Understand Segregation of Duties and How to Create It

What is segregation of duties and how can you achieve it? In this post, I answer these two questions. Iโve seen business owners, nonprofits, and governments lose millions because they did not understand the risk of not having sufficient segregation of duties. For instance, $53 million was stolen by Rita Crundwell because the City of Dixon did not have this safeguard. So, you can stop reading now, but you would be wise to continue.
What is segregation of duties?
Itโs the performance of different accounting processes by different people.
Why is this important?
It makes it more challenging for someone to steal. When more eyes ๐ are on the accounting processes, itโs more likely theft will be seen (if it occurs). And most potential fraudsters donโt want to go to jail, so fraud decreases.
One-person accounting system
Suppose there is only one person in accounting (weโll call him Bob). Bob performs all duties, including the following for accounts payable:
โreceiving vendor invoices,
โsigning checks (or making electronic payments),
โentering transactions in the general ledger,
โreconciling the bank statements,
โadding new vendors to the account payable module
Bob is the poster child of a lack of segregation of duties. To make matters worse, no one is reviewing his work, and he is not providing any reports to anyone (such as the owners).
Can Bob steal without detection? Absolutely.
Lessening Theft with Segregation of Duties
How can this business lessen theft?
Add more people (more eyes ๐) to accounting.
For example, Bob could enter invoices and tee up payments, but Sally approves them (e.g., signs the checks or pulls the trigger on the electronic payments). Sallyโs approval involves her review of each invoice for appropriateness. In this setup, Sally has no rights to enter invoices, no rights to the general ledger, other than viewing. And the computer will not process payments without Sallyโs approval. In other words, it takes Bob and Sally to make a payment.
We now have the following segregation:
Bookkeeping โ Bob
Approval – Sally
So, by adding one person to the accounts payable process, we have lowered the theft potential. Weโve created some segregation of duties. It may not be perfect, but the threat of theft is less.
Canโt Afford to Hire Sally
If this is a small business, the owner may not have the money to hire Sally.
What can be done?
Have the owner review documents such as:
โBank reconciliations (and the cleared checks showing who was paid)
โMonthly budget to actual reports showing the budgeted revenues and expenses and actual amounts
โGeneral ledger (the owner can scan the general ledger detail for appropriateness)
What have we done? Weโve added more eyes ๐ to the process. Why? We need this safeguard due to the lack of segregation of duties.
Accounting Processes
Accounting processes include:
It is desirable to segregate each of these accounting processes for each accounting area such as:
โBilling and collections
โAccounts payable and expenses
โPayroll
โPlant, property, and equipment
โInventory
Reviews as an Internal Control
If segregation of duties is not possible, include a review process of some type such that a potential fraudster will know another person will see what they do.
Reviews can be performed by (these are just examples):
โan owner
โan outside CPA (maybe once or twice a year, for example)
โthe ownerโs spouse
โthe controller of another entity that the owner controls
Of course, you can also require an audit of the entity (more eyes ๐ ) at year-end.
So, should auditors report a lack of segregation of duties to the business owners and board members?
Auditor Reporting
Auditors should report a lack of segregation of duties to the owners and board members. This communication will normally be in writing, especially if the control weakness is in an area where material theft can occur.
Should the auditor communicate the lack of segregation of duties if he or she knows the owners and board members are already aware of the internal control weakness (say, youโve communicated this in previous years)?
Yes.
Summary
More eyes on the accounting processes will lower the risk of theft. Do what you can now to create proper segregation of duties and prevent financial losses.