Auditing Basics: How to Distinguish Between Errors and Fraud
When you find misstatements as you perform an audit, you’re responsible for making an assessment. You alone must determine whether the misstatement represents an error or fraud. Errors aren’t deliberate. Fraud takes place when you find evidence of intent to mislead.
Keep in mind that the dollar amount of the misstatement doesn’t make a difference when assigning a badge of fraud. It doesn’t make any difference if the intentional misstatement is material or immaterial: Fraud is fraud.
Here are some common errors you’ll come across:
Inadvertently taking an expense to the wrong account: For example, an advertising expense shows up as an amortization expense. The two accounts are next to each other in the chart of accounts, and the data entry clerk made a simple keying error.
Booking an unreasonable accounting estimate for allowance for bad debt expense: The person who made this mistake may have simply misinterpreted the facts. The allowance for bad debt arises because generally accepted accounting principles call for the matching of revenue and expenses for the same financial reporting period. Each period, a certain amount of credit sales have to be recorded as bad debt. That way, revenue isn’t overstated in the current period.
Businesses use many different methods to estimate bad debt. A common method is to allocate a percentage of gross sales to bad debt. The percentage can be an industry average or the actual percentage of bad debt to gross sales experienced by the company in the past. Some companies allocate all invoices that are past due more than 120 days to bad debt.
Incorrectly applying accounting principles: Recording assets at their cost rather than their market value is an example of an accounting principle. Make sure the company hasn’t inadvertently made an adjustment to increase the value of assets (such as land or buildings) to their appraised value rather than cost. It’s never appropriate to change the value of a fixed asset on the balance sheet from its original cost.
Fraud occurs when someone purposefully produces deceptive data. You need to be on the lookout for two types of fraud:
Misstatements due to fraudulent financial reporting: In this type of fraud, management or owners are usually involved, and the fraud is facilitated by overriding internal controls.
Misstatements because of the misappropriation of assets: This type of fraud is usually perpetrated by nonmanagement employees.
Fraud can take the form of the falsification or alteration of accounting records or the financial statements. Deliberately making a mistake when coding expense checks is fraud. So is intentionally booking a lower allowance for bad debt than is deemed reasonable by normal estimation methods.
Fraud also includes intentional omissions of significant information. For example, if a company knows its largest customer is getting ready to close its doors and doesn’t disclose this fact, that’s fraud. Not properly disclosing loss contingencies is another example — for instance, if a company doesn’t disclose that it’s likely going to lose a lawsuit brought against it and the damages can be reasonably estimated.
Of course, the theft of assets such as cash, inventory, or equipment is also fraud. Paying personal expenses out of the company checking account is fraud. Another example is taking company computers home to use personally.
Your authoritative source on fraud is Statement on Auditing Standards (SAS) No. 99, which gives plenty of great descriptions of fraudulent activities and expands on the characteristics of fraud