CHAP 14 - Lecture notes
bs economics (bse1)
Review Questions:
1. Distinguish between the terms errors and fraud.
The difference between fraud and error would be whether the fundamental
conduct that causes the financial statement misrepresentation is intentional
or not. Fraud is done on purpose and frequently involves the hiding of facts
and use of deception. On the other hand, an accidental misstatement in the
financial statements, such as the omission of an item or disclosure, is
referred to as an error.
2. Distinguish between fraudulent financial reporting and
misappropriation of assets. Discuss likely difference between these
two types of fraud on the fair presentation of financial statements.
Employees' theft of assets is referred to as asset misappropriation. It usually
arises as a result of a lack of internal controls or a breach of existing controls.
Having such proper internal controls in the company could likewise be the
most effective strategy to avoid asset theft. Moreover, it has been frequently
insignificant in peso numbers and has little impact on the fair presentation of
financial accounts, yet there are occasional situations of serious theft of
assets that can have a massive effect. On the contrary, management's willful
distortion of financial information or theft of assets, which is covered up by
falsifying financial statements, is referred to as fraudulent financial reporting.
In several instances, the sums being acquired on this act are really
substantial and may have an impact on the financial statements' fair
presentation. Furthermore, it is fundamentally difficult to detect since
internal controls can be bypassed by one or more members of management.
3. Define fraud and explain the two types of misstatements that are
relevant to auditor’s consideration of fraud.
Fraud is a deliberate act that involves deceit and resulting in a substantial
misrepresentation of financial statements. There are two types of
misstatements namely: fraudulent financial reporting and misappropriation
of asset. The former is being referred to as the deliberate misreporting of
financial statistics in order to misrepresent the organization's financial
situation. The latter, on the contrary, occurs when a criminal takes or
misuses an organization's asset. This is also being referred to as ‘employee
fraud’.
4. What are the most common approaches that perpetrators use to
commit fraudulent financial reporting?
The most common ways in which fraudulent financial reporting can take
place include:
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
Manipulation, falsification or alteration of accounting records or
supporting documents

Omission or misrepresentation of events, transactions or other
significant information

Intentional misapplication of accounting principles.
5. You are asked to be interviewed by a student newspaper
regarding the nature of accounting fraud. The reporter says, “As I
understand it, assets misappropriations are more likely to be found
in small organizations, but not in large organization. On the other
hand, fraudulent financial reporting is more likely to be found in
larger organizations.’’ How would you respond to the reporter’s
observation?
His observation towards fraudulent financial reporting which states that ‘it is
more likely to be found in larger organizations’ is premised on the reality that
large organizations tends to intentionally manipulate their reported financial
results in order to gain profit from increasing their stock prices, which small
organizations don’t have, especially sole proprietorship who does not issue
financial statements to external parties. Nevertheless, all businesses that
have employees, may it be a small or large organization, might face the risk
of asset misappropriation. It just happened that this fraud scheme has
become prevalent in small firms since it does not need financial statements,
making it easier for the culprit to perpetrate the crime. On this matter, I
believe that a company's asset and financial records should constantly be
scrutinized. By this way, suck kinds of fraud may be avoided and corruption
inside the organization may be stopped.
6. The fraud triangle identifies incentives, opportunities, and
rationalization as the three elements associated with most fraud.
Describe how each of these elements is necessary for fraud to occur.

Incentives – When there are higher incentives or pressures, justification
for deceit is more likely to occur.

Opportunities – Fraud likely occurs when the perpetrator perceives the
lack or absence of control, management's power to overrule controls or
when the culprit considers the chance of being captured to be low.

Rationalization - People are likely to justify engaging in dishonest
behavior. Some people have an attitude, personality, or a set of ethical
ideals that enables them to do a dishonest conduct willfully. Individuals
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who are ordinarily honest can, nonetheless, perpetrate fraud if they are
put under enough pressure.
7. If one of the 3 elements of the fraud triangle is not present, can
fraud still be perpetrated? Explain.
As per the Fraud Triangle theory, for workplace fraud to occur, all three
characteristics must be involved since each of these factors have a role in
the accomplishment of the same. The perpetrator's purpose may be
anything from personal benefit to avarice, depending on the incentive or
pressure used. Fraud requires opportunities since it is at this point that they
take advantage of any flaws in the business transaction's control. With
regard to this matter, organizations should have effective internal controls in
every operation so that no employee, whatever of their intentions, has that
opportunity. Finally, rationalization creates the mentality that the deception
committed will be justified. Each of these three factors had a distinct part in
motivating the criminal to commit fraud, and they should all be taken into
account since they are all crucially significant in the circumstances.
8. Identify factors (red flags) that would be strong indicators of
opportunities to commit fraud.
Some of the opportunities to commit fraud that the top management should
consider include the following:

