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Journal Entries and Adjustments—Your

Biggest Fraud Danger

Delwyn D. DeVries and Jack E. Kiger

R
ecent business in progress rather than
reports provide False journal entries and other adjustments may expense the costs; and
examples of the be your biggest exposure to fraud. They figured • improperly adjust
use of journal entries prominently in some of the latest corporate allowances.
and other adjustments scandals, including those at WorldCom, Cen-
to falsify financial dant, and Xerox. What special actions must audi- Under the Sar-
statements at World- tors take to keep your company safe from this banes-Oxley Act, man-
Com, Cendant, and kind of fraud? © 2004 Wiley Periodicals, Inc.
agement is responsible
Xerox. WorldCom for evaluating and
accounting managers reporting on the effec-
recorded bogus, unsupported used relatively small inappropri- tiveness of controls. In addition,
journal entries to increase rev- ate journal entries and adjust- management is required to certi-
enues and to reclassify expenses ments to misstate large balance- fy the quarterly and annual
to fixed assets. Cendant’s senior sheet and income-statement financial statements they submit
management made “top-side” accounts. Management has used to the SEC. Although the specif-
adjustments to the financial state- inappropriate journal entries to: ic mechanisms for perpetrating
ments without recording any jour- recent frauds differ, numerous
nal entries. Cendant executives • mask the diversion of funds; similarities exist between the
concealed their top-side adjust- • record adjustments to frauds involving journal entries
ments by subsequently making increase revenue fraudulently; and adjustments. We will discuss
back-dated fraudulent journal • improperly adjust segment the role of journal entries and
entries. Xerox senior managers information; adjustments in the financial
manipulated revenues and earn- • improperly reverse expenses statement preparation process,
ings by recording top-side adjust- against purchase accounting the controls management may
ments to the financial results reserves; implement over journal entries
from normal transaction process- • improperly write off receiv- and other adjustments, and pro-
ing of sales and leasing transac- ables against purchase cedures auditors should follow
tions. Collectively, these and other reserves and avoid reducing when auditing them.
companies’ managers have recent- income;
ly used journal entries and other • understate payables by reclas- THE ROLE OF JOURNAL
adjustments to misstate financial sifying payables as revenue; ENTRIES AND OTHER
statements by billions of dollars. • improperly decrease ADJUSTMENTS IN FINANCIAL
While inappropriate journal accounts payable and general STATEMENT PREPARATION
entries or adjustments may be and administrative expenses;
massive, in other high-profile • improperly capitalize costs as Statement of Accounting
cases, management allegedly fixed assets or construction Standards No. 94 (SAS 94)

© 2004 Wiley Periodicals, Inc.

Published online in Wiley InterScience (www.interscience.wiley.com). DOI 10.1002/jcaf.20023 57
58 The Journal of Corporate Accounting & Finance

describes two types of journal and eliminations may then be review.) Managers at senior,
entries used in financial state- made. intermediate, and lower lev-
ment preparation—standard jour- Journal entries and adjust- els should monitor internal
nal entries and nonstandard ments may be recorded by a com- controls over the financial
journal entries. Standard journal bination of manual and automated reporting process.
entries record recurring business steps and procedures and subject • Duties for preparing, approv-
transactions and adjustments to manual and automated con- ing, and entering journal
such as sales, purchases, cash trols. Hence, journal entries and entries should be segregated.
receipts, and payments. In addi- other adjustments may exist in • Policies and procedures
tion, they record periodic either electronic or paper form— involving journal entries and
accounting estimates such as bad or both—in a given setting. other adjustments should be
debt expense, accrued payroll, documented and distributed
and depreciation expense. Stan- INTERNAL CONTROLS OVER to personnel involved in ini-
dard journal entries are recurring JOURNAL ENTRIES AND OTHER tiating entries to the general
and generally subject to the enti- ADJUSTMENTS ledger, transaction process-
ty’s controls. Nonstandard entries ing systems, or consolidation
are used to record nonrecurring The primary objective of process.
events such as asset impairments internal controls over journal • A person not involved in
or nonrecurring transactions such entries and other adjustments is preparing or processing
as a business combination. entries or adjustments
Nonstandard journal should reconcile the finan-
entries increase risk to the Standard journal entries are recurring cial statements to the
auditor in that they may and generally subject to the entity’s underlying accounting
conceal attempts by man- records.
agement to manipulate controls.
financial position and Preparing Journal Entries
results of operations and and Other Adjustments
may be recorded in practi-
cally any account. to provide reasonable assurance • Each entry should be pre-
Other adjustments arise for the reliability of financial pared by a person with req-
when entities use spreadsheets or reporting. Management is respon- uisite knowledge and com-
special software such as Hyperi- sible for establishing and moni- petence.
on or Cognos to group general toring the system of internal con- • Entries should be identified
ledger accounts and make con- trols, including controls over the with adequate descriptions
solidating adjustments, reclassi- broad process of financial report- and/or supporting documen-
fications, and other adjustments ing, preparing and approving tation including calculations.
to determine financial statement journal entries and adjustments, • Each entry should be signed
amounts. Other adjustments maintaining documentation and by the preparer and should
include elimination of intercom- an audit trail, and processing include a consecutive num-
pany transactions and profits, journal entries and adjustments. ber identifying the entry
allocation of tax credits, reclassi- sequence in the month, date
fication of data to appropriate Broad Controls Relating to prepared, and reporting peri-
segments, and amortization of Journal Entries and the od/general ledger date.
goodwill. In large multinational Financial Reporting Process • Journal entry forms and
companies for which multiple online screens should be
general ledgers are utilized, • Senior management should preformatted with account
adjustments may be made to set a tone at the top that numbers for standard journal
convert from local generally expects integrity, ethics, and entries and approval criteria.
accepted accounting principles other components of a posi-
(GAAP) to U.S. GAAP, and then tive control environment Approving Journal Entries and
foreign currency translation and over the financial reporting Other Adjustments
other adjustments may be made process. (This may be
before the accounts are com- accomplished through lead- Approval of entries should
bined. Additional adjustments ership, direction, and be documented with signatures

© 2004 Wiley Periodicals, Inc.

May/June 2004
and dates by persons with suffi-
cient accounting and business
expertise to evaluate the appro-
priateness of entries. Individuals
approving entries, particularly
nonstandard journal entries,
should have defined transaction-
level authority based on dollar
amount limits (either aggregate
or individual line item).
Maintaining Documentation
and an Audit Trail
An audit trail should be doc-
umented for all entries, whether
initiated and recorded online or
created in paper form and
entered in batch mode. Entries
should be documented in
sufficient detail to specifi-
cally identify the purpose,
support/calculations, dates,
and individuals involved in
the preparation, approval,
and recording of the
entries.
Processing Journal Entries
and Adjustments
• Data entry controls over
recording and batch input of
entries should require appro-
priate documentation and
approval before entries are
recorded.
• A record, log, or journal of
entries or adjustments
should be maintained in
which entries are consecu-
tively numbered. The objec-
tive of this control is to have
a complete listing of all
entries or adjustments. The
details of this listing should
be compared to those of
prior periods for consistency
and identification of new or
unusual entries.
• Automated exception report-
ing of back-dated entries and
entries in excess of specific
dollar amounts, specific line
© 2004 Wiley Periodicals, Inc.
items, etc., should be
reviewed to identify or
detect unusual or inappropri-
ate entries. Unusual items
should be investigated.
AUDITING JOURNAL ENTRIES
AND OTHER ADJUSTMENTS
When auditing journal
entries and other adjustments,
auditors should (a) obtain an
understanding of the entity’s
financial reporting process and
controls over journal entries and
other adjustments, (b) determine
the nature, timing, and extent of
audit testing, (c) identify and
select journal entries and other
An audit trail should be documented
for all entries, whether initiated and
recorded online or created in paper
form and entered in batch mode.
adjustments for testing, and (d)
test the selected journal entries
and adjustments.
Obtain an Understanding of
the Entity’s Financial
Reporting Process and Its
Controls over Journal Entries
and Other Adjustments
Because of the risk of inten-
tional or unintentional misstate-
ments related to nonstandard
journal entries and other adjust-
ments that occur in the financial
reporting process, auditors
should obtain a thorough under-
standing of the entity’s financial
reporting process and the con-
trols surrounding journal entries
and other adjustments. This
understanding should include
knowledge of the process to ini-
tiate, record, and process stan-
dard and nonstandard journal
entries and other adjustments
59
and the related controls. To gain
this understanding, the auditor
may read procedure manuals,
inquire of individuals involved in
the financial reporting process,
and observe the process. In addi-
tion to focusing on the controls
relating to journal entries and
other adjustments, the auditor
should focus on controls over the
integrity of the process used to
generate reports. Auditors may
choose to perform tests of these
controls as a basis for reducing
the extent of substantive testing
of journal entries and other
adjustments.
Determine the Nature,
Timing, and Extent of
Audit Testing
As a basis for deter-
mining the nature, timing,
and extent of audit proce-
dures for journal entries
and other adjustments, the
auditor should consider
the assessment of the risk of
material misstatement due to
fraud, the effectiveness of con-
trols that have been implement-
ed over journal entries and other
adjustments, the nature of the
entity’s financial reporting
process, red flags that suggest
the possibility of fraudulent
journal entries or adjustments,
and additional cautions.
The Auditor’s Assessment of the
Risk of Material Misstatement Due
to Fraud
SAS 99 specifies that audi-
tors make a comprehensive
assessment of the risk of materi-
al misstatement due to fraud.
When the auditor determines
that the risk of fraudulent journal
entries is high due to questions
regarding the management
integrity, the auditor should
reassess his or her client-accep-
tance decision. The risk assess-
60
ment should include a brain-
storming session in which the
auditors discuss the following:
• ways that management could
originate and post inappro-
priate journal entries or
adjustments;
• unusual combinations of
debits and credits the
engagement team should be
looking for; and
• types of journal entries or
adjustments that could pro-
duce a material misstatement
that standard audit proce-
dures would not detect.
The Effectiveness of Controls That
Have Been Implemented over
Journal Entries and Other
Adjustments
When the auditor has
determined that controls
over the preparation and
posting of journal entries
and adjustments are effec-
tive by testing them, the
auditor may reduce the
extent of substantive testing
but not eliminate it. Audit proce-
dures for testing journal entries
and other adjustments must
include the identification and
testing of specific entries and
adjustments.
The Entity’s Financial Reporting
Process and the Nature of the
Evidence That Can Be Examined
The nature of the financial
reporting process will affect the
procedures for testing journal
entries and other adjustments.
Testing should include journal
entries and adjustments record-
ed by manual as well as auto-
mated steps and procedures.
When entries and adjustments
are recorded electronically,
extracting data may require an
auditor with IT knowledge and
skills or the use of an IT spe-
cialist. In an IT environment,
The Journal of Corporate Accounting & Finance
the auditor may employ com-
puter-assisted audit techniques
(for example, report writers,
data extraction tools, or other
systems-based techniques) to
identify the journal entries and
other adjustments to be tested.
Red Flags That Suggest the
Possibility of Fraudulent Entries or
Adjustments
Auditing standards identify
red flags that may indicate the
presence of fraudulent journal
entries and adjustments.
Fraudulent entries have unique
identifying characteristics
• entries made to unrelated,
unusual, or seldom-used
accounts;
The nature of the financial reporting
process will affect the procedures for
testing journal entries and other
adjustments.
• entries made by individuals
who typically do not make
journal entries;
• entries recorded at the end
of the period or as post-
closing entries that have lit-
tle or no explanation or
description;
• entries made either before
or during the preparation of
the financial statements that
do not have account num-
bers; or
• entries containing round
numbers or a consistent end-
ing number.
