Chapter 15: ERRORS AND IRREGULARITIES IN THE TRANSACTION CYCLES OF THE BUSINESS ENTITY

Expected Learning Outcomes

After studying the chapter, you should be able to …

Understand errors and frauds that may be committed in the business processes, namely:
a. Sales and Collection Cycle
b. Acquisition and Payment Cycle
c. Payroll and Personal Cycle

While business is different individuals can have striking different characteristics, most of them have
some fundamental conceptual characteristics and practices in common. The three basic business
transaction cycles include:

1. Sales and Collection Cycle

2. Acquisitions and Payment Cycle
3. Payroll and Personnel Cycle

Management should establish controls to ensure that these transactions are appropriately handled and
recorded. However, if internal controls are not properly implemented, or are overridden, fraud and
errors may occur. This chapter presents errors and fraudulent activities that could result if there is poor
internal control.

I. Sales and Collection Cycle

1. Errors in Recording Sales and Collections Transactions

Errors in recording sales include mechanical errors, such as using a wrong piece or
wrong quantity, recording sales in the wrong period (cutoff errors), a bookkeeper’s
failure to understand proper accounting for a transaction, and so on. Internal controls
are designed to prevent or detect many of these kinds of errors.

2. Frauds in Sales and Collections

Frauds in sales generally relate to fraudulent financial reporting. In contrast, frauds in
cash collections relate to misappropriation of assets, typically accomplished by clerks or
management-level employees.

a. Fraudulent financial reporting involving sales typically results in overstated sales or

understated sales returns and allowances. Managers under pressure to achieve
high profits may inflate sales to meet target profits established by senior managers,
to obtain bonuses, to retain the respect of senior managers, or even to keep their
jobs. The following methods can be used to increase sales fraudulently:
  Recording fictitious sales (creating fictitious shipping documents, sales
invoices, and so on)
 Recording valid transactions twice
 Recording in the current period sales that occurred in the succeeding period
(improper cutoff)
 Recording operating leases as sales
 Recording deposits as sales
 Recording consignments as sales
 Recording sales when the chance of a return is likely
 Following revenue recognition practices that are not in accordance with
PFRS
 Recognizing revenue that should be deferred

b. Misappropriation of Assets: Withholding Cash Receipts

1. Skimming
This refers to the act of withholding cash receipts without recording them.
Detection of unrecorded cash receipts is very difficult; however, unexplained
changes in the gross profit percentage or sales volume may indicate that cash
receipts have been withheld.
2. Lapping
This technique is used to conceal the fact that cash has been abstracted; the
shortage in one customer’s account is covered with a subsequent payment
made by another customer. An employee who has access to cash receipts and
maintains accounts receivable can engage in lapping. Routine testing of details
of collections compared with validated bank deposit slips should uncover this
fraud.
3. Kitting
This is another technique used to cover cash shortage or to inflate cash balance.
Kiting involves counting the cash twice by using the float in the banking system.
(Float is the gap between the time the check is deposited or added to an
account and the time the check clears or is deducted from the account it was
written on). Analyzing and verifying cash transfers during the days surrounding
year-end should reveal this type of fraud.

II. ACQUISITIONS AND PAYMENTS CYCLE

1. Errors in the Acquisition and payments Cycle

 The following may occur in the acquisition and payments cycle:
 Failing to record a purchase in the proper period (cutoff errors)
 Recording goods accepted on consignment as a purchase
 Misclassifying purchases of assets and expenses
 Failing to record a cash payment
 Recording a payment twice
 Failing to record prepaid expenses as assets

Entities normally design controls to prevent these errors from occurring or to detect
errors if they do occur. When such controls exist, auditors test the controls to assess
their effectiveness. If the controls are not effective, auditors should perform
substantive tests to determine that the financial statements do not contain material
misstatements that arose because of possible errors.

2. Frauds in the Acquisition 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).

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 PERSONAL CYCLE

Historically, errors and irregularities involving payroll have been reported to occur
frequently and are largely undetected.
1. Errors
The most errors can occur in the payroll and personnel cycle are:
a) Paying employees at the wrong rate.
b) Paying employees for more hours than they worked.
c) Charging payroll expense to the wrong accounts; and
d) Keeping terminated employees on the payroll.

Good internal control can be established to prevent these errors from occurring and to
detect them if they do occur.

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.
Detecting fictitious employees on the payroll is very difficult; 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 the approved or paying employees for more hours that
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
total hours worked and paid for. Analytical procedures that focus on cost per unit of
actual production can also be helpful in detecting excess payments to employees.

c. Failure to Record Payroll

Companies having difficulty meeting profit targets or not-for-profit entities having
difficulty managing costs and expenses might fail to record a payroll. The omission
of payroll can be difficult to hide unless a similar amount of revenues or receipts has
been omitted. Analytical procedures can be performed to test the reasonableness
of payroll cost.

d. Inappropriate Assignment of Labor Costs to Inventory

A company having difficulty meeting profit targets might assign to inventory labor
cost that should have been charged to expense. Analytical procedures such as
comparing costs incurred to budgeted cost and verification of valuation of inventory
are some of the useful techniques in detecting such fraud.