Effective Control Environments:

Effective Control Environments: Getting the most “bang for your buck” through segregation of duties. May 12, 2008

Presented By Lee S. Buby, CPA Haskell & White LLP SOX 404 Practice Leader lbuby@hwcpa.com

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Definitions and Misconceptions Segregation of Duties

John Tonsick’s keynote address this morning was on FRAUD Statistic referenced: The Association of Certified Fraud Examiners estimates that the average U.S. business loses 5% of its gross revenue to employee fraud and abuse; that comes to about $9 per day, per U.S. employee. Definitions and Misconceptions (cont.)

This is a big problem. Definitions and Misconceptions (cont.)

Definitions and Misconceptions (cont.) Financial And Emotional Aspects

Definitions and Misconceptions (cont.) “Hank”

Association of Certified Fraud Examiners Stat: After examining 1,100 cases of occupational fraud in 2006, the ACFE said the average theft scheme costs a business about $159,000. About one-quarter of the theft schemes cost a business more than $1 million. Definitions and Misconceptions (cont.)

Sadly, by the time a fraud scheme is uncovered, it’s safe to assume the money has already been spent. So, a lot of businesses hesitate to expend the time and energy to recoup the money. This would be throwing good money after bad… Definitions and Misconceptions (cont.)

Segregation of Duties (“SOD”) by definition, is an anti-fraud control. It is, in fact, the most effective anti-fraud control. It prevents a single employee from beingable to negatively affect a company. This is the case regardless of whether an employee wishes to do so, or might otherwise do accidentally. Definitions and Misconceptions (cont.)

Control Types They come in many shapes and sizes: Manual, Automated, Entity-Level, Transaction-Level, and, of course, Preventive and Detective. Definitions and Misconceptions (cont.)

Auditing Standard No. 5 Defines each: Preventive controls have the objective of preventing errors or fraud that could result in a misstatement of the financial statements from occurring. Detective controls have the objective of detecting errors or fraud that has already occurred that could result in a misstatement of the financial statements. Definitions and Misconceptions (cont.)

My two cents worth: Detective Control – An activity that identifies an accounting error, whether intentional or not, after it has been recorded. This is usually a procedure performed external to the processing of transactions, designed specifically to identify errors of a specific nature. Examples: reviews, exception reports, reconciliations, financial analysis, etc. Definitions and Misconceptions (cont.)

My two cents worth: Preventive Control – An activity or environmental condition that does not allow an error, whether intentional or not, to be recorded in an accounting ledger. Definitions and Misconceptions (cont.)

The ability to contribute to a control environment more efficiently directly correlates to the cost/benefit effects of the ongoing operation of preventive vs. detective controls. Definitions and Misconceptions (cont.)

Because of the preventive nature, proper SOD is the most powerful control an organization can have for either fraud or unintentional errors. Definitions and Misconceptions (cont.)

Confucius Say: Definitions and Misconceptions (cont.)

Confucius Say: Man who run in front of car get ‘tired’. Definitions and Misconceptions (cont.)

Confucius Say: Man who run behind car get ‘exhausted’. Definitions and Misconceptions (cont.)

Moral of the Story: Make sure the Company is the one driving the car, controlling the speed and direction. Definitions and Misconceptions (cont.)

Segregation of Duties “Not as simple as it sounds.” Definitions and Misconceptions (cont.)

Segregation of Duties – Process Attributes: Authorization Custody of Assets Recording Control Activity Definitions and Misconceptions (cont.)

Segregation of Abilities– Process Attributes: Authorization Custody of Assets Recording Control Activity Definitions and Misconceptions (cont.)

Segregation of Abilities– Process Attributes: Authorization and Responsibility Access to potential (personal) benefit Recording Control Activity Definitions and Misconceptions (cont.)

Example of a fraud committed without actual access to an asset: Excerpt from an ACFE article: “An internal investigation found [She] stole thousands of dollars a week from the hotel between April 2006 and September 2007. [She] canceled non-existent reservations and ordered refunds to seven different credit cards she opened, stealing $200 to $1,100 at a time until she had taken so much money her managers had to postpone a renovation of the hotel. Definitions and Misconceptions (cont.)

Deterring the misappropriation of assets Deterring the creation of liability Definitions and Misconceptions (cont.) =

Segregation of Abilities– Process Attributes: Authorization and Responsibility Access to potential (personal) benefit Recording** Control Activity Definitions and Misconceptions (cont.)

How many organizations have appropriate segregation of duties? Definitions and Misconceptions (cont.)

0 Definitions and Misconceptions (cont.)

In business, ignorance is not bliss. Definitions and Misconceptions (cont.)

Control Objectives – Taking the prevention of fraud and mistakes seriously. Segregation of Duties

How much of your time is spent ‘fixing’ mistakes? Control Objectives

NO company grows ‘well’ in these back-end functions. Control Objectives

Effective controls help gain efficiencies that allow a company to cut costs and/or position its existing resources to handle foreseeable growth without increasing costs. - The ability to grow WELL - Control Objectives

“Through the Auditor’s Goggles” Control Objectives

Companies seem to think that a formal SOD assessment is not necessary because the concept is so elementary or futile. Control Objectives

2. If attempted, done so using very poor assessment tools pulled from national firms’ rusty, generic template arsenals. Control Objectives

3.Management and consultants tend to come to the conclusion that there are few, or no significant SOD issues out of ‘thin air’. Control Objectives

4.Only the most obvious SOD issues are called out as a result of a walkthrough/process document and are often discounted as unavoidable due to the size of the organization. Control Objectives

Particularly in 404 implementations: a large portion of controls identified as ‘key’ are, in effect, a segregation of dutiescontrol. As much as 75%, if viewed through our goggles of ‘Segregation of Abilities’ Control Objectives

The Paradigm Shift: Performing an appropriate SOD assessment will actually define and formally identify each of the existing issues and allow management to address them one by one. If the risk of loss (or potential liability) is small, management may choose to accept it, or it may be satisfied that an already existing, detective control is sufficient. Control Objectives

Remember: The potential for FRAUD is at risk, so identifying ALL possibilities and permutations and then deciding what is or isn’t a severe issue is more prudent than presupposing that there’s no way a particular process/area could result in a significant occurrence. Control Objectives

Assessment Methods Segregation of Duties

From: To: Assessment Methods

Identify all significant accounting-related processes (or, ‘cycles’) Break these processes down into sub-process components, both transaction-level and general (i.e. steps in performing a check run vs. vendor creation) Assessment Process:

In a two-dimensional manner (one-to-one), compare each step to identify whether an individual performing both processes would have the ability to both obtain personal value and affect the recording of it and highlight the intersection of these functions. This is an area of ‘ideal SOD’. Assessment Process:

Identify which of these steps requires access, either physical or electronic, to perform. For those steps that require neither, assume anyone can do them. Assessment Process:

Effective Control Environments: