Chapter 3

Ethics, Fraud, and Internal

Control

Principles of Accounting Information

Systems, Asia Edition
James A. Hall

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Business Ethics

Business ethics involves finding the answers to

two questions:
 How do managers decide on what is right in
conducting their business?
 Once managers have recognized what is right,
how do they achieve it?

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 Four Main Areas of Business Ethics

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Computer Ethics
concerns the social impact of computer technology (hardware,
software, and telecommunications).

What are the main computer ethics issues?

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 Figure 3-1 Fraud Triangle
Pressure Opportunity
No Fraud

Pressure Opportunity

Ethics

Fraud
Ethics
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Legal Definition of Fraud

 False representation
 Material fact
 Intent to deceive
 Justifiable reliance
 Injury or loss

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 Underlying Problems

 Lack of Auditor Independence

 Lack of Director Independence
 Questionable Executive Compensation
Schemes
 Inappropriate Accounting Practices

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Employee Fraud

 Committed by non-management personnel

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 Management Fraud
 Perpetrated at levels of management above the
one to which internal control structure relates

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Fraud Schemes

Three categories of fraud schemes according to

the Association of Certified Fraud Examiners:
A. fraudulent statements
B. corruption
C. asset misappropriation

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 A. Fraudulent Statements

 Misstating the financial statements to make

the copy appear better than it is
 Usually occurs as management fraud
 May be tied to focus on short-term financial
measures for success
 May also be related to management bonus
packages being tied to financial statements

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B. Corruption
 Examples:
 bribery
 illegal gratuities
 conflicts of interest
 economic extortion

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 C. Asset Misappropriation

 Most common type of fraud and often occurs as

employee fraud
 Examples:
 making charges to expense accounts to cover theft of
asset (especially cash)
 lapping: using customer’s check from one account to
cover theft from a different account
 transaction fraud: deleting, altering, or adding false
transactions to steal assets

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Internal Control Objectives

According to AICPA SAS
1. Safeguard assets of the firm
2. Ensure accuracy and reliability of accounting
records and information
3. Promote efficiency of the firm’s operations
4. Measure compliance with management’s
prescribed policies and procedures

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 Modifying Assumptions to the
Internal Control Objectives
 Management Responsibility

 Reasonable Assurance

 Methods of Data Processing

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Limitations of Internal Controls

 Possibility of honest errors

 Circumvention via collusion
 Management override
 Changing conditions

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 Exposures of Weak Internal
Controls (Risk)
 Destruction of an asset
 Theft of an asset
 Corruption of information
 Disruption of the information system

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The Internal Controls Shield

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 Preventive, Detective, and Corrective
Controls

Figure 3-3

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Five Internal Control Components:

SAS 78 / COSO
1. Control environment
2. Risk assessment
3. Information and communication
4. Monitoring
5. Control activities

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 1: The Control Environment
 Integrity and ethics of management
 Organizational structure
 Role of the board of directors and the audit
committee
 Management’s policies and philosophy
 Delegation of responsibility and authority
 Performance evaluation measures
 External influences—regulatory agencies
 Policies and practices managing human
resources
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2: Risk Assessment
 Identify, analyze and manage risks relevant to
financial reporting:
 changes in external environment
 risky foreign markets
 significant and rapid growth that strain internal
controls
 new product lines
 restructuring, downsizing
 changes in accounting policies

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 3: Information and Communication
 The AIS should produce high quality information
which:
 identifies and records all valid transactions
 provides timely information in appropriate detail to
permit proper classification and financial reporting
 accurately measures the financial value of
transactions
 accurately records transactions in the time period in
which they occurred

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4: Monitoring
The process for assessing the quality of internal
control design and operation

 Separate procedures—test of controls by internal

auditors
 Ongoing monitoring:
 computer modules integrated into routine
operations
 management reports which highlight trends and
exceptions from normal performance

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 5: Control Activities
 Policies and procedures to ensure that the
appropriate actions are taken in response to
identified risks
 Fall into two distinct categories:
 IT controls—relate specifically to the computer
environment
 Physical controls—primarily pertain to human
activities

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Two Types of IT Controls

 General controls—pertain to the entitywide

computer environment
 Application controls—ensure the integrity of
specific systems

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 Six Types of Physical Controls

 Transaction Authorization
 Segregation of Duties
 Supervision
 Accounting Records
 Access Control
 Independent Verification

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Physical Controls
Transaction Authorization
 used to ensure that employees are carrying
out only authorized transactions
 general (everyday procedures) or specific
(non-routine transactions) authorizations

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 Physical Controls
Segregation of Duties
 In manual systems, separation between:
 authorizing and processing a transaction
 custody and recordkeeping of the asset
 subtasks
 In computerized systems, separation between:
 program coding
 program processing
 program maintenance

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Physical Controls
Supervision
 a compensation for lack of segregation; some
may be built into computer systems
Accounting Records
 provide an audit trail

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 Physical Controls

Access Controls
 help to safeguard assets by restricting
physical access to them
Independent Verification
 reviewing batch totals or reconciling
subsidiary accounts with control accounts

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