The sudden implosion of many companies at the dawn of the Third Millennium was not a repudiation of GAAP. It was a breakdown in the system of checks and balances that supported GAAP. Even governmental and charitable organizations were infected.

The revenue recognition principle still applies, even though companies reported as current income cash they would not receive for several years. The consistency principle was routinely violated as depreciation schedules were strung out over several years, falsely lowering expenses and thus increasing income. The prudence principle flew out the window as the wildest revenue forecasts drove investors to a fury. Managers, in collusion with their auditors, mocked the full disclosure principle as they reported nonexistent income and hid liabilities behind offshore partnership shells.

Yes, these have been some hard times for managers and accountants—and harder for lots of investors. As a manager, you should understand the temptations that will be placed before you. If you work in a public company, the pressure on quarterly earnings can crush you like a bug if you don’t meet your numbers. If you work for a privately held firm, bankers and taxing authorities will show great interest in your financial reports.

By providing a check on unscrupulous managers, the audit function should stop the sort of abuses that have resulted in corporate scandal. The audit function failed in most cases through personal cupidity on the part of auditors rather than structural flaws in the audit process.

Your business should have two types of audits. An internal audit will look at things like financial controls to make it harder for assets to be diverted from within the company. An external audit will declare that the firm’s financial reports meet GAAP standards. Both are often conducted simultaneously.

Studies suggest that internal business fraud losses average 6% of revenue of all U.S. business revenue. A small percentage of owners make off with the most money, but employees are the most active. Since we have just learned about the materiality constraint, ask yourself if 6% of revenue is worth trying to recover. Yes, the cost/benefit constraint does kick in.

Table 2-2. Business fraud loss

A series of best practices have developed over time to control internal fraud. These internal controls cover the handling of cash and cash-generating items such as invoices and purchase orders, access to computer systems and programs, and preparation of financial statements.

The most common types of fraud committed by employees involve making charges to expense accounts to cover theft of cash/inventory, “lapping” (using a customer’s check from one account to cover theft from a different account) and transaction fraud, deleting, altering, or adding false transactions to
steal assets.

Fraud by owners and managers often takes place at management levels above the one to which the internal control structure applies. Management fraud frequently involves using financial statements to create the illusion that the entity is healthier and more prosperous in order to cover misappropriation of assets. The misappropriation is usually shrouded in a maze of complex business transactions.

Internal controls include such procedures as monitoring activities, segregating financial responsibilities, physical control of cash and convertible assets, procedural controls for things like numbered invoices, access control to sensitive areas, and various authorization and approval levels.

In establishing internal controls, good management decisions help in creating a positive work environment. If the controls are presented as prudent for the health of the company and designed to help protect employees from suspicion, acceptance is high. If the cost/benefit threshold is crossed and the controls restrict work and increase frustration, they often increase the possibility of fraud.

If your company has no internal controls or does not pay attention to them, it could be beneficial to have an audit with a stated objective of examining internal controls. After all, a main reason for internal controls is to reduce the risk to the integrity of the firm’s financial statements.

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