The auto dealership industry is experiencing some significant changes that underscore the importance of strong, well-managed internal controls. The sales slowdown, for example, has slashed the amount of income commission-based employees are earning, creating a temptation to supplement their earnings by committing fraud. Shrinking staffs result in fewer employees available to perform critical accounting tasks, weakening the segregation of duties in some dealerships and making imperative the efficient operation of internal controls.

Many dealerships neglect to re-evaluate their internal controls after initial implementation, but savvy dealers, chief financial officers, and controllers are taking the time to examine them. What controls are currently in place? Do they require adjustment? Should new controls be added? Has new technology affected the internal controls? By asking these and other questions, dealerships can increase the strength of their internal controls and reduce the risk of losses that cut into profits.

Common Weaknesses of Internal Controls

Our expertise with dealerships indicates that several internal-control-related areas are particularly vulnerable in the industry. The following is a partial list of internal control questions dealers should consider.

• Is the dealership's bank reconciliation performed regularly, and are the adjustments posted promptly?  Bank reconciliations should be done, at a minimum, on a monthly basis (and preferably on a daily basis) by an employee who is not involved in the dealership's check-writing function. It’s not enough for that employee to identify all of the discrepancies between the bank's records and the dealership's general ledger; the employee also must post all of the adjustments to maintain the accuracy of the financial records throughout the month. Distributions to the owner, floor plan payoffs, lien payoffs, and other electronic funds transfers that are not posted to the books on a timely basis can easily distort the financial picture, potentially leading to cash management issues for the dealership.

• Does the parts pad agree with the general ledger?  Dealerships should reconcile the parts pad with the general ledger on a monthly basis. Failing to reconcile these opens a door to employee fraud. The parts manager, for example, could sell parts and pocket the cash without suspicion or adjust numbers on the pad to boost department performance measures. One parts manager issued a falsified customer credit return to his own credit card. To account for the $5,000 of parts that were never actually returned, he provided adjusting journal entries to the accounting department to adjust the inventory level on the general ledger, which were never questioned by the accounting department. The discrepancy between the parts pad and the general ledger should have raised questions.

• Who signs the dealership's checks?  The employee or employees charged with signing checks should not also be responsible for posting journal entries or reconciling the bank's and dealership's records, and they should not have easy access to checks. Although many dealers address the issue by requiring two signatures on every check, the reality is that checks often clear banks without both signatures. At one single-point store, 253 checks with only one signature cleared the bank in a one-month period, amounting to almost $1 million in disbursements. The signature provided was that of the office manager, who also posted journal entries and reconciled the dealership's accounts.  She easily could have been, unbeknownst to anyone, writing checks to herself.

• Is the warranty schedule reviewed for aged items? 

Aged warranty receivables mean the dealership is missing out on cash due back from the factory. Worse yet, an employee could use the schedule to hide journal entries covering misappropriation. If the warranty schedule is not reviewed routinely, the employee can simply credit cash for the removed funds and debit warranty receivables.

• Does someone independent of the new- and used-vehicle department take a physical inventory of the new and used vehicles?

In an audit of a large Mercedes store, an observation of the new-vehicle inventory could not account for 10 new Mercedes. Upon questioning, the new car manager explained that he had allowed a few salespeople to borrow the vehicles for the day.  Soaring gas prices make it especially tempting for sales staff to borrow vehicles these days. Independent inventories will reduce the likelihood of employees playing such games.

• Are dealership purchases made from an approved vendor list?

Dealers are often surprised to discover that they purchase some of their service supplies from the service manager's brother-in-law. These arrangements do not necessarily result in inflated prices, but, ideally, a multiple-store dealership can obtain price concessions by purchasing all of its supplies from a single vendor. Deals with friends and relatives undermine these arrangements. By restricting purchases to an approved vendor list, dealers can avoid this problem.

• Which employees are allowed to post journal entries?

Testing at one dealership revealed that a cashier could post journal entries. Given the cashier's responsibility for collecting and processing cash received, granting the cashier authority to post journal entries created a risk for the dealership. The cashier would be able to siphon cash and cover the differences with write-offs through journal entries.

