disbursements are properly recorded and that related legal requirements (such as payroll tax deposits) are complied with.
• Grants, gifts, and bequests
  To ensure that all grants, gifts, and bequests are received and properly recorded, and that compliance with the terms of any related restrictions is adequately monitored.
• Fixed assets
  To ensure that fixed assets are acquired and disposed of only upon proper authorization, are adequately safeguarded, and properly recorded.

Additional internal controls are also required to ensure proper recording of donated materials, pledges and other revenues, accurate, timely financial reports and information returns, and compliance with other government regulations.

Achieving these objectives requires your organization to clearly state procedures for handling each area, including a system of checks and balances in which no financial transaction is handled by only one person from beginning to end. This principle, called segregation of duties, is central to an effective internal controls system. Even in a small nonprofit, duties can be divided up between paid staff and volunteers to reduce the opportunity for error and wrongdoing. For example, in a small organization, the director might approve payments and sign checks prepared by the bookkeeper or office manager. The board treasurer might then review disbursements with accompanying documentation each month, prepare the bank reconciliation, and review canceled checks.

The board and executive director share the responsibility for setting a tone and standard of accountability and conscientiousness regarding the organization's assets and responsibilities. The board, usually through the work of the finance committee, fulfills that responsibility in part by approving many aspects of the internal control accounting system. Common areas requiring board attention include:

• Check issuance
  The number of signatures on checks, dollar amounts which require board approval or board signature on the check, who authorizes payments and financial commitments, etc.
• Deposits
  How payments made in cash (for admissions, raffles, weekly collection plate, etc.) will be handled, etc.
• Transfers
  If and when the general fund can borrow from restricted funds, etc.
• Approval of plans and commitments before they are implemented
  The annual budget and periodic comparisons of financial statements with budgeted amounts, leases, loan agreements, and other major commitments.
• Personnel policies
  Salary levels, vacation, overtime, compensatory time, benefits, grievance procedures, severance pay, evaluation, and other personnel matters.

The Accounting Procedures Manual
The policies and procedures for handling financial transactions are best recorded in an Accounting Procedures Manual, describing the administrative tasks and who is responsible for each. The manual does not have to be a formal document, but rather a simple description of how functions such as paying bills, depositing cash, and transferring money between funds are handled. As you start to document these procedures, even in simple memo form, the memos themselves can be kept together to form a very basic Accounting Procedures Manual. Writing or revising an Accounting Procedures Manual is a good opportunity to see whether adequate controls are in place. In addition, having such a manual facilitates smooth turnover in financial staff.

Maintaining Effective Controls
The executive director is commonly responsible for overseeing the day-to-day implementation of these policies and procedures. Due to the number of detailed requirements involved if your organization receives government funding, there should be one person in the organization (possibly the grant administrator) with the responsibility of understanding and monitoring those specific regulations and compliance factors.

The auditor's management letter is an important indicator of the adequacy of your internal accounting control structure, and the degree to which it is maintained. The management letter, which accompanies the audit and is typically addressed to the board as trustees for the organization, cites significant weaknesses in the system or its execution. By reviewing the management letter with the executive director, asking for responses to each internal control lapse or recommendation, and comparing management letters from year to year, the board has a useful mechanism for monitoring its financial safeguards and adherence to financial policies.

As your nonprofit changes and matures, and your funding and programs change, you will need to periodically review the internal accounting control system which you have established and modify it to include new circumstances (bigger staff, more restricted funding, etc.) and regulations (such as receiving federal awards with increased compliance demands.)

Components of the Accounting System
Think of the accounting system as a wheel whose hub is the general ledger (G/L). Feeding the hub information are the spokes of the wheel. These include:

• Accounts receivable
• Accounts payable
• Order entry
• Inventory control
• Cost accounting
• Payroll
• Fixed assets accounting

These modules are ledgers themselves. We call them subledgers. Each contains the detailed entries of its specific field, such as accounts receivable. The subledgers summarize the entries, then send the summary up to the general ledger. For example, each day the receivables subledger records all credit sales and payments received. The transactions net together then go up to the G/L to increase or decrease A/R, increase cash and decrease inventory.

We'll always check to be sure that the balance of the subledger exactly equals the account balance for that subledger account in the G/L. If it doesn't, then there's a problem.

Differences between Manual and Automated Ledgers
Think of the G/L as a sheet of paper on which transactions from all four categories of accounts-assets, liabilities, income, and expenses-are recorded. Some of them flow up from various subledgers, and some are entered directly into the G/L through a general journal entry. An example of such a direct entry would be the payment on a loan.

The same concept of a sheet of paper holds for each subledger that feeds the general ledger. A computerized accounting system works the same way, except that the general ledger and subledgers are computer files instead of sheets of paper. Entries are posted to each and summarized, then the summary is sent up to the G/L for posting.

ORGANIZATION OF THE ACCOUNTING DEPARTMENT
Organize your small-business accounting system by function. Often there's just one person there to do all the transaction entries. From an internal control standpoint, this isn't desirable. Having too few people doing all the accounting opens the door for fraud and embezzlement. Companies with more people assign functions in such a way that those done by the same person don't pose a control threat.

Having the same person draft the checks and reconcile the checking account is a good example of how not to assign accounting duties. We'll talk extensively about internal control later. However, for now, small businesses often can't afford the number of people needed for an adequate separation of duties. The internal control structure that we'll install in your new accounting system helps mitigate that risk through mechanics and procedures rather than expensive people.

Assignment of Duties
Here's your first assignment: Figure out who is going to do what in your new accounting system. The duties and areas of responsibility we need to assign include:

• Overall responsibility for the accounting system
• Management of the computer system (if you're using one)
• Accounts receivable
• Accounts payable
• Order entry
• Cost accounting
• Monthly reporting
• Inventory control
• Payroll (even if you use an outside payroll service, someone must be in control and responsible)
• Internal accounting control
• Fixed assets

In many cases the same person will do many of these things. However, these are the areas we'll be dealing with in setting up the accounting system.

The person you assign to be in overall charge of the system should be the one who is most familiar with accounting. If you are just starting your company, you might want to think about the background of some of your new employees. At least one should have the capacity to run the accounting system. If you find it difficult to determine someone's expertise in a field with which you are unfamiliar, here are some solutions:

• Have them interviewed by an expert. Your own CPA will probably be glad to interview a few for you.
• Carefully check references from past jobs. Ask detailed questions on exactly what they did in the accounting function. Compare the answers with what they say they did.
• Ask them some accounting questions. It may sound odd that you (of all people) should be asking such questions. However, even if you can't judge the technical merit of the answers, you can get a feel for how comfortable they are with the subject and the authority with which they answer.

* Source ( Adams - Accounting for the New Business: The Strategies and Practices You Need to Account for Your Success by Christopher R. Malburg, CPA, MBA )