How to Succeed Where FTX Failed: The Case for Financial Controls

By Bill Leetham, Heather Ogan

As all experienced CFOs know, effective financial controls are essential for any company to succeed over the long term. And from time to time, companies with poor internal controls (business practices, policies, systems, procedures) crash into a brick wall. From what’s been covered in recent media, FTX is a very high-profile example of a company lacking these essential guardrails. Unfortunately, FTX is but one of a number of other company situations that don’t receive such publicity but still end up ruining investor and founder equity values.

Since financial controls are so important to avoiding a severe loss of capital, why don’t more companies put them in place? Sometimes management has a mistaken belief that they have things under control and therefore nothing unforeseen could possibly happen to them. Sometimes they believe the controls they have implemented are effective when they’re actually not. Others simply fail to implement controls because they believe they are too costly and burdensome to execute in terms of both time, training, and system investment.

We beg to differ.

The Business Case for Investment in Financial Controls

At FLG, we know that that solid financial controls can be implemented that are not only effective, but also make a company more efficient and more profitable.

A strong set of financial controls is not a checklist, however. Solid approaches here vary by industry and by company.

A control is a process identifying accountabilities and setting in place measurements and procedures designed to protect a company’s assets or limit its liabilities. Company assets will definitely include cash and may also include accounts receivable, inventory, and/or fixed assets. Liabilities include accounts payable or debt. Operating and capital expenditures also need controls.

Here are three important sets of financial controls that every company should  consider adopting:

#1: Build a Roadmap: Materiality Matters

Every company should create their own roadmap to developing an appropriate set of internal control procedures, and at the right levels of authority for accountability. Begin by examining your business. Prioritize your biggest risk exposures (assets, liabilities, expenditures). In many companies (tech companies, for example), payroll is often the biggest expense. In other companies (e.g.,  consumer-based), it might be inventories or other assets. The key is to scale the controls to the level of risk and materiality. So, a company putting in place strict purchasing requirements for office supplies that don’t represent more than 1% of operating expenses makes little sense.

#2: Private Companies (not just Public Ones): Close the Books Monthly

We cannot emphasize this simple strategy enough, especially for startups/emerging companies on the private side. Close your books timely – this means every month, and as soon as possible after the last day of financial transactions of the period is complete. This imperative is a valuable tool for management, but also a great control point.

Closing the books should include these three key steps:

Reconcile Bank Accounts (and Cash Positions) Monthly

Always reconcile all your bank accounts monthly. Reconciling your cash accounts is the first, and in our view, the most important month-end close activity. This will ensure that all your cash in-flows and out-flows for the period have been recorded. The bank reconciliation should include reviewing all uncleared checks and pending ACH and wire transactions, investigating and understanding why they have yet to clear. Virtually all accounting systems allow you to download transactions from your bank. This should be a really easy exercise for any finance team. If this isn’t easy, that should be a flag to your finance team that your banking process is too complex.

Another important financial control in the Cash area, whether in the procure-to-pay (PTP) or order-to-cash (OTC) work stream, is segregation of duties within the accounting organization. Unfortunately, this isn’t always possible in the case of startups and smaller companies. But even in these growing enterprises, the finance team can make sure that whenever possible the person authorizing payments or managing deposits is not the same individual performing the bank reconciliation process. The monthly bank reconciliation report along with the company’s actual bank statements should be reviewed by someone outside the daily cash operations process. This might be the CFO, for example, but it can even be the CEO.

And do take advantage of fraud mitigation services available from your banks such as “positive pay,” where you upload the amounts of valid vendor and supplier payments to the bank before sending them on to recipients.

Reconcile Significant Balance Sheet Accounts

Monthly reconciliations should also include both accounts receivable and accounts payable. If you use third-party systems to manage either or both of these functions, make sure their month-end balances tie exactly to your general ledger. This is simplified by assigning each of these separate systems to a single general ledger account for each. Let’s say accounts receivable is Account 1200, for example. Never allow any recording of any other transactions into Account 1200 other than receivable activity/transactions. If you must accrue revenue for some reason into AR, you should always create a separate account (maybe Account 1201) for accrued revenues. By not mixing multiple types of transactions into a single account, your monthly reconciliation process will go much more quickly.

One final note about accounts receivable: you should examine the aging of your receivables monthly. Who isn’t paying you? Find out why. Assign old receivables to someone specifically tasked with collecting them. If at all possible, do away with accepting check deposits or disbursing funds through paper checks. Accounting systems, banks and third-party companies all have reasonable ACH systems to handle these transactions electronically.

If you use third-party systems for handling payroll, record these transactions in dedicated general ledger accounts. You will want to reconcile both the expense and balance sheet account balances for payroll.  Maybe you’ve chosen 5 general ledger expense accounts for payroll: Salary, Bonus, Commission, Benefits, and Taxes. Don’t record accruals to those accounts. If you need to accrue any amounts for those accounts, create separate general ledger accounts called Accrued Salary, Accrued Bonus, etc. By doing this, you can quickly and easily take a year-to-date report from your payroll system and tie it exactly to the year-to-date values in your general ledger. This helps makes your reconciliation and flux analysis quick and easy.

Reconcile these accounts (and all “accrual” accounts) monthly to ensure the methodology being used to determine these estimates is reasonable, and that related financial statement balances are fairly presented. These types of accounts by their nature have a higher risk of misstatement errors, and are more susceptible to fraud. Again, use dedicated general ledger accounts for these so that they are easy to reconcile.

Lock Down Your General Ledger

Ensure that your accounting system allows only those individuals with appropriate permissions to open and lock posting periods. Once you’ve closed a month, use your accounting system’s locking capability to prevent prior period entries from “clouding the picture.” You don’t want unseen transactions to slip by because somebody was able to record them in a prior period that is already “closed” and is therefore no longer being watched. If your systems permit, you may want to just “soft close” your books before moving on to the flux analysis step, then “hard close” once the flux is completed and any corrections or missing transactions identified have been posted.

#3: Do a Flux Analysis: Compare Expense Variance to Budget/Plan, Last Year, Last Period, Forecast

Once your books are closed, have your Controller or Accounting Manager provide a written explanation of any unusual month-to-month variances in all key P&L and balance sheet accounts and be sure the variance explanation provided really covers the “why.” A flux analysis is only helpful if it is thoroughly done. You should always review expense variances from month-to-month, but be sure your comparison periods make sense for your business. If you have a seasonal business, make sure your flux analysis takes this into account. If you have a budget or plan or forecast, understand variances there, too. Have your Controller also provide explanations for any unusual account balances; for example, credit balances in accounts that should have debit balances. You want to make sure errors (or rogue transactions) aren’t being hidden in infrequently used or reviewed accounts.

As a company, if you do these three things every month, you’ll eliminate a huge amount of control risk. You’ll also want to add additional specific monthly controls for company-specific areas of exposure. These might be for inventory purchases or remaindering, purchase of fixed assets, travel expenses, non-cash compensation (ESOPs etc.), or anything else that represents a material asset or expense.  There are also other things you can do periodically (quarterly, biannually) such as reviewing your payroll employee master file and your vendor master file to ensure you don’t have any “ghost employees” and/or fake vendors.

If you need help evaluating your company’s current suite of financial controls or with recommendations for designing more robust control processes, do get in touch with us at FLG – we are happy to help.