CHAPTER 15: ERRORS AND IRREGULARITIES IN THE TRANSACTION
CYCLES OF THE BUSINESS ENTITY
SUMMARY REPORT
I. Sales and Collections Cycle
This cycle involves activities related to selling products or services and collecting payments from
customers. Errors and fraud in this area can significantly affect a company’s revenue and cash flow.
1. Errors in recording Sales and Collections Transactions
These are unintentional mistakes that often arise from:
● Using incorrect pricing or quantities when entering sales data.
● Recording a sale in the wrong accounting period (known as cutoff errors), which affects
the timing of revenue recognition.
● A bookkeeper’s misunderstanding of how to properly account for a transaction, leading
to misclassification or incorrect journal entries.
Internal controls such as approval procedures, training, and accounting checks are intended to
prevent or detect these errors early.
2. Frauds in Sales and Collections
Such frauds are typically committed by employees with access to financial records or cash,
including clerks or even managerial staff. Strong segregation of duties, regular audits, and
surprise cash counts can help prevent these incidents.
a. Fraudulent Financial Reporting (Sales)
Fraudulent financial reporting related to sales often leads to overstated sales or
understated sales returns and allowances. This manipulation is usually driven by
management’s pressure to meet profit targets, earn bonuses, maintain job security, or
gain recognition from superiors.
Common fraudulent methods include:
● Recording fictitious sales (e.g., fake shipping documents or invoices)
● Duplicating valid transactions
● Improper sales cutoff (recording future sales in the current period)
● Misclassifying operating leases as sales
● Recording deposits or consignments as sales
● Recognizing sales with a high likelihood of return
● Applying revenue recognition methods not aligned with PFRS
● Recognizing revenue that should be deferred
b. Misappropriation of Assets: Withholding Cash Receipts
1. Skimming is the fraudulent act of withholding cash receipts without recording
them in the books. It typically occurs before the cash is entered into the
accounting system, making detection challenging.
Examples include:
■ A cashier not ringing up a sale and pocketing the cash.
■ An employee underreporting a sale in the accounts receivable records
and taking the difference when the customer pays the full invoice
amount.
Indicators of skimming may include unexplained changes in gross profit
percentage or sales volume, which could suggest missing or unrecorded cash
receipts.
2. Lapping is a fraud where an employee hides stolen cash by using money from
one customer’s payment to cover another customer’s missing payment. This can
be detected by comparing cash receipts with bank deposit records.
3. Kiting is a fraud involving counting the same cash twice by exploiting the time
gap (float) between when a check is deposited and when it clears. Checking cash
transfers around year-end helps uncover this fraud.
II. Acquisitions and Payments Cycle
1. Errors in the Acquisitions and Payments Cycle
In the Acquisitions and Payments Cycle, common errors include:
○ Cutoff Errors: Recording purchases in the wrong accounting period.
○ Consignment Mistake: Treating consigned goods as owned purchases.
○ Misclassification: Confusing asset purchases with expenses.
○ Unrecorded Payments: Forgetting to record cash payments.
○ Duplicate Payments: Recording the same payment twice.
○ Prepaid Expense Errors: Not recognizing prepaid expenses as assets.
Companies usually have controls to prevent or detect these errors. Auditors test these controls,
and if they are weak, auditors do detailed checks to ensure financial statements are accurate and
free from major mistakes.
2. Frauds in the Acquisitions and Payments Cycle
a. Paying for Fictitious Purchases
This involves the perpetrator creating a fictitious invoice (and sometimes a receiving report,
purchase order and so forth) and processing the invoice for payment. Alternatively, the
perpetrator can pay the invoice twice.
b. Receiving Kickbacks
In this scheme, a purchasing agent may agree with a vendor to receive a kickback (refund
payable to the purchasing person on goods or services acquired from the vendor).
This is usually done in return for the agent's ensuring that the particular vendor receives an
order from the firm. Often a check is made payable to the purchasing agent and mailed to the
agent at a location other than his or her place of employment. Sometimes the purchasing agent
splits the kickback with the vendor's employee for approving and paying it. Detecting kickbacks
is difficult because the buyer's records do not reflect their existence. However, when vendors are
required to submit bids for goods or services, the likelihood of kickbacks is reduced.
c. Purchasing Goods for Personal Use
Goods or services for personal use may be purchased by executive or purchasing agents and
charged to the company's account. To execute such a purchase, the perpetrator must have
access to blank receiving reports and purchase approvals or must connive with another
employee. Fraud involving the purchase of goods for personal use is more likely to go unnoticed
when perpetual records are not maintained.
III. Payroll and Personnel Cycle
The payroll and personnel cycle is one of the most sensitive areas in an organization, as it involves
regular payments to employees and is prone to both errors and fraud if not properly controlled.
Historically, payroll-related errors and irregularities have occurred frequently and often go undetected
without strong internal control measures.
1. Errors
The most common errors in this cycle include:
○ Paying for hours not actually worked,
○ Recording payroll expenses under the wrong accounts,
○ Failing to rePaying employees at incorrect rates,
○ move terminated employees from the payroll system.
These errors, though sometimes unintentional, can have significant financial impacts. Proper
internal controls are essential to prevent and detect such mistakes. These controls may include
timely reconciliation of payroll records, verification of timesheets, and proper documentation for
changes in employee status or compensation.
2. Payroll-Related Frauds
Two major types of fraud often arise in the payroll system:
a. Fictitious Employees
This type of fraud involves adding non-existent employees to the payroll and collecting their
wages. It is difficult to detect but can be controlled through surprise payroll distributions,
involvement of independent personnel in distributing checks, and examination of employee files
and time records.
b. Excess Payments to Employees
This fraud occurs when employees are paid more than they are entitled to—either through
inflated hourly rates or false working hours. To combat this, any changes in pay rates should be
approved by the personnel department. Additionally, total hours worked should be closely
monitored, and analytical procedures such as comparing labor costs to production output should
be performed to detect any discrepancies.
c. Failure to Record Payroll
Companies under financial pressure may omit payroll expenses to appear more profitable,
though such omissions are hard to conceal unless matched by omitted revenue. Analytical
procedures help assess if payroll costs are reasonable.
d. Inappropriate Assignment of Labor Cost
To inflate profits, companies might improperly classify labor costs as inventory instead of
expenses. Comparing actual costs to budgets and verifying inventory valuation can help detect
this type of fraud.