• Who approves journal entries?

Journal entries represent a valuable tool for hiding fraud. A parts manager could prepare a journal entry to write of parts inventory, or the controller might make an entry reflecting a lien payoff to account for the check she cut to pay of her credit card. Management should regularly review the original journal entries to understand and verify the purpose of all entries.

• How much do the employees earn?

Some dealers are taken aback when presented with a listing of the 10 highest-paid employees in the dealership. The dealer may find that some employees are paid more than he realizes, or even that pay plans have been altered without his approval.  If the general manager takes home a 25 percent commission rather than the approved 20 percent, the difference can prove significant.

• Is the employee responsible for key controls over disbursements monitored?

During a recent analysis, a dealer learned that the office manager was posting accounts payable invoices, preparing checks, signing checks, reconciling the bank statement, posting journal entries, approving new vendors, and accounting for check sequence. The appropriate segregation of duties in the cash disbursement area is essential. Overlapping duties create a situation ripe for fraud. Where practical, for example, the employee who posts accounts payable should not also be responsible for signing the checks.

Managing the Risks

Crowe Horwath LLP has developed a self-assessment tool called the Client Assessed Risk Diagnostic that can help dealers take an individualized, risk-based approach to managing their internal controls. This Web-based tool walks users through a specific series of questions related to dealership operations, internal control procedures, and the segregation of duties. The resulting data is processed and reviewed by specialists who deliver a report that categorizes the dealership's key controls as high, medium, or low risk.

After these areas are identified, the specialists work with the dealer to develop a plan for mitigating the risk. The plan might address the optimal segregation of duties, based on the company's size and characteristics, including the number of available employees. Or it could focus on ways to ensure that existing controls are both efficient and effective.

A risk-based approach to internal controls management can facilitate a more targeted internal audit of a dealership. In the past, a dealership would typically follow a standard internal audit program, applying similar procedures at all locations and conducting the same tests every year, regardless of respective risks.

A dealership could now begin by performing an analysis of the existing internal controls and segregation of duties. Those controls deemed to work properly are periodically tested, but those identified as defective would be remedied prior to testing. Dealers also can use the analysis and testing as a foundation for satisfying documentation requirements of external auditors.

Controlling the Controls

In today's tight economy, dealers cannot afford to ignore the risks posed by substandard internal controls. With Crowe's new self-assessment tool, dealers can efficiently analyze their control risk and develop a tailored long-term plan to mitigate that risk and reduce related losses.

Tony Allison is an executive with Crowe Horwath LLP in the South Bend , Ind. , office. He can be reached at 574.236.8630 or tony.allison@crowehorwath.com.

Rick Cerda is a senior manager with Crowe Horwath LLP in the Oak Brook, M., office. He can be reached at 630.575.4240 or rick.cerda@crowehorwath.com.

Ed Reinhard is an executive with Crowe Horwath LLP in the Columbus , OH office.  He can be reached at 614.469.001 or ereinhard@crowehorwath.com.

Under U.S. Treasury rules issued in 2005, we must inform you that any advice in this communication to you was not intended or written to be used, and cannot be used, to avoid any government penalties that may be imposed on a taxpayer.

This article is published with the understanding that the authors are not rendering legal, accounting or other professional advice or opinions on specific facts or matters and, accordingly, assume no liability whatsoever in connection  with its use.  Reprinted with permission.  Crowe Horwath LLP.  Copyright 2008. All rights reserved.

Crowe Horvath LLP is a member of Horvath International Association, a Swiss association (Horvath). Each member firm of Horvath is a separate and independent legal entity. Crowe Horwath LLP and its affiliates are not responsible or liable for any acts or omissions of Horvath or any other member of Horwath and specifically disclaim any and all responsibility or liability for acts or omissions of Horvath or any other Horvath member. Accountancy services in several states are rendered by Crowe Chizek and Company LLC, which is a member of Horvath. This material is for informational purposes only and should not be construed as financial or legal advice. Please seek guidance specific to your organization from qualified advisers in your jurisdiction. 0 2008 Crowe Horwath LLP