What is Fraud in Auditing? Types, Reasons

  • Post last modified:21 April 2021
  • Reading time:10 mins read
  • Post category:Finance

What is Fraud?

According to SA 240 “The fraud refers to intentional misrepresentations regarding financial information by one or more individuals among management, employees or third parties.”

Fraud may involve:

  • Manipulation, falsification or alteration of records or documents.
  • Misappropriation of assets.
  • Suppression or omission of transactions from records.
  • Recording of a transaction without substance.
  • Misapplication of the accounting policies knowingly.

Errors in Auditing

“The term error refers to unintentional mistake in financial information.” Error includes:

a. Mathematical or clerical mistake in the records. b. Oversight or misinterpretation of facts. c. Misapplication of accounting policies unknowingly.

Fraud may be perpetrated by manipulation of accounts. Errors on the other hand, may creep in accounts due to omission or clerical errors on the part of employees.

Errors may classified as:

  • Errors of omission
  • Errors of commission
  • Errors of principle
  • Errors of duplication
  • Compensating errors

Reasons for Frauds & Errors

  1. Ignorance of employees about accepted accounting principles & policies. This happens due to not knowing something.

  2. Inappropriate account classification by employees during reconciliation of subsidiary ledgers with the controlling accounts.

  3. Carelessness on the part of those involved in the accounting work.

  4. A desire to conceal the effect of defalcations or shortages of one kind or another.

  5. A tendency of the management to permit prejudice or bias to influence the interpretation of transactions or their presentation in the financial statements.

  6. With the purpose of tax evasion.

  7. Intentional efforts committed by a persona:
    • To show up or depress the picture
    • Convert the error to a personal benefit.

Events leads to risk of fraud or Error

SA 240 on fraud & errors lists the following events which may increase
the risk of fraud & error

  1. Weakness in design of internal control system & non-compliance with laid down control procedures.

  2. Doubts about the integrity or competence of the management.

  3. Unusual pressures within the entity.

  4. Unusual transactions such as transactions with related parties, excessive payment for certain services.

  5. v. Problems in obtaining sufficient & appropriate audit evidence.

Types of Fraud

  1. Misappropriation or embezzlement of cash
  2. Misappropriation of Goods
  3. Fraudulent Manipulation of Accounts
  4. Teeming & Lading
  5. Window Dressing

Misappropriation or embezzlement of cash

Misappropriation means wrongful conversion or fraudulent application of cash.

Embezzlement means any fraudulent application of another’s property by
any person to whom it has been entrusted.

Misappropriation or embezzlement may be committed by:

  • Non recording of cash sales.
  • Making false entries in account of customers.
  • Showing payments against purchases never made.
  • Non recording of credit notes for purchase return.
  • Non recording of cash received against unusual sales.

Misappropriation of Goods

It may be committed by recording wrong purchases. Fraud by way of misappropriation of goods is easier to commit in case of goods which though high priced & not bulky. Fraud of such nature can be detected by-:

  • Proper maintenance of accounts as to purchases & sales.
  • Regular stocktaking.
  • Strict check on incoming & outgoing goods.

Fraudulent Manipulation of Accounts

Such fraud is caused when a person

  • Make or causes a false entry in the business records.
  • Altered, erased, removed or destroyed a true entry from records.
  • Prevents the making of a true entry or causes the omission there of.

Generally, fraud by manipulation of accounts is committed by person holding high positions in the business.

Teeming & Lading

It is the one of the type of fraud that is committed in connection with the receipt of cash. It means using the funds of the company for personal purpose without any authority. If this type of fraud not prevented in time, it may lead to bigger fraud. This can be prevented by-

  • The transactions are in cheques.
  • The work of collecting cash, depositing into bank, recording the same in cashbook & of issuing receipts shall be allocated that no one person in charge of all these activities.

Window Dressing

It means the practice of arranging the disposition of assets & liabilities in such a way that affairs of business as shown in subsequent balance sheet do not truly represent the normal financial position.

  • Meaning: Window dressing stands for mis-presentation of accounts with a view to present a better picture of the state of financial affairs than it’s actual. The window dressing thus shows an improved financial position than what it really is.

  • Difficult to detect: The detection of such manipulation of account is difficult because:
    • Generally the persons in higher management are associated with this manipulation &
    • It is done in methodical manner.

  • Methods: Window dressing can be done in various ways:
    • Selecting inappropriate accounting principles. Eg. Method of depreciation
    • Capitalizing revenue expenses or vice versa.
    • Grouping items in different manner.
    • Treating certain items differently on the basis of legal interpretation, etc.

  • Objects of window dressing:
    • To show more profit & to give managerial personnel more remuneration where remuneration is linked with profit.
    • To attract more loans, credits etc. from bankers & financial institutions.
    • To avoid the incidence of income tax or other taxes.
    • To declare dividends when there are insufficient profits.
    • To attract potential investors for subscribing the public issues.

Internal Audit

Many large organizations have system of internal audit within the organization as an internal part of the internal control. They have a separate audit department. The scope & function of this department vary considerably from organization to organization.

Internal audit is the review of the various operations of the company & of its records by staff specially appointed for the purpose. This review may be periodical or maybe even continuous.

Internal Audit is an integral part of internal control. It should be understood that internal control is not merely internal check or internal audit; it is a system of control as a whole.

Internal Control

Internal Controls are to be an integral part of any organization’s financial and business policies and procedures. Internal controls consist of all the measures taken by the organization for the purpose of;

  • Protecting its resources against waste, fraud, and inefficiency;
  • Ensuring accuracy and reliability in accounting and operating data;
  • Securing compliance with the policies of the organization;
  • Evaluating the level of performance in all organizational units of the organization. Internal controls are simply good business practices.

Leave a Reply