CHAPTER 3

Understanding the Basics of Financial Accounting

Where It All Begins

Clearly we have seen in the previous chapter that despite its increased exposure, better corporate governance, and general increased awareness, financial fraud is not going away. While financial fraud includes the increasing problem of identity theft and other nontraditional crimes, our focus here remains on the use of accounting systems and circumventing controls to achieve financial gain.

No forensic investigation can be undertaken without some knowledge of accounting principles. So much of the media coverage of the recent events involving Enron, WorldCom, Computer Associates, AIG, Tyco, Adelphia, Madoff, and others has focused on manipulation of financial results. The financial crimes perpetrated on smaller companies, as evidenced by the ACFE survey, included fraudulent disbursements, where funds are disbursed through false invoices or forging company checks; skimming, where cash or other payments are stolen before they ever get recorded; and cash larceny, where cash or other payments are stolen after they are recorded. Even if you are not examining a company's books and records yourself, you may well be talking to the people who are, and need to know how an accounting system works in order to understand their language. The purpose of this chapter is to introduce you to some fundamental concepts that will show you how money moves through an organization and how financial transactions should be recorded. It is important to note while we refer to “businesses,” much of the discussion applies similarly to nonprofit organizations, governmental bodies, and other entities.

Accounting is a method of tracking business activities in a particular time period (whether a week, a month, or a year). Such tracking is needed internally for owners and decision makers to have timely information on the performance of their business. Although most savvy business owners and executives may have day-to-day control over their business, as organizations grow larger and their business becomes more complex, the need for more detailed information increases. However, as recent events have shown, people on the outside of a business also need financial information. Their need for information results from the relationship they have with the particular organization. An investor will want to know about results and the company's financial stability. Similarly, a creditor will want to know whether the outstanding debt is likely to be paid, and a potential investor or vendor will need information on the company before moving forward into a financial relationship.

As we will see throughout this book, many corporate frauds are described as crimes committed within the accounting system of the organization. The accounting system comprises the methods by which companies record transactions and financial activities. It tracks the business activity of an entity and usually is categorized as recording data (i.e., the initial entry into the company's records), classifying information into related items, and then summarizing the data for the end user to readily understand.

It is important to have a basic understanding of bookkeeping and accounting, forming a level of expectation to be used when requesting and reviewing the financial activity of an entity. There are two primary bases of accounting: accrual basis and cash basis. While most major companies and organizations use and report on the accrual basis, it is not uncommon for smaller businesses to maintain their books on the cash basis. At year-end, cash basis businesses may or may not convert their records to the accrual basis for reporting purposes. At its basic level, cash basis accounting is the receipt of funds into an entity, and the payment for goods or services—deposits and checks. Revenue is recorded when it is received (deposited), and expenses are recorded when they are paid (check, wire, electronic payment, credit card, etc.). The cash basis, while common for running businesses, generally is not widely used for financial statement reporting purposes.

Conversely, under the accrual basis of accounting, revenue is recognized (recorded) when it is earned (not necessarily when it is collected), and expenses are recorded when they are incurred (not necessarily when they are paid). The accrual basis includes two major areas: accounts receivable (customer sales on account) and accounts payable (vendor purchases on account). The accrual basis conforms to generally accepted accounting principles (otherwise known as “GAAP”), and is the most common basis for all three levels of reporting on financial statements issued (audits, reviews, and compilations).

Although internal fraud historically has centered on manipulation of accounting entries, recent events have been focused more directly on financial statements and the manipulation of the underlying data. From an early age, accountants are taught that the financial statements are a “snapshot,” one point in time to capture the profitability (or unprofitability) and financial position of an entity. While much coverage of financial fraud centers around “audits” and the role of auditors, it should be noted that there are actually three levels of reporting on financial statements: compilations, reviews, and audits. While the standards, level of assurance, and cost of each vary dramatically—with compilations providing the lowest level of assurance at the lowest cost, and audits providing the highest level of assurance with the greatest cost—the risk of financial statement fraud can occur at any of the three levels. In compilation engagements, outside accountants simply format and report management's results and balances consistent with GAAP. Compilations entail no other services, procedures, or analytics—they are simply financial reporting. With reviewed financial statements, the mid-level service, accountants provide the same reporting as for compilations, but also perform inquiry and analytical review procedures over the information. As with compilations, though, no opinion is expressed on the financial statements. The final and highest level of assurance is the audit. Audited financial statements are reported in accordance with GAAP, as with compilations and reviews, but detailed audit procedures are performed not only on the financial results and balances, but also on the internal controls of the organization being audited. In certain cases, additional procedures are performed to ensure compliance with laws and/or program requirements. Auditors express an opinion on the financial statements, typically an unqualified or “clean” opinion. It is important to note that with all three levels, the outside accountant or auditor does not state that the financial statements are accurate, but rather reports that the financial statements are reasonable and free of material misstatement.

