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ERRORS AND
IRREGULARITIES IN THE
TRANSACTION CYCLES OF
THE BUSINESS ENTITY
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While businesses in different individuals can

have striking different characteristics, most
have some fundamental conceptual
characteristics and practices in common.
THREE BASIC BUSINESS
TRANSACTION CYCLES

1. Sales and Collections Cycle

2. Acquisitions and Payments Cycle
3. Payroll and Personnel Cycle
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Management should establish controls to

ensure that these transactions are
appropriately handled and recorded. However,
if internal controls are not properly
implemented, or are overridden, fraud and
errors may occur.
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SALES AND COLLECTIONS

CYCLE
SALES AND
COLLECTIONS CYCLE

The Sales/Revenue and Collection Cycle of an entity consists of

the activities related to the exchange of goods and
services with customers and the collection of revenue
in cash.

Different entities may have different sources of revenue. This

will depend on factors such as the nature of business
(merchandising, manufacturing, or service).
SALES AND
COLLECTIONS CYCLE
For a trading concern, the classes of transactions in the sales
and collection cycle involve:
A. Sales (cash and credit);
B. Sales adjustments (discounts, returns and allowances,
and uncollectible accounts provisions and write-offs); and
C. Cash receipts (collections on accounts and cash sales)
SALES AND
COLLECTIONS CYCLE
The following are the typical accounts affected by the sales
and collections cycle:
1. Sales
2. Accounts and notes receivable
3. Sales returns and allowances
4. Cash in bank (debits from cash receipts)
5. Sales discount
6. Allowance for uncollectible accounts
7. Uncollectible accounts expense
8. Inventories (merchandise, finished goods)
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FRAUD AND ERRORS IN THE

SALES AND COLLECTIONS
CYCLE
SALES AND
COLLECTIONS CYCLE
1. Errors in Recording Sales and Collections
Transactions

• Errors in recording sales includes mechanical errors, such

as:
- using a wrong piece or wrong quantity,
- recording sales in a 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

SALES AND
COLLECTIONS CYCLE

2. Frauds in Sales and Collections

• Frauds in sales – generally relate to fraudulent financial

reporting
• Frauds in cash collections – relate to misappropriation of
assets, typically accomplished by clerks or management-
level employees.
SALES AND
COLLECTIONS CYCLE

a. Fraudulent Financial Reporting

- 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,
or even to keep their jobs.
SALES AND
COLLECTIONS CYCLE
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.
SALES AND
COLLECTIONS CYCLE
b. Misappropriation of Assets: Withholding Cash
Receipts
1. Skimming
2. Lapping
3. Kiting
SALES AND
COLLECTIONS CYCLE
1. Skimming
- The act of withholding cash receipts without recording them.

Examples:
- When a cashier in a retail store does not ring up a transaction and takes
the cash;
- 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,

SALES AND
COLLECTIONS CYCLE
2. Lapping
- 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.
SALES AND
COLLECTIONS CYCLE
3. Kiting
- Is another technique used to cover cash shortage or to inflate
cash balance;
- Involves counting the cash twice by using the float in
the banking system

Float – 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

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EXPENDITURES CYCLE
EXPENDITURE CYCLE
• The Expenditure Cycle involves the activities associated with the
acquisition and payment of goods and services, plant assets, and labor.
For a trading concern, the major classes of transactions in this cycle
are:
1. Acquisitions
2. Cash disbursements
3. Payroll

• For a manufacturing firm, production cycle transactions and

warehousing transactions are included in the expenditure cycle in
addition to the above-mentioned major classes of transactions.
EXPENDITURE CYCLE
• This cycle does not include the acquisition of short-term or long-
term debt, or the reacquisition of a company’s share capital.
These transactions are considered to be part of the investing
and financing cycles.
• Transactions in the expenditure cycle often affect more financial
statement accounts than the other cycles combined. On the
financial position, the expenditure cycle impacts on all current
assets, except marketable securities and receivables, and all
plant and intangible assets, and many current liabilities.
• Transactions in this cycle involve major expenses reflected in the
Income Statement such as salaries and wages, taxes, utilities,
advertising, repairs and other expenses.
EXPENDITURE CYCLE
• Typically, the accounts affected y the expenditure cycle are:
1. Purchases
2. Accounts and notes payable – trade
3. Purchase returns and allowances
4. Cash in bank (credits for cash disbursements)
5. Purchase discount
6. Inventories (merchandise; finished goods; raw materials;
goods in process)
7. Manufacturing and operating expenses requiring cash
payments
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FRAUD AND ERRORS IN THE

