A small business owner arrives at the office to find a pile of checks on his desk awaiting his signature. Included are large, critical payments to raw material suppliers, and payments to the utility companies for electricity, water and natural gas used in the manufacturing process. There’s also a check to an office furniture supplier and a local charity. The checks were prepared by the trusted Accounting Clerk, who has been with the company for over 20 years and is the sister of the owner’s next-door neighbor. The pile does not include any additional paperwork, just the checks. The owner, needing to move on to more pressing issues, quickly signs the checks and returns them to the Accounting Clerk for mailing.
Does this scenario sound familiar? Unfortunately, it’s the status quo for many small to mid-sized companies.
One of the more challenging elements of running any business is risk management. One method of minimizing risk is the purchase of insurance to help a business recover from a loss. But, insurance cannot PREVENT the loss. There are some events and related losses can be prevented. This is where INTERNAL CONTROLS become an important part of the overall efforts to manage the risks businesses face each day.
Business owners usually concentrate on things like selling, strategic business development, new products, making sure orders ship on time and keeping customers happy. After these priorities are addressed, there may not be a lot of time left for identifying, assessing and managing the business’ risks. Those risks, though, are very real and can lead to disastrous results if they’re left unattended. Think about all of the processes your business uses each day…purchasing, manufacturing, receiving materials or inventory, shipping orders, invoicing customers, collecting customer payments, paying suppliers, and many others. Each of these processes has distinct risks attached to them. The good news is that all of these risks can be reduced, and in some cases eliminated, by putting proper controls in place.
The controls used by businesses to reduce or eliminate risk of loss may be just simple checks and balances. Most internal controls may only require a small change in process, and yet can significantly reduce risk. In some of our upcoming blogs, we will be covering a number of internal control topics. Today, we want to introduce one high-level principle that should be used within any business to manage, direct and control the outflow of cash.
Very simply, it’s called the “three-way match”, or “triple match.” This is a method of verifying the receipt of the correct amount and type of inventory prior to making payment to the supplier. In many cases, internal controls are procedures that manage activities within a department. Here, the relationship between the Purchasing Department, the Receiving Dock and Accounts Payable is verified. Since the end result of this process is an outflow of money, a business owner should know EXACTLY what the outgoing payments are for, and that they match what was ordered and what was received.
So how do you conduct this three-way match? Most small businesses are already doing the core activities that make the three-way match process useful, and usually a minimal commitment of additional time:
- Issuing purchase orders to suppliers
- Receiving materials, inventory or supplies
- Paying the suppliers’ invoices
These activities are the basic parts of the three-way match, which assures that WHAT WAS INVOICED matches WHAT WAS RECEIVED, which matches WHAT WAS ORDERED. This process is supported by the matching of three documents related to each of the numbered steps above:
- Your company’s Purchase Order, including exact item descriptions, quantities and prices
- Your company’s Receiving Report (which is often a copy of the PO with the quantities blanked out, so that the receiving dock doesn’t know the amount that they are expected to get from the truck.) This is used by the employee receiving the material to count and record exactly what is being received.
- The Supplier’s Invoice, which should match all of the items on both of the above documents – or, at the very least, the Receiving Report.
This is the focus of the internal control. These three activities, Purchasing, Receiving and Accounts Payable, are conducted by three different departments and different employees. And this control is in place to assure that the company pays for what they receive – no more, no less, and that it matches what they ordered.
When the three items all match, the Accounts Payable staff is cleared to issue payment to the supplier. And, they attach the supporting documents to the check, so that the person signing the checks can review the documents and verify that the payment is correct.
So, let’s get to some logical questions:
Q Must the three-way match be done for each and every payment that goes out?
A No. Some payments are for invoices that don’t relate to receipts of material from the dock. In those cases, such as payments for Utilities or Rent, it is appropriate to match the payment amount against the prior payments to assure that they are consistent, or at least that a significant difference can be explained. But the company may also be purchasing services. In this case, the Purchase Order was issued, but there is no receipt at the dock. There still needs to be a verification for “receipt of services.” In this case there is a different three way match. The person who requested the Purchase Order must approve that the work was completed. That becomes the third match of the approval process.
Q What if the quantity that the dock writes on the receiving document doesn’t match the Purchase Order?
A The first issue here is whether the quantity matches the packing list sent along with the shipment. If the count matches the shipping documentation, then the determination needs to be made as to whether the order was shipped complete, is a partial shipment or an over shipment.
Q What if the quantity at the dock doesn’t match the packing slip?
A There are two possibilities here. Either the person doing the count was incorrect, or the shipment was incorrect. It’s important to recount the merchandise. Normal procedure is to have someone new do the recount.
Q That seems like a lot of work for small purchases, it this really necessary all the time?
A For merchandise receipts, it’s advisable to establish a dollar amount for invoices and payments that require the three-way match. For instance, you don’t want your employees counting each paper clip received with a $48 invoice from your office supply vendor, but you will want to verify that you got a package of paper clips. However, $3,900 worth of raw materials that comes in on several pallets should be reviewed and verified. So, it’s important to establish a dollar threshold for the level where these counts and matches would be required.
Q Is it really necessary for the owner to verify each and every payment?
A Well, that really depends on the owner. Even in large companies, it is important that a spot check be done occasionally by a higher level manager or officer. But in small companies, it isn’t unusual for the owner to be the only person with check signing authority. If someone else is signing the checks, the verification that the amounts and quantities are correct is an important part of keeping a business on track, and assuring that payments are being made properly.
If a company’s outside accountant does a Review of the company’s financials at the end of the year, they will want to verify that these controls are in place. Randomly checking on payments is part of their verification process. Having files in order, with the proper backup, will minimize the amount of time taken for the field part of any year end work, whether by the bank or the outside accountant.
Other common occurrences that affect the three-way match process include back orders and partial shipments. Some suppliers will ship partial orders while back ordering the remainder. This usually results in multiple invoices and receiving records against a single PO, and requires additional tracking and diligence by employees. It is also common for some suppliers to ship within certain tolerances (i.e. +/- 10%). For instance, this is true in purchasing printing. In those cases, it is unlikely that the quantities will exactly match the PO. But, as long as the receiving report, packing slip and the invoice match, and they both are within acceptable tolerances of the original PO, then payment of an invoice is most likely acceptable.
There are many additional internal controls that small businesses can and should implement to help reduce risk and operate more efficiently. The three-way match is a good example of a relatively simple process that will provide the small business owner with a higher level of confidence in a very important function within the business. In the coming months, we will cover additional processes and controls that small businesses can use to their advantage.
CFO Simplified specializes in development and installation of policies, procedures and controls that make sense for your small business. Please see our website, www.CFOsimplified.com, for additional information on this and other critical financial services for your business.