Chapter 14: FRAUD AND ERROR Misstatements arising from Fraudulent Financial Reporting

Expected Learning Outcomes The intentional manipulation of reported financial

After studying the chapter, you should be able to … results to misstate the economic condition of the
1. Explain what fraud means. organization is called fraudulent financial reporting. The
2. Explain the major types of misstatements, namely perpetrator of such a fraud generally seeks gain through the
a. Misstatements arising from misappropriation of rise in stock price and the commensurate increase in
assets personal wealth. Sometimes the perpetrator does not seek
b. Misstatements arising from misappropriations of direct personal gain, but instead uses the fraudulent
assets and explain financial reporting to “help” the organization avoid
3. Give and explain the elements of a fraud triangle. bankruptcy or to avoid some other negative financial
4. Give and explain the risk factors contribute to outcome.
misappropriation of assets. Three common ways in which fraudulent financial
5. Explain who is primarily responsible for the reporting can take place include:
prevention and detection of fraud in a business 1. Manipulation, falsification, or alteration of accounting
enterprise. records or supporting documents.
6. Give and explain the risk factors that contribute to 2. Misrepresentation or omission of events, transactions, or
fraudulent financial reporting. other significant information.
INTRODUCTION 3. Intentional misapplication of accounting principles.
In the previous chapters, corporate governance has
been described as the process by which the owners and THE FRAUD TRIANGLE
various stakeholders of an organization exert control The Fraud Triangle characterizes incentives,
through requiring accountability for the resources entrusted opportunities and rationalizations that enable fraud to exist.
to the organization. The three elements of the fraud triangle are:
This chapter introduces fraud risk and errors and Incentive to commit fraud
how they be reduced if not totally avoided by having Opportunity to commit and conceal the fraud
effective internal control – a tool of good corporate Rationalization – the mindset of the fraudster to justify
governance. committing the fraud.
Fraud is an intentional act involving the use of
deception that results in a material misstatement of the INCENTIVES OR PRESSURES TO COMMIT FRAUD
financial statements. Two types of misstatements are Incentives relating to asset misappropriation include:
relevant to auditors’ consideration of fraud: (a) Personal factors, such as severe financial considerations
misstatements arising from misappropriation of assets, and Pressures from family, friends, or the culture to live a
(b) misstatements arising from fraudulent financial more lavish lifestyle than one’s personal earnings allow
reporting. for
Intent to deceive is what distinguishes fraud from Addictions to gambling or drugs
errors. Auditors routinely find financial errors in their The incentives include the following for fraudulent
client’s books; but those errors are not intentional. financial reporting:
Management compensation schemes
TYPES OF MISSTATEMENTS Other financial pressures for either improved earnings
a. Misstatements arising from misappropriation of assets or an improved balanced sheet
b. Misstatements arising from fraudulent financial Debt covenants
reporting Pending retirement or stock option expirations
Personal wealth tied to either financial results or
Misstatements arising from misappropriation of assets survival of the company
Asset misappropriation occurs when a perpetrator Greed – for example, the backdating of stock options
steals or misuses an organization’s assets. Asset was performed by individuals who already had millions
misappropriations are the dominant fraud scheme of pesos of wealth through stock.
perpetrated against small business and the perpetrators are
usually employees. Asset misappropriations can be OPPORTUNITIES TO COMMIT FRAUD
accomplished in various ways, including embezzling cash One of the most fundamental and consistent
receipts, stealing assets, or causing the company to pay for findings in fraud research is that there must be an
goods or services that were not received. opportunity for fraud to be committed. Some of the
opportunities to commit fraud that the top management
Asset misappropriation commonly occurs when employees: should consider include the following:
Gain access to cash and manipulate accounts to cover up Significant related-party transactions
cash thefts. A company’s industry position, such as the ability to
Manipulate cash disbursements through fake dictate the terms or conditions to suppliers or
companies. customers that might allow individuals to structure
Steal inventory or other assets and manipulate the fraudulent transactions
financial records to cover up the Fraud. Management’s inconsistency involving subjective
judgments regarding assets or accounting estimates
 Simple transactions that are made complex through an kickbacks paid by vendors to the entity’s purchasing
unusual recording process agents in return for inflating prices, payments to
Complex or difficult to understand transactions, such as fictitious employees).
financial derivatives or special-purpose entities. Using an entity’s assets for personal use (for example,
Ineffective monitoring of management by the board, using the entity’s assets as collateral for a personal loan
either because the board of directors is not independent or loan to a related party).
or effective, or because there is a domineering manager
Complex or unstable organizational structure Misappropriation of assets is often accompanied by
Weak or nonexistent internal controls false or misleading records or documents in order to conceal
the fact that the assets are missing or have been pledged
RATIONALIZING THE FRAUD without proper authorization.
For asset misappropriation, personal
rationalizations often revolve around mistreatment by the A. Incentives/ Pressures
company or a sense of entitlement by the individual 1. Personal financial obligations may create pressure on
perpetrating the fraud. Following are some common management or employees with access to cash or other
rationalizations for asset misappropriation: assets susceptible to theft to misappropriate those assets.
