Errors and Frauds
There is a difference between an error and a fraudulent action even though both have the same impact on the company’s financial statements. They cause the financial statements to show a false picture of the company’s financial position. They lead to material misstatements causing the company to have an unfair advantage over other companies in the same industry. The potential investors may make decisions that they would not have made had they known the true or correct position.
The difference between an error and a fraudulent action is the intention of the individual (Ernst and Young, 2011). An error is unintentional. There is no ill motive in the individual. He does not do it for his own advantage. It is unintentional and it usually occurs when there is a clerical or mathematical error in the calculation of item balances in the financial statements or an unintentional misapplication of accounting policies (FRC, 1995). To detect mathematical errors there should be supervisory control in departments. There should be someone who calculates and records the transactions while another person recalculates and confirms the figures. This will enhance accuracy. To avoid misinterpretation of accounting policies, there should be an internal audit department in the organization. It will carry out audits of all the departments, especially the financial department to ensure that accounting policies are being adhered to.
There should also be regular training of the financial staff and management on accounting policies in order to ensure that they all understand what they need to do. Training should be conducted whenever there is a change in the accounting policies. External auditors also play a major role in ensuring that the financial statements are prepared in accordance with the accounting policies.
The management should heed the findings in the management letter that the external auditor’s issue to the company. A fraud, on the other hand, is an intentional misrepresentation of the items in the financial statements. There are different kinds of fraud that may occur in a company. There may be theft or misappropriation of the company’s assets. Staff may also record fictitious transactions in the cash book. The company should ensure there is proper segregation of duties in the finance department and all the other departments that handle any stock such as procurement and marketing.
The custodian should not be the person maintaining the records or authorizing the stock handover to other staff in the organization. This will make it extremely hard for an individual to steal from the company. In order to prevent the recording of fictitious transactions in the cash book, bank reconciliations must be prepared by a separate staff and supervised for accuracy.
Tests for Unrecorded liabilities
The auditor needs to confirm that there are no unrecorded liabilities left out in the financial statements. This will lead to an understatement of the expenses which will overstate the profit of the company. It is an area where the employees may commit fraud. There are certain audit procedures that should be carried out to ensure that this does not take place. The auditor should scrutinize the cash disbursements carried out by the company at the beginning of a new financial period. Supporting documents should be obtained and the auditor should confirm whether the goods were received before or after the balance sheet date. If the goods were received before the balance sheet date the payments will fall under unrecorded liabilities.
The auditor should also obtain the vendor’s file from the client and scrutinize the processed invoices and statements and confirm that the entries have matching entries in the ledger. The auditor should also scrutinize the unprocessed invoices and look at the description of the goods ordered and the delivery notes. This is to ensure that all goods delivered were accounted for in the correct financial period. The auditor should also engage the client and find out if there are any other sources of unprocessed invoices, commitments made by management, or contingent liabilities. He or she should confirm whether they were recorded in the previous financial statements or not. The auditor should get a listing of the accounts payable from the client.
A sample of the balances can be selected and the auditor carries out third-party confirmations where the clients are asked to confirm the status of their accounts. The auditor may also get the suppliers whose balances have just been settled showing nil balances and confirm their balances with the suppliers themselves. This will confirm the balances recorded in the financial statements. The auditor may find that the information from the third parties conflicts with the information in the financial statements. This will show the auditor that there are unrecorded liabilities. Third-party confirmations are very important since it is information that does not come from the client. In carrying out these procedures the auditor will have performed cut-off tests. At the end of the year, auditors participate in the inventory stock count. The auditor should record the serial number of the last receipt note of the year and confirm with the invoices of the vendors to ensure that all goods which have been received have been accounted for.
Overstatement of accounts receivable
Accounts receivables are one of the areas that are highly susceptible to fraud. The management may overstate the figures for the accounts receivables in order to overstate the sales of the company. This will help the company to overstate the profit earned in a particular period. The accounts receivables may be overstated by both the senior and junior employees. The junior employees overstate the balances in order to cover their own embezzlement. The senior employees on the other hand tamper with the records as they want to inflate the company’s share prices. They also want to get good ratings to get financing for the company’s capital projects (Caparon & Wentzel, 2008).
The company therefore should put in place adequate internal controls to ensure that there is no overstating of the debtor balances. First of all, there should be a segregation of duties in the area of accounts receivables. The person receiving the payments from the debtors should not be the one who is handling or maintaining the records. Where there is no segregation of duties, an officer may receive payment and not record it in order to steal the money. There is also teeming and lading where the staff may delay recording the payment in order to use the money and then return it later. The auditor should confirm that all the cash and cheques received are recorded and banking is done regularly. There should be a supervisor who confirms that the sales information has been recorded well in the ledgers.
Accounts receivable may also be overstated where there are no controls over bad debts provision and writing off of bad debts. This is a very critical area (Ricci, 2011).
The auditor should confirm that for a client to be given credit there is a supervisor who has to give the approval. There should be separate staff that authorizes any revision to the provisions in the financial statements. The aging of the debtors should be carried out and proper procedures documented that show how the debts are classified till it reaches the point where the company can consider writing them off. Senior staff should be responsible for writing off the bad debts. The auditor may also need to carry out third-party confirmations with the debtors to confirm the payments that they have made to the company.
