FRAUD IN FINANCIALSTATEMENTS
1
CHAPTER 1
LITERATURE REVIEW1.1: OVERVIEW OF ACCOUNTING SYSTEMS
Accounting systems go back thousands of years. Ancient societies used relatively crudesystems, and more sophisticated methods were developed during the reign of the RomanEmpire. Accounting helped bring about the Industrial Revolution, and today, accountingis the underlying foundation (the "language") of business and finance. Accounting isessential for evaluating the efficiency of a business, and it does this by recording ahistory of a business's failures, successes, and projections for the future. Accounting iscommonly defined as:
"
The art of recording, classifying, summarizing, and interpreting monetarytransactions and events of a financial character
."
1.1.1: Bookkeeping
Bookkeeping is a system of checks and balances for the recording of expenses andincome. Actually, anything that qualifies as a "transaction" (or exchange of goods andservices) should be subject to bookkeeping, but usually anything recordable in terms of dollars and cents is what goes in the "books." The basic rule of bookkeeping is for numbers to be recorded in the right place, and for this, you need a system of "accounts."An "account" can be numerical or it can be a description of the category for that account.For example, if you buy something for your business and get a receipt for it, the receiptmay not be itemized, so you write something on the receipt like "Office Supplies - stapler and staples." This way, your bookkeeper can at least identify the descriptive category for the right account.There are two methods of bookkeeping:
•
The single-entry method; and
•
The double-entry method.The single-entry method arranges all financial transactions in chronological order, muchlike the Register pages of the checkbook that comes with a checking account. Single-entry is fine for personal finance, especially when automatic deductions and deposits take place, but it doesn't readily classify transactions according to category or type.
1
Dixon, R. (1993).
The McGraw-Hill 36-Hour Accounting Course
. NY: McGraw-Hill.
2
The double-entry method requires that every transaction affect two or more accounts.For example, when you buy an office desk and pay cash for it, two accounts are affected,cash and office furniture. The account called "Cash" gets a negative entry, called"credit," and the account called "Office Furniture" gets a positive entry, called "debit."
Every transaction must have at least one credit and one debit that perfectly "zero" eachother out
. However, various types of transactions may be recorded differently becauseyou didn't pay cash, but instead charged an item, which made it a liability, recorded inaccounts payable. This is just one example, and the following table shows how debitsand credits affect different types of accounts, and these rules make up the primary waysthe T-account format is used in ledgers. Various credits or liabilities may incur a financecharge, just as various debits, or purchases, incur some depreciation, so this (along withsome other business practices) will most probably require what are called "balancingentries" to keep everything coming out to zero.Account TypeDebitCreditASSETSIncreasesDecreasesLIABILITIESDecreasesIncreasesEQUITYDecreasesIncreasesINCOMEDecreasesIncreasesEXPENSESIncreasesDecreasesThere are two recognized methods of recording transactions:
•
The cash basis; and
•
The accrual basis.Under the cash basis, receipts (revenue) are recorded when cash is
received
, andexpenditures (expenses) are recorded when cash is
paid out
. Meaning that a companywhich ordered, say, computer paper in December and doesn't receive it until Januaryrecords the transaction as having occurred in January. Doctors, dentists, lawyers, andother professionals widely use the cash basis method.Under the accrual basis, revenue is recorded when
earned
, and expenses are recordedwhen
incurred
. That is a company would record its computer paper liability inDecember, and the account called Expenses (for the paper not yet received) might bedebited along with balancing entries someplace else (like Assets or Income) that producethe corresponding credits.
It should be noted that there is a perfectly acceptable third method of recordingtransactions, called the "hybrid" method. Under the hybrid method, revenue is reportedvia a cash basis and expenses are reported via an accrual basis. The hybrid method ismost commonly found in small (contractor) businesses where the "timing" betweenobligations and payments of expenses is of short duration and most income is handled ona cash basis. If there is no material distortion of income and expenses, the hybrid method
2
Dixon, R. (1993).
The McGraw-Hill 36-Hour Accounting Course
. NY: McGraw-Hill.
3
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2.8: Misleading disclosure for Frauds in Financial Statements
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