BUILDING INTERNAL CONTRO LS JOSEPH A. FABIANO JOSEPH A.

FABIANO, CPA, is an audit engagement partner with Kirkland Albrecht & Fredrickson, LLC (www.kafgroup.com). A strong set of internal controls can help construction companies not only detect fraud, but also streamline processes, reduce waste, and strengthen accounting functions. You often hear the term "internal controls," but what does this mean to you and your construction 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 consistently monitored by management to ensure compliance and to determine whether they are working properly or need to be modified. Strong internal controls generally rely on a segregation of accounting duties, which prevents a single employee from both perpetrating and concealing fraud. During even the best of economic times, fraud is not uncommon in the construction industry. In tough economic times, however, it's a problem that grows appreciably worse. For various reasons, contractors historically have had weaker internal controls than in other industries. That may be alarming because even the best of companies are at risk. U.S. businesses lose more than 5 percent of annual revenues to fraud, according to the Association of Certified Fraud Examiners. That translates to more than $652 billion in fraud losses each year. Fraud isn't the only reason contractors need to think about adopting formal internal controls. Controls help streamline processes, reduce waste, and strengthen accounting functions. This all helps improve the business.

In the construction industry, internal controls are particularly valuable because contractors tend to have operations scattered over various work sites. Fiscal controls are important to companies of all sizes, but small to mid-size contractors especially because they often do not have enough bookkeeping personnel to properly segregate accounting responsibilities. While this lack of gatekeepers makes it easier to commit fraud, it also fosters a higher number of honest mistakes. For example, a masonry contractor may pay for a higher quality of stone than was actually delivered. Or an invoice may not include a discount that was promised. Or an invoice may be correct but inadvertently paid twice. Mistakes can be prevented when all transactions are cross-checked, but that requires more than one or two people making accounting decisions. Formal internal controls help reduce honest and dishonest accounting mistakes. Internal controls can be developed in various ways, but there are a few key accounting functions that should be closely monitored by any control system. Those areas are discussed here in further detail. Cash When it comes to protecting cash, there can't be enough safeguards. 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. The best protected contractors have bank statements delivered directly to the owner's residence or unopened at their office. Cancelled checks should be reviewed for unauthorized payees, forged signatures, and unusually large dollar amounts. Review the statement for debit or credit memos and unusual items. Contractors should consider bonding all employees who handle money. Other key controls over cash include the following: 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 that includes a detailed listing of the source of the receipts. Consider dual signature requirements on all checks over a preset 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 that management reviews large cash disbursement transactions. Signature stamps should never be used. Blank checks should not be signed and kept for future use, even if held in a locked environment.

Accounts receivable All accounts receivable should be reviewed by management each month, with special attention given to accounts approaching 90 days old. Only the owner should have the authority to write off old receivables, and an explanation of such should be kept in a formal record. 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. Some construction companies make it the responsibility of project managers to collect receivables. This helps segregate the accounts receivable duties so that the employees responsible for entering cash receipts are not part of the collection process. Accounts payable 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 job site, such as an employee's residence. Some important tips to note are: When a check is signed, it should not be returned to the person responsible for check preparation. Purchase orders should be pre-numbered. All purchase order numbers should be accounted for at all times as either used, voided, or still available. A gap in numerical sequence may indicate a problem.

Consider where invoices are sent, such as the office or job site. If invoices are lying around the job site, payment can be delayed, hidden, or lost, 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 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. The following methods can be helpful in managing payroll: Handing out paychecks at the job site 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 that were not distributed to an employee should be returned to the corporate offices. All overtime should be approved by the appropriate supervisor. 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. W-2s should be reviewed at year-end by management to ensure employees' annual salaries look reasonable. 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. Internal co ntrols specif ic to construction Some internal controls on construction projects specifically are:

1. 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 job site to the office and who is responsible for this procedure. 2. 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 that will likely generate a loss upon completion. Likewise, a job that 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 that caused the unexpected windfall. Management should perform surprise job site visits to ensure procedures are being followed, locate unrecorded invoices, and make sure the job is on track. Job site equipment and materials should be secured when there are no employees present to protect these assets from theft. 3. Subcontractor responsibilities 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!

 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. There are many ways such controls can be implemented, and contractors should receive guidance from their certified public accountants on proper implementation. 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 keeps the business's profits where they belongwith the business. 2012 Thomson Reuters/RIA. All rights reserved.