A sample of the debtors may be selected especially those debtors with high balances who have not made any payments in a long time. The statements should be sent to third parties for confirmation. The accounts receivable should be linked to documents that provide an audit trail. The auditor should be able to link the debtor and all the payments to the purchase orders, shipping documents, and delivery notes. The auditor will be able to deduct any anomalies when he or she performs these procedures.
Management Assertions are at risk
The accountant’s explanation that he did not bank the cheques issued out at the end of the year in order to avoid a negative cash balance cannot be accepted by the auditor. On the preparation of financial statements, there are assertions that have been made by the management which the internal auditor has to confirm that they are true. The management assertions are several. They are existence or occurrence, completeness, rights, and obligations, accuracy, allocation or valuation, and classification (Ratcliffe & Landes, 2009).
The user of the financial statements expects that the company’s assets for the financial period actually exist and the transactions recorded have occurred. All the events that have occurred at a particular period should be recorded or captured fully. The assets and liabilities which are the rights and obligations of the company should be presented accurately.
The assets should be valued correctly and there should be no material misstatements. Cut-offs should be observed and the expenses and income earned recorded in the correct period. The rights and obligations should be described appropriately and put in the correct classification such as long-term and short-term liabilities.
The accountant’s explanation to the auditor puts several of these assertions at risk. First of all, the cash balance in the balance sheet is erroneous and the amount should be an overdraft. The cash balance does not really exist therefore it is a false representation.
Secondly, there is no completeness in the financial information since the cheques issued out have not been recorded. In rights and obligations, the accountant has overstated the company’s liabilities. Some of the company’s obligations have been settled yet the accountant has not recorded this. Cut-offs have also not been observed. In preparing the financial statements, expenses have to be recorded in the correct period. This helps the user to know the correct net profit and gross profit earned in the mentioned period. In refusing to record the cheques, the bank balance may be overstated leading to an overstatement of the gross or net profit.
There is also a lack of full disclosure in the financial statements. Cash balances and accounts payable balances are used to calculate the liquidity ratios of the company. Refusing to show an overdraft in the financial statements shows that the company is more liquid however this is a false representation. Finally, the cash balance will appear as a current asset in the financial statements yet it is supposed to appear as an overdraft in the current liabilities. The assertion of classification has therefore been compromised. The accountant’s actions will make all the management assertions to be at risk. Such actions will lead to material misstatements influencing the user of the financial statements to make the wrong investment decisions. The auditor should inform the management of the accountant’s action and recommend that the management puts internal controls to prevent such actions from happening in the future. The accountant should be trained on the dangers of engaging in such practices.
Bank Reconciliations
Employees may commit fraud by manipulating bank reconciliations. Bank statements are reconciled with the cash balance in the company’s books to ensure that the balances tally. Bank reconciliations are necessitated by certain entries in the bank account that are not yet recorded in the cash book. Are cheques that the company has issued out that have not yet been presented to the bank by clients? There are also certain ledger charges or other bank charges that have reduced the balance in the account. There are also cheques that might have been unpaid and the company has recorded the amounts in the cash book. There are several audit procedures that may be performed to ensure that there are no misstatements in the cash book. First of all, the auditor should get from the bank statements for a certain audit period which could be three months.
The auditor should match the entries in the statements with the entries in the cash books. He or she should get the explanations were there any discrepancies.
The auditor needs to confirm that there is segregation of duties in the area of bank reconciliations. The person authorizing a payment, recording the payment, and the one doing the reconciliations should be different. The auditor also needs to ask whether reconciliations have ever been carried out and scrutinize the reconciliations to ensure that they were conducted well.
It is very easy for fraud to occur where the employee recording the transactions is the same staff doing the reconciliations. The auditor should also check whether there is supervisory control over the bank reconciliation processes. A supervisor should review the bank reconciliations and approve the reconciling entries. Supervisory control ensures that reconciliations are conducted and that the reconciling entries are correct.
Lack of segregation of duties, supervisory controls, or bank reconciliations should act as a red flag for the auditor. If the bank reconciliations are not carried out, there are three kinds of misstatements that will occur. There will be the understatement of bank charges. This will overstate the profit. The bank charges will not be recorded in the cash book to reduce the balance in the cash book.
Secondly, where there are unpaid cheques, there will be the understatement of the debtors. Once the accountant receives the cheques, he will reduce the number of debtors. However, if the cheques are not yet paid, the debtors’ balances have not reduced. Thirdly, on the issue of cheques by the company, the accountant will reduce the accounts payable balances yet the cheques have not yet been presented to the bank for payment. The creditor balances will therefore be overstated. Bank reconciliations eliminate such misstatements.
References
Caparon, C. & Wentzel, B. 2008, ‘Accounts Receivable Sarbanes – Oxley Compliancy with Improved Cash Flow Forecasting’. A Cforia Software White Paper, pp. 1-8.
Ernst and Young 2011, Detecting financial statement frauds. Web.
FRC 1995, 110: Fraud and Error. Web.
Ratcliffe, T. & Landes, C 2009, ‘Understanding Internal Controls and Internal Control Services’. Journal of Accountancy. Web.
Ricci, C 2011, ‘Manipulating Receivables: A Comparison Using the SEC’s Accounting and Auditing Enforcement Releases’. Journal of Applied Business and Economics, no. 12, vol. 5, pp. 35-55.