Fraud is justified to save a family member or loved one 2. Adverse relationships between the entity and employees
from financial crisis. with access to cash or other assets susceptible to theft may
We will lose everything (family, home, car and so on) if motivate those employees to misappropriate those assets.
we don’t take the money For example, adverse relationships may be created by the
No help is available from outside following:
This is “borrowing”, and we intend to pay the stolen a. Known or anticipated future employee layoffs.
money back at some point b. Recent or anticipated changes to employee
Something is owed by the company because others are compensation or benefit plans
treated better c. Promotions, compensation, or other rewards
We simply do not care about the consequences of our inconsistent with expectations.
actions or of accepted notions of decency and trust; we
are for ourselves. B. Opportunities
For fraudulent financial reporting, the rationalization 1. Certain characteristics or circumstances may increase the
can range from “saving the company” to personal greed, and susceptibility of assets to misappropriation. For example,
may include the following: opportunities to misappropriate assets increase when
This is one-time thing to get us through the current following situation exist:
crisis and survive until things get better a. Large amounts of cash on hand processed.
Everybody cheats on the financial statements a little; we b. Inventory items that are small in size, of high value, or
are just playing the same game. in high demand.
We will be in violation of all of our debt covenants c. Fixed assets which are small in size, marketable, or
unless we find a way to get this debt off the financial lacking observable identification of ownership.
statements 2. Inadequate internal control over assets may increase the
We need a higher stock price to acquire company XYZ, susceptibility of misappropriation of those assets. For
or to keep our employees through stock options, and so example, misappropriation of assets may occur because of
forth. the following:
a. Inadequate segregation of duties or independent
RISK FACTORS CONTRIBUTORY TO MISAPPROPRIATION OF checks.
ASSETS b. Inadequate oversight of senior management
Misappropriation of assets involves the theft of an expenditures, such as travel and other reimbursements.
entity’s assets and is often perpetrated by employees in c. Inadequate management oversight of employees
relatively small and immaterial amounts. However, it can responsible for assets, for example, inadequate
also involve management who are usually more able to supervision or monitoring of remote locations.
disguise or conceal misappropriations in ways that are d. Inadequate job applicant screening of employees with
difficult to detect. Misappropriation of assets can be access to assets.
accompanied in a variety of ways including: e. Inadequate record keeping with respect to assets.
Embezzling receipts (for example, misappropriating f. Inadequate system of authorization and approval of
collections on accounts receivable or diverting receipts transactions (for example, in purchasing)
in respect of written-off accounts to personal bank g. Inadequate physical safeguards over cash, investments,
accounts). inventory, or fixed assets.
Stealing physical assets or intellectual property (for h. Lack of complete and timely reconciliation of assets
example, stealing inventory for personal use or for sale, i. Lack of timely and appropriate documentation of
stealing scrap for resale, colluding with a competitor by transactions, for example, credits for merchandise
disclosing technological data in return for payment). returns.
Causing an entity to pay for goods and services not j. Lack of mandatory vacations for employees performing
received (for example, payments to fictitious vendors, key control functions.
k. Inadequate management understanding of information overridden, for example, because the individual is in a
technology, which enables information technology position of trust or has knowledge of specific weakness in
employees to perpetrate a misappropriation. internal control.
l. Inadequate access controls over automated records, Fraudulent financial reporting often involves
including controls over and review of computer systems management override of controls that otherwise may appear
event logs. to be operating effectively. Fraud can be committed by
management overriding controls using such techniques as:
C. Attitude / Rationalization Recording fictitious journal entries, particularly close
1. Disregard for the need for monitoring or reducing risks to the end of an accounting period, to manipulate
related to misappropriation of assets. operating results or achieve other objectives.
2. Disregard for internal control over misappropriation of Inappropriately adjusting assumptions and changing
assets by overriding existing controls or by failing to judgments used to estimate account balances.
correct known internal control deficiencies. Omitting, advancing or delaying recognition in the
3. Behavior indicating displeasure or dissatisfaction with the financial statements of events and transactions that
entity or its treatment of the employee have occurred during the reporting period.
4. Changes in behavior or lifestyle that may indicate assets Concealing, or not disclosing, facts that could affect the
have been misappropriated. amounts recorded in the financial statements.
5. Tolerance of petty theft. Engaging in complex transactions that are structured
to misrepresent the financial position or financial
RISK FACTORS CONTRIBUTORY TO FRAUDULENT performance of the entity.
FINANCIAL REPORTING Altering records and terms related to significant and
Fraudulent financial reporting may be unusual transactions.
accomplished by the following:
Manipulation, falsification (including forgery), or C. Rationalizations
alteration of accounting records or supporting Individuals may be able to rationalize committing a
documentation from which the financial statements are fraudulent act. Some individuals possess and attitude,
prepared. character or set of ethical values that allow them knowingly
Misrepresentation in, or intentional omission from, the and intentionally to commit a dishonest act. However, even
financial statements of events, transactions or other otherwise honest individuals can commit fraud in an
significant information. environment that imposes sufficient pressure on them.
Intentional misapplication of accounting principles
relating to amounts, classification, manner of RESPONSIBILITY FOR THE PREVENTION AND DETECTION
presentation, or disclosure. OF FRAUD
Fraudulent financial reporting involves intentional The primary responsibility for the prevention and
misstatements including omissions of amount or disclosures detection of fraud rests with both those charged with
in financial statements to deceive financial statement users. governance of the entity and management. It is important
It can be caused by the efforts of management to manage that management, with the oversight of those charged with
earnings in order to deceive financial statement users by governance, place a strong emphasis on fraud prevention,
influencing their perceptions as to the entity’s performance which may reduce opportunities for fraud to take place, and
and profitability. Such earnings, management may start out fraud deterrence, which could persuade individuals not to
with small actions or inappropriate adjustment of commit fraud because of the likelihood of detection and
assumptions and changes in judgments management. punishment. This involves a commitment to creating a
Pressures and incentives may lead these actions to increase culture of honesty and ethical behavior which can be
to the extent that they result in fraudulent financial reinforced by an active oversight by those charged with
reporting. In some entities, management may be motivated governance. In exercising oversight responsibility, those
to reduce earnings by a material amount to minimize tax or charged with governance consider the potential override of
inflate earnings to secure bank financing. controls or other inappropriate influence over the financial
reporting process, such as efforts by management to manage
A. Incentive / Pressure earnings in order to influence the perceptions of analysts as
Incentive or pressure to commit fraudulent to the entity’s performance and profitability.