Significant related-party transactions

A company’s industry position, such as the ability to dictate terms or
conditions to suppliers or customers that might allow individuals to
structure fraudulent transactions

Management’s
inconsistency
involving
regarding assets or accounting estimates

Simple transactions that are made to understand transactions, such as
financial derivatives or special-purpose entities

Ineffective monitoring of management by the board

Complex organizational structure

Weak internal controls
subjective
judgements
9. Is the ability to rationalize the fraud an important aspect to
consider when analyzing a potentially fraudulent situation? What
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are some of
perpetrators?
the
common
rationalizations
used
by
fraud
Rationalization is an important aspect to consider when analyzing a
potentially fraudulent situation because an auditor, who is a critical thinker,
may quickly discover or recognize many excuses a criminal may employ in
their reasoning and could be more prepared to stop the deception. Some of
the common rationalizations used by fraud perpetrators include the
following:

Personal circumstances, such as a family emergency that necessitates
the funds.

“This is a one-time thing to get us through the current crisis and
survive until things get better”

A worker who claims they are entitled anything because they are
underpaid or devalued in some way.

“We simply do not care about the consequences of our actions or of
accepted notions of decency and trust; we are for ourselves”.

No help is available from outside

“This is ‘borrowing’, and we intend to pay the stolen money back at
some point”.
10. Define and illustrate kiting. What controls should the client
institute to prevent it?
Kiting is accomplished by transferring funds from one bank account to
another toward the end of the fiscal year, registering the deposit in the
second account but not the payout on the first division's account until the
following fiscal period. To avoid kiting, the client institute should maintain a
bank transfer timetable. All transfers to and from a client's bank, as well as
transfers between the latter, are detailed in the schedule. To minimize
duplicate counting of funds, withdrawal and deposit dates should have been
documented in the same fiscal quarter.
Exercise 1:
Legend:
A-Opportunity
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B-Pressure
C-Rationalization
1. The business has no cameras or security devices at its
warehouse. (A)
2. Managers are expected to grow business or be fired. (B)
3. A worker sees other employees regularly take inventory for
personal use. (C)
4. No one matches the cash in the register to receipts when shifts
end. (A)
5. Officers are expected to show rising income or risk dismissal.
(B)
6. A worker feels that fellow employees are not honest. (C)
Exercise 2:
Legend:
1-An incentive to commit fraud
2-An opportunity to commit fraud
3-A rationalization for committing fraud
a. There was intense pressure to keep the corporation's stock
from declining further. This pressure came from investors,
analysts, and the CEO, whose financial well-being was
significantly dependent on the corporation's stock price. (1)
It is considerable to keep the corporation’s stock from declining
further, nevertheless, when investors and CEOs are keeping pressure
from the stock price, for its own interest, there is a huge possibility for
the CEO and other investors' financial security to decrease.
b. A group of top-level management was compensated (mostly in
the form of stock options) well in excess of what would be
considered normal for their positions in this industry. (1)
Providing a top-level management group more money through stock
options offers them a greater incentive for deception because these
kinds of actions somehow encourages greed.
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c. Top management of the company closely guards internal
financial info, to the extent that even some employees on a
need-to-know basis are denied full access. (2)
The denial of access by individuals to internal financial information
makes for fraud opportunities. It would certainly give a lot more
freedom for the culprit to do such illegal actions.
d. Managing specific financial ratios is very important to the
company, and both management and analysts are keenly
observant of variability in key ratios. Key ratios for the
company changed very little even though the ratios for the
overall industry were quite volatile during the time period. (1)
As the whole organization had been unstable, the management would
have the chance to engage in fraud. Whereas this circumstance does
not create an ethical case, it will provide a chance for employees to
conduct fraud to improve the standing of the organization
e. In an effort to reduce certain accrued expenses to meet budget
targets, the CEO directs the general accounting department to
reallocate a division’s expenses by a significant amount. The
general accounting department refuses to acquiesce to the
request, but the journal entry is made through the corporate
office. An account in the general accounting department is
uncomfortable with the journal entries required to reallocate
divisional expenses. He brings his concerns to the CFO, who
assures him everything will be fine and that the entries are
necessary. The accountant considers resigning but he doesn't
have another job lined up and is worried about supporting his
family. Therefore, he voices his concerns to either the internal
or external auditors. (3)
Herewith, the accountant felt uncomfortable about what the CFO is
trying to accomplish which made him address his concern to the CFO.
Afterwards, he considers resigning but did not pursue so, since he
thinks he has no other job and is he concerned as well about his
family's well-being once he became jobless. With regards to these, he
thinks the fraud is justifiable since he's going to lose it all and want to
keep his family out of financial instability.
f. Accounting records were either nonexistent or in a state of
such disorganization that significant effort was required to
locate or compile them. (2)
Herewith, the records are either non-existent or disruptive which
means they try to avoid auditing the issue. It therefore creates an
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opportunity for the culprit to commit criminal acts since the structure
and the internal controls of the organization are unstable and
insufficient.
Exercise 3:
State your opinion as to who should bear the loss of the fraudulent
financial reporting. Include in your discussion a list of your potential
bearers of the loss, and state why you believe they should or not
should bear the loss.
It is really obvious that the one who shall bear the loss of fraudulent financial
reporting is also the person who committed it. If the total assets or liabilities
of the firm are less than 600,000, the yearly financial statements should be
attested to by the financial supervisor or chief financial officer of the firm.
Meaning to say, the individual who is responsible for this particular scope of
job, specifically for preparing the financial statements of the company, shall
be held accountable for all the loss that may be incurred. The other
investigator who is demonstrably innocent shall be liable for damages.
However, the Auditor of the person responsible may also be punished
between 40 000 and 4 000 pesos when the Committee determines
inappropriate certification which results damage to the public.
Multiple Choice:
1. B
2. B
3. B
4. D
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Chapter 15 – Errors and Irregularities in the Transaction Cycles of
the Business Entity
Review Questions:
1. Define what is meant by a control and weakness in internal
control. Give two examples of each in the sales and collection cycle.
A control is an established internal control method that assists in the
prevention of erroneous accounting system inputs or omissions. A weakness
occurs when controls are insufficient to achieve a certain transaction-related
goal.
Control:

The credit department's administration is wholly separate from the
sales department.

Prices, quantities, extensions, footings, credit discounts, and freight
terms are independently confirmed against client orders on sales
invoices.

The billing department is distinct from the accounts receivable and
shipping departments.

Any discounts granted that aren't part of the company's standard
policy must be approved by a competent authority.
Weakness:

Error in recording sales and collection transactions.

Frauds in Sales and Collection
2. Frank Dizon, a highly competent employee of Breezewater Sales
Corporation, had been responsible for accounting-related matters
for two decades. His devotion to the firm and his duties has always
been given increased responsibility. Both the president of
Breezewater and the partner of an independent CPA firm in charge
of the audit were shocked and dismayed to discover that Dizon had
embezzled more than P5,000,000 over a 10-year period by not
recording billings in the sales journal and subsequently diverting
the cash receipts. What major factors permitted the defalcation to
the place?
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The failure to appropriately separate the accounting obligation to record
billing in the sales journal from the custodial obligation of cash receipts was
the most significant defect in the entity's internal control that permitted the
theft to occur. When one staff performs both duties, it may occur that the
assets might be misused for personal profit and the records adjusted to
remove him from the charge of assets, with an increase in risk. Furthermore,
separating asset custody from accounting employees is meant to prevent
asset misuse
Exercise 1
a. Cash received from collections of accounts receivable in the
subsequent period is recorded as current period receipts.
- A corporate policy stating that only the amount of cash received
before the end of the month shall be recorded by the end of the
month in the cash cutoff.
b. The allowance for uncollectible accounts is inadequate because
of the client’s failure to reflect depressed economic conditions
in the allowance.
- Conduct an examination of account collectivity at year's end and
provide consumers with an assessment of the probability of the
account collectivism.
c. Several accounts receivable are in dispute as a result of claims
of defective merchandise.
- Default claims should promptly be documented by the customer
after reception of the claim in order to maintain the balance of
receivables precisely.
d. The pledging of accounts receivable to the bank for a loan is
not disclosed in the financial statements.
- All the necessary information from the controller should be
preserved in a document.
e. Goods shipped and included in the current period sales were
returned in the subsequent period.
- Any returns applicable to products shipped and sales documented
should be maintained in the record book.
f. Several accounts receivable in the accounts receivable master
file are not included in the aged trial balance.
- An external agency should reconcile the master receivable file.
g. One account receivable in the accounts receivable master file
is included on the aged trial balance twice.
- An external agency should reconcile the master receivable file.
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h. Long-term interest-bearing notes receivable from affiliated
companies are included in accounts receivable.
- For receivables collected from connecting firms, separate accounts
should be maintained.
i. The trial balance total does not equal the amount in the
general ledger.
- The trial balance and the overall balance in the general ledger shall
be footed and reconciled.
Exercise 2:
Weakness
No declaration is made of bonding
There was no support for the
envelope system. Functional
controls it could give were
neglected.
The finance committee is
responsible for the auditing function
and the management of the cash
function; however, the auditing
functions have not been carried out
by the latter.
The Finance Committee does not
exercise its collecting duties.
Apparently, no written guidelines
have been developed for processing
cash collections.
Too much control over collecting