The balance sheet should convey the financial position of the business at one point in time (e.g., at the company's year-end), listing the company's assets and liabilities, together with the company's equity. The concept of the balance sheet comprises what is known as the accounting equation—the fact that assets always equal liabilities plus equity. The father of double-entry bookkeeping, Luca Pacioli, who developed the accounting process in the late fifteenth century, believed that one should not sleep until the debits equaled the credits. The facts alone from Chapter 2 clearly should cause us to lose sleep over the propriety of what is underlying those debits and credits!

Beyond the balance sheet, the core financial statements include the income statement, statement of cash flows, and footnotes. The income statement reports the entity's revenues and expenses for the reporting period. While the level of detail will vary, every income statement must include certain elements, such as gross sales, cost of sales (or cost of goods sold, if either is applicable), gross margin or gross profit, operating costs, and net income or loss (total revenue less total expenses). The income statement identifies whether the entity was profitable for the period.

The statement of cash flows identifies all the sources and uses of funds during the reporting period. Many forensic accountants and fraud examiners contend the entity's cash flows are the best indicator of both the health of the reporting entity as well as the potential for fraudulent activity. The cash activity is broken down into three primary areas: operations, financing, and investments.

Footnotes to the financial statements describe aspects of the reporting entity, such as the nature of the business and related parties, and are required for the financial statements to be in conformity with GAAP. Compilation-level financial statements can omit the footnotes, but the omission must be reported in the compilation report. There are many specific accounting pronouncements, standards, and rules dictating the required footnotes as well as the content of disclosure. Someone investigating an entity would learn a significant amount about the entity by reviewing the footnotes in addition to analyzing the three primary financial statements. Unfortunately, this is often overlooked by analysis and investigators.

The Five Accounting Cycles

To understand how fraud occurs within businesses, it is important to understand how the cycles work within an accounting system. Specifically, the cycles are defined as:

Sales and Accounts Receivable

The fundamental concept of any business involves getting business (sales) from customers, billing for those goods or services, and then making sure the accounts receivable are collected. In terms of the accounting equation and accounting cycle, the revenue from sales appears on a company's income statement, and the respective accounts receivable appears on the balance sheet. Cash sales and collections on accounts receivables directly affect the cash balance, which is a balance sheet item.

Within this part of the cycle are steps that a business must undertake to minimize its financial risk. These steps include approval of new customers and credit limits before entering into new business relationships; having a system for receiving and recording orders from customers and then invoicing them; and then collecting the amounts owed from customers, along with the appropriate system for making adjustments to customers’ accounts for returns, write-offs, and so on.

Fundamental within this accounting cycle are the safeguards put in place by a company—the internal controls to minimize the opportunity for theft or misappropriation. While no different from other aspects of the accounting cycle, it is relevant to note them here. At the same time, the concept behind these controls is similar for all cycles. Specifically:

• Separation of duties. This is a fundamental concept of accounting and one through which companies can prevent many fraud schemes by properly segregating the functions of custody, authorization, and recordkeeping. For the sales and accounts receivable cycle, this would apply to separating the credit function and sales function (thereby minimizing the chances of granting credit to an unsuitable potential customer in order to force a sale). Similarly, sales recording and receipt of payments also should be separated, as should recording adjustments and credit memos.
• Physical safeguards of assets. On the most basic level, this should involve restriction of access to computers by access rights assigned to individual users with specific passwords, physical locks, and the use of a bank's lock box for customer payments. Instead of payments coming directly to the organization where cash and payment processing would be completed by company employees, all payments would go directly to the bank for processing. The organization would receive batches of copies of payments received, along with quicker access to their funds.
• Audit trail (i.e., adequate and proper documentation of transactions). As with other cycles, the need for adequate documentation in an accounting system is fundamental. At a minimum, this should include prenumbered documents for sales orders, shipping documents, sales invoices, credit memos, and remittance advices (or a computer system that assigns numbers as printed, but with sufficient controls over access limited by specific passwords for users).
• Approval process. This process extends to credit approval, write-off approval, and the shipment of products. One employee who processes these types of transactions should have to seek a separate employee, perhaps a supervisor, to approve the transactions.
• Independent checks on the system (whether by an internal function or an outside source). While many companies have an internal audit function, others do not consider themselves large enough for such a system. In both cases, the organization needs to have some kind of independent monitoring. This should, at a minimum, include independent preparation of bank and other account reconciliations, supervision, and perhaps the use of an outside accountant as an additional monitor.