Fraudulent entries are usually made
to accounts that have certain
characteristics
While inappropriate journal
entries and adjustments may be
made to any account, frequently
they are applied to accounts that:
• contain transactions that are
complex or unusual in
nature;
• contain significant estimates
and period-end adjustments;
• have been prone to errors in
the past;
• have not been reconciled on
a timely basis or contain
unreconciled differences;
• contain intercompany trans-
actions; or
• are otherwise associated
with an identified risk of
material misstatement due
to fraud.
Fraudulent entries are often
processed outside the normal
course of business as:
• nonstandard entries that are
not subject to the level of
control applied to recurring
transactions or
• other adjustments such
as consolidating adjust-
ments, report combinations,
and reclassifications that
are not subject to the enti-
ty’s internal controls.
Additional cautions
• Any entries from prior peri-
ods that were reversed at the
beginning of the subsequent
period should be scrutinized
carefully.
• Auditors should look for
unusual entries made during
both the quarter-end and
year-end cut-off procedures.
An auditor engaged to
review interim financial
information may choose to
perform tests of journal
entries and other adjust-
ments concurrently with the
review of interim financial
information.
• Auditors should consider
looking for unusual entries
that affect revenue since
auditing standards require
the auditor to ordinarily pre-
© 2004 Wiley Periodicals, Inc.
May/June 2004
sume a high risk of the mis-
statement of revenue.
Identify and Select Journal
Entries and Other Adjustments
for Testing
Before selecting entries and
adjustments to test, the auditor
must identify the entire popula-
tion of journal entries and
adjustments affecting the finan-
cial statements. An auditor’s
ability to detect fraud is adverse-
ly affected if he or she lacks
access to all of the journal
entries and adjustments. For this
reason, the auditor should apply
appropriate procedures to assess
completeness of the entries
being audited. The nature
and extent of these proce-
dures should depend on the
engagement risk assess-
ments and the client’s sys-
tems for recording transac-
tions. In circumstances
where journal entries and
other adjustments are accumulat-
ed in a journal, log, or listing,
and are subject to controls as
they are processed, the task of
ascertaining that the auditor has
identified all entries and adjust-
ments may be easier. At the
other extreme, if controls over
the accumulation of entries is
limited and entries are simply
posted on a schedule combining
accounts, the auditor must exer-
cise more care to ensure that he
or she is considering all entries
and adjustments.
For entities that have several
locations or components, the
auditor should consider the need
to select journal entries from
those units based on the follow-
ing factors: (a) the nature and
amount of assets and transactions
executed at the location or com-
ponent; (b) the degree of central-
ization of records or information
processing; (c) the effectiveness
© 2004 Wiley Periodicals, Inc.
of the control environment, par-
ticularly with respect to manage-
ment’s direct control over the
exercise of authority delegated to
others and its ability to effective-
ly supervise activities at the loca-
tion or component; (d) the fre-
quency, timing, and scope of
monitoring activities by the enti-
ty or others at the location or
component; and (e) judgments
about materiality of the location
or component.
When selecting specific
entries or adjustments for test-
ing, the auditor should consider
several factors. First, the audi-
tor’s assessment of risk of mate-
rial misstatement due to fraud
An auditor’s ability to detect fraud is
adversely affected if he or she lacks
access to all of the journal entries
and adjustments.
may direct the auditor to test
specific types of journal entries
or adjustments. Second, auditors
should test entries and adjust-
ments that are not subject to
effective controls. (However,
they should also perform some
substantive tests of areas where
controls have been determined to
be effective.) In addition, audi-
tors should consider the charac-
teristics of fraudulent entries or
adjustments, the nature and com-
plexity of the accounts to which
entries or adjustments are made,
and journal entries or adjust-
ments processed outside the nor-
mal course of business.
Auditors should ask
accounting and data entry per-
sonnel whether they were
requested to make any unusual
entries during the period. In
addition, the auditor should con-
sider asking selected program-
mers and IT staff about the exis-
61
tence of unusual or unsupported
entries. The auditor should
inquire about these specific
entries and whether any were
initiated directly by top manage-
ment outside the accounting
process. Because such entries
may involve management over-
ride of controls, auditors must
test to determine the appropriate-
ness of these entries and adjust-
ments. While auditors cannot be
assured that client personnel will
answer truthfully about known or
suspected fraud, they are more
likely to provide information if
they are asked directly.
