MODULE 14

ERRORS AND IRREGULARITIES IN THE TRANSACTION CYCLES

OF THE BUSINESS ENTITY

Errors are simple mistakes. In the context of a business, errors are mistakes that can impact
the business in either a negative or a positive manner. They represent actions or decisions
that someone, or something, made that is contrary to what the standard procedure, or entity
objectives, would have expected to be made. They are inadvertent, erroneous actions with
no mal intent of any kind.

Irregularities occur when the normal, or appropriate, procedure for a given situation is
intentionally violated. Irregularities can be office thefts, as noted in the diagram to the right,
or they can be intentional irregularities reported in the financial statements to boost the
company's share price.

A. Sales and Collection Cycle

● also known as the revenue, receivables, and receipts (RRR) cycle
● refers to the set of processes that start when a customer purchases goods or
services and ends when your business receives full payment.
● series of operating events that collectively serve to attract and help consumers
select goods and services, deliver the goods and services requested, and collect
payments
● The parts of the audit most affected by the tests of controls and substantive tests of
transactions for the sales and collection cycle are the balances in accounts
receivable, cash, bad debt expense, and allowance for doubtful accounts.
Sales and Collection Cycle Process

● The process begins when a customer approaches the company and files a customer
purchase order. The sales department receives the document and prepares a sales
order that is then sent to the credit department for a credit check. Remember that
salespeople will not perform credit checks because their position as a
salesperson may influence their bias when making credit decisions on
customers. This separation is called segregation of duties. Once the credit
department approves the customer and the order, the sales order is sent to the
shipping department, which will generate a shipping document, also referred to as a
bill of lading or a waybill. The approved sales order and the shipping document are
then sent to the accounts receivable clerk, who then generates a sales invoice and
makes the necessary journal entry. Finally, once the cash is received from the
customer, accounting or treasury records the credit to cash and debits the balance in
accounts receivable.
● [Link]
/
●

Sales and Collection Cycle Errors

Mechanical errors are types of mistakes that are prevented or detected by internal controls.
● incorrect piece or amount
Example : Error of original entry is when the wrong amount is posted to an
account. The sales manager approved the price of goods ordered by a customer, but
he wrote down the wrong price.
Effect: The error posted for the wrong amount would also be reflected in any of the
other accounts related to the transaction. In other words, all of the accounts involved
would be in balance but for the wrong amounts.
● recording sales in the wrong period (cutoff errors)
Example: A cutoff error happens when a business sales that were shipped after
year- end were recorded in sales for the year. Cut-off errors arise when companies
recognize revenue and purchases based on the date on which the sales
invoices/purchase invoices are generated rather than the date on which the risk and
reward are transferred to the buyer.
Effect: A cutoff error in recording sales transactions resulting in misstatement affects
revenue in the income statement, and accounts receivable (or cash) and retained
earnings in the balance sheet.
● bookkeeper's inability to comprehend appropriate accounting for a transaction
● Example: A bookkeeper correctly recorded an amount but against a different
account, wrong debit or credit of accounts.
● Effect: Incorrect recording by bookkeepers may result in error in income statement. It
will directly affect the balance sheet because increased or decreased profit is
required to get transferred to the capital account.

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:

• Recording fictitious sales (creating fictitious shipping documents, sales invoices, and so on)
• Recording valid transactions twice
• Recording in the current period sales that occurred in the succeeding period (improper
cutoff)
• Recording operating leases as sales
• Recording deposits as sales
• Recording consignments as sales
• Recording sales when the chance of a return is likely
• Following revenue recognition practices that are not in accordance with PFRS
• Recognizing revenue that should be deferred

B. Misappropriation of Assets: Withholding Cash Receipts

1. Skimming
● 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.

2. Lapping
● This technique is used to conceal the fact that cash has been abstracted; the
shortage in one customer's account is covered with a subsequent payment made by
another customer.
● An employee who has access to cash receipts and maintains accounts receivable
can engage in lapping. Routine testing of details of collections compared with
validated bank deposit slips should uncover this fraud.

3. Kiting
● 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).
Analysing and verifying cash transfers during the days surrounding year-end should
reveal this type of fraud.

B. Acquisitions and Payment Cycle

Goods, services and assets are acquired and paid for in order to continue with business
activities that will generate revenue.

The Acquisition and Payment Cycle (also referred to as the PPP Cycle for Purchases,
Payables, and Payments) consists mainly of two classes of transactions. The first class is
the acquisition class. The typical journal entry for this class of transactions is a debit to
inventory or an expense and a credit to accounts payable. The classification assertion is
highly important in this scenario because there are many possible debits that can fulfill the
journal entry.

