Part A: Accounting foundations
Introduction to accounting
Key takeaways
- Accounting identifies, records, classifies, summarises and communicates financial information about an entity so that its users can make informed decisions.
- Internal users such as management and employees run and control the entity with it; external users such as investors, lenders, regulators and tax authorities rely on published accounts they cannot verify themselves.
- Assets = Liabilities + Equity underlies every transaction, and a fraudulent entry distorts one side of it without a genuine corresponding change.
- The accounting cycle runs from source documents to journals, ledgers, the trial balance and the financial statements.
- Management keeps the records, prepares the statements and is responsible for preventing and detecting fraud through its own controls; the external auditor only gives a reasonable, not absolute, assurance opinion on them.
Definition of accounting
Accounting is the process of identifying, recording, classifying, summarising and communicating financial information about an entity, so its users can make informed decisions, the foundation a forensic examiner must understand thoroughly before they can recognise where and how it has been deliberately misused.
Objectives of accounting and users of accounting information
Accounting equation
The fundamental accounting equation, Assets = Liabilities + Equity, underlies every transaction recorded and every financial statement prepared, and understanding how a fraudulent entry distorts one side of this equation without a genuine corresponding change is a recurring forensic technique.
Accounting concepts and conventions
The accounting cycle
- Source documents: invoices, receipts, cheques, the original evidence of a transaction
- Journals: the initial, chronological record of transactions
- Ledgers: transactions classified and summarised by account
- Trial balance: a check that total debits equal total credits
- Financial statements: the final output communicated to users
Who is responsible for the accounts
Caparo Industries plc v Dickman [1990] 2 AC 605 (House of Lords)
Who the preparers and auditors of accounts answer to. The statutory audit exists so that the members as a body can hold the directors to account, and no duty is owed to individual investors relying on the accounts to deal in shares. It is the starting point for understanding the division of responsibility for the accounts, because it separates the directors' responsibility for the accounts from the auditor's responsibility for an opinion on them.
Re Kingston Cotton Mill Co (No 2) [1896] 2 Ch 279 (Court of Appeal)
What the auditor of those accounts must do: exercise the skill, care and caution of a reasonably competent, careful and cautious auditor, as a watchdog rather than a bloodhound, entitled to rely on trusted officers unless something arises to arouse suspicion. The contrast with a forensic accountant, who is engaged precisely because suspicion has already arisen, runs through the rest of this paper.
The cases in this chapter are genuine, reported authorities; none is invented for illustration.
Regulatory bodies in accounting
- Professional institutes (e.g. ICPAK in Kenya, IFAC internationally), setting professional and ethical standards
- Government regulatory bodies (e.g. tax authorities, financial regulators), enforcing statutory compliance
- Standard-setting bodies (IASB for IFRS, IPSASB for IPSAS), issuing the accounting standards themselves
Exam tip
The division of responsibility for the accounts is frequently tested through the recurring 'who is responsible for detecting fraud' scenario, management is responsible for prevention and detection through its own controls, external auditors provide reasonable, not absolute, assurance and are not primarily fraud detectors, do not conflate the two roles.
Self-check
(a) A board member says: 'We have external auditors, so fraud detection is their responsibility, not ours.' Correct this statement using the division of responsibility for the accounts. (5 marks)
(b) Distinguish between accrual basis and cash basis accounting, and explain why accrual basis is harder for a fraudster to manipulate convincingly at first glance, but easier to manipulate through timing. (5 marks)
(c) A company changes its inventory valuation method with no disclosed reason, immediately after a period of declining profit. Using the consistency and prudence concepts, explain why this is a fraud indicator worth investigating. (4 marks)
(d) State the accounting equation, and explain how a fictitious sale distorts it without a genuine corresponding change. (4 marks)
Show worked answer
(a) The statement is incorrect. Management is responsible for maintaining accurate records, preparing financial statements, and for fraud prevention and detection through its own internal controls. External auditors are responsible for independently opining on whether the statements are fairly presented, providing reasonable, not absolute, assurance, they are not primarily fraud detectors, and a statutory audit is not designed specifically to catch fraud. Responsibility for fraud prevention and detection sits with management and those charged with governance, not with the external auditor. (5 marks)
(b) Accrual basis recognises transactions when they occur economically, regardless of when cash moves; cash basis recognises transactions only when cash is actually received or paid. Accrual basis is harder to manipulate convincingly at first glance because it must reconcile against a genuine underlying economic event (a delivery, a service rendered) rather than a simple cash movement, but it is easier to manipulate through TIMING, since the fraudster controls the judgement call of exactly when a transaction is 'economically' recognised, for example recording revenue a period early, a manipulation cash basis accounting (tied to the harder-to-fake fact of cash actually moving) resists more directly. (5 marks)
(c) The consistency concept expects the same accounting methods to be applied period to period, so a sudden, unexplained change is itself a fraud indicator, especially when it coincides with a period of declining profit, since changing methods is a known technique for artificially improving reported results. The prudence concept expects assets and income not to be overstated, an undisclosed change timed to flatter a weak period suggests the change may be serving that purpose rather than a genuine, defensible accounting judgement, warranting closer investigation of the change's actual effect on reported profit. (4 marks)
(d) Assets = Liabilities + Equity. A fictitious sale typically records a debit to receivables (an asset) and a credit to revenue (which flows into equity through retained earnings), inflating both assets and equity, without any genuine corresponding change, no cash was ever received, no genuine obligation from a real customer exists, and the 'asset' (the fictitious receivable) will never actually be collected, eventually surfacing as an unexplained bad debt or a balance that never converts to cash. (4 marks)