How to Distinguish Errors from Fraud
When you find misstatements, you’re responsible for making a fraud-versus-error assessment. Errors aren’t deliberate; fraud is. Specifically, fraud is defined as willful intent to deceive.
Keep in mind that the dollar amount of the misstatement doesn’t make a difference when assigning a badge of fraud. Whether the intentional misstatement is material or immaterial makes no difference; 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, income isn’t overstated in the current period.
Incorrectly applying accounting principles: Recording assets at their cost rather than their market value is an example of correctly applying 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. Changing the value of a fixed asset on the balance sheet from its original cost is almost never appropriate.
Fraud occurs when someone intends to deceive. You need to be on the lookout for two types of fraud:
Misstatements due to fraudulent financial reporting: In this type of fraud, management employees or owners are usually involved, and overriding internal controls facilitates the fraud. For example, the person committing fraud may go around the revenue-recognition internal controls set in place to book a cash sale as a loan from a shareholder.
Misstatements because of the misappropriation of assets: Non-management employees usually perpetrate this type of fraud. For example, an employee in the payroll department may create and pay a fictitious employee. Then, the fictitious employee’s paycheck is cashed by the employee — a misappropriation of the asset cash.
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. Intentionally booking a lower allowance for bad debt than is deemed reasonable by normal estimation methods is another type of fraud.
Omitting key information
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.
One example of asset theft is paying for goods or services the company didn’t receive, which can take place in related party transactions. A related party transaction occurs when a company sells to or buys from other businesses or individuals who are deemed to have significant influence over the company.
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. It also explains the topic of professional skepticism and the fact that brainstorming discussions among your audit team regarding the risk of material misstatements due to fraud are a requirement of every audit engagement.