financial reporting may exist when management is under
pressure, from sources outside or inside the entity, to Chapter 15: ERRORS AND IRREGULARITIES IN THE
achieve an expected (and perhaps unrealistic) earnings TRANSACTION CYCLES OF THE BUSINESS ENTITY
target or financial outcome – particularly since the Expected Learning Outcomes
consequences to management for failing to meet financial After studying the chapter, you should be able to …
goals can be significant. Understand errors and frauds that may be committed in the
business processes, namely:
B. Opportunities a. Sales and Collection Cycle
b. Acquisition and Payment Cycle
A perceived opportunity to commit fraud may exist c. Payroll and Personal Cycle
when an individual believes internal control can be
 While business is different individuals can have striking This technique is used to conceal the fact that cash
different characteristics, most of them have some has been abstracted; the shortage in one customer’s account
fundamental conceptual characteristics and practices in is covered with a subsequent payment made by another
common. The three basic business transaction cycles customer. An employee who has access to cash receipts and
include: maintains accounts receivable can engage in lapping.
1. Sales and Collection Cycle Routine testing of details of collections compared with
2. Acquisitions and Payment Cycle validated bank deposit slips should uncover this fraud.
3. Payroll and Personnel Cycle 3. Kitting
Management should establish controls to ensure This is another technique used to cover cash
that these transactions are appropriately handled and shortage or to inflate cash balance. Kiting involves counting
recorded. However, if internal controls are not properly the cash twice by using the float in the banking system.
implemented, or are overridden, fraud and errors may occur. (Float is the gap between the time the check is deposited or
This chapter presents errors and fraudulent activities that added to an account and the time the check clears or is
could result if there is poor internal control. deducted from the account it was written on). Analyzing
and verifying cash transfers during the days surrounding
I. Sales and Collection Cycle year-end should reveal this type of fraud.

1. Errors in Recording Sales and Collections Transactions II. ACQUISITIONS AND PAYMENTS CYCLE
Errors in recording sales include mechanical
errors, such as using a wrong piece or wrong quantity, 1. Errors in the Acquisition and payments Cycle
recording sales in the wrong period (cutoff errors), a The following may occur in the acquisition and payments
bookkeeper’s failure to understand proper accounting for a cycle:
transaction, and so on. Internal controls are designed to Failing to record a purchase in the proper period (cutoff
prevent or detect many of these kinds of errors. errors)
Recording goods accepted on consignment as a
2. Frauds in Sales and Collections purchase
Frauds in sales generally relate to fraudulent Misclassifying purchases of assets and expenses
financial reporting. In contrast, frauds in cash collections Failing to record a cash payment
relate to misappropriation of assets, typically accomplished Recording a payment twice
by clerks or management-level employees. Failing to record prepaid expenses as assets
Entities normally design controls to prevent these
a. Fraudulent financial reporting involving sales typically errors from occurring or to detect errors if they do occur.
results in overstated sales or understated sales returns and When such controls exist, auditors test the controls to assess
allowances. Managers under pressure to achieve high their effectiveness. If the controls are not effective, auditors
profits may inflate sales to meet target profits established by should perform substantive tests to determine that the
senior managers, to obtain bonuses, to retain the respect of financial statements do not contain material misstatements
senior managers, or even to keep their jobs. The following that arose because of possible errors.
methods can be used to increase sales fraudulently:
Recording fictitious sales (creating fictitious shipping 2. Frauds in the Acquisition and Payments Cycle
documents, sales invoices, and so on)
Recording valid transactions twice a. Paying for Fictitious Purchases
Recording in the current period sales that occurred in This involves the perpetrator creating a fictitious
the succeeding period (improper cutoff) invoice (and sometimes a receiving report, purchase order
Recording operating leases as sales and so forth) and processing the invoice for payment.
Recording deposits as sales Alternatively, the perpetrator can pay the invoice twice.
Recording consignments as sales
Recording sales when the chance of a return is likely b. Receiving Kickbacks
Following revenue recognition practices that are not in In this scheme, a purchasing agent may agree with
accordance with PFRS a vendor to receive a kickback (refund payable to the
Recognizing revenue that should be deferred purchasing person on goods or services acquired from the
vendor).
b. Misappropriation of Assets: Withholding Cash
Receipts c. Purchasing Goods for Personal Use
1. Skimming Goods or services for personal use may be purchased by
This refers to the act of withholding cash receipts executive or purchasing agents and charged to the
without recording them. Detection of unrecorded cash company’s account. To execute such a purchase, the
receipts is very difficult; however, unexplained changes in perpetrator must have access to blank receiving reports and
the gross profit percentage or sales volume may indicate purchase approvals or must connive with another employee.
that cash receipts have been withheld. Fraud involving the purchase of goods for personal use is
2. Lapping more likely to go unnoticed when perpetual records are not
maintained.
