CHAPTER 3:

Ethics, Fraud, and

Internal Control

Presented by:
RICHARD VINCE DEPUNO and JOHN ARVIN MACALALAD
 OBJECTIVES FOR CHAPTER 3
 Broad issues pertaining to business ethics
 Ethical issues related to the use of information technology
 Distinguish between management fraud and employee fraud
 Common types of fraud schemes
 Key features of SAS 78 / COSO internal control framework
 Objects and application of physical controls
 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:
 employees
 management
 stakeholders
 Litigation
 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?
FOUR 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?
 Privacy
 Security—accuracy and confidentiality
 Ownership of property
 Equity in access
 Environmental issues
 Artificial intelligence
 Unemployment and displacement
 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
 The misrepresentation must have resulted in justifiable reliance
upon information, which caused someone to act
 The misrepresentation must have caused injury or loss
Figure 3-1 Fraud Triangle

Pressure Opportunit
y No Fraud

Pressure Opportunit
y

Ethics

Fraud
Ethics
 ENRON, WORLDCOM, ADELPHIA
UNDERLYING PROBLEMS
 Lack of Auditor Independence: auditing firms also engaged by their clients to
perform non-accounting 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 loans, 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
 Enron made elaborate use of special purpose entities.
 WorldCom transferred transmission line costs from current expense accounts
to capital accounts.
 SARBANES-OXLEY ACT OF 2002
Its principal reforms pertain to:
 Creation of the Public Company Accounting Oversight Board
(PCAOB)
 Auditor independence—more separation between a firm’s
attestation and non-auditing activities
 Corporate governance and responsibility—audit committee
members must be independent and the audit committee must
oversee the external auditors
 Disclosure requirements—increase issuer and management
disclosure
 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 more healthy and
prosperous than it actually is
 Involves misappropriation of assets, it frequently is
shrouded in a maze of complex business transactions
 FRAUD SCHEMES
Three categories of fraud schemes according to the
Association of Certified Fraud Examiners:
A. fraudulent statements
B. corruption
C. asset misappropriation
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
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
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
 MODIFYING ASSUMPTIONS TO THE
INTERNAL CONTROL OBJECTIVES
Management Responsibility
The establishment and maintenance of a system of internal control is
the responsibility of management.
Reasonable Assurance
The cost of achieving the objectives of internal control should not
outweigh its benefits.
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 WEAK INTERNAL
CONTROLS (RISK)
 Destruction of an asset
 Theft of an asset
 Corruption of information
 Disruption of the information system
THE INTERNAL CONTROLS
SHIELD
PREVENTIVE, DETECTIVE, AND
CORRECTIVE CONTROLS

Figure 3-3
 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
2. Risk assessment
3. Information and communication
4. Monitoring
5. Control activities
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
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
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
Auditors must obtain sufficient knowledge of the
IS to understand:
 the classes of transactions that are material
 how these transactions are initiated [input]
 the associated accounting records and accounts used in processing [input]
 the transaction processing steps involved from the initiation of a transaction
to its inclusion in the financial statements [process]
 the financial reporting process used to compile financial statements,
disclosures, and estimates [output]

[red shows relationship to the general AIS model]

 4: Monitoring
- The process for assessing the quality of internal control design
and operation
[This is feedback in the general AIS model.]
 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
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
 TWO TYPES OF IT
CONTROLS
 General controls—pertain to the entitywide computer
environment
 Examples: controls over the data center, organization databases,
systems development, and program maintenance
 Application controls—ensure the integrity of specific
systems
 Examples: controls over sales order processing, accounts
payable, and payroll applications
 SIX TYPES OF PHYSICAL
CONTROLS
 Transaction Authorization
 Segregation of Duties
 Supervision
 Accounting Records
 Access Control
 Independent Verification
Transaction Authorization
 used to ensure that employees are carrying out only
authorized transactions
 general (everyday procedures) or specific (non-
routine transactions) authorizations
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
Supervision
 a compensation for lack of segregation; some may
be built into computer systems

Accounting Records
 provide an audit trail
Access Controls
 help to safeguard assets by restricting physical access to them

Independent Verification
 reviewing batch totals or reconciling subsidiary accounts with
control accounts
 Nested Control Objectives for
Transactions
TRANSACTION

Control
Objective 1 Authorization Processing

Control
Objective 2 Authorization Custody Recording

Control General
Objective 3
Journals Ta 1 Subsidiary
Ledgers Ledger
 Physical Controls in IT Contexts

Transaction Authorization
 The rules are often embedded within computer programs.
 EDI/JIT: automated re-ordering of inventory without human intervention

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.
 Physical Controls in IT Contexts

Supervision
 The ability to assess competent employees becomes more
challenging due to the greater technical knowledge required.

Accounting Records
 ledger accounts and sometimes source documents are kept
magnetically
 no audit trail is readily apparent
 Physical Controls in IT Contexts
Access Control
 Data consolidation exposes the organization to computer fraud and excessive
losses from disaster.

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.