FRAUD
Fraud is really a false representation or entry which is made always intentionally with some mischievous objectives.
Misappropriation of Cash. Usually, Cash is misappropriated by:
(i) The theft of Cash receipts and Petty Cash.
(ii) The theft of Cheques and other negotiable instruments.
(iii) Payments made to fictitious creditors or workmen.
Misappropriation or defalcation of cash is a very easy affair. Anybody with a little skill on his part can misappropriate money, especially in a big business-house where the contacts between the proprietor and the persons handling cash are not so close as in the case of a small proprietary business. A transaction relating to the receipt of cash may either go totally unrecorded or recorded at a figure less than the actual one in the Cash Book and, thus, the total or a part of the cash may be pocketed by the cashier.
Similarly. it is possible to record false payment of money and to enter cash payment at more than the actual figure. In this way, there may be concealment of money by the cashier. Thus, in a big business, strict control should be exercised over the receipt and payment of cash so that there may be a system of checking the work of one clerk automatically by another. Technically, such a system is known in auditing as a system of internal check which is dealt with later in detail.
The following are some of the examples of misappropriation of cash:
(a) Sales
(i) omitting to record sales and pocketing money received from customers,
(ii) teeming and lading, i.e., concealing money received from first customer and entering in his account the cash received from second one; In order to ensure that no customer account is kept outstanding for a long period, this process is adopted for all the subsequent collections till the fraud is discovered. Thus, misappropriation of cash is concealed by a false entry relating to a later transaction. Such a fraud can be prevented if customers are advised to issue Crossed Cheques or ‘A/c Payee Cheques and are kept well informed by issuing statements of account at regular intervals.
(iii) making fictitious entries for discount, returns, bad debts, etc., in the customers’ accounts;
(iv) omitting to enter cash received from sales;
(v) misappropriating money received from the sale of goods on ‘sale or return’ basis or per V.P.P by showing such goods as returned in the books.
(b) Purchases
(i) recording fictitious purchases and thus, misappropriating the cash involved;
(ii) suppressing credit notes received from creditors for purchase returns and discount;
(c) Receipt of Cash
(i) concealing cash received on miscellaneous or extraordinary account (e.g. from sale of some rejected stock or from a debtor declared previously as bad debt, etc.);
(ii) misappropriating money-receipt on bills receivable account discounted with a bank; (iii) omitting to record cash received by a cashier as a donation and removing the counterfoil of the receipt from the receipt book;
(d) Payment
(i) misappropriating money shown as wages in the wage sheet by entering dummy names of workers therein.
Misappropriation of Goods. Usually, it is seen that the proprietors of business-houses do not bother so much for the misappropriation of goods as for the defalcation of money, The defalcation of goods is easy in those business-houses which produce or deal with goods which are less bulky and are of higher value.
Thus, goods can be misappropriated by:
(i) The actual theft of stock; and/or
(ii) Issuing fictitious credit notes to customers where there is collusion of the employee with the customer.
Fraud in respect of goods cannot easily be detected. When the auditor can detect the misappropriation of cash by making a close scrutiny of cash book, salesman’s reports, counterfoils of receipt books, credit notes and other vouchers, he has to depend, to a considerable extent, on the system of internal check in operation with regard to sales and purchases. Where this system is good and efficient, collusion between two or more persons must have occurred for committing fraud of a serious nature which cannot be detected easily.
Only detailed checking by the auditor can bring fraud to light. He should check up the stock records, purchases and sales very carefully.
Manipulation of Accounts. The falsification of accounts without corresponding defalcation is not so common as the misappropriation of cash or goods. The accounts of a business can be falsified by making false entries in respect of fictitious sales or purchases not necessarily resulting in the same type of misappropriation. It is true that whenever such a class of fraud occurs, it involves usually very large amounts and it can be detected with a great difficulty by the auditor because it is committed by high officials of a business, viz., Directors, Managers or other responsible persons.