III. PAYROLL AND PERSONAL CYCLE Chapter 16: INTERNAL CONTROL AFFECTING ASSETS
Expected Learning Outcomes
Historically, errors and irregularities involving After studying the chapter, you should be able to …
payroll have been reported to occur frequently and are 1. Describe the internal control over the major components
largely undetected. of assets of a business enterprise namely;
a. Cash
1. Errors b. Financial Investments
The most errors can occur in the payroll and c. Receivables: Accounts and Notes are related revenue
personnel cycle are: accounts
a. Paying employees at the wrong rate. d. Inventories and related Cost of Goods sold
b. Paying employees for more hours than they worked. e. Property, Plant and Equipment
c. Charging payroll expense to the wrong accounts; and 2. Understand the potential misstatements (due to errors) of
d. Keeping terminated employees on the payroll. the asset accounts and how weakness in internal control
Good internal control can be established to prevent increases the risks of misstatements.
these errors from occurring and to detect them if they do
occur. INTERNAL CONTROL OVER CASH TRANSACTIONS
Most of the processes relating to cash handling are
2. Frauds involving Payroll the responsibility of the finance department, under the
The major payroll-related frauds include; director of the treasurer. These processes include handling
a. Fictitious Employees and depositing cash receipts; signing checks; investing idle
Adding fictitious employees to the payroll is one of cash; and maintaining custody of cash, marketable securities,
the most common defalcations. Detecting fictitious and other negotiable assets. In addition, the finance
employees on the payroll is very difficult; but auditors do department must forecast cash requirements and make both
sometimes perform a surprise payoff as a deterrent to this short-term and, long-term financing arrangements.
form of defalcation. Alternatively, the auditor may turn the Ideally, the functions of the finance department and
check distribution over to an official not associated with the accounting department should be integrated in a manner
preparing payroll, signing checks, or supervising workers. that provides assurance that:
Personnel files and the employees’ completed time cards and 1. All cash that should have been received was in fact
time tickets may also be examined to substantiate the received, recorded accurately and deposited promptly.
existence of absent employees. 2. Cash disbursements have been made for authorized
purposes only and have been properly recorded.
b. Excess Payments to Employees 3. Cash balances are maintained at adequate, but not
Increasing the rate above the approved or paying excessive, levels by forecasting expected cash receipts and
employees for more hours that they worked are the most payments related to normal operations. The need for
common ways of paying employees more than they are obtaining the loans for investing excess cash is thus made
entitled to receive. These practices can be substantially known on a timely basis.
reduced by requiring personnel department officials to A detailed study of the business processes of the
authorize changes in pay rates and by monitoring total hours company is necessary in developing the most efficient
worked and paid for. Analytical procedures that focus on control procedures, but there are some general guidelines to
cost per unit of actual production can also be helpful in good cash handling practices in all types of business. These
detecting excess payments to employees. guidelines for achieving internal control over cash may be
summarized as follows:
c. Failure to Record Payroll 1. Do not permit any one employee to handle a transaction
Companies having difficulty meeting profit targets from beginning to end.
or not-for-profit entities having difficulty managing costs 2. Separate cash handling from record keeping.
and expenses might fail to record a payroll. The omission of 3. Centralize receiving of cash to the extent practical.
payroll can be difficult to hide unless a similar amount of 4. Record cash receipts on a timely basis.
revenues or receipts has been omitted. Analytical 5. Encourage customers to obtain receipts and observe cash
procedures can be performed to test the reasonableness of register totals.
payroll cost. 6. Deposit cash receipts daily.
7. Make all disbursements by check or electronic fund
d. Inappropriate Assignment of Labor Costs to Inventory transfer, with the exception of small expenditures from petty
A company having difficulty meeting profit targets cash.
might assign to inventory labor cost that should have been 8. Have monthly bank reconciliation prepared by employees
charged to expense. Analytical procedures such as not responsible for the issuance of checks or custody of cash.
comparing costs incurred to budgeted cost and verification The completed reconciliation should be reviewed promptly
of valuation of inventory are some of the useful techniques by an appropriate official.
in detecting such fraud. 9. Monitor cash receipts and disbursements by comparing
recorded amounts to forecasted amounts and investigating
variances from forecasted amounts.
 collected from have access to
Potential Misstatements - Cash Receipts customers and cash receipts
writes off the and those who
Description of Examples Internal Control related make entries
Misstatement weakness or receivables. into the
Factors that accounts
Increase the Risk Error: receivable
of the • A bookkeeper records.
Misstatement accidentally fails • Inadequate
Recording Fraud: to record reconciliations
Fictitious cash • Overstating • Lack of payments on a of subsidiary
receipts cash receipts on segregation of receivable. records of
the books by duties of the accounts
transferring functions of receivable with
cash between access to cash the general
bank accounts and record ledger control
without keeping; no account.
appropriate effective review Early (late) Fraud:
recording of the of bank recognition of • Holding the Ineffective board
transfer to reconciliations. cash receipts – cash receipts of directors, audit
cover up an “cutoff problems” journal open to committee, or
embezzlement record next internal audit
of cash. year’s cash function; “tone at
Failure to record Fraud: receipts as the top” not
receipts from • A cashier fails • Inadequate having conductive to
cash sales to ring up and supervision of occurred in this ethical conduct;
record cash cashiers; failure year. undue pressure to
sales and to encourage show improved
embezzles the customers to Error: financial position.
cash. obtain cash • Recording cash • Failure to list
receipts. receipts based and deposit cash
Error: • Inadequate on bad receipts on a
• A bookkeeper controls for information timely basis.
accidentally reconciling cash about date of
omits the register tapes receipt.
