C3 Ethics, Fraud, and Internal Control

CHAPTER 3: ETHICS, FRAUD, AND INTERNAL CONTROL
BUSINESS ETHICS:
- Why should we be concerned about ethics in the business world?
- Ethics are needed when conflicts arise – the need to choose
- In business, conflicts may arise between:
1. Employees
2. Management
3. Stakeholders
- Litigation
- Involves finding the answers to two questions:
1. How do managers decide on what is right in conducting their business?
2. Once managers have recognized what is right, how do they achieve it?
MAIN AREAS OF BUSINESS ETHICS

COMPUTER ETHICS
- Concerns the social impact of computer technology (hardware, software, and
telecommunications)
- What are the main computer ethics issues?
1. Privacy
2. Security – accuracy and confidentiality
3. Ownership of Property
4. Equity in Access
5. Environmental Issues
6. Artificial Intelligence
7. Unemployment and Displacement
8. Misuse of Computer
LEGAL DEFINITION OF FRAUD

 False Representation: false statement or disclosure
 Material Fact: a fact must be substantial in inducing someone to act
 Intent to Deceive: must exist
 Misrepresentation must have resulted in justifiable reliance upon information,
which caused someone to act
 The misrepresentation must have caused injury or loss
FRAUD TRIANGLE
ILLUSTRATION: 2008 ACFE STUDY OF FRAUD
 Loss due to fraud equal to 7% of revenues – approximately $994 billion
 Loss by position with the company
POSITION % OF FRAUD LOSS $

Owner / Executive 23% 834,000
Manager 37% 150,000
Employee 40% 70,000
 Other results: higher losses due to men, employees acting in collusion, and
employees with advanced degrees
ILLUSTRATION: Enron, WorldCom, Adelphia’s Underlying Problems

 Lack of Auditor Independence: auditing firms also engaged by their clients to
perform nonaccounting activities
 Lack of Director Independence: directors who also serve on the boards of other
companies, have a business trading relationship, have a financial relationship as
stockholders or have received personal loads, or have an operational relationship
as employees
 Questionable Executive Compensation Schemes: short-term stock options as
compensation result in short-term strategies aimed at driving up stock prices at the
expense of the firm’s long-term health
 Inappropriate Accounting Practices: a characteristic common to many financial
statement fraud schemes
o Enron made elaborate the use of special purpose entities
o WorldCom transferred transmission line costs from current expense
accounts to capital accounts
SARBANES – OXLEY ACT OF 2002
- Its principal reforms pertain to:
1. Creation of the Public Company Accounting Oversight Board (PCAOB)
2. Auditor independence: more separation between a firm’s attestation and
non – auditing activities
3. Corporate governance and responsibility: audit committee members must
be independent and the audit committee must oversee the external auditors
4. Disclosure requirements: increase issuer and management disclosure
5. New federal crimes for the destruction of or tampering with documents,
securities, fraud, and actions against whistleblowers
EMPLOYEE FRAUD
- Committed by non-management personnel
- Usually consists of: an employee taking cash or other assets for personal gain by
circumventing a company’s system of internal controls
MANAGEMENT FRAUD
- Perpetrated at levels of management above the one to which internal control
structure relates
- Frequently involves using financial statements to create an illusion that an entity is
healthier and more prosperous than it actually is
- Involves misappropriation of assets, it frequently is shrouded in a maze of complex
business transactions
CATEGORIES OF FRAUD SCHEMES (Association of Certified Fraud Examiners)

A. Fraud 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
B. Corruption
- Examples:
 Bribery
 Illegal gratuities
 Conflicts of interest
 Economic extortion
- Foreign Corrupt Practice Act of 1977:
 Indicative of corruption in business world
 Impacted accounting by requiring accurate records and internal
controls
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
INTERNAL CONTROL OBJECTIVES (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
MODIFYING ASSUMPTIONS TO THE INTERNAL CONTROL OBJECTIVES
1) Management Responsibility
- The establishment and maintenance of a system of internal control is the
responsibility of management.
2) Reasonable Assurance
- The cost of achieving the objectives of internal control should not outweigh
its benefits.
3) Methods of Data Processing

- The techniques of achieving the objectives will vary with different types of
technology.
LIMITATIONS OF INTERNAL CONTROLS
 Possibility of honest errors

 Circumvention via collusion
 Management override
 Changing conditions--especially in companies with high growth
EXPOSURES OF WEAEK INTERNAL CONTROLS (RISK)

 Destruction of an asset
 Theft of an asset
 Corruption of information
 Disruption of the information system
INTERNAL CONTROLS SHIELD
PREVENTIVE, DETECTIVE, AND CORRECTIVE CONTROLS