The second class of transactions in the acquisition and payment cycle is the cash
disbursements class. The typical journal entry for this class is simply a debit to accounts
payable and a credit to cash. All in all, this cycle is mainly about incurring payables and
paying off those payables with cash.

The acquisitions and payments cycle includes the following classes of transactions and
balances:

Statement of financial position

● Accounts Payable

Statement of comprehensive income

● Credit purchases
● Cash purchases
● Purchase returns
● Purchases received
● Interest on late payments
● Expenses

Typical Business Functions and Important Documents

Although many companies follow different internal processes and use electronic-based
methods, the following flowchart is a typical business process in the acquisition and payment
cycle.
Errors and Fraud in the 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)

Cut-off is the process of ensuring that financial transactions and events are appropriately
and accurately accounted for in the correct accounting period.

Cut-off errors arise when companies recognize revenue and purchases based on the date
on which the sales invoices/purchase invoices are generated rather than the date on which
the risk and reward are transferred to the buyer. It can result to failure of financial statements
in embodying essential characteristics or assertions which they should,
including:Completeness and Accuracy

● 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.

C. Payroll and Personnel Cycle

● Payroll Cycle – refers to the process of paying employees for their work. It is also
known as the pay cycle. This cycle usually includes activities such as calculating and
processing payroll, deducting taxes and other withholdings. Frequency on this can
vary depending on the organization, but they typically occur on a regular basis.

- Payroll is an important aspect of a business. It affects employee morale and reflects

a business’s financial stability and reputation. Because employees rely on their
paychecks, errors or untimely payment can create a lack of trust. But when
paychecks are accurate and delivered in a timely manner, employees are more
engaged and motivated.

● Personnel Cycle – refers to various activities which involve managing an

organization’s workforce. This cycle typically includes activities such as recruiting and
hiring employees, onboarding and training of new hires, managing employee
performance, and administering benefits and other employee programs. This can
vary depending on the need of the organization and can be a continuous process as
the organization grows and changes.
 - This business process is important as it determines what type of employees are
going to work for the company, making sure that its workforce is composed of skilled
and capable people who are able to maintain and even improve the business as a
whole.

● Errors and irregularities under these circumstances can lead to dissatisfaction

among employees, as well as potential legal or regulatory issues. Similarly,
irregularities such as fraudulent timekeeping or falsified payroll records can result in
financial losses for the organization and damage to its reputation.

On the other hand, errors and irregularities with such organization with regards to
personnel cycle could occur during activities such as hiring and performance
evaluation wherein it may lead to poor job performance if the organization does not
properly vet job candidates. Similarly, irregularities such as nepotism or favoritism
can result in perceptions of unfair treatment and undermine morale within the
organization.

Errors in the payroll and personnel cycle

1. Paying employees at the wrong rate
2. paying employees for more hours than they worked
3. charging payroll expense to the wrong accounts
4. keeping terminated employees on the payroll.

Frauds that involves payroll

1. Fictitious employees – creating fake employees in the payroll system where
such pockets the money (wage).
2. Excess payments to employees – increase in the approved amount or rate of
actual pay (wage)
3. Failure to record payroll – having difficulty managing costs and expenses
might fail to record a payroll
4. Inappropriate assignment of labor cost to inventory – company having
difficulty meeting profit targets might assign to inventory, labor cost that
should have been charged to expense

● How to minimize errors and frauds:

- Limit access to payroll records - Access to payroll information should be
limited to designated employees. At the same time, limit the extent of access
that each designated user has. For instance, if you have an employee that is
responsible for running payroll, ensure that he or she only has access to
payroll information that is necessary for payroll processing If there is another
employee that manages that company’s bank accounts for payroll, only grant
him or her access to view payroll records without the editing functionality. This
minimizes the risk of unauthorised access to confidential payroll information.

- Inspect payroll records - Regularly checking your business’s payroll records is

crucial if you are not the person running payroll. You should trust the person
 running payroll, but you should also make sure that they do not make any
mistakes. You should regularly inspect your business’s payroll records to
make sure everything is accurate. Inspecting payroll records is a good
monthly task. If you check payroll records each month, problems will not go
unnoticed for long periods of time.

- Have time cards approved twice - To make sure a time card is correct, you
and the employee should both approve the time card. The employee’s
approval says they checked the time card before submitting it to you. Your
approval allows you to make sure the employee is not manipulating their
hours.

- Get your records audited - Have someone periodically audit your payroll
records. The audit makes sure you are running your payroll correctly. The
audit also helps make sure you are paying the right amounts to your
employees and tax agencies.

- Use security measures - You should lock up your payroll records so

unauthorized people cannot access them. Your electronic records should be
protected behind a strong password. If you have paper records, they should
be locked up somewhere, such as a filing cabinet.