Types of Errors and Frauds in Auditing (with examples)
The basic duty of an auditor is to examine the books of account and relevant documents so that he can report on the financial condition of his client’s business. In the process of this examination of accounts, certain errors and frauds may be detected. In fact, detection and prevention of fraud and errors is the secondary objective of an audit exercise, the primary being the expression of opinion. In this blog, we have discussed the different types of errors and frauds that an auditor may come across during the course of his auditing procedure.
Types of Errors in Auditing
Errors are usually unintentional mistakes in the recording or presentation of financial information. They can be of various types, the most common of which are as follows:
1. Clerical Errors:
Clerical errors are those that arise on account of incorrect recording, posting, totalling, or balancing in the books. For example, an amount received from R has been credited to Q. Here, even though there is a wrong posting, the trial balance will agree. Clerical errors are subdivided into three categories:
These errors occur because of wrong recording/posting either wholly or partially of the amount in the book of Original Entry or ledger accounts or wrong computations, wrong totalling, wrong balancing, and wrong casting of subsidiary books. For example, Rs. 20,000 is paid to a supplier and the same is recorded in the cash book. However, while posting to the ledger account, the supplier’s account is debited by Rs. 2,000. Such type of errors may arise due to the carelessness of the clerks. Most of the time, these errors will get reflected in the Trial Balance and can be detected by routine checking of the books.
Some other instances of errors of commission can be:
- Wrong posting of amounts
- Posting on the wrong side
- Posting in the wrong account
- Mistakes in totalling and balancing
- Errors in carrying forward the totals to Trial Balance, etc.
B. Errors of Omission:
These errors occur when transactions are not recorded in the books of original entry or are not posted to the ledger. For example, sales are not recorded in the sales book, and invoices are not entered in the purchase book. Similarly, a supplier, for example, is paid Rs. 50,000. The entry in the cash book is made on the credit side, but the posting to the supplier’s account is omitted. Errors caused by complete omission have no effect on the trial balance, whereas errors caused by partial omission have an effect on the trial balance and can be discovered more easily.
C. Compensating Errors or Offsetting Errors:
When two or more errors are committed in such a manner that the effect of these errors on the debits and credits is nil, these errors are referred to as compensating errors. For example, A’s account, which was supposed to be debited for Rs. 500, was credited for Rs. 500, and B’s account, which was supposed to be credited for Rs. 500, was debited for Rs. 500. These two errors will cancel out the effect of each other. Both sides of the trial balance will be equally affected. As a result, unless a thorough investigation is conducted, these errors are difficult to identify.
2. Errors of principle:
Errors of principle are one of the most common types of errors detected during the auditing process.
Errors of principle occur when a fundamental principle of accounting is not followed correctly when recording a transaction. For example, if the allocation of expenditure or receipt between capital and revenue is incorrect, or if the closing stock is over-valued. Though the trial balance will not disagree, the Profit and Loss Account may be significantly affected. Further, such errors might be made intentionally to falsify the accounts or unintentionally owing to the lack of knowledge of fundamental accounting concepts & conventions. Thus, a thorough examination is required to identify such errors.
In order to detect them, the auditor should particularly pay attention to those items where an error of principle is most likely to occur. For example, transactions of fixed assets, advertisement expenditure, and so on.
3. Errors of duplication:
Errors of this type are made when an entry in the book of Original Entry is recorded twice and hence, is also posted twice to the ledger. Such errors do not affect the trial balance as debits and credits will be equal. To prevent such errors, clerks should adopt a practice of distinctively marking the invoices and other vouchers after they have been entered in the book of Original Entry. Moreover, duplicate invoices should be maintained in separate files and must also be stamped “duplicate” so that they don’t get mixed with the original ones.
Types of Frauds
Other than the different types of errors, an auditor may also locate some frauds during his auditing exercise.
Fraud is always committed intentionally with the goal of defrauding the owners or proprietors of the organization. If frauds go undetected, they may have an impact on the assessment of the auditor about the financial position and operating results of the organization. As a result, the auditor must be extremely cautious in order to uncover such frauds. In the context of auditing, fraud can be broadly classified into two types: Misappropriation and Falsification.
1. Misappropriation of assets:
Misappropriation of assets is normally called “employee fraud”. Employees in an organization may get involved in committing fraud to obtain an illegal advantage or personal gain. Such frauds generally involve the theft of assets, mostly cash or goods from the business.
A. Misappropriation of cash:
Misappropriation, also known as defalcation of cash is very common in large businesses since the owner has very minimal control over the receipts and payments of cash. Cash can be misappropriated in a variety of ways, including:
- Suppressing the receipts
- Recording less amount than the amount actually received
- Recording of fictitious payments
- Recording of fictitious purchases to misappropriate cash
- Recording more amount than the amount actually paid
To detect such misappropriation of cash, the auditor should verify the Cash Book with original records, counterfoils or receipt book, supporting documents, bills register, salesmen’s diary, invoices, wage sheets, vouchers, and so on. The auditor should also ensure that an adequate internal check system is being used in the organization to strictly regulate cash receipts and payments.
B. Misappropriation of goods:
Misappropriation of goods is also a common way to commit fraud especially when goods are not bulky and are of high value. A common example could be when good production is classified as defective or scrap and is used for personal purposes. Unless proper records of stock inward and outward are maintained in an organization, it is quite difficult to locate such misappropriation of goods. Only proper accounting for purchases and sales, stock taking, and stock inspections at regular intervals can reduce the likelihood of such fraud.
2. Falsification or manipulation of accounts:
Many times, accounts of the organization are manipulated by those in charge of the top management in order to attain some specific objectives. Hence, it is also called “management fraud”. The accounts are prepared in such a manner that they disclose a distorted picture of the company’s affairs and not the correct picture. The true picture of the company is concealed. There are many ways through which the accounts of a company are manipulated, some of which are as follows:
- Charging less or excess depreciation (or charging depreciation on non-existent assets)
- Inflating or deflating incomes and expenses
- Writing off less or excess bad debts
- Provisioning for less or excess doubtful debts
- Under-valuation or over-valuation of closing stock
- Suppressing sales and purchases or showing fictitious values of sales and purchases
- Classifying capital expenditure as revenue and vice versa
Commonly, there are two ways in which manipulation or falsification of accounts is done. These are:
A. Window dressing:
Window dressing is when accounts of a company are prepared in such a way that they showcase a better financial position of the business than it actually has. It involves misrepresentation of financial results to deceive the users. The objective behind this may be:
- To obtain credit
- To attract potential shareholders or partners
- To earn more commission when payment is directly linked to performance or profits
- To win the confidence of investors and shareholders
- To increase the market price of shares by paying higher dividends so that the shares held may be sold
B. Secret reserves:
Manipulation of accounts through “secret reserves” is when accounts of a company are prepared in such a way that they disclose a worse financial picture than what the business actually has. The objective behind this may be:
- To reduce or avoid the tax liability
- To hide the true position from the company’s competitors
- To decrease the market price of shares by not paying dividends or by paying lower dividends so that the shares may be bought at a much lower price
Remember, manipulation of accounts either through window dressing or secret reserves is generally committed by those who manage and control the organization such as directors, managers, financial controllers, etc. Also, the internal control procedures may be overridden by the management’s directive to give effect to this kind of fraud. Thus, it is extremely difficult to detect this kind of fraud. The auditor has to make detailed inquiries and has to be extraordinarily vigilant to arrive at the correct picture.
Wrapping up (Types of errors and fraud in auditing)
While errors are usually unintentional, frauds are committed deliberately. To detect them and to give a fair opinion on the financial condition of a business, it is important that auditors adopt a thorough approach to auditing as far as possible. Especially when doubtful situations are there to arouse suspicion, the auditors are expected to extend their audit procedures to confirm or dispel that doubt.
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