CHAPTER 15  Recording fictitious sales (creating fictitious

shipping documents, or sales invoices)

ERRORS AND IRREGULARITIES IN THE TRANSACTION
 Recording valid transactions twice
CYCLES OF THE BUSINESS ENTITY
 Recording in the current period sales that
Businesses in different individuals have differences in characteristics and occurred in the succeeding period (improper
most have some fundamental conceptual characteristics practices in common. cutoff)
 Recording operating leases as sales
Three (3) business transaction cycles:
 Recording deposits as sales
1. Sales and Collection Cycle  Recording consignment as sales
2. Acquisitions and Payments Cycle  Recording sales when the chance of a return is
3. Payroll and Personnel Cycle likely
 Following revenue recognition practices that are
Management should establish controls to ensure that transactions are
not in accordance with PFRS (IFRS 15)
appropriately handled and recorded. Improperly implemented internal
controls, overridden, fraud and errors may occur.  Recognizing revenue that should be deferred.
b.) Misappropriation of Assets: Withholding Cash Receipts
Errors and fraudulent activities that could result if there is poor internal 1. Skimming
control: It is the act of withholding cash receipts without
recording them.
I. Sales and Collections Cycle
 Retail cashier does not ring up a transaction
1. Errors in Recording Sales and Collections Transactions –
and takes the cash.
Errors in recording sales include mechanical errors (wrong
 Employee with access to cash receipts and
piece or wrong quantity, recording sales in wrong
period/cutoff errors, bookkeeper failing to understand proper maintains accounts receivable records will
accounting transactions. Internal controls are designed to record a sale at an amount lower than the
prevent or detect many of these kinds of errors. invoice amount.
2. Frauds in Sales and Collections –  Customer pays, the employee takes the
Frauds in sales generally relate to fraudulent financial difference between the invoice and the
reporting. Frauds in cash collections relate to amount recorded as receivable.
misappropriation of assets (accomplished by clerks or Detection of unrecorded cash receipts is
management-level employees). difficult; unexplained changes in the gross profit
a.) Fraudulent Financial Reporting percentage or sales volume may indicate that
This involves sales typically results in overstated sales or cash receipts have been withheld.
understated sales returns and allowances. Managers
under pressure to achieve high profits may inflate sales 2. Lapping
to meet target profits required by senior manages for A technique used to conceal the fact that cash has
bonuses, retaining respect of senior managers, or been abstracted; the shortage in one customer’s
keeping their jobs. account is covered with a subsequent payment made
Methods can be used to increase sales fraudulently: by another customer.
 Employee who has access to cash receipts This involves the perpetrator creating a fictitious invoice
and maintains accounts receivable can (receiving report or purchase order) and processing the invoice
engage in lapping. for payment. Alternatively, the perpetrator can pay the invoice
twice.
Routine testing of details of collections b.) Receiving Kickbacks
compared with validated bank deposit slips A purchasing agent may agree with a vendor to receive a
should uncover this fraud. kickback (refund payable to the purchasing person on goods or
3. Kiting services acquired from the vendor).
A technique used to cover cash shortage or to inflate This is done in return for the agent’s ensuring that the vendor
cash balance. It involves counting the cash twice by receives an order from the firm. A check is made payable to the
using the float in the banking system. purchasing agent and mailed to the agent at a location other than
- Float is the gap between the time the check is his or her place of employment. The purchasing agent splits the
deposited or added to an account and the time kickback with the vendor’s employee for approving and paying
the check clears or is deducted from the account it. It is difficult to detect kickbacks because the buyer’s records
it was written on. do not reflect their existence. When vendors are required to
submit bids for goods and services, the likelihood of kickbacks is
Analyzing and verifying cash transfers during the reduced.
days surrounding year-end should reveal this type of c.) Purchasing Goods for Personal Use
fraud. Goods or services for personal use may be purchased by
executive or purchasing agents and charged to the company’s
II. Acquisitions and Payments Cycle
account. To execute such a purchase, the perpetrator must have
1. Errors in the Acquisitions and Payments Cycle
access to blank receiving reports and purchase approvals or must
The following may occur in the acquisitions and payments cycle:
connive with another employee. Fraud involving the purchase of
 Failing to record a purchase in the proper period (cutoff
goods for personal use is more likely to go unnoticed when
errors)
perpetual records are not maintained.
 Recording goods accepted on consignment as a purchase
 Misclassifying purchases of assets and expenses
 Failing to record a cash payment III. Payroll and Personnel Cycle
 Recording a payment twice Historically, errors and irregularities involving payroll have been
 Failing to record prepaid expenses as assets reported to occur frequently and are largely undetected.
Entities design controls to prevent such errors, or to detect such errors if they 1. Errors
occur. When such controls exist, auditors test the controls to assess their The most errors that can occur in the payroll and personnel
effectiveness. If the controls are ineffective, auditors should perform are:
substantive tests to determine that the financial statements do not contain a) Paying employees at the wrong rate
material misstatements that arose because of possible errors. b) Paying employees for more hours than they worked
c) Charging payroll expenses to the wrong accounts
2. Frauds in the Acquisitions and Payments Cycle d) Keeping terminated employees on the payroll
a.) Paying for Fictitious Purchases 2. Frauds involving Payroll
The major payroll-related frauds include:
a. Fictitious Employees
Adding fictitious employees to the payroll is one of the
most common defalcations. It is difficult to detect
fictitious employees on payroll but auditors do
sometimes perform a surprise payoff as a deterrent to
this form of defalcation.
Alternatively, the auditor may turn the check distribution
over to an official not associated with preparing payroll,
signing checks, or supervising workers. Personnel files
and the employees’ completed time cards and time
tickets may also be examined to substantiate the
existence of absent employees.
b. Excess Payments to Employees
Increasing the rate above that approved or paying
employees for more hours than they worked are the most
common ways of paying employees more than they are
entitled to receive. These practices can be substantially
reduced by requiring personnel department officials to
authorize changes in pay rates and by monitoring the
total hours worked and paid for. Analytical procedures
that focus on cost per unit of actual production can also
help detect excess payments to employees. CHAPTER 16
c. Failure to Record Payroll INTERNAL CONTROL AFFECTING ASSETS
Companies having difficulty meeting profit targets or
not-for-profit entities having difficulty managing costs INTERNAL CONTROL OVER CASH TRANSACTIONS
and expenses might fail to record a payroll. The Processes relating to cash handling are the responsibility of the finance
omission of payroll can be difficult to hide unless a department, under the direction of the treasurer. These processes include:
similar amount of revenues or receipts has been omitted.
Analytical procedures can be performed to test the  Handling and depositing cash receipts
reasonableness of payroll cost.  Signing checks
d. Inappropriate Assignment of Labor Costs to Inventory  Investing idle cash
A company having difficulty meeting profit targets  Maintaining custody of cash
might assign to inventory labor costs that should have  Marketable securities
been charged to expense. Analytical procedures such as  Other negotiable assets
comparing costs incurred to budgeted cost and
verification of valuation of inventory are some of the The finance department must forecast cash requirements and make both
useful techniques in detecting such fraud. short-term and long-term financing arrangements.
The functions of the finance department and the accounting department
should be integrated in a manner that assures that:
1. All cash that should have been received was, received, recorded the books by transferring functions of access to
accurately and deposited promptly. cash between bank accounts cash and record
2. Cash disbursements are made for authorized purposes only and are without appropriate keeping; no effective
properly recorded. recording of the transfer to review of bank
3. Cash balances are maintained at adequate, but not excessive, levels cover up an embezzlement reconciliations.
by forecasting expected cash receipts and payments related to normal of cash.
operations. The need for obtaining loans for investing excess cash is Failure to record Fraud: Inadequate
receipts from cash A cashier fails to ring up and supervision of
thus made known on a timely basis.
sales record cash sales and cashiers; failure to
A detailed study of the business processes of the company is necessary in embezzles cash. encourage customers
developing the most efficient control procedures and there are general to obtain cash
guidelines to good cash handling practices in all types of business. The receipts.
guidelines for achieving internal control over cash may be summarized as:
Error: Inadequate controls
1. Do not permit any one employee to handle a transaction from A bookkeeper accidentally for reconciling cash
beginning to end. omits the recording of the register tapes and
2. Separate cash handling from record keeping. receipts from one cash accounting records;
3. Centralize receiving of cash to the extent practical. register for the day inadequate controls
for reconciling bank
4. Record cash receipts on a timely basis.
accounts.
5. Encourage customers to obtain receipts and observe cash register
Failure to record Fraud:
totals. cash from A cashier embezzles cash
6. Deposit cash receipts daily. collection of payments by customers on
7. Make all disbursements by check or electronic funds transfer, but the accounts receivable receivables, without Lack of segregation
small expenditures on petty cash. recording the receipts in the of duties between
8. Have monthly bank reconciliation prepared by employees who are customers’ accounts. personnel who have
not responsible for the issuance of checks or custody of cash. The access to cash
completed reconciliation should be reviewed promptly by an A bookkeeper accidentally receipts and those
appropriate official. who has access to cash who make entries
9. Monitor cash receipts and disbursements by comparing recorded receipts embezzles cash into the accounts
amounts to forecasted amounts and investigating variances from collected from customers receivable records.
forecasted amounts. and writes off the related
receivables.
Potential Misstatements – Cash Receipts
Error:
Internal Control A bookkeeper accidentally Inadequate
Deception of Weakness or fails to record payment on a reconciliations of
Misstatements Examples Factors that receivable subsidiary records of
Increase the Risk of accounts receivables
Misstatement with the general
Recording fictitious Fraud: Lack of segregation ledger control
cash receipts Overstating cash receipts on of duties of the account.
Early (late) Fraud: Ineffective board of with merchandise accounts, or no controls
recognition of cash Holding the cash receipts directors, audit purchases. over the posting process.
receipts – “cutoff journal open to record next committee, or Duplicate recording Error: Ineffective controls for
problems” year’s cash receipts as internal audit and payment of A purchase is recorded review and cancellation of
having occurred in this year. function; “tone at the purchases when an invoice is supporting documents
top” not conductive received from a vendor signed by the check signer.
to ethical conduct; and recorded again
undue pressure to when a duplicate
show improved invoice is sent by the
financial position. vendor
Unrecorded Fraud: Ineffective control over
Failure to list and disbursements In conjunction with record-keeping for access
Error: deposit cash receipts recorded (but to cash.
Recording cash receipts on a timely basis. deposited) cash
based on bad information receipts, an employee
about date of receipt. writes and chases an
unrecorded check for
the identical amount.
Potential Misstatements – Cash Disbursements

Description of Examples Internal Control INTERNAL CONTROL OVER FINANCIAL INVESTMENTS

Misstatement Weakness or Factors that
Increase the Risk of the The most important group of financial investments, consists of marketable
Misstatement stocks and bonds because they are found more frequently and usually are of
Inaccurate recording of Fraud: Inadequate segregation of greater peso value than the other kinds of investment holdings. Other types
a purchase or A bookkeeper prepares duties of record keeping of investments often encountered include:
disbursement a check to himself and and preparing cash
records it as having disbursements, or check  Commercial paper issued by corporations
been issued to a major signer does not review and  Mortgages and trust deeds
supplier. cancel supporting  Cash surrender value of life insurance policies
documents.
Internal auditors must be concerned with derivatives used to hedge various
Ineffective control for financial and operational risks or for speculation. Derivatives are financial
Error: matching invoices with instrument that “derive” their value from other financial instruments,
A disbursement is receiving documents underlying assets, or indexes.
made to pay an invoice before disbursements are
for goods that have not authorized. A simple derivative would involve a commitment by a company to purchase
been received. a commodity at a certain price at some point in the future. Other derivatives
Ineffective accounting are much more complex, involving relationships between fluctuations in
Disbursements for coding procedures may European interest rates and the price of copper.
travel and result from incompetent
entertainment are accounting personnel, The major elements of adequate internal control over financial investments
improperly included inadequate chart of include the following:
1. Formal investment policies that limit the nature if investments in  Face amount or par value
securities and other financial instruments.  Certificate number
2. An investment committee of the board of directors that authorizes  Number of shares
and reviews financial investment activities for compliance with  Date of acquisition
investment policies.  Name of broker
3. Separation of duties between executive authorizing purchases and  Cost
sales of securities and derivative instruments, the custodian of the
 Terms
securities and the person maintaining the records of investments.
 Any interest or dividend payments received
4. Complete detailed records of all securities and derivative instruments
owned the related provisions and terms. Actual interest and dividends should be compared to budgeted amounts, and
5. Registration of securities in the name of the company. significant variances should be investigated.
6. Periodic physical inspection of securities on hand by an internal
auditor or an official having no responsibility for the authorization, The purchase and sale of investments often is entrusted to a responsible
custody, or record keeping of investments. financial executive, subject to frequent review by an investment committee
7. Determination of appropriate accounting for complex financial of the BOD.
instruments by competent personnel. Potential Misstatements – Financial Investments
Segregation of the functions of custody and record keeping is achieved by Description of Examples Internal Control
the use of an independent safekeeping agent (stockholders, bank or trust Misstatement Weakness or Factors
company). The independent agent has no direct contact with the employee that Increase the Risk
responsible from maintaining accounting records of the investments in of the Misstatement
securities, concealing fraud through falsification of accounts are reduced. Misstatement of Fraud: Ineffective board of
Securities not placed in the custody of an independent agent, they should be recorded value of Misstatement of the directors, audit
kept in a bank safe-deposit box under the joint control of two or more of the investments value of closely held committee, or internal
company’s officials. investment. audit function; not
conducive to ethical
Joint control means that neither of the two custodians may have access to the conduct; undue
securities except in the presence of the other. pressure to meet
earnings target.
A list of securities in the box should be maintained in the box, and the
deposit or withdrawal of securities should be recorded on this list along with Error: Inadequate accounting
the date and signatures of person present. The safe-deposit box rental should Failure to record manual; incompetent
be in the name of the company, not in the name of an officer having custody changes in market accounting personnel.
of securities. value of investments.
