Chapter 3

Ethics, Fraud, and Internal Control

Accounting Information Systems, 6th edition

James A. Hall

COPYRIGHT © 2009 South-Western, a division of Cengage Learning. Cengage Learning and South-Western
are trademarks used herein under license
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
Factors that Contribute to
Fraud
2004 ACFE Study of Fraud
Loss due to fraud equal to 6% of revenues—
approximately $660 billion
Loss by position within the company:

Other results: higher losses due to men,

employees acting in collusion, and employees
with advance degrees
Enron, WorldCom, Adelphia
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 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
 Computer Fraud Schemes
Theft, misuse, or misappropriation of assets by
altering computer-readable records and files
Theft, misuse, or misappropriation of assets by
altering logic of computer software
Theft or illegal use of computer-readable
information
Theft, corruption, illegal copying or intentional
destruction of software
Theft, misuse, or misappropriation of computer
hardware
 Using the general IS model, explain how fraud can
occur at the different stages of information processing?
Data Collection Fraud
This aspect of the system is the most vulnerable
because it is relatively easy to change data as it is being
entered into the system.
Also, the GIGO (garbage in, garbage out) principle
reminds us that if the input data is inaccurate,
processing will result in inaccurate output.
Data Processing Fraud
Program Frauds
altering programs to allow illegal access to and/or
manipulation of data files
destroying programs with a virus
Operations Frauds
misuse of company computer resources, such as
using the computer for personal business
Database Management Fraud
Altering, deleting, corrupting, destroying, or stealing
an organization’s data
Oftentimes conducted by disgruntled or ex-employee
Information Generation Fraud
Stealing, misdirecting, or misusing computer output
Scavenging
searching through the trash cans on the computer
center for discarded output (the output should be
shredded, but frequently is not)
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
 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
Information and Communication
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

[red shows relationship to the general AIS model]

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
Physical Controls
Transaction Authorization
used to ensure that employees are carrying out only
authorized transactions
general (everyday procedures) or specific (non-
routine transactions) authorizations
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
Physical Controls
Supervision
a compensation for lack of segregation; some may
be built into computer systems
Accounting Records
provide an audit trail
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
 Nested Control Objectives for
Transactions

Control Authorization Processing

Objective 1

Control Authorization Custody Recording

Objective 2

Custody Recording

Control Authorization Task 1 Task 2 Task 1 Task 2

Objective 3
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
Physical Controls in IT Contexts
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.
Physical Controls in IT Contexts
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.
Physical Controls in IT Contexts
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.