Purchases and Accounts Payable

In order to manufacture and/or supply goods and services, a business obviously must procure and pay for the goods and services that underlie its sales. In terms of the accounting equation and accounting cycle, the expenses appear on a company's income statement, and the respective accounts payable appear on the balance sheet. Similar to cash sales, cash purchases and payments of accounts payable directly affect the cash balance, which is a balance sheet item.

The steps and controls for safeguarding a company's assets within purchasing and accounts payable are similar to those within the sales and accounts receivable cycle. These steps include approving new vendors and ensuring they actually exist and are legitimate businesses; proper processing of purchase orders; proper handling of the receipt and recording of goods and services; recording of liabilities; and processing invoices for payment.

This is one of the accounting cycles that is susceptible to breakdowns in controls, for it involves the flow of funds out from an entity. The safeguarding of a company's assets thus proves just as important, if not more so, in this cycle.

In terms of the accounts that companies typically have in their “chart of accounts” (i.e., the roadmap through their financial statements), this cycle can affect many different balance sheet and income statement accounts. Specifically, depending on what is purchased, the purchases and accounts payable cycle can affect balance sheet accounts, including cash, inventory, and prepaid expenses (collectively “current assets”); equipment, land, buildings, and accumulated depreciation (“fixed assets”); accounts payable and accrued expenses (“current liabilities”); as well as other assets and liabilities.

Similarly, in the income statement, just about every account is affected by this cycle, from cost of sales or cost of goods sold (which typically, when deducted from sales, results in a company's gross profit or gross margin) to all of the entity's expenses, such as administration, travel, advertising, professional fees, and taxes, among many others.

Within the same guidelines as for the sales and accounts receivable cycle, fundamental controls are essential, especially over the reconciliation of accounts, including the entity's bank accounts. Without regular (typically monthly) monitoring and timely independent reconciliations of the company's bank accounts, the true financial position cannot be known. Similarly, the propriety of transactions and completeness of information cannot be known. At its simplest level, the person who generates checks, the person who signs checks, the person who mails checks, and the person who reconciles the bank account (or accounts) cannot be one and the same. This is a fundamental principle of accounting, which, while it may not exactly date back to Luca Pacioli, still harks back to Pacioli's quote. Once again: “He who does business without knowing all about it, sees his money go like flies.” Thus segregation of duties is critical within this financial cycle.

Along with the reconciliation process, the concepts of budgeting, tendering (bidding process), and vendor knowledge are also very important. These processes also include segregation of duties, proper approvals, and audit trail through proper documentation. Similar to the other accounting cycles, proper documentation includes prenumbered purchase requisitions, purchase orders, receiving reports, and checks. With the advent of sophisticated computer software, many systems now print this information as documents are generated. This therefore puts the onus on a business to safeguard entry to the accounting system and to be in a position to identify who accesses the system and when. Limiting access at key points specific to each individual user makes it more difficult for one person to compromise the system without collusion.

At the entry level of this cycle, acceptance of a new vendor, system controls must include background checks on the vendor in order to ensure that the business exists and is legitimate. Establishing and monitoring credit limits is another fundamental control in the safeguarding of the company's assets. Companies also should have bid and procurement policies to ensure competitive bidding and to minimize the opportunity for purchasing managers to compromise their position.

Another developing area of concern is electronic payments. All too often the internal controls within a company limit who can sign physical checks, but when it comes to the electronic disbursing of funds, the authority frequently and at times unknowingly is delegated to nonauthorized signers. Funds can be paid from corporate accounts via wire transfers, online transfers, automated clearinghouse (ACH) transactions, electronic fund transfers (ETF), and automatic debits (vendor automatically withdraws funds from the account). It is critical that every organization's internal controls address the areas of electronic disbursements, to ensure only authorized individuals have the ability to disburse funds by any means.