recording of and accounting
the receipts records; Potential Misstatements – Cash Disbursements
from one cash inadequate
register for the controls for Description of Examples Internal Control
day. reconciling Misstatements Weakness or
bank accounts. Factors that
Increase the Risk
of the
Failure to record Fraud: Misstatement
cash from • A cashier • Lack of Inaccurate Fraud:
collection of embezzles cash segregation of recording of a • A bookkeeper • Inadequate
accounts payments by duties between purchase or prepares a check segregation of
receivable customers on personnel who disbursement to himself and duties or
receivables; have access to records it as record keeping
without cash receipts having been and preparing
recording the and those who issued to a major cash
receipts in the make entries supplier. disbursements,
customers’ into the or check signer
accounts. accounts Error: does not
receivable • A disbursement review and
• A bookkeeper records. is made to pay an cancel
accidentally • Lack of invoice for goods supporting
who has access segregation of that have been documents.
to cash receipts duties between received.
embezzles cash personnel who • Disbursements • Ineffective
 for travel and control for 1. Formal investment policies that limit the nature of
entertainment matching investments in securities and other financial instruments.
are improperly invoices with 2. An investment committee of the board of directors that
included with receiving authorizes and reviews financial investment activities or
merchandise documents compliance with investment policies.
purchases. before 3. Separation of duties between the executive authorizing
disbursements purchases and sales of securities and derivative instruments,
are authorized. the custodian of the securities, and the person maintaining
the records of investments.
• Ineffective 4. Complete detailed records of all securities and derivative
accounting instruments owned and the related provisions and terms.
coding 5. Registration of securities in the name of the company.
procedures 6. Periodic physical inspection of securities on hand by an
may result internal auditor or an official having no responsibility for the
from authorization, custody, or record keeping of investments.
incompetent 7. Determination of appropriate accounting for complex
accounting financial instruments by competent personnel.
personnel, In many concerns, segregation of the functions of
inadequate custody and record keeping is achieved by the use of an
chart of independent safekeeping agent, such as a stockholder, bank
accounts, or no or trust company. Since the independent agent has no
controls over direct contact with the employee responsible from
the posting maintaining accounting records of the investments in
process. securities, the possibilities of concealing fraud through
Duplicate Error: falsification of the accounts are greatly reduced. If securities
recording and • A purchase is • Ineffective are not placed in the custody of an independent agent, they
payment of recorded when controls for should be kept in a bank safe-deposit box under the joint
purchases an invoice is review and control of two or more of the company’s officials. Joint
received from a cancellation of control means that neither of the two custodians may have
vendor and supporting access to the securities except in the presence of the other. A
recorded again documents by list of securities in the box should be maintained in the box,
when a duplicate the check and the deposit or withdrawal of securities should be
invoice is sent by signer. recorded on this list along with the date and signatures of all
the vendor. persons present. The safe-deposit box rental should be in
Unrecorded Fraud: the name of the company, not in the name of an officer
disbursements • In conjunction • Ineffective having custody of securities.
with recorded control over
(but deposited) record keeping Potential Misstatements - Financial Investments
cash receipts, an for and access Description of Examples Internal Control
employee writes to cash. Misstatement Weakness or
and chases an Factors that
unrecorded Increase the Risk
check for the of the
identical amount. Misstatement
Misstatement of Error:
INTERNAL CONTROL OVER FINANCIAL INVESTMENTS recorded value of • Failure to • Inadequate
The most important group of financial investments investments record change accounting
consists of marketable stocks and bonds because they are in market manual;
found more frequently and usually are of greater peso value values of incompetent
than the other kinds of investment holdings. Other types of investments. accounting
investments often encountered include commercial paper personnel.
issued by corporations, mortgages, and trust deeds, and the Fraud:
cash surrender value of life insurance policies. The internal • Misstatement of • Ineffective
auditors also must be concerned with derivatives that are the value of board of
used to hedge various financial and operational risks or for closely held directors, audit
speculation. Derivatives are financial instruments that investment. committee, or
“derive” their value from other financial instruments, internal audit
underlying assets, or indexes. function; not
The major elements of adequate internal control over conducive to
financial investments include the following: ethical
conduct;
 undue Misstatement Weakness or
pressure to Factors that
meet earnings Increase the
targets. Risk of the
Unauthorized Fraud: Misstatement
investment • An employee • Inadequate Recording Fraud:
transactions with access to segregation of unearned • Recording • Ineffective
securities duties of revenue fictitious sales board of
converts them record keeping without directors,
for personal use. for and receiving a audit
custody of customer order committee, or
securities. or shipping the internal audit
Incomplete Error: goods. function;
recording of • Failure to record • a. inadequate • Intentional over undue
investments derivative accounting shipment of pressure to
agreements manual; goods. meet earnings
which are incompetent targets. “top
embedded in accounting management
other personnel. Errors: action” not
agreements. • b. inadequate • Recording sales conductive to
monitoring by based on the ethical
internal receipt of orders conduct.
auditors. from customers • Ineffective
rather than the billing process
INTERNAL CONTROL OVER RECEIVABLES shipment of in which
Accounts receivable include not only claims against goods. billing is not
customers arising from the sales of goods or services, but • Inaccurate tied to
also a variety of miscellaneous claims such as loans to billing and shipping
officers or employees, loans to subsidiaries, claims against recording of information.
various other firms, claims for tax refunds and advantages to sales. • Ineffective
suppliers. • Recording cash controls for
that represents a testing
Sources and Nature of Notes Receivable liability (e.g., invoices, or
Notes receivable are written promises to pay receipt of a ineffective
certain amounts at future dates. Typically, notes receivable customer’s input
is used for handling transactions of substantial amount; deposit) as validation
these negotiable documents are widely used. In banks, and revenue. checks and
other financial institutions, notes receivable usually computer
constitutes the single most important asset. reconciliations
to ensure the
Internal Control of Accounts Receivable and Revenue accuracy of
To understand internal control over accounts databases.
