Financial misstatement schemes, with a median loss of $766,000, are the most costly type of fraud, according to the "Occupational Fraud 2024: A Report to the Nations" study by the Association of Certified Fraud Examiners. Auditors and forensic accountants play a crucial role in detecting these frauds by examining journal entries for errors and irregularities. Here’s how they conduct these tests and what they seek to uncover.
Suspicious entries
Statement on Auditing Standards (SAS) No. 99, Consideration of Fraud in a Financial Statement Audit, provides valuable audit guidance that can be applied when investigating fraudulent financial statements. It notes that “material misstatements of financial statements due to fraud often involve the manipulation of the financial reporting by … recording inappropriate or unauthorized journal entries throughout the year or at period end.”
Financial misstatement comes in many forms. For example, out-of-period revenue can be recorded to inflate revenue — or checks can be held to hide current-period expenses and boost earnings. Accounts payable can be understated by recording post-closing journal entries to income. Or expenses can be reclassified to reserves and intercompany accounts, thereby increasing earnings.
To detect these types of scams, SAS 99 requires financial statement auditors to:
- Learn about the entity’s financial reporting process and controls over journal entries and other entries,
- Identify and select journal entries and other adjustments for testing,
- Determine the timing of the testing,
- Compare journal entries to source documents, such as invoices and purchase orders, and
- Interview individuals involved in the financial reporting process about inappropriate or unusual activity relating to the processing of journal entries or other adjustments.
Forensic accountants also follow audit guidelines when investigating allegations of financial misstatement. And financial statement auditors may call on these experts when they notice significant irregularities in a company’s financial records.
Testing procedures
AICPA Practice Alert 2003-02, Journal Entries and Other Adjustments identifies several common denominators among fraudulent journal entries. Auditors will ask for access to the company’s accounting system to test journal entries made during the period for signs of fraud.
Specifically, they tend to scrutinize entries made:
- To unrelated, unusual, or seldom-used accounts,
- By individuals who typically don’t normally make journal entries,
- At the end of the period or as post-closing entries that have little or no explanation or description,
- Before or during the preparation of the financial statements without account numbers, and
- To accounts that contain transactions that are complex or unusual and that have significant estimates and period-end adjustments.
Other red flags include adjustments for intercompany transfers and entries for amounts made just below the individual’s approval threshold or containing large, round dollar amounts.
Getting professional help
Financial misstatements can be costly. However, your organization can take steps to minimize its risk. External financial statement audits, surprise audits, and forensic accounting investigations can help identify vulnerabilities and unearth anomalies. Contact an Axley & Rode advisor for more information.
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