Human Resources and Payroll

By definition, this aspect of the cycle includes recruitment, retention, and remuneration of employees, and the related underlying data of time records, expense reports, and other matters.

From an accounting cycle perspective, there are many accounts primarily affected by these functions, specifically, cash and payroll taxes payable on the balance sheet, and salaries/payroll, payroll taxes, benefits, travel and entertainment, and other related expenses on the income statement.

The safeguards for this cycle are necessary for the prevention of nonexistent (also known as “ghost”) employees, falsified hours and overtime, false expense reports, and false medical claims. It is critical that there is segregation between the individuals who manage human resources, such as adding, changing, and terminating employees within the payroll system, and the individuals who process payroll (enter time information, calculate earnings and taxes, generate the paychecks, etc.). In any system of controls where the same individuals perform both functions, there is the high risk that fraud can occur through payroll and go undetected.

Again, the underlying fundamental concepts are similar to those for all other accounting cycles, with the need for proper documentation (i.e., timecards, timesheets, timely entry into a computerized timekeeping system, etc.); proper approval (related to hiring, firing, overtime, travel, etc.), and separation of duties. In terms of segregation, this would include separating the functions of entering and maintaining employee demographics, inputting salary and hourly pay information, reviewing and approving each payroll prior to processing, processing the payroll, distributing paychecks, and approving the payroll and related payroll tax expenses.

Inventory and Storage/Warehousing

This cycle encompasses the purchasing function as it relates to the company's inventory, but it also includes the warehousing of products for both manufacture and resale. Physical control is therefore as important as the other system controls within the other accounting cycles.

The processes for this cycle, from an accounting standpoint, include processing requisitions for purchases, receipt of raw materials and finished goods, storage of raw materials and finished goods, and shipment of goods to customers.

From an accounting cycle perspective, this function mainly affects inventory on the balance sheet and cost of goods sold in the income statement. Important in this process is the maintenance of an audit trail—specifically, key reports and information, such as receiving reports; maintaining perpetual inventory records; and control over requisitions and shipping documents.

Proper segregation of duties is also essential to this accounting cycle. For example, separation of receiving, warehouse custody, and purchase authorization will help prevent an unauthorized purchase from being physically received (and diverted) without being received into the system. In addition, those with custody over the warehouse should not conduct, or be the lead in conducting, the physical count of inventory. It also goes without saying that physical security is critical for this particular cycle.

Capital Expenditures

This accounting cycle is also known as the capital acquisition and repayment cycle, or the financing cycle. It includes the borrowing of funds, the debt of a company, and so on. Several transactions surround this part of the cycle, specifically recording of capital purchases and the related financing (including debt and interest); payment of interest and dividends; and any equity financing.

From an accounting cycle perspective, this function commonly affects cash, fixed assets, long-term and short-term liabilities (such as mortgages and lines of credit), capital and retained earnings on the balance sheet, and interest expense paid on the debt on the income statement.

An audit trail once again will assist in the safeguarding of the company's assets through, for example, control over bank deposits and authorizations for loans. An entity must ensure the existence and maintenance of proper documentation of any capital purchases, loans, journal entries, stock certificates, and related information. In addition, duties should be segregated, such as stock issuance and handling of cash, as well as separating accounting from handling of cash.

Journals: Subsidiary and General

As previously discussed, the activities, and hence the transactions, of a business that underlie the entity's financial statements all fall within the accounting cycles. The term “month-end closing,” which signifies an organization's closing of its books at the end of a particular period, relates to the recording of transactions and reconciliations of various accounts and balances, to ensure everything was completely, accurately and timely recorded. Properly designed and functioning month-end procedures help ensure the propriety of the underlying data. Depending on the size and complexity of the organization, the cycle does not have to wait until month-end, and can be completed daily, weekly, monthly, quarterly, or annually. It goes without saying an organization that records, reviews, and reconciles on a more regular basis (e.g., monthly) will likely have fewer differences and also less fraud than an organization that performs these functions on a less frequent basis (e.g., annually).

So what is a journal? Typically, a journal is described as a chronological listing of individual transactions of the business activities. It also has been defined as an accounting book of original entry where transactions are initially recorded.1 The journal essentially shows each transaction and the corresponding debit and credit entries, and identifies which accounts they affect within the chart of accounts.

