Frauds: Definitions, Circumstances and Types
Chapter Eight
Syllabus topic 2, "Errors & Frauds – Definitions, Reasons and Circumstances, Types of Error, Types of frauds, Risk of fraud and Error in Audit, Auditors Duties and Responsibilities in case of fraud."
Pages 19 to 21 of 98
In one line
A fraud is an intentional act to obtain an unjust advantage, and in a set of accounts it takes one of three forms: cash is taken, goods are taken, or the accounts are made to say something untrue.
The statutory definition
Explanation (i) to section 447 of the Companies Act 2013.
"Fraud" in relation to affairs of a company or any body corporate includes any act, omission, concealment of any fact or abuse of position committed by any person or any other person with the connivance in any manner, with intent to deceive, to gain undue advantage from, or to injure the interests of, the company or its shareholders or its creditors or any other person, whether or not there is any wrongful gain or wrongful loss.
Two points from that wording.
- It includes an omission and a concealment, not only a positive act.
- It does not require an actual gain or loss. The intent is enough, which is why an attempted fraud that failed is still a fraud.
The reasons and circumstances
| Circumstance | Why it produces fraud |
|---|---|
| Weak internal control | The opportunity exists |
| No segregation of duties | One person both handles the asset and records it |
| Excessive trust in one person | The cashier who has "always" done it and never takes leave |
| Personal pressure | Debt, illness, a habit, a lifestyle |
| A sense of grievance | Passed over, underpaid, badly treated |
| Pressure on management to show results | Targets, loan covenants, a share price, a bonus |
| A dominant chief executive | Nobody in the company can say no |
| Complex or unusual transactions | Concealment is easier where nothing is routine |
Type one: misappropriation of cash
Cash is the asset most often taken because it is the easiest to convert.
| Method | How |
|---|---|
| Receipts not recorded | A cash sale is made and no entry passed |
| Teeming and lading | Money from customer B is used to cover money stolen from customer A's payment, then C's covers B's; the shortfall rolls forward |
| Fictitious discounts and bad debts | A customer's payment is taken and the balance written off as a bad debt or a discount |
| Dummy or ghost workers | Names on the wage sheet who do not exist, with the money drawn |
| Fictitious purchases | Invoices passed for goods never delivered |
| Inflated or duplicated expenses | The same voucher paid twice; personal expenses passed as the company's |
| Cheques altered after signature | Payee or amount changed |
Teeming and lading is the one MU's examiner names, and it is worth two sentences: the shortfall never closes, it only moves, so it is detected by an independent confirmation of debtors' balances or by a surprise reconciliation of the receipts of one day against the bankings of that day.
Frauds: Definitions, Circumstances and Types
Type two: misappropriation of goods
Harder than cash to convert, easier to conceal in a large stock.
| Method | How |
|---|---|
| Theft of stock | Goods removed and the records left to absorb it as wastage |
| Issue without authority | Goods issued on a forged or unauthorised requisition |
| Falsified receipts | Fewer goods received than the invoice says, with the difference shared |
| Overstated wastage or scrap | Real losses inflated to cover theft |
The controls are physical rather than documentary: gate passes, a perpetual inventory compared with a physical count, and separation of the storekeeper from the person who records the stock.
Type three: manipulation of accounts
The most serious, and the one committed by management.
| Method | Direction |
|---|---|
| Recording fictitious sales, or holding the sales ledger open after the year end | Profit overstated |
| Omitting purchases or expenses | Profit overstated |
| Overvaluing closing stock | Profit overstated |
| Not providing for depreciation or doubtful debts | Profit overstated |
| Capitalising revenue expenditure | Profit overstated |
| Undervaluing closing stock, or over-providing | Profit understated |
| Charging capital expenditure to revenue | Profit understated |
| Creating excessive secret reserves | Profit understated |
Why anyone would understate profit is a question worth answering: to reduce tax, to depress the share price before buying, to resist a wage claim, or to smooth a good year into a bad one.
Window dressing is the general name for manipulation that makes the position look better than it is, and it need not change the profit at all: paying creditors just before the year end to improve the current ratio is window dressing.
The three compared
| Misappropriation of cash | Misappropriation of goods | Manipulation of accounts | |
|---|---|---|---|
| Who | Employees, usually junior | Employees, storekeepers | Management |
| What is taken | Money | Goods | Nothing is taken |
| Object | Personal gain | Personal gain | To deceive the reader of the accounts |
| Amount | Usually small, often repeated | Usually small, often repeated | Often very large |
| Detected by | Vouching, confirmations, reconciliations | Physical count, control accounts | Analytical review, and questioning judgment |
| Danger to the audit opinion | Usually immaterial | Usually immaterial | Directly material |
The last row is the reason this classification matters to an auditor. A clerk taking Rs 20,000 a year rarely makes the statements untrue. A board overstating profit by Rs 2 crore does, and it is the fraud the audit is really designed against.
Quick revision
| Statutory definition | Explanation (i) to section 447: act, omission, concealment or abuse of position, with intent to deceive or gain undue advantage, whether or not there is any gain or loss |
| Three types | Misappropriation of cash; misappropriation of goods; manipulation of accounts |
| Teeming and lading | Later receipts cover earlier stolen ones; the shortfall rolls forward |
| Window dressing | Making the position look better without necessarily changing the profit |
| Who commits manipulation | Management |
| Which type endangers the opinion | Manipulation, because it is material by design |
Frauds: Definitions, Circumstances and Types
Test yourself
- Give the statutory definition of fraud and name the section.
- Does a fraud require an actual gain or loss?
- Explain teeming and lading and say how it is detected.
- Name four methods of manipulating accounts to overstate profit.
- Why would management understate profit?
Answer in one sentence
1. Explanation (i) to section 447 of the Companies Act 2013: any act, omission, concealment of a fact or abuse of position, with intent to deceive, to gain undue advantage from or to injure the interests of the company or its shareholders, creditors or any other person.
2. No, the definition applies whether or not there is any wrongful gain or wrongful loss, so the intent is enough.
3. Money stolen from one customer's payment is covered by a later customer's, and the shortfall rolls forward indefinitely; it is detected by independently confirming debtors' balances or by reconciling one day's receipts against that day's bankings.
4. Recording fictitious sales, omitting purchases or expenses, overvaluing closing stock, and failing to provide for depreciation or doubtful debts.
5. To reduce tax, to depress the share price before buying shares, to resist a wage claim, or to smooth a good year into a following bad one.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.