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Ch03 Ethics, Fraud and Internal Control

Chapter 3 of 'Accounting Information Systems' discusses the importance of business ethics, particularly in relation to fraud and internal controls. It defines fraud, distinguishes between employee and management fraud, and outlines various fraud schemes, including asset misappropriation. The chapter also emphasizes the necessity of a robust internal control framework to safeguard assets and ensure accurate financial reporting.

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18 views31 pages

Ch03 Ethics, Fraud and Internal Control

Chapter 3 of 'Accounting Information Systems' discusses the importance of business ethics, particularly in relation to fraud and internal controls. It defines fraud, distinguishes between employee and management fraud, and outlines various fraud schemes, including asset misappropriation. The chapter also emphasizes the necessity of a robust internal control framework to safeguard assets and ensure accurate financial reporting.

Uploaded by

Jack Filipino
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Accounting Information Systems, 6th

edition
James A. Hall

ADMAS UNIVERSITY
Warsame Djamal
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 internal control framework
Objects and application of physical
controls
What is Ethics
Moral principles that govern a person's behavior or the conducting of an
activity.
The branch of knowledge that deals with moral principles.
They define what’s right and wrong, and outline the kind of
behavior that businesses should not engage in.
For responsible decision making in a business environment, a
good set of ethics is the key.
Business Ethics
Why should we be concerned about
ethics in the business world?
Because Ethics are needed when
conflicts arise in business