The following are some of the devices to falsify accounts:
(i) providing less or more or not providing for depreciation on various as
(ii) overvaluation or undervaluation of assets and liabilities; or
(iii) inflating or deflating profits by entering non-existent items as sales, purchases or returns; or
(iv) changing capital expenditure to revenue account or vice-versa; or
(v) inflating profits by omitting to record some items of expenditure or showing less profits by entering fictitious expenditure; or
(vi) utilizing secret reserves without making the fact known to the shareholders during period when there is no profit or less profit; or
(vii) showing income of the next year to the current year’s Profit & Loss Account or not recording the accrued income in the Profit & Loss Account with the object of manipulating the accounts thereby; or
(viii) window dressing, i.e., showing outwardly a more prosperous position than what it actually is. It is a process by which the Balance Sheet is made to show a state of affairs that is far better than the normal position of the business. Just to improve the working capital position of the business; if an overdraft is extinguished before the date of Balance Sheet out of the proceeds of a loan from a subsidiary company, it would not be justifiable.
(ix) Inflating or suppressing purchases and expenses;
(x) Inflating or suppressing sales and other items of income;
(xi) Inflating or deflating the value of closing stock; and
(xii) Failing to adjust outstanding liabilities or prepaid expenses.
In short, the falsification of accounts may take any of the following forms:
(i) Inflation of the values of assets;
(ii) Omission or undervaluation of liabilities:
(iii) Inflation of profits to enhance commission payable to officials or to affect share values;
(iv) Window dressing.
Auditor’s Duty
The duty of an auditor is quite significant in relation to the detection and prevention of errors and fraud. He knows fully well that he has to detect such acts of errors and fraud on the one side and also to prevent them from occurring in future on the other. Really, it is difficult for him to do so since fraud in usually committed by the officers who are presumed to be honest, sincere and responsible.(BCom Introduction to Auditing Notes Study Material)
Detection. It is true that the auditor should exercise considerable care and skill and only then he can detect errors and fraud. He can be successful in his task if he carries routine checking and vouching most carefully and checks thoroughly books of accounts, ledger accounts and vouchers. Thus, his duty is mainly confined to making intelligent and careful enquiry.
In doing so, if he is not successful but feels that he has exercised a great degree of skill, care and tact, his job is over. However, he will decide himself the degree and level of the scrutiny. If to the best of his knowledge, care and skill, he certifies the accounts as correct, he cannot be held responsible for an error or fraud which is still there in the accounts.
Prevention. So far as the prevention of errors and fraud is concerned, he cannot do anything concrete directly. All that he can do is to advise his client and tell him the way to prevent their future occurrence if he is asked for that. His job is simply to give advice but it is the proprietor who is responsible for getting things done. It is certain that if his advice is taken properly in the right spirit, chances of errors and fraud can be reduced to the minimum. (BCom 3rd Year Introduction to Auditing Notes Study Material)
Then, the visits made by the auditor to check accounts serve also as a considerable influence on those employees responsible for maintenance of accounts which are to be audited. The persons responsible for the maintenance of accounts know well that the books prepared by them would be subjected to a close scrutiny by the auditor and if some errors and fraud are found therein, they will be held responsible for such acts of gross negligence and bad name.
Hence, under this fear, they always try to be on their guard. This is a sort of moral influence exercised by the auditor which helps a lot in the prevention of further occurrence of errors and fraud. (BCom 3rd Year Introduction to Auditing Notes Study Material)
It would not be out of place here to quote an extract from the decision given by the learned Judge in the case of Kingston Cotton Mills Company (1896) that “an auditor is a watch-dog and not a blood-hound.” The decision clearly makes an indication of the auditor’s duty in regard to the detection of errors and fraud.
There are two important points in the judgment :
Firstly, an auditor is a watch-dog which means that he is appointed to look after the interests of those who happen to be the owners of a business. A watch-dog is kept and fed by his owners and as such, he on his part looks after his owner’s interests. Hence, the auditor should leave no stone unturned in detecting errors and fraud so that he can protect the interests of his client sincerely, honestly and tactfully.
Secondly, an auditor is not a blood-hound. It is no part of his duty to take those to task who have been found guilty of committing errors and fraud. He should not be malicious towards those whom he finds to be responsible for any act of negligence and manipulation or misappropriation. He has to be sincere, honest and methodical in his approach without in any way causing any harm to the persons whose work he has to certify. This is the real meaning of the above-quoted statement.