receivable and revenue, one must consider the various • Inadequate
components, including the control environment, risk accounting
assessment, monitoring, the (accounting) information and manuals;
communication system, and control activities. incompetent
accounting
Control Environment personnel
Because of the risk of intentional misstatement of Early (late) Fraud:
revenues, the control environment is very important to recognition of • Holding the sales • Ineffective
effective internal control over revenue and receivables. revenue – “cutoff journal open to board of
Management should establish a tone at the top of the error” record next directors,
organization that encourages integrity and ethical financial year’s sales as audit
reporting. These ethical standards should be communicated having occurred committee, or
and observed throughout the organization. Also, incentives in the current internal audit
for dishonest reporting, such as undue emphasis on meeting year. function; not
unrealistic sales or earnings targets, should be eliminated. conducive to
ethical
Potential Misstatements – Revenue / Receivables Error: conduct;
Description of Examples Internal Control • Recording sales undue
 in the wrong pressure to officer.
period based on meet sales Overestimation Fraud:
incorrect targets. of the amount of • Misstating the • Ineffective
shipping revenue earned percentage of board of
information. • Ineffective completion of directors,
cutoff several projects audit
procedures in by a committee, or
the shipping construction internal audit
department. company using function; not
Recording Fraud: the percentage conducive to
revenue when • Recording sales • Ineffective of completion ethical
significant when the board of method revenue conduct;
uncertainties customer is directors, recognition. incompetent
exist likely to return audit • Overestimating individuals
the goods. committee, or the percentage involved in
internal audit of completion on the estimation
Error: function; not projects by a process.
• Recording sales conducive to construction • Aggressive
when the ethical company using attitude of
customer’s conduct; the percentage management
payment is undue of completion toward
contingent upon pressure to method of financial
the customer meet sales revenue reporting;
receiving targets. recognition. incompetent
financing or personnel
selling the goods • Aggressive involved in
to another party attitude of the estimation
(e.g., management / accounting
consignment toward process.
sales). financial
reporting; Internal Control over Notes Receivable
incompetent As previously stated, a basic characteristic of
chief effective control consists of the subdivision of duties. As
accounting applied to notes receivables, this principle requires that:
officer. 1. The custodian of notes receivable not have access to cash
Recording Fraud: or to general accounting records.
revenue when • Recording • Ineffective 2. The acceptance and renewal of notes be authorized in
significant franchise board of writing by a responsible official who does not have
services still revenue when directors, custody of the notes.
must be the franchises audit 3. The write-off defaulted notes be approved in writing by
performed by are sold even committee, or responsible officials and effective procedures adopted for
seller though an internal audit subsequent follow-up of such defaulted notes.
obligation to function; not
perform conducive to INTERNAL CONTROL OVER INVENTORIES AND COST OF
significant ethical GOODS SOLD
services still conduct; The importance of adequate internal control over
exists. undue inventories and cost of goods sold from the viewpoint of
pressure to both management and the auditors can scarcely be
Error: meet sales overemphasized. In come companies, management stresses
• Amount of targets. controls over cash and securities but pays little attention to
revenue earned control over inventories. Since many types of inventories
on franchise is • Aggressive are composed of items not particularly susceptible to theft,
miscalculated attitude of management may consider controls to be unnecessary in
management this area. Such thinking ignores that fact that controls for
toward inventories affect nearly all the functions involved in
financial producing and disposing of the company’s products.
reporting;
incompetent Potential Misstatements – Inventory / Cost of Goods sold
chief Description of Examples Internal Control
accounting Misstatement Weakness or
Factors that
 Increase the Risk
of the • Ineffective
Misstatement controls or
Misstatement of Fraud: supervision of
inventory costs • Intentional • Ineffective physical
misstatement of board of inventory.
production directors,
costs assigned audit Early (late) Fraud: • Ineffective
to inventory. committee, or recognition of • Intentional board of
• Intentional internal audit purchases – recording of directors, audit
misstatement of function; “tone “cutoff purchases in committee, or
inventory to the top” not problems”. the subsequent internal audit
prices. conducive to period. function; “tone
ethical at the top” not
Errors: conduct; conducive to
• The assignment undue ethical
of direct labor pressure to conduct; undue
costs, direct meet earnings Errors: pressure to
material costs, targets. • Recording meet earnings
or factory purchases of targets.
overhead to • Ineffective cost the current
inventory items accounting period in the • Ineffective
inaccurate. system; failure subsequent accounting
• Erroneous to update period. procedures
pricing of standard costs that do not tie
investory on a timely recorded
basis. purchases to
• Ineffective receiving data.
input
validation INTERNAL CONTROL OVER PROPERTY, PLANT AND
controls on the EQUIPMENT
database of The term property, plant and equipment includes
inventory; all tangible assets with a service life of more than one year
ineffective that are used in the operation of the business and are not
supervision of acquired for the purpose of resale. Three major subgroups
the personnel of such assets are generally recognized:
that enter the 1. Land, such as property used in the operation of the
costs on the business, has the significant characteristic of not being
final inventory subject to depreciation.
schedule. 2. Building machinery, equipment and land improvements,
Misstatement of Fraud: such as fences and parking lots, have limited service lives
inventory • Items are stolen • Ineffective and are subject to depreciation.
quantities with no journal physical 3. Natural resources (wasting assets), such as oil wells, coal
entry reflecting controls over mines, and tracts of timber, are subject to depletion as the
the theft. inventories. natural resources are extracted or removed.