For example, sales to individual customers commonly are made in the form of sales invoices. Invoices generally are recorded within the sales journal, and payments received from customers for those sales are recorded on the cash receipts journal. Likewise, purchases would be reflected on the purchase journal, and cash disbursements would be found on the disbursements journal. Depending on the size and sophistication of the organization as well as the accounting system being utilized, individual journals may or may not exist. The important thing is that the individual, line-by-line transactions within each accounting area can be identified based on the type or nature of the transaction (e.g., sale, receipt, purchase, etc.).

These individual transactions, the underlying debit and credit entries, form the basis from which amounts are transferred to their respective journals, and ultimately into their respective accounts on the general ledger. The general ledger accumulates all the transactions and balances of all the journals. The activity may transfer automatically to the general ledger, or it may have to be manually posted to the general ledger. Further, the activity may come into the general ledger in line-item detail, or it may be posted in batch summary form, requiring the detailed records of each subsidiary (or supporting) journal to identify the individual transactions. For example, the sales and cash receipts activity likely occurs within accounts receivable. The activity for the month, sales and receipts, post to the corresponding accounts receivable account on the balance sheet, and sales and related accounts on the income statement.

Hence, the controls and audit trail, which we discussed within the various aspects of the accounting cycles, are critical to the ability to trace individual transactions and the documents that support them.

Entries also can be made directly to the general ledger, adjusting balances or recording activity common during month-end processing. Many financial statement frauds have been perpetrated and/or concealed through the use of general journal entries, necessitating the AICPA to specifically include within the auditor's standard for assessing the risk of fraud the requirement to review all general journal entries posted by the entity.

All the transactions of all the ledgers and journals flow into the general ledger for the entity. The general ledger report identifies the beginning balance for each account at the start of the reporting period, as well as the ending balance within each account. The detailed general ledger report shows all the activity (transactions) for the reporting period. A summary of the reported balances per the general ledger report is contained within the trial balance report. Once adjusted, the final balances per the general ledger (and consequently the trial balance) reports are formatted into the financial statements (balance sheet and income statement) for the organization.

This process is important for financial investigators. To trace the balances and activity as reported on an organization's financial statements, you will need to request the underlying trial balance reports, general ledgers, and all subsidiary or supporting ledgers and journals (sales, receipts, etc.) to enable a drill-down in reverse from the reported results and balances to the underlying supporting detail (individual transactions).

Conclusion

At the beginning of this chapter, we spoke of how Luca Pacioli believed that a person should not go to sleep at night until the debits equaled the credits. In most banks and retail establishments, tellers and cashiers cannot end their shift and go home until their drawer has been counted and balanced. At the end of a designated accounting period (e.g., at the end of each month), an entity will prepare a trial balance—a listing of all account balances in the general ledger. The ending balance per each subsidiary ledger or journal also must agree to its control account on the general ledger. For example, a listing is prepared of all accounts receivable balances from the subsidiary ledger, which should then be agreed or reconciled to the accounts receivable balance on the general ledger.

The simplified explanation of the accounting cycles and the journal system illustrates how relatively simple Pacioli's double-entry system of bookkeeping vision was. However, the complexity of the human mind and the deviation from accepted behavior require businesses to drill down beneath the surface of simple bookkeeping and maintain control over every transaction and the manner in which transactions are recorded.

Without controls and checks and balances, the system will be undermined, and the integrity of all the data will also be compromised.

Armed with a basic knowledge of accounting and recordkeeping performed by most organizations, we next have to look at the form of each entity. While much of the accounting activity will be common to every form of entity, nuances and differences do exist and are worth noting, which will be the next topic of discussion in Chapter 4.

Suggested Readings

CPA's Handbook of Fraud and Commercial Crime Prevention. Durham, NC: American Institute of Certified Public Accountants, 2000.

Jackson, P. Luca Pacioli: Unsung Hero of the Renaissance. Cincinnati: OH: South-Western Publishing, 1990.

Macve, R. H. “Pacioli's Legacy.” In New Works in Accounting History, edited by T. A. Lee, A. Bishop, and R. H. Parker. New York and London: Garland Publishing, 1996.

Pacioli, L. Summa de Arithmetica. Toscalano: Paganino de Paganini, 1523.

Taylor, R. E. No Royal Road: Luca Pacioli and His Times. Chapel Hill: University of North Carolina Press, 1942.

Note

1. InvestorWords.com.