Auditors should introduce an
element of unpredictability
regarding the dollar
amount and types of jour-
nal entries and other
adjustments tested. Several
reports indicate that com-
panies have been able to
perpetrate fraud when, over
a period covering several
engagements, management
was able to determine the audi-
tor’s scope and/or strategy and,
based on that, design inappropri-
ate journal entries and other
adjustments that were not tested.
Computer-assisted audit
techniques (CAATs) may be used
to identify the journal entries and
other adjustments to be tested or
to detect the following:
• entries made at unusual
times of day, that is, outside
regular business hours;
• entries made by unusual
users, blank or nonsensical
user names, senior manage-
ment, or the IT staff; and
• electronic entries that,
through management manip-
ulation, are not documented
in the general ledger.
Also, CAATs may be used to fil-
ter out recurring transactions in
order to identify nonrecurring
62
transactions and to foot the detail
in accounting records. CAATs
should be designed specifically
to assist in evaluating whether all
journal entries and other adjust-
ments are included in the popula-
tion to be reviewed.
Test Selected Journal Entries
and Adjustments
The auditor should test the
appropriateness of selected jour-
nal entries and other adjustments
in all engagements, including
those in which the risk of fraud-
ulent journal entries is assessed
as low. Those tests are per-
formed to confirm that entries
are appropriately approved by
management, adequately sup-
ported, and reflect the underlying
events and transactions. Such
tests should be designed to
detect misstatements that result
from either unintentional errors
or fraud. Approvals should be
documented and made by indi-
viduals authorized to do so. The
nature of an entry or adjustment
will determine the necessary
support. For example, an adjust-
ment allocating tax benefits to
segments should be based on
schedules determining the tax
benefit and a schedule allocating
the benefit. When evaluating
whether an entry or adjustment
Delwyn D. DeVries, PhD, CPA, CISA, is an assistant professor of accounting and information management
at the University of Tennessee, where he teaches information management and auditing. Jack E. Kiger,
PhD, CPA, is the W. L. Slagle Professor of Accounting at the University of Tennessee, where he teaches
auditing and financial accounting.
The Journal of Corporate Accounting & Finance
reflects underlying events and
transactions, auditors may be
required to examine underlying
evidence related to the events or
transactions. For example, when
evaluating an entry to adjust an
inventory valuation allowance,
an auditor would consider the
economic factors affecting the
net realizable value of the inven-
tory, which may include examin-
ing evidence about the mar-
ketability of the inventory. Since
many adjustments relate to
accounting estimates, the auditor
should follow guidance on audit-
ing estimates in SAS 57.
DOCUMENTATION OF THE
AUDIT
Audit documentation should
show that the accounting records
agree or reconcile with the
financial statements or other
information being reported on.
The procedures performed rela-
tive to the entity’s financial
reporting process and journal
entries and other adjustments
and the audit conclusions
reached should be documented.
This documentation should
include:
• the auditor’s understanding
of the financial reporting
process;
• the auditor’s understanding
and assessment of internal
controls relating to journal
entries and other adjustments;
• the auditors’ response to
identified risks of fraudulent
financial reporting;
• the procedures the engage-
ment team used to assess the
completeness of the popula-
tion of journal entries and
other adjustments subject to
review and testing;
• the journal entries and other
adjustments that were select-
ed for testing and the basis
for selection;
• the procedures performed to
audit the journal entries and
other adjustments;
• the audit conclusions
reached;
• the reconciliation of the
accounting records to the
financial statements; and
• the personnel who per-
formed and reviewed the
work.
BIBLIOGRAPHY
American Institute of Certified Public
Accountants. (2003). AICPA profes-
sional standards (Vol. 1). New York:
Author.
American Institute of Certified Public
Accountants. (2003). Practice alert no.
03-2: Journal entries and other adjust-
ments. New York: Author.
© 2004 Wiley Periodicals, Inc.