• Inventory • Ineffective Acquisition and disposals of property, plant and
quantities in board of equipment are usually large in dollar amount, but
locations not directors, concentrated in only a few transactions. Individual items of
visited by audit plant and equipment may remain unchanged in the accounts
auditors are committee, or for many years.
systematically internal audit
overstated. function; “tone Internal Control over Plant and Equipment
at the top” not The amounts invested in plant and equipment
Errors: conducive to represents a large portion of the total assets of many
• Miscounting of ethical industrial concerns. Maintenance, rearrangement and
inventory by conduct; depreciation of these assets are major expenses in the
personnel undue income statement. The total expenditures for the assets and
involved in pressure to related expenses make strong internal control essential to
physical meet earnings the preparation of reliable financial statements. Errors in
inventory. targets. the measurement of income may be material if assets are
scrapped without their cost being removed from the
accounts, or if the distinction between capital and revenue expenses targets.
expenditures is not maintained consistently. The losses that recorded as
inevitably arise from uncontrolled methods of acquiring, property, plant
maintaining, and retiring plant and equipment are often and equipment • Inadequate
greater than the losses from fraud in cash handling. acquisitions to accounting
In large enterprises, the auditors may expect to overstate manual;
find an annual plant and budget used to forecast and control income. incompetent
acquisitions and retirements of plants and equipment. Many accounting
small companies also forecast expenditures for plant assets. Error: personnel.
Successful utilization of a plant budget presupposes the • Purchases of
existence of reliable and detailed accounting records for equipment
plant and equipment. A detailed knowledge of the kinds, erroneously
quantities and condition of existing equipment is an reported in
essential basis for intelligent forecasting of the need for maintenance
replacements and additions to the plant. and repairs
Other key controls applicable to plant and equipment are as expense
follows: account.
1. A subsidiary ledger consisting of a separate record for Failure to record Error:
each unit of property. An adequate plant and equipment retirements of • An asset that • Inadequate
ledger facilitate the auditor’s work in analyzing additions property, plant has been accounting
and retirements, in verifying the depreciation provision and equipment replaced is policies, e.g.,
and maintenance expenses, and in comparing discarded due to failure to use
authorizations with actual expenditures. its lack of value, retirement
2. A system of authorization requiring advance executive without an work orders.
approval of all plant and equipment acquisitions, whether accounting
by purchase, lease of construction. Serially numbered entry.
capital work orders are a convenient means of recording Improper Error:
authorizations. reporting of • A “gain” • Inadequate
3. A reporting procedure assuring prompt disclosure and unusual recorded on an accounting
analysis of variances between authorized expenditures transactions. exchange of manual;
and actual costs. non-monetary incompetent
4. An authoritative written statement of company policy assets that lacks accounting
distinguishing between capital expenditures and revenue commercial personnel.
expenditures. A dollar minimum ordinarily will be substance.
established for capitalization; any expenditures of a lesser
amount will automatically classified as charges against Chapter 17: INTERNAL CONTROL AFFECTING LIABILITIES
current revenue. AND EQUITY
5. A policy requiring all purchases of plant and equipment to Expected Learning Outcomes
be handled through the purchasing department and After studying the chapter, you should be able to …
subjected to a standard routine for receiving, inspection 1. Describe the internal control over liabilities and equity
and payment. accounts, namely
6. Periodic physical inventories designed to verify the a. Accounts Payable
existence, location and condition of all property listed in b. Other Debts (Notes Payable, Bonds)
the accounts and to disclose the existence of any c. Equity (Share Capital, Dividends)
unrecorded units. 2. Understand the potential misstatements due to error or
7. A system of retirement procedures, including serially fraud of the liability and equity accounts and how weakness
numbered retirement work orders (bottom), stating in internal control contributes to the risks of misstatements.
reasons for retirement and bearing appropriate approvals.
INTERNAL CONTROL OVER ACCOUNTS PAYABLE
Potential Misstatements – Investments in Property, Plant, The term accounts payable (often referred to as
and Equipment vouchers payablefor a voucher system) is used to describe
Description of Examples Internal Control short-term obligations arising from the purchase of goods
Misstatements Weakness or and services in the ordinary course of business. Typical
Factors that transactions creating accounts payable include the
Increase the Risk acquisition on credit of merchandise, raw materials, plant
of the assets and office supplies.
Misstatement Invoices and statements from supplies usually
Misstatement of Fraud: evidence accounts payable arising from the purchase of
acquisition of • Expenditures • Undue goods or services and most other liabilities. However,
property, plant for repairs and pressure to accrued liabilities (sometimes called accrued expenses)
and equipment maintenance meet earnings generally accumulate over time, and management must
make accounting estimates of the year-end liability. Such are authorized.
estimates are often necessary for salaries, pensions, interest, Duplicate Error:
rent, taxes and similar items. recording of • A purchase is • Ineffective
In thinking about internal control over accounts purchases recorded controls for
payable, it is important to recognize that the accounts when an review and
payable of one company are the accounts receivable of other invoice is cancellation of
companies. It follows that there is little danger of errors received from supporting
being overlooked permanently since the client’s creditors a vendor and documents by
will generally maintain complete records of their receivables recorded the check
and will inform the client if payment is not received. This again when a signer.
feature also aids auditors in the discovery of fraud, since the duplicate
perpetrator must be able to obtain and respond to the invoice is sent
demands for payment. Some companies, therefore, may by the
choose to minimize their record keeping of liabilities and to vendor.
rely on creditors to call attention to any delay in making Late (early) Fraud:
payment. recording of cost • Purchases • Ineffective
of purchase – journal board of
Discussion of internal control applicable to “cutoff problems” “closely directors, audit
accounts payable may logically be extended to the entire early” with committee, or
purchase or acquisition cycle. this period’s internal audit
purchases function; “tone
Potential Misstatements – Accounts Payable recorded as at the top” not
Description of Examples Internal Control having conducive to
Misstatement Weakness or occurred in ethical
Factors that subsequent conduct; undue
Increase the Risk period. pressure to
of the meet earnings
Misstatement target.
