Module 14

Errors and Irregularities in the Transaction Cycles of the Business Entity
1. Errors in Recording Sales and Collections Transactions

 Errors in recording sales include mechanical errors, such as using a wrong piece or wrong quantity, recording
sales in the wrong period (cutoff errors), a bookkeeper’s failure to understand proper accounting for a transaction,
and so on. Internal controls are designed to prevent or detect many of these kinds of errors.
2. Frauds in Sales and Collections
 Frauds in sales generally relate to fraudulent financial reporting. In contrast, frauds in cash collections relate to
misappropriation of assets, typically accomplished by clerks or management-level employees.
a. Fraudulent Financial Reporting
 Fraudulent financial reporting involving sales typically results in overstated sales or understated
sales returns and allowances.
 Managers under pressure to achieve high profits may inflate sales to meet target profits established
by senior managers, to obtain bonuses, to retain the respect of senior managers, or even to keep
their jobs. The following methods can be used to increase sales fraudulently:
o Recording fictitious sales (creating fictitious shipping documents, sales invoices, and so on)
o Recording valid transactions twice
o Recording in the current period sales that occurred in the succeeding period (improper cutoff)
o Recording operating leases as sales
o Recording deposits as sales
o Recording consignments as sales
o Recording sales when the chance of a return is likely
o Following revenue recognition practices that are not in accordance with PFRS
o Recognizing revenue that should be deferred
b. Misappropriation of Assets: Withholding Cash Receipts
 Skimming
o This refers to the act of withholding cash receipts without recording them. An example is
when a cashier in a retail store does not ring up a transaction and takes the cash. Another
example is when an employee who has access to cash receipts and maintains accounts
receivable records can record a sale at an amount lower than the invoice amount. When the
customer pays, the employee takes the difference between the invoice and the amount
recorded as a receivable. Detection of unrecorded cash receipts is very difficult; however,
unexplained changes in the gross profit percentage or sales volume may indicate that cash
receipts have been withheld.
 Lapping
o This technique is used to conceal the fact that cash has been abstracted; the shortage in one
customer's account is covered with a subsequent payment made by another customer. An
employee who has access to cash receipts and maintains accounts receivable can engage in
lapping. Routine testing of details of collections compared with validated bank deposit slips
should uncover this fraud.
 Kiting
o This is another technique used to cover cash shortage or to inflate cash balance. Kiting
involves counting the cash twice by using the float in the banking system. {Float is the gap
between the time the check is deposited or added to an account and the time the check clears
or is deducted from the account it was written on). Analyzing and verifying cash transfers
during the days surrounding year-end should reveal this type of fraud.
Acquisitions and Payments Cycle
1. Errors in the Acquisitions and Payments Cycle
The following may occur in the acquisitions and payments cycle:
• Failing to record a purchase in the proper period (cutoff errors)

• Recording goods accepted on consignment as a purchase
• Misclassifying purchases of assets and expenses
• Failing to record a cash payment
• Recording a payment twice
• Failing to record prepaid expenses as assets
Entities normally design controls to prevent these errors from occurring or to detect errors if they do occur. When such
controls exist, auditors test the controls to assess their effectiveness. If the controls are not effective, auditors should
perform substantive tests to determine that the financial statements do not contain material misstatements that arose
because of possible errors.
2. Frauds in the Acquisitions and Payments Cycle

a. Paying for Fictitious Purchases
This involves the perpetrator creating a fictitious invoice (and sometimes a receiving report, purchase order
and so forth) and processing the invoice for payment. Alternatively, the perpetrator can pay the invoice twice.
b. Receiving Kickbacks
In this scheme, a purchasing agent may agree with a vendor to receive a kickback (refund payable to the
purchasing person on goods or services acquired from the vendor). This is usually done in return for the
agent’s ensuring that the particular vendor receives an order from the firm. Often a check is made payable to
the purchasing agent and mailed to the agent at a location other than his or her place of employment.
Sometimes the purchasing agent splits the kickback with the vendor's employee for approving and paying it.
Detecting kickbacks is difficult because the buyer's records do not reflect their existence. However, when
vendors are required to submit bids for goods or services, the likelihood of kickbacks is reduced.
c. Purchasing Goods for Personal Use

Goods or services for personal use may be purchased by executive or purchasing agents and charged to the
company's account. To execute such a purchase, the perpetrator must have access to blank receiving reports
and purchase approvals or must connive with another employee. Fraud involving the purchase of goods for
personal use is more likely to go unnoticed when perpetual records are not maintained.
Payroll and Personnel Cycle
Historically, errors and irregularities involving payroll have been reported to occur frequently and are largely undetected.
1. Errors
The most errors that can occur in the payroll and personnel cycle are
a) paying employees at the wrong rate,

b) paying employees for more hours than they worked,
c) charging payroll expense to the wrong accounts, and
d) keeping terminated employees on the payroll.
Good internal control can be established to prevent these errors from occurring and to detect them if they do occur.
2. Frauds involving Payroll

The major payroll-related frauds include
a. Fictitious Employees
Adding fictitious employees to the payroll is one of the most common defalcations. Detecting fictitious
employees on the payroll is very difficult; but auditors do sometimes perform a surprise payoff as a deterrent
to this form of defalcation. Alternatively, the auditor may turn the check distribution over to an official not
associated with preparing payroll, signing checks, or supervising workers. Personnel files and the employees’
completed time cards and time tickets may also be examined to substantiate the existence of absent
employees.
b. Excess Payments to Employees
Increasing the rate above that approved or paying employees for more hours than they worked are the most
common ways of paying employees more than they are entitled to receive. These practices can be
substantially reduced by requiring personnel department officials to authorize changes in pay rates and by
monitoring total hours worked and paid for. Analytical procedures that focus on cost per unit of actual
production can also be helpful in detecting excess payments to employees.
c. Failure to Record Payroll
Companies having difficulty meeting profit targets or not-for-profit entities having difficulty managing costs
and expenses might fail to record a payroll. The omission of payroll can be difficult to hide unless a similar
amount of revenues or receipts has been omitted. Analytical procedures can be performed to test the
reasonableness of payroll cost.
d. Inappropriate Assignment of Labor Costs to Inventory
A company having difficulty meeting profit targets might assign to inventory labor cost that should have been
charged to expense. Analytical procedures such as comparing costs incurred to budgeted cost and verification
of valuation of inventory are some of the useful techniques in detecting such fraud.

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Errors and Irregularities in the Transaction Cycles of the Business Entity

1. Errors in Recording Sales and Collections Transactions

Acquisitions and Payments Cycle

1. Errors in the Acquisitions and Payments Cycle

The following may occur in the acquisitions and payments cycle:

• Failing to record a purchase in the proper period (cutoff errors)

2. Frauds in the Acquisitions and Payments Cycle

c. Purchasing Goods for Personal Use

Payroll and Personnel Cycle

a) paying employees at the wrong rate,

2. Frauds involving Payroll

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