ACQUISITIONS AND
PAYMENTS CYCLE
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
•
ACQUISITIONS AND
PAYMENTS CYCLE
1. Errors in the Acquisitions and Payments Cycle

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.
Definitions:
• Test of controls – is an audit procedure to test the
effectiveness of a control used by a client entity to provide or
detect material misstatements. Depending on the results of this
test, auditors may choose to rely upon a client’s system of controls as
part of their auditing activities. However, if the test reveals that
controls are weak, the auditors will enhance their use of
substantive testing, which usually increases the cost of an
audit.

• Substantive testing – is an audit procedure that examines the

financial statements and supporting documentation to see if
they contain errors. These tests are needed as evidence to support
the assertion that the financial records of an entity are complete,
ACQUISITIONS AND
PAYMENTS CYCLE
2. Frauds in the Acquisitions and Payments Cycle

a. Paying for fictitious purchases

b. Receiving kickbacks
c. Purchasing goods for personal use
ACQUISITIONS AND
PAYMENTS CYCLE
2. Frauds in the Acquisitions and Payments Cycle

a. Paying for fictitious purchases – 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.
ACQUISITIONS AND
PAYMENTS CYCLE
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/her place of employment. Sometimes, the
purchasing agent splits the kickback with the vendor’s employee for
approving and paying it.
ACQUISITIONS AND
PAYMENTS CYCLE
c. Purchasing goods for personal use

Goods or services for personal use may be purchased by the 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 (i.e., when
using the periodic inventory system).
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PAYROLL AND PERSONNEL

CYCLE
PAYROLL CYCLE
• Payroll transactions involve the events and activities relative
to executive and employee compensation. This class of
transactions includes salaries of personnel, wage earners
(factory workers), sales persons’ commissions, bonuses to
executives, payroll taxes, pensions and profit sharing plans, and
other employees’ fringe benefits.

• The primary errors or irregularities that may occur are a padded

payroll, and misappropriation of unclaimed paychecks. The
auditor should therefore adopt procedures that will enable him
to detect such occurrences.
PAYROLL AND
PERSONNEL CYCLE
1. Errors
The most common 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.
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FRAUD AND ERRORS IN THE

PAYROLL CYCLE
PAYROLL AND
PERSONNEL CYCLE
2. Frauds involving payroll

The major payroll-related frauds include:

a. Fictitious employees;
b. Excess payments to employees;
c. Failure to record payroll;
d. Inappropriate assignment of labor costs to inventory.
PAYROLL AND
PERSONNEL CYCLE
a. Fictitious employees

• Adding fictitious employees to the payroll is one of the most common

defalcations.
• Detecting fictitious employees in the payroll is very difficult, but
auditors do sometimes perform a surprise payoff (i.e., surprise
payment of salaries) as 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.
PAYROLL AND
PERSONNEL CYCLE
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. In
other words, the auditor may re-compute the cost per unit of actual
production in order to know if the rate charged to direct labor is
compliant with the rate set by the company.
PAYROLL AND
PERSONNEL CYCLE
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 hid unless a similar amount
of revenues or receipts has been omitted.
• Analytical procedures can be performed to test the reasonableness of
payroll cost.

*Analytical procedures are auditing procedures that involve analysis of

relationship between financial and non-financial data. These involve
investigation of identified variances and relationships that seem
PAYROLL AND
PERSONNEL CYCLE

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 and inventory are some of the useful
techniques in detecting such fraud.
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Synthesis:

• What are the three basic transaction

cycles?
• What are the common errors and
fraudulent activities that occur in each
transaction cycle?