Module IV: Errors and Frauds

Course coordinator: Dr. Noor Rizvi

Introduction
Secondary objective of auditing: Examination of books of accounts with
supporting vouchers and documents in order to detect and prevent error
and fraud.

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Meaning of Errors and Frauds
Errors are unintentional misstatements or omissions of amounts or
disclosures in financial statements.
Example: Recording in wrong books, or wrong account or wrong totaling
and so on.

Fraud refers to intentional misrepresentation of financial information

with the intention to deceive. Frauds can take place in the form of
manipulation of accounts, misappropriation of cash and
misappropriation of goods.

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Meaning of Errors and Frauds……..
Financial Statements prepared by an enterprise may contain errors and
omissions which may not fairly present the company’s financial position
and results of operations.

Errors and omissions essentially indicate a lack of motive to defraud. But

when these happen with a motive these are called as frauds.

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Classification of Errors
Errors

Clerical Errors Errors of Principle

Errors of Omission Errors of Commission Compensating Errors

Complete Omission

Partial Omission
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 Errors of Omission
These errors arise as a result of some act of omission on the part of the person
responsible for the maintenance of books of account. It refers to the omission
of a transaction at the time of recording in subsidiary books or posting to
ledger. Omission may be complete or partial.
(a) Complete Omission: When any particular transaction has not at all been
entered in the journal or in the book of original entry, it cannot be posted
into the ledger at all and complete error of omission will occur. Thus, will
not be disclosed in the trial balance
(b) Partial Omission: This means that the transaction is entered in the
subsidiary book, but is not posted to the ledger, such errors affect the
agreement of trial balance e.g. recorded the debit; but forgot to record the
consequent credit. 6
 Errors of Commission
These mistakes are committed because of ignorance, lack of proper accounting
knowledge and carelessness of the accounting staff.
1. Error of recording: Sold good to Mr. X for US$ 500; but in the cash books it is
recorded as US$550. In the other account the amount was recorded
correctly.
2. Error of posting: When info. entered in the journal are wrongly recorded in
ledger. Such as not recording the correct amount, or correct account, or
correct side. A common mistake, for example, is to transpose figures - to
write US$ 115 instead of US$ 151.
3. Error of casting (totalling): balancing an account. For eg: if total is
US$12,000 and you record it as US$ 13,000 (Overcasting) or US$11,000
(Undercasting)
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4. Error of carrying forward: Usually when books are maintained manually.
 Compensating Errors
Errors that arise from excess debits or under debits of account which get
neutralized by the excess credits or under credits to the same account.
• One error is compensated by other error.
• An error on the debit side of an account has been compensated for by a
similar error on the credit side of another account

For example: An extra debit of US$ 200 in purchase account may be

compensated by an extra credit of US$ 200 in sales account.

Thus, compensating errors do not affect the agreement of trial balance.

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 Errors of Principle
These errors arise because of the failure to differentiate between capital
expenditure and revenue expenditure and capital receipts and revenue
receipts.

These errors do not affect the agreement of trial balance.

For example: Debiting purchase of furniture to office expenses account,

crediting sale of furniture to sales account, etc.

Trial balance will tally.

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 Errors Disclosed By Trial Balance
Trial balance in general, discloses any error which affects one side of the
account. These errors are disclosed by the trial balance as both sides of trial
balance do not agree.
Examples:
1. Error in carrying forward the total of one page the next page.
2. Error in posting from book of subsidiary record to ledger.
3. Error in balancing an account.
4. Posting an amount on the wrong side of a ledger account.
5. Double posting to an account.
6. Error in carrying a balance of an account to the trial balance.

Note: (Complete set of Commission and Partial Ommission) 10

 Errors Not Disclosed By Trial Balance
The agreement of a trial balance is only a check of arithmetical accuracy of
the ledger but it is not a conclusive proof as to the absolute accuracy of the
books. The following errors will not affect the agreement of trial balance.
Examples:
1. Errors of Complete Omission
2. Compensatory Errors
3. Errors of Principle

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Frauds
• It is management’s responsibility to prevent and detect fraud – not
the auditors.
• Auditors are not expected to find every fraud, but they are expected
(with reasonable assurance) to find material misstatements, whether
innocent or fraudulent.
• Fraud must be communicated to those charged with governance if it
results in material misstatement or if management is implicated.
• It is important, even for what appears to be a small fraud, to
investigate how long it has been going on for, how much is involved
and who is behind the fraud.
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 Types of Frauds
1. Misappropriation or Defalcation (cash or goods)
The act of stealing something that you have been trusted to take care of and
using it for yourself. It is committed by obtaining a material advantage by a
person by unfair or wrongful means.

2. Manipulation of accounts
Manipulation is usually done in accounts by misrepresentation or omission
of figures and facts in such a way that the accounts tend to reflect a position
other than real which fulfils the motive of the person behind manipulation.
For example: inflating the profits or assets for showing better financial
position than it really is could be the motive of a person.
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 Misappropriation of Accounts : Methods
1. Misappropriation of cash or goods
2. Omission to record cash receipts
3. Teeming and Lading (Lapping)
4. Kitting
5. Intentional errors in balancing cash book
6. Payment by duplication of source document

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 Misappropriation of Accounts : Methods
1. Misappropriation of cash or goods: Misappropriation of cash is most
common method of fraud practiced by the employees. However, obtaining
of goods or properties by an employee through unfair or wrongful means
also leads to misappropriation.

2. Omission to record cash receipts: Under this method some of the cash
receipts are not at all recorded in the books of account.

