Segregation of Duties in Accounting for Small Businesses

Segregation of duties (SoD) in accounting is an internal control mechanism that prevents fraud and error, and proper SoD ensures checks and balances within the business. When there is no SoD in place, opportunities to commit fraud might arise, especially if it incentivizes the perpetrators.

Due to limited administrative workforces, small businesses often face challenges in SoD as some admin employees have to handle two or three roles to cope. Good small business internal control dictates that some duties aren’t meant to be delegated to a single person. The existence of incompatible duties increases the risk of fraud, which is why the participation of the small business owner is a necessary compensating control to offset the existence of incompatible duties.

There are three general functions that must be segregated. Let’s discuss each below.

1. Authorization

Individuals who can authorize transactions cannot also be responsible for recording transactions nor should they have custody of the assets. If an authorizing person has access to the physical assets and records, it increases the risk of fraud and misappropriation of assets. Hence, employees who can authorize transactions mustn’t be involved in bookkeeping or safekeeping of physical assets.

For instance, the person who authorizes a check to be written shouldn’t be the same person who records the check in the bookkeeping software or reconciles the checking account. If it’s impossible to do this, it’s best to delegate approval functions to the small business owner.

2. Recording & Reconciliation

Individuals who record transactions, such as accounts receivable (A/R) staff, accounts payable (A/P) staff, and bookkeeper, mustn’t handle authorization and custody roles. Looking at the accounting process and bookkeeper’s responsibilities can help you spot incompatible duties affecting recording and reconciliation functions.

To illustrate, if the A/P staff can authorize payment for business expenses, they can create and approve fictitious expenses and steal money from the business. Moreover, individuals who reconcile accounts, such as bank accounts, mustn’t handle custody roles because since they have access to cash payments from customers, they can alter A/R records and steal customer payments.

Today, the most common business frauds arising from inadequate SoD in recording functions are the following:

Fraudulent Act	Definition	How To Eliminate Fraud Through Proper SoD and Other Controls
Check Kiting	This scheme uses check floats to access nonexistent cash as unauthorized credit. However, advances in technology and check clearing facilities make it easy to uncover this fraud.	Ensure that the last person signing the check is the one who will send it to the vendor Match the total amount in the voucher with the check Use online payment systems more often to reduce the use of checks within the business Require monthly bank reconciliations and review check transactions near month end (most kiting schemes are done near month end to avoid the check being reported in the current month’s bank statement)
Lapping	It is a type of skimming where the perpetrator steals money from one customer and uses the payment of another customer to cover the fraud. Lapping can occur if there is no proper SoD in custody and recording functions.	Separate recording (A/R clerk or bookkeeper) and custody function (cashier) with respect to customer A/R and payments Assign another employee other than the A/R clerk, bookkeeper, or cashier to send out customer statements of accounts (customers are aware of their outstanding balances, and they’ll surely protest if they’re being charged for invoices already paid) Encourage customers to pay directly to the bank, electronic fund transfer, or credit cards
Payroll Fraud	This can exist if there is no proper SoD in payroll, such as letting the business bookkeeper or payroll accountant maintain, collect and compute timesheets, prepare payslips, disbursement payroll, and record payroll entries.	Separate HR and payroll accounting functions Review payroll calculations Match the employee master list with payroll calculations to check if all employees are included in the payroll (or to spot if there are fictitious employees or terminated employees still in the payroll)

With proper SoD, you can reduce the risk of fraud in the business, but only up to a certain level. Collusions may exist within the company even if there’s proper SoD.

Prevent the proliferation of fraud and error by reading our A/R best practices and A/P best practices.

3. Custody

Individuals who have access to assets, such as keys to the storage room and access to the business’s bank accounts, mustn’t handle recording and authorization functions.

Let’s assume the company driver has the authority over fuel expenses. If they think fraudulently, they can be creative and charge the fuel expenses of their personal vehicle as fuel expenses of the company trucks. To mitigate this fraud risk area, they mustn’t have the authority to approve fuel expenses. Rather, the business may give them cash for fuel and require them to surrender receipts. Alternatively, they may use a corporate card for fuel expenses for ease of use.

List of Incompatible Duties in the Business Cycle

We listed a set of incompatible duties per function below. To apply this table in your small business, you must first classify employees with authorization, recording, and custody roles. Then, review the job descriptions of each employee and check if there are incompatible duties included. Remember, employees should never have duties listed under more than role like authorization, recording, or custody.

For instance, an employee with authorization roles has the following responsibilities: review sales returns, approve sales returns, and prepare sales orders. If we check the incompatible duties in the Revenue and A/R cycle, we’ll see that the preparation of sales orders isn’t a duty of an employee with authorization roles. You may remove the incompatible duty from the job description to maintain proper SoD.

If it’s impossible to remove an incompatible duty from an employee’s job description due to a limited workforce, the business owner must compensate for this SoD violation by placing another level of oversight on that employee.

Cash Receipts & Disbursements

Authorization	Recording	Custody
Approving customer refunds for in-store sales returns Reviewing and approving deposit slips Approving petty cash amounts and replenishments Approving disbursements	Updating cash records Reconciling bank and credit card accounts Preparing deposit slip Preparing checks for disbursements	Receiving cash payments from A/R customers Receiving cash payments from in-store sales Receiving and opening check payments in the mail Sending approved vendor checks for payment Paying approved customer refunds Depositing cash in the bank Handling petty cash box and reimbursing petty expenses Signing disbursement checks

Revenue & A/R

Authorization	Recording	Custody
Approving requests for credit Reviewing requests for sales returns Approving sales returns Approving customer refunds for sales returns	Preparing sales orders Invoicing customers Sending customer statement of accounts Sending payment reminders Updating customer accounts for credit sales and payments	Receiving sales returns from customers Examining goods returned

Expenses & A/P

Authorization	Recording	Custody
Approving request for purchase of inventory and office supplies ^a Approving vouchers for payment^c	Preparing purchase order Assembling of voucher package for processing vendor payments Reviewng voucher package for inconsistencies and errors Preparing check for vendor payments ^d Updating vendor records for credit purchases and payments	Preparing a request for purchase of office supplies & expenses ^b Receiving goods delivered by vendor for inventory purchased Signing vendor checks ^c

Notes & Explanations:

In a multi-department setup for large businesses, it is the requesting department head who shall approve purchases. But in a small business setup, the approval of inventory and office supplies purchases rests on the owner or any manager.
The department requesting the purchase of inventory or office supplies is the department that has custody over these assets. Hence, it is only fitting that they make the request.
The one who signs the check must not be the same person approving payment. Signing of checks is a custody role because the person signing must have custody and access to the business’ bank accounts. If these two roles rest on the small business owner, there’s no violation of SoD.
It is okay to delegate the preparation of checks to an employee (e.g., bookkeeper and A/P clerk). Even if these employees have access to company checks, they can’t forge or falsify checks since another person (see Note C) will review the check voucher and sign the check.

Inventory & Shipping

Authorization	Recording	Custody
Authorizing release of goods for customer orders Approving goods for shipment Approving request for purchase of inventory	Updating inventory records	Safekeeping inventory in the storage area or warehouse Preparing goods for shipment Accepting returned goods Preparing a request for purchase of inventory

Payroll & Human Resources

Authorization	Recording	Custody
Approve paid time offs (PTOs) and sick leaves Approve performances bonuses and salary increases Hire and fire employees Promote or demote employees Approve payroll checks	Calculate payroll and applicable taxes ^a Update payroll accounts Pay payroll-related taxes	Preparing employee time sheets ^b Distributing payroll checks to employees ^c