College of Accountancy and Business Administration 

A.Y. 2021-2022

GROUP 4

MODULE 12: ERRORS AND IRREGULARITIES IN

THE TRANSACTION CYCLES OF THE BUSINESS
ENTITY

Submitted by:
Distor, Joejick
Espejo, Jocelyn
Nadal, Joanna Marie
Paguyo, Jhon Michael
Villaruz, John Wilbert
Vinluan, Joanna

ERRORS AND IRREGULARITIES IN THE TRANSACTION CYCLES OF THE BUSINESS ENTITY

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 Errors and Irregularities in the transaction cycles of the business
entity

While businesses in different individuals can have striking different characteristics, most have
some fundamental conceptual characteristics are practices in common. The three basic
transaction cycles include

1. Sales and collections cycle

2. Acquisitions and payments cycle
3. Payroll and personnel cycle

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. This chapter presents the errors and fraudulent
activities that could result if there is Poor internal control.

A. Sales and collections cycle

Errors in recording sales and collections transactions
Errors in recording sales include mechanical errors, such as using a wrong piece or wrong
quantity, recording sales in the 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 these kinds of errors.

Frauds in sales and collections

Frauds in sales generally relate to fraudulent financial reporting. In contrast, frauds in cash
collections relate to misappropriation of assets, typically accomplished by clerks or
management-level employees.

a. Fraudulent financial reporting

Fraudulent financial reporting involving sales typically results in overstated sales or
understand sales returns and allowances. Managers under pressure to achieve high profits
may inflate sales to meet target profits established by senior managers, to obtain bonuses,
to retrain the respect of senior managers, or even to keep their jobs. 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

ERRORS AND IRREGULARITIES IN THE TRANSACTION CYCLES OF THE BUSINESS ENTITY

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 • Following revenue recognition practices that are not in accordance with PFRS
• Recognizing revenue that should be deferred

b.Misappropriation of assets: withholding cash receipts

• Skimming
This refers to the act of withholding cash receipts without recording them. An example
is when a cashier in a retail store does not ring up transaction and takes the cash.
Another example is 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, unexplained changes in the gross profit percentage or sales
volume may indicate that cash receipts have been withheld.

• Lapping
This technique 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.

• Kiting
This is another technique used to cover cash shortage or to inflate cash balance. Kiting
involves counting the cash twice by using the float in the banking system. (float is 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 day surrounding year-end should reveal this type of fraud.

B. Acquisitions and payments cycle

Errors in the acquisitions and payment cycle
The following may occur in the acquisitions and payment cycle:
• Failing to record purchase in the proper period (cutoff errors)
• Recording goods accepted on consignment as a purchase
• Misclassifying purchase of assets and expenses
• Failing to record a cash payment
• Recording a payment twice
• Failing to record prepaid expenses as assets

Entities normally design controls to prevent these errors from occurring or to detect
errors if they do occur. When such controls exist, auditions test the controls to asses
their effectiveness. If the controls are not effective, auditors should perform substantive
test to determine if that the financial statements do not contain material misstatements
that arose because of possible errors.

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 Frauds in the acquisitions and payment cycle
● Paying for fictitious purchases
This involve 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.

● 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 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 or
her place of employment. Sometimes the purchasing agent splits the kickback
with the vendor’s employee for approving and paying it. Detecting kickbacks is
difficult because the buyer’s records do not reflect their existence. However,
when vendors are required to submit bids for goods or services, the likelihood of
kickbacks is reduced.

● Purchasing goods for personal use

Good or services for personal use may be purchased by executive or purchasing
agents and charged to the company’s account. To execute such a purchase, the
perpetrator must have access to the 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.

C. Payroll and personnel cycle

Historically, errors and irregularities involving payroll have been reported to occur frequently
and are largely undetected.

Errors:
The most errors that can occur in the payroll and personnel cycle are
• Paying employees at wrong rate
• Paying employees for more hours than they worked
• Charging payroll expense to the wrong accounts, and 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.

Frauds involving payroll

The major payroll-related frauds include
• Fictitious employees
Adding fictitious employees to the payroll is one of the most common defalcations.
Detecting fictitious employees on the payroll is very difficult; but auditors do sometimes
to perform a surprise payoff as a deterrent to this form of defalcation. Alternatively, the
auditor may turn the check distribution over to an official not associated with preparing

ERRORS AND IRREGULARITIES IN THE TRANSACTION CYCLES OF THE BUSINESS ENTITY

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 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.

• 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.

• 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 o payroll. The omission of
payroll can be difficult to hide unless a similar amount of revenues or receipts has been
omitted. Analytical procedures can be performed to test the reasonableness of payroll
cost.

• 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 of inventory are some of
the useful techniques in detecting such fraud.

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