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:
– employees
– management
– stakeholders
Litigation
Four Main Areas of Business Ethics
Behavioral Stage Theory of Moral
Development
 Computer Ethics…
concerns the social impact of computer technology (hardware,
software, and telecommunications).
What are the main computer ethics issues?
 Privacy
 Security and accuracy
 Ownership of property
 Environmental issues
 Equity in access
 Artificial intelligence
 Unemployment and displacement
 Computer misuse
 Internal control integrity
 What is Fraud?
Five Conditions 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
 2002 CFE Study of Fraud
Loss due to fraud equal to 6% of revenues—
approximately $600 billion
Loss by position within the company:

Other results: higher losses due to men,

employees acting alone, employees with
advance degrees
 Enron, WorldCom, Adelphia
The Underlying Problems
Lack of Auditor Independence: auditing firms also engaged by their
clients to perform nonaccounting activities such as actuarial
services, internal audit outsourcing services, and consulting
Lack of Director Independence: directors who have a personal
relationship by serving on the boards of other companies, have a
business trading relationship as key customers or suppliers, have a
financial relationship as primary stockholders or have received
personal loans, or have an operational relationship as employees
Questionable Executive Compensation Schemes: short-term stock
options as compensation scheme 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 to hide
liabilities through off-balance-sheet accounting.
– WorldCom transferred transmission line costs from current
expense accounts to capital accounts, allowing them to defer
some operating expenses and report higher earnings.
 Sarbanes-Oxley Act
Signed into law July 2002
Its principal reforms pertain to:
– The 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, including off-the-balance
items
– New federal crimes for the destruction of or
tampering with documents, securities fraud, and
actions against whistleblowers
 Why Fraud Occurs

Fire needs...

Oxygen Fuel

Spark
 Sumber : James hall

Why Fraud Occurs

Available Situational
Opportunities Pressures
poor internal an employee is
controls experiencing
financial difficulties

Personal Characteristics
personal morals of individual employees
 Fraud Triangles Sumber: romney

Opportunity
Commit Attitude
Rationalization
Opportunity

Justification
Convert
Conceal Lack
Of
Pressure Personal

Financial Financial

Employee
Financial
Lifestyle Emotional Industry Statement
Condition Mgt
Characteristic
 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
It is perpetrated at levels of management above
the one to which internal control structure
relates.
It frequently involves using the financial
statements to create an illusion that an entity is
more healthy and prosperous than it actually is.
If it 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 extent 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
Theft, misuse, or misappropriation of assets by
altering computer data
Theft, misuse, or misappropriation of assets by
altering software programming
Theft or illegal use of computer
data/information
Theft, corruption, illegal copying or destruction
of software or hardware
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 phase of the system is most vulnerable

because it is very easy to change data as it is
being entered into the system.
Also, GIGO (garbage in, garbage out)
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 SAS No. 78
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
 Auditing Standards
Auditors are guided by GAAS (Generally Accepted
Auditing Standards)
3 classes of standards
– general qualification standards
– field work standards
– reporting standards
For specific guidance, auditors use the AICPA’s
SASs (Statements on Auditing Standards)
 SAS No. 78
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. AIS is particularly concerned
with the internal control structure.
 Five Internal Control
Components: SAS No. 78

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, and
– 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 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
– performance reviews--results vs. forecasts
– information processing
general controls
applications controls
– segregation of duties
– physical controls
 Segregation of Duties
In manual system, separation between:
– authorizing and processing a transaction
– custody and recordkeeping of the asset
– subtasks
In computerized system, segregation
should exist between:
– program coding
– program processing
– program maintenance
 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
Authorization
used to ensure that employees are carrying
out only authorized transactions
general (everyday procedures) or specific
(non-routine transactions) authorizations
Supervision
a compensation for lack of segregation; some
may be built into computer systems
 Physical Controls
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
 Internal Controls in CBISs

Transaction Authorization
The rules are often embedded within
computer programs.
– EDI/JIT: automated re-ordering of
inventory without human intervention
 Internal Controls in CBISs

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.
 Internal Controls in CBISs
Supervision
The ability to assess competent
employees becomes more challenging
due to the greater technical knowledge
required.
 Internal Controls in CBISs

Accounting Records
ledger accounts and sometimes source
documents are kept magnetically
– no audit trail is readily apparent
 Internal Controls in CBISs

Access Control
Data consolidation exposes the organization
to computer fraud and excessive losses from
disaster.
 Internal Controls in CBISs

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.