SAS 78 / COSO
- Describes the relationship between the firm’s:
 Internal control structure
 auditor’s assessment of risk, and
 the planning of audit procedures
- How do these three interrelate?
 The weaker the internal control structure, the higher the assessed level of
risk; the higher the risk, the more auditor procedures applied in the audit.
FIVE INTERNAL CONTROL COMPONENTS (SAS 78 / COSO)

1) 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
2) Risk assessment
- Identify, analyze and manage risks relevant to financial reporting:
1. changes in external environment
2. risky foreign markets
3. significant and rapid growth that strain internal controls
4. new product lines
5. restructuring, downsizing
6. changes in accounting policies
3) Information and communication
- The AIS should produce high quality information which:
1. identifies and records all valid transactions
2. provides timely information in appropriate detail to permit proper
classification and financial reporting
3. accurately measures the financial value of transactions
4. accurately records transactions in the time period in which they
occurred
- Auditors must obtain sufficient knowledge of the IS to understand: [red
shows relationship to the general AIS model]
1. the classes of transactions that are material
 how these transactions are initiated [input]
 the associated accounting records and accounts used in
processing [input]
2. the transaction processing steps involved from the initiation of a
transaction to its inclusion in the financial statements [process]
3. the financial reporting process used to compile financial
statements, disclosures, and estimates [output]
4) Monitoring
- The process for assessing the quality of internal control design and
operation [This is feedback in the general AIS model.]
1. Separate procedures: test of controls by internal auditors
2. Ongoing monitoring:
 computer modules integrated into routine operations
 management reports which highlight trends and exceptions
from normal performance
5) Control activities
- Policies and procedures to ensure that the appropriate actions are taken in
response to identified risks
- Fall into two distinct categories:
1. IT controls: relate specifically to the computer environment
2. Physical controls: primarily pertain to human activities
TWO TYPES OF IT CONTROLS

1) General controls
- pertain to the entity wide computer environment
- Examples: controls over the data center, organization databases, systems
development, and program maintenance
2) Application controls
- ensure the integrity of specific systems
- Examples: controls over sales order processing, accounts payable, and
payroll applications
SIX TYPES OF PHYSICAL CONTROLS

1) Transaction Authorization
- used to ensure that employees are carrying out only authorized transactions
- general (everyday procedures) or specific (non-routine transactions)
authorizations
2) Segregation of Duties
- In manual systems, separation between:
o authorizing and processing a transaction
o custody and recordkeeping of the asset
o subtasks
- In computerized systems, separation between:
o program coding
o program processing
o program maintenance
3) Supervision
- a compensation for lack of segregation; some may be built into computer
systems
4) Accounting Records
- provide an audit trail
5) Access Control
- help to safeguard assets by restricting physical access to them
6) Independent Verification
- reviewing batch totals or reconciling subsidiary accounts with control
accounts
NESTED CONTROL OBJECTIVES FOR TRANSACTIONS

PHYSICAL CONTROLS IN IT CONTEXTS
1) Transaction Authorization
- The rules are often embedded within computer programs
 EDI/JIT: automated re-ordering of inventory without human
intervention
2) Segregation of Duties
- A computer program may perform many tasks that are deemed
incompatible.
- Thus the crucial need to separate program development, program
operations, and program maintenance.
3) Supervision
- The ability to assess competent employees becomes more challenging due
to the greater technical knowledge required.
4) Accounting Records
- ledger accounts and sometimes source documents are kept magnetically
 no audit trail is readily apparent
5) Access Control
- Data consolidation exposes the organization to computer fraud and
excessive losses from disaster
6) Independent Verification
- When tasks are performed by the computer rather than manually, the need
for an independent check is not necessary.
- However, the programs themselves are checked.

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CHAPTER 3: ETHICS, FRAUD, AND INTERNAL CONTROL

MAIN AREAS OF BUSINESS ETHICS

LEGAL DEFINITION OF FRAUD

POSITION % OF FRAUD LOSS $

ILLUSTRATION: Enron, WorldCom, Adelphia’s Underlying Problems

CATEGORIES OF FRAUD SCHEMES (Association of Certified Fraud Examiners)

INTERNAL CONTROL OBJECTIVES (AICPA SAS)

1) Safeguard assets of the firm

3) Methods of Data Processing

LIMITATIONS OF INTERNAL CONTROLS

 Possibility of honest errors

EXPOSURES OF WEAEK INTERNAL CONTROLS (RISK)

PREVENTIVE, DETECTIVE, AND CORRECTIVE CONTROLS

FIVE INTERNAL CONTROL COMPONENTS (SAS 78 / COSO)

TWO TYPES OF IT CONTROLS

SIX TYPES OF PHYSICAL CONTROLS

NESTED CONTROL OBJECTIVES FOR TRANSACTIONS

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