Inaccurate Fraud:
recording of a • A bookkeeper • Inadequate INTERNAL CONTROL OVER OTHER DEBTS
purchase or prepares a segregation of Business corporations obtain substantial amounts
disbursement check to duties of of their financial resources by incurring debt and issuing
himself and record keeping capital stock. The acquisition and repayment of capital is
records it as and preparing sometimes referred to as the financial cycle. This
having been cash transaction cycle includes the sequence of procedures for
issued to a disbursements authorizing, executing, and recording transactions that
major , or check involve bank loans, mortgages, bonds payable, and capital
supplier. signer does stock as well as the payment of interests and dividends.
not review and
Error: cancel Internal Control over Debt
• A supporting
disbursement documents. Authorization by the Board of Directors
is made to Effective internal control over debt begins with the
pay an • Ineffective authorization to incur the debt. The bylaws of a corporation
invoice for controls for usually require that the board of directors approve
goods that matching borrowing. The treasurer of the corporation will prepare
have not invoices with the following:
been receiving a report on any proposed financing explaining the need
received. documents for funds
before the estimated effect of borrowing upon future earnings,
disbursements the estimated financial position of the company in
are authorized. comparison with others in the industry both before and
Misappropriation Fraud: after the borrowing, and;
of purchases • Goods are • Ineffective alternative methods of raising the funds
ordered but controls for Authorization by the board of directors will include
delivered to matching review and approval of such matters as:
an invoices with the choice of a bank or trustee
inappropriate receiving the type of security
address and documents registration with the SEC
stolen. before agreements with investment bankers
disbursements
 compliance with requirements of the state of of directors must establish the valuation on the noncash
incorporation assets received.
listing of bonds on a securities exchange Authority for all dividend actions rests with the
After the issuance of the long-term debt, the board of directors. The declaration of a dividend must specify not
directors should receive a report stating the net amount only the amount per share but also the date of record and
received and its disposition as, for example, acquisition of the date of payment.
plant assets, addition to working capital, or other purposes.
Independent Registrar and Stock Transfer Agent
Use of an Independent Trustee In appraising internal control over share capital,
Bonds issues are always for large amounts – the first question that the auditors consider is whether the
usually many millions of pesos. Therefore, only relatively corporation employs the services of an independent share
large companies issue bonds: small companies obtain long- registrar and a share transfer agent or handles its own
term capital through mortgage loans or other sources. Any capital share transactions. Internal control is far stronger
company large enough to issue bonds and able to find a when the services of an independent share registrar and a
ready market for the securities will almost always utilize the stock transfer agent is utilized because the banks or trust
services of a large bank as an independent trustee. companies acting in these capacities will have the
The trustee is charged with the protection of the experience, the specialized facilities, and the trained
creditors’ interests and with monitoring the issuing personnel to perform the work in an expert manner.
company’s compliance with the provisions of the indenture. Moreover, by placing the responsibility for handling share
The trustee also maintains the following: capital certificates in separate and independent
detailed records of the names and addresses of the organizations, the corporation achieves to the fullest extent
registered owners of the bonds, the internal control concept of separation of duties.
cancels old bond certificates and issues new ones when
bond change ownership, Internal Control over Dividends
follows procedures to prevent over issuance of bond The nature of internal control over the payment of
certificates, dividends, as in the case of stock issuance, depends primarily
istribute interest payments, and distributes principal upon whether the company performs the function of
payments when the bonds mature. dividend payment itself or utilizes the services of an
Internal control is strengthened by the fact that the independent dividend-paying agent. If an independent
trustee does not have access to the issuing company’s assets dividend-paying agent is used, the corporation will provide
or accounting records and the fact that the trustee is a large the agent with a certified copy of the dividend declaration
financial institution with legal responsibility for its actions. and a check for the full amount of the dividend. The bank or
trust company serving as stock transfer is usually appointed
Interest Payments on Bonds and Notes Payable to distribute the dividend, since it maintains the detailed
Many corporations assign the entire task of paying records of shareholders. The agent issues dividend checks
interest to the trustee for either bearer bonds or registered to individual shareholders and sends the corporation a list of
bonds. Highly effective control is then achieved, since the the payments made. The use of an independent fiscal agent
company will issue a single check for the full amount of the is to be recommended from the stand-point of internal
semiannual interest payment on the entire bond issue. control, for it materially reduces the possibility of fraud or
error arising in connection with the distribution of
INTERNAL CONTROL OVER OWNERS’ EQUITY dividends.
The three (3) principal elements of strong internal control In a small corporation that does not use the
over share capital and dividends: services of a dividend-paying agent, the responsibility for
1. the proper authorization of transactions by the board of payment of dividends is usually lodged with the treasurer
directors and corporate office, and the secretary. After declaration of a dividend by the
2. the segregation of duties in handling these transactions board of directors, the secretary prepares a list of
(preferably the use of payments), and shareholders as of the date of record, the number of shares
3. the maintenance of adequate records. held by each, and the amount of dividend each is to receive.
The total of these individual amounts is proved by
Internal Control on Equity multiplying the dividend per share by the total number of
outstanding shares.
Control of Share Capital Transactions by the Board of
Directors
All changes in share capital accounts should receive
formal advance approval by the board of directors. The
board of directors must determine the number of shares to
be issued and the price per share; if an installment plan of
payment is to be used, the board must prescribe the terms.
If plant and equipment, services, or any consideration other
than cash is to be accepted in payment for shares, the board