How to Distinguish Between Fraud And Error
Irregularity found in financial statements leads to two possibilities; fraud or error. What’s the difference between the two?
The difference between fraud and error lies in the intention. Simply put, fraud is an act that is intentionally carried out to benefit certain individuals or groups and causes detrimental effect to others, while errors are acts of unintentional mistake or negligence.
There are at least two categories of Irregularities:
- One-time irregularities: these are irregularities that only appears once or several times for one project partner and not regularly in expenditure of same type or the same type of partner or project. They are caused by intentional or unintentional mistakes and in generally isolated incidents. This form of irregularity tends to fall into the category of error. As for the forms of errors among others are:
– writing error (clerical error)
– Error of commission
– Compensating error
– Principle error
- Systemic irregularities: these are repeated errors due to serious failures in management and control system. These irregularities often occur and affect the operations in overall, for example, many projects with certain partners and many expenses from certain types of items. This form of the disorder is suspected of being fraudulent. The general forms of fraud among others are:
– Embezzlement of funds
– Misuse of company assets
– Fake invoice
Culture, company size, operational complexity, business changes have a significant influence on potential irregularities. For example, the transition of payment methods from manual to digital is very vulnerable to fraud and errors.
Although the forms of fraud and error are clearly different, yet it is not easy to detect and decide whether an irregularity falls into the category of error or fraud.
For example, a chain of home improvement retail consistently showed stronger gross margins, but its physical inventory is consistently shrinking. The problem still exists even though the retail has applied preventive and detection measures to find the suspected inventory thefts. Yet, then the problem was traced to clerks in the merchandising department who did not understand the vagaries of retail accounting. The clerks incorrectly entered the list prices into the accounting system which caused miscalculation. A case of suspected fraud turned out to be of an error one.
However, this example can also be simulated as a fraud. It is possible that the irregularity in the retail financial statements was initially stated as an error by the auditor. However, the company unexpectedly went bankrupt and it was found that the company’s cashiers were involved in the inventory theft. Then, the auditor was penalized and the case was declared as a fraud.
As the example illustrates, to distinguish between fraud and error is a daunting task, even for an experienced auditor. A thorough investigation is needed and it is a good first step to check the old accounting records in order to diagnose the irregularity that generally includes:
– Inadequate audit trail; transactions without proof, documents missing
– Transactions that are not recorded in full
– Inventory; cash and other physical assets do not exist
– Assets or liabilities that are not recorded or misstated in income or expenses
– Business and personal assets and transactions that should be separated