In brief, the following is a brief sketch of the auditing standards:
1. An auditor should check the internal check system in force and examine its working in practice.
2. He should ensure how far accountancy principles have been followed in recording business transactions and it is to be seen whether the work of recording has been made in pursuance with the policies of the management.
3. He has to see that the accounts have been drawn in conformity with the Companies Act, and
4. Finally, he should check that the Balance Sheet exhibits a true and fair view of the state of affairs.
However, his responsibility for not detecting errors and fraud will rest upon the following factors:
1. He has fulfilled his duty with the prevailing standards of performance adopted by the profession.
2. He has exercised reasonable care, skill and intelligence in his work.
3. He has not overlooked the materials which would have aroused his suspicion about fraud and errors.
4. The loss has actually arisen on account of his negligence.
5. He has seen the substantial accuracy of the statements of accounts besides checking the arithmetical accuracy.
The Council of the Institute of Chartered Accountants of India has expressed its in regard to the duties of an auditor that while conducting an audit, the auditor bear in mind the possibility of the existence of fraud or other irregularities in the ac under audit. The financial position may be mis-stated as a result of defalcations and other irregularities. The auditor recognizes that any fraud, if sufficiently material. may his position as to whether the accounts show a true and fair view and he takes this into account in conducting an audit.
The duty of safeguarding the assets of the company is primarily that of the management and the auditor is entitled to rely upon the safeguards and internal controls instituted by the management, although he will, of course, take into account any deficiencies he may note therein while drafting his audit programme. If an audit is to be conducted with the object of discovering fraud, in the first place, it would take a considerable amount of time and it would not be possible to complete the audit within the time limit prescribed by law for the presentation of accounts to shareholders. (BCom 3rd Year Introduction to Auditing Notes Study Material)
It is further stated that if after the auditor has completed his audit, a fraud is discovered pertaining to that period, it does not necessarily mean that the auditor has been negligent or that he has not performed his duties competently. The auditor does not guarantee that once he has signed the report on the accounts, no fraud exists. If he has conducted his audit by applying due care and skill in connection with the professional standards expected of him and has exercised reasonable care and skill, the auditor would not be held responsible for not having discovered that fraud. (BCom 3rd Year Introduction to Auditing Notes Study Material)
LIMITATIONS OF AUDIT
Then, a word about the limitations of audit. The duties discussed heretofore make it clear that an auditor has nothing more to do than merely checking, ticking, totalling and vouching the books and accounts. The ultimate object of his work is to detect clerical errors pertaining to the accounts. Hence, the scrutiny done by the auditor appears to be a sort of routine work which he does with a reasonable care as he is bound to do it. This is simply his professional liability. (BCom 3rd Year Introduction to Auditing Notes Study Material)
Apart from these, an auditor has to depend upon books of accounts and other reco presented before him. He never thinks of intentions of those who have prepared then these intentions are malafide and there are manipulation in the accounts, the auditor not be in a position to bring them to light. He has also to depend upon the opinion experts as he is not expert in all fields-technical, legal or others.
Actually, it is rather difficult to find the accounts as complete and genuine everywhere. For example, the details about stock-in-trade cannot be perfectly complete as it is not possible to fix exactly the cost or market price of each item in the stock which may or may not be marketable on a particular day. Practically, it is never found out.
Similarly, it cannot be said whether raw materials or other goods are of use to the business or not. For electricity and coal, it is never established whether excessive expenditure has been incurred in these items or the business can acquire them with less expenditure and can thus function more economically. (BCom 3rd Year Introduction to Auditing Notes Study Material)
These are the basic questions which are never answered by an auditor in his report. It shows, therefore, that audit is historian’s record within certain limitations. He has nothing to do with finances, ethics and effective management. These are actually the fields which an auditor must cover during his work so as to enable the business to function more efficiently and economically, but he does not. What is the use of audit, then?