was exerted by the Finance
Secretary.
Recommended Improvement
Key personnel and participants who
collect and pay cash have to be
bonded.
The system of envelopes should be
promoted. The amount contributed
should be indicated by ushers on an
external envelope. Envelope
donations are reported individually
and the empty collection envelopes
are recognized.
An audit committee should be
created to conduct regular audit
processes or to involve independent
auditors.
The Finance Committee must take
on a more active role in monitoring.
The number of counters should be
increased to at least two and cash
should stay under common
monitoring until it has been counted
and registered to highlight any
inconsistencies.
The responsibility of the Financial
Secretary should be limited to
record keeping as far as possible.
Exercise 3
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For each of the following misstatements in property, plants, and
equipment accounts, state an internal control that the client can
implement to prevent the misstatement from occurring.
1. The asset lives used to depreciate equipment are less than
reasonable, expected useful lives.
- Use depreciation tables of government studies. Review invoices and reports
received from vendors.
2. Capitaliz able as set s ar e ro ut in ely expe ns ed as re pair s
and m aint enance, perishable tools, or supplies expense.
- Establish some kind of method where you can simply decide which
elements need to be capitalized and verified internally.
3. Construction equipment that is abandoned or traded for
replacement equipment is not removed from the accounting
records.
- As for the Office Manager, necessitate him to report regularly whether or
not abandonments or substitutions have occurred.
4. Depreciation expense for manufacturing operations is charged
to administrative expenses.
- Check depreciation charges internally.
5. Tools necessary for the maintenance of equipment are
stolen by company employees for their personal use.
- Designate individual tools and count them on a regular basis.
6. Acquisitions of property are recorded at incorrect amounts.
- Make sure internal teams validate the recording of the qualities obtained.
7. A loan against existing equipment is not recorded in the
accounting records. The cash receipts from the loan never reached
the company because they were used for the down payment on a
piece of equipment now being used as an operating asset. The
equipment is also not recorded in the records.
- Mandate all cash deposits to the bank account directly.
Exercise 4:
The following types of internal controls are commonly used by organizations for
property, plant, and equipment:
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1.A fixed asset master file is maintained with a separate record for
each fixed asset.
 Completeness, existence
- To ensure that mistakes in registering assets are reduced.
2.Written policies exist and are known by accounting personnel
to differentiate between capitalizable additions, freight,
installation costs, replacements, and maintenance expenditures.
 Classification
- To reduce mistakes with regard to accounting categorization.
3.Acquisitions of fixed assets in excess of $20,000 are approved
by the board of directors.
 Existence
- In order to avoid inadequate buying.
4.When practical, equipment is labeled with metal tags and is
inventoried on a systematic basis.
 Completeness, existence
- to have a proper monitoring with their products and safeguard against loss
of fixed assets.
5.Depreciation charges for individual assets are calculated for each
asset; recorded in a fixed asset master file that includes cost,
depreciation, and accumulated depreciation for each asset; and
verified periodically by an independent clerk
 Accuracy
Reducing such erroneous recording and depreciation computation.
5.Depreciation charges for individual assets are calculated for each asset;
recorded n a fixed asset master file that includes cost, depreciation,
and accumulated depreciation for each asset; and verified periodically by an
independent clerk
Multiple Choice:
1. B
2. B
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3. C
4. B
5. D
6. C
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