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 Misappropriation of Accounts : Methods
3. Teeming and Lading (Lapping): Also called Short banking. This method is used
where identical or near identical amounts are received from various customers
periodically. It involves the allocation of one customer's payment to another
customer's account to make the books balance, often to hide a shortfall or theft.
4. Kiting: Floating funds b/w bank accounts to inflate your cash balance Under
this method, a bearer cheque is drawn and encashed for personal benefit but
not recorded in the books of account. Subsequently another cheque is received
on another bank and deposited in the first bank as a cover against the first
withdrawal. Similarly, a cheque is received on a third bank and deposited in the
second bank and this process goes on. The bank statement will show as if these
were contra entries except for the latest cheque which will be shows as “cheque
issues but not cleared” in the bank reconciliation statement.
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 Misappropriation of Accounts : Methods
3. Teeming and Lading (Lapping): Also called Short banking. This method is used
where identical or near identical amounts are received from various customers
a c c e ss
periodically. It involves the allocation of one customer's
to g a in payment to another
customer's account to make the books balance,
d o t h is i ts sh
often to hidecaashortfall or theft.
m ig h t e rs ta t e
4. Kiting: Floating funds
m p a n y
b/w bank accounts
t o r o v
to inflate your cash balance Under
this method, o
A ca bearer cheque c d i
isedrawn
r and encashed for personal benefit but
rt te rm r
not recorded inhthe
to s o books of account.toSubsequently
a u d i another cheque is received
on another bank and deposited
e to an in the first bank as a cover against the first
a la n c
withdrawal.bSimilarly, a cheque is received on a third bank and deposited in the
second bank and this process goes on. The bank statement will show as if these
were contra entries except for the latest cheque which will be shows as “cheque
issues but not cleared” in the bank reconciliation statement.
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 Misappropriation of Accounts : Methods
5. Intentional errors in balancing cash book: This practice is used to misappropriate cash
by making errors deliberately in casting, balancing or carryforwards of cash balances.
The misappropriation can be done either by overcasting payments or under-casting
receipts. This could be prevented if another personal check the totals cashbook at some
periodical intervals and payments or receipts are compared with the approved
vouchers.
6. Payment by duplication of source documents: Presenting two sets of source documents
to cheque signatories and thus effecting two separate payments for one transaction is
yet another trick practiced in many cases. The duplicate payment is either fully
misappropriated or shared with the payee by having mutual understanding on such
transactions.
This is done by mixing the documents give the impression of separate transactions.
Generally, some time gap is provided to represent the duplicate set of documents to the
cheque. 18
 Manipulation of Accounts : Methods
1. Overstatement of Stock: It may be done by double counting of certain high
value stock items, overvaluation of certain items or by recording twice the same
value of transaction and disregarding slow-moving and obsolete items.

2. Overstatement of Sales: It may be done by recording of sales invoices relating

to post balance sheet date in the financial year related for audit creating
fictitious documents in support of unreal credit sales and treating sale of fixed
asses as sale of goods.

3. Understatement of purchases: It may be done by pre-dating or omitting to

record year-end invoices and treating purchases as goods received on sale of
return basis.
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 Manipulation of Accounts : Methods
………
4 Manipulation of expenses: If the intention of the manipulator is to show
better profit margin or some other similar position, the revenue expenditure
on advertisement or normal repairs on machinery and plant will be treated as
capital expenditure.

5. Overstatement of Assets: It may be done by showing asset at inflated value

by computing depreciation incorrectly, and including intangible assets as fixed
assets or by following fair value concept.

6. Understatement of Liabilities: This is done by omitting to record some of

the liabilities or by creating less value fake bills or by making inadequate
provision against outstanding liabilities.
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 Misstatements
• All misstatements should be communicated to management.
• Management asked to correct them or explain why not. Often the audit
committee will be involved in these discussions.
• Assess materiality of uncorrected misstatements.
• Obtain written representations from management that they believe
uncorrected misstatements are not material.
• If management refuses to correct a misstatement which the auditor thinks is
material, then the auditor will have to issue either a qualified or adverse
opinion.
• Note: it is management responsibility to correct errors in the financial
statements. Auditors cannot unilaterally adjust the financial statements that
have been prepared by management.
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EXTRA READINGS

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• Reference: Video Check Kiting (fraud scheme) – YouTube;
Lapping (fraud scheme) – YouTube ; https://youtu.be/fn4MK5kNnTA
• Research paper discussed in the class

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 Lapping and Kiting
Lapping is a type of skimming in which the perpetrator steals money from
one account and uses money from a different account to cover it up.

Kiting floating funds between two or more bank accounts to inflate the cash
balance.
The term "check kiting" first came into use in the 1920s. It stemmed from a
19th-century practice of issuing IOUs and bonds with zero collateral. That
practice became known as flying a kite, as there was nothing to support the
loan besides air.

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 Kiting
Example:
Let's say you have a checking account at Bank ABC and a checking account at Bank XYZ. You use the Bank
ABC account to pay the household utility bills, and your electric bill is set up on autopay. Your electric bill
this month is $200, and it's going to come out of the Bank ABC account today. However, you only have
$15 in the account.

You could move money into the account from the Bank XYZ account, but that account only has $5 in it,
so that won't work. If you engage in kiting, you would write a Bank XYZ check for $200 to the Bank ABC
account. You take the $200 check to Bank ABC, which instantly credits your ABC account with $200 --
enough to pay the bill. You do this knowing that you don't have $200 in the Bank XYZ account but that
actually takes two days for the check to settle. In other words, you won't see a $200 deduction in your
Bank XYZ account for two days. If, say, your $1,000 paycheck is scheduled to be deposited into the Bank
XYZ bank account tomorrow, you might be tempted to do this, but the act of transferring money you
don't have is still kiting.
Present position:
Kiting is more difficult to pull off these days, because settlement times have shortened dramatically.
Banks also often put holds on deposits, and of course they charge hefty fees for bounced checks. 25