This is also one of the limitations of the audit that the auditor is influenced by the doings of those in management. The reason is quite simple. He is appointed by the shareholders and directors who pay him his remuneration or fee. Hence, he cannot think otherwise on any moment.
An auditor is said to be a watch-dog and he is appointed to protect the interests of owners or shareholders. It is true that he should work as a financial police force so that he may prevent anti-social activities and the misuse of powers. Unless financial controls are properly exercised, an efficient management is rather an impossible task. (BCom 3rd Year Introduction to Auditing Notes Study Material)
It will also not be out of place to mention here that the times are changing fast and the business world is being shaped almost daily with new devices and procedures. The problems are being complicated day-by-day as such, unless an auditor is familiar with the modern changes, he cannot perform his functions with ability and prudence. (BCom 3rd Year Introduction to Auditing Notes Study Material)
Hence, capable persons are needed in every country to perform the work of audit so that the business may be properly directed and administered. This will depend upon the co-operation, specially between the businessmen, the government and persons conducting audit.
ADVANTAGES OF AUDIT
It is no more controversial that accounting is a necessity while auditing is a luxury. People now get their accounts audited by a qualified auditor so that they may be sure of the smooth running of their business and validity of the investment that they have made therein.
It is of utmost importance to get accounts audited in a proprietary concern to see that the business is running efficiently: in a partnership firm to ensure healthy relations among partners and especially to decide questions like valuation of goodwill at the time of entry, retirement and death of a partner, and in joint-stock company in which shareholders invest their money and presume their capital intact if the accounts of such a company are audited by some qualified auditor. Needless to mention, the shareholders of a company have virtually no direct stake in its day-to-day administration. This is why audit is made compulsory under the Companies Act.
The advantages of audit can be grouped into the following categories:
For Business itself
(i) The accounts of a business and its financial position can be examined by an independent and qualified auditor.
(ii) Errors and fraud are located very easily at an early date and chances of their further occurrence are reduced to the minimum.
(iii) The auditing of accounts makes the clerks who maintain them alert, careful and vigilant, and more so, they prepare accounts very carefully in future and keep them up-to-date. (BCom 3rd Year Introduction to Auditing Notes Study Material)
(iv) Money can easily be borrowed from banks and other money-lenders on the basis of properly audited accounts.
(v) The business itself enjoys better reputation if its accounts are audited by an independent auditor.
(vi) The auditor, if he audits a business regularly, can come into a close touch with the working of that business and hence, can give concrete suggestions to improve it if he is asked to do so.
(vii) Audit is useful in case business is managed by some agent or representative of its owner.
For the Owners of a Business
(viii) If the business is owned by a sole trader, he can rely well on the audited accounts and on his accounts clerks who are responsible for the maintenance of accounts. (BCom 3rd Year Introduction to Auditing Notes Study Material)
(ix) If the business is organised as a partnership firm, its partners can utilize the audited accounts to settle their disputes in regard to adjustment of capital and valuation of goodwill at the time of admission, retirement and death of a partner.
(x) If the business is constituted as a joint-stock company, its shareholders who reside at places distant from the head office of the company can rely on audited accounts and can be sure of their investment being safe with the company.
(xi) If it is a trust, its trustees can easily make their position clear before others by getting the accounts audited by an outside and impartial auditor.
For Others
(xii) The audited accounts of previous year are helpful in the settlement of claims by the insurance company in case of fire.
(xiii) The banks or investors or other money-lenders can take decisions for granting loans to business houses on the basis of their properly audited accounts.
(xiv) The purchaser of a business can easily calculate the amount of purchase consideration on the basis of its audited accounts.
(xv) The taxation authorities can very well rely on the audited accounts for the purpose of imposing Sales-tax, Income-tax, Wealth-tax, Expenditure-tax, etc.
(xvi) The audited accounts of a business can be produced in support of a legal case before the Court. It forms a basis to determine action in bankruptcy and insolvency cases. (BCom 3rd Year Introduction to Auditing Notes Study Material)
(xvii) In the case of employer-employee disputes, audited accounts are helpful in the determination of profits and trends of profitability. Trade union disputes can be easily settled on the basis of audited accounts of a concern.