Accounting Basics to Uncover Embezzlement
By Frank L. McElroy

Protecting a company from embezzlement requires that in-house lawyers have a basic understanding of various accounting roles and when to call in expert help.

As an unfortunate part of any business, there are almost endless opportunities for employees to take advantage of their positions to misappropriate money from their employers. Often, those activities go undetected for months, if not years, and lead to significant losses.

Although companies may have internal-controls systems in place, even the most robust and comprehensive plans are worthless if not properly implemented, followed, monitored and updated.

What's worse, many companies wrongfully assume that their accountant is already providing services that will protect them. A company that has engaged a tax return preparer or accountant to attest to its financial statements has not purchased an insurance policy to protect it from employees who are stealing money. In fact, that company has not even engaged the accountant to scour all company records to detect fraud or misappropriation.

Instead, the American Institute of Certified Public Accountants' (AICPA) standards for tax return services and Internal Revenue Service Circular 230 state that a tax return preparer may rely in good faith on information furnished by clients without verification, unless something appears incomplete, inconsistent or incorrect.

Likewise, the AICPA standards applicable to what are called attest services (such as compilation, review and auditing of financial statements) state that company management, not the accountant, is responsible for designing, implementing and maintaining internal controls and preventing and detecting fraud.

Even if the accountant is performing an audit, those services will not necessarily catch the embezzlement of client funds. Ultimately, the information on a company's financial statements is management's representation, not the accountant's.

The truth, therefore, is that accountants rely on the company's representations to perform their services. Although there are, of course, situations where a tax return preparer or auditor will uncover a misappropriation or embezzlement, there are significantly more situations where theft can go undiscovered. The ultimate responsibility for detecting a problem is management's. The most difficult setback for companies often occurs when a member of management is the one who is involved in the misappropriation.

Get Proper Help

Uncovering misappropriations requires a different kind of accounting service than tax advice or financial statement attest work — namely, forensic accounting. Some accountants provide traditional services, such as audits or tax return preparation, in addition to forensic accounting work. But others specialize in forensic accounting and have been certified by various organizations such as the Association of Certified Fraud Examiners and AICPA.

Unfortunately, companies generally will not engage the services of a forensic accountant or other consultant until they have identified a problem. But some take a more proactive approach. Instead of waiting for a problem to be discovered, they engage an accountant to review their systems, suggest improvements and look into specific areas where the company has concerns. Such action can help these companies avoid embezzlement all together, which can be a significant cost savings.

On the other end of the spectrum are companies who not only wait for a problem to arise before seeking a solution but also decide to limit the scope of the forensic accountant's work once an issue has arisen. Often this happens because the company only maintains partial insurance coverage for the loss, wants to deal only with known issues in the false hope that the problems are limited to one employee, or simply desires to keep costs low. The company chooses to cut corners by only allowing the forensic accountant access to particular years, accounts or segments of a company.

A thorough investigation by the forensic accountant, however, can identify any accomplices within the company and identify the full range of issues the company must address to make sure that the same mistakes do not occur again. Without allowing the forensic accountant to provide that range of service, the company may find itself in same situation once again.

Finally, although the best result would be the return of any stolen money by the embezzling employee, the reality is that most of the embezzlers I have seen do not keep the stolen money in a savings account for a rainy day. Instead, they spend the money on frivolous services and items that are difficult, if not impossible, to recover.

In those instances, the companies and their counsel often seek to hold someone other than themselves responsible for their loss. The company's own contributory negligence sometimes makes this difficult. This path will require the company to corroborate the loss with the results of the forensic accountant's work. A good forensic accountant will be engaged to prepare a comprehensive report that systematically identifies not only the loss incurred, but the weaknesses and deficiencies identified in the company's controls.

The services of accountants may be useful in not only identifying a misappropriation that already has occurred but also in finding ways to prevent such activities in advance. The most important thing for a company and its in-house counsel to remember, though, is that the company must take action and fulfill its responsibility for protecting its own interests, no matter who may be assisting it.

Frank L. McElroy is a shareholder in Forrest McElroy, PC in Houston, representing accountants from claim prevention to litigation. He regularly sees what happens when companies misunderstand the scope of the services their accountants are providing them.

Reprinted with permission from the November 5, 2012 edition of the Texas Lawyer © 2012 ALM Media Properties, LLC. All rights reserved.

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