Unauthorized Fraud: Inadequate segregation
Complete detailed records of all securities and derivative instruments owned investment An employee with of duties of record-
are essential to satisfactory control. These records frequently consists of a transactions access to securities keeping for and
subsidiary record for each security and derivative instrument, with such coverts them for custody of securities.
identifying data as: personal use.
Incomplete recording Error: Inadequate accounting
 Exact name of investments Failure to record manual; incompetent
derivative agreements accounting personnel. Potential Misstatements – Revenue / Receivables
which are embedded in
other agreements. Inadequate monitoring Description of Examples Internal Control
by internal auditors. Misstatement Weakness or Factors
that Increase the Risk
of the Misstatement
INTERNAL CONTROL OVER RECEIVABLES Recording unearned Fraud: Ineffective board of
revenue Recording fictitious directors, audit
Accounts receivable include not only claims against customers arising from sales without committee, or internal
the sale of goods or services, but also a variety of miscellaneous claims such receiving a customer audit function; undue
as loans to officers or employees, loans to subsidiaries, claims against order or shipping the pressure to meet
various other firms, claims for tax refunds and advantages to suppliers. goods. earnings targets. “Top
management action”
Sources and Nature of Notes Receivables Intentional over not conductive to
Notes receivable are written promises to pay certain amounts at future dates. shipment of goods ethical conduct.
Typically, notes receivable is used for handling transactions of substantial
Errors: Ineffective billing
amount; these negotiable documents are widely used. In banks and other
Recording sales based process in which billing
financial institutions, notes receivable usually constitutes the single most on the receipt of is not tied to shipping
important asset. orders from customers information.
Internal Control of Accounts Receivable and Revenue rather than the
shipment of goods.
To understand internal control of accounts receivable and revenue, consider
the various components, including the control environment, risk assessment, Inaccurate billing and Ineffective controls for
monitoring, the (accounting) information and communication system and recording of sales. testing invoices, or
control activities. ineffective input
validation checks and
computer
reconciliations to
Control Environment ensure the accuracy of
databases.
Due to risk of intentional misstatement of revenues, the control environment
is very important to effective internal control over revenue and receivables.
Recording cash that Inadequate accounting
Independent audit committee of the BOD is important because it monitors represents a liability manual; incompetent
management’s judgments about revenue recognition principles and estimates, (receipt of a accounting personnel.
as well as an effective internal audit function. customer’s deposit) as
revenue.
Management should establish a tone at the top of the organization that
Early (late) Fraud: Ineffective board of
encourages integrity and ethical financial reporting. These ethical standards
recognition of revenue Holding the sales directors, audit
should be communicated and observed throughout the organization. Also, – “cutoff error” journal open to record committee, or internal
incentives for dishonest reporting (undue emphasis on meeting unrealistic next year’s sales as audit function; not
sales or earnings targets) should be eliminated. having occurred in the conducive to ethical
current year. conduct; undue Overestimation of the Fraud: Ineffective board of
pressure to meet sales amount of revenue Misstating the directors, audit
targets. earned. percentage of committee, or internal
completion of several audit function; not
Error: Ineffective cutoff projects by a conducive to ethical
Recording sales in the procedures in the construction company conduct; incompetent
wrong period based on shipping department. using the percentage individuals involved in
incorrect shipping of completion method the estimation process.
information. revenue recognition.
Recording revenue Fraud: Ineffective board of Aggressive attitude of
when significant Recording sales when directors, audit management toward
uncertainties exist the customer is likely committee, or internal Overestimating the financial reporting;
to return the goods. audit function; not percentage of incompetent personnel
conducive to ethical completion on projects involved in the
conduct; undue by a construction estimation/accounting
pressure to meet sales company using the process.
targets. percentage of
completion method of
revenue recognition.
Error: Aggressive attitude of
Recording sales when management toward
the customer’s financial reporting; INTERNAL CONTROL OVER NOTES RECEIVABLE
payment is contingent incompetent chief A basic characteristic of effective control consists of the subdivision of
upon the customer accounting officer.
duties. This principle requires that:
receiving financing or
selling the goods to 1. The custodian of notes receivable not have access to cash or to
another party general accounting records.
(consignment sales). 2. The acceptance and renewal of notes be authorized in writing by a
Recording revenue Fraud: Ineffective board of responsible official who does not have custody of the notes.
when significant Recording franchise directors, audit
3. The write-off of defaulted notes be approved in writing by
services still must be revenue when the committee, or internal
performed by seller franchises are sold audit function; not responsible officials and effective procedures adopted for subsequent
even though an conducive to ethical follow-up of such defaulted notes.
obligation to perform conduct; undue
significant services pressure to meet sales
still exist. targets.

Aggressive attitude of
Error: management toward
Amount of revenue financial reporting;
earned on franchise is incompetent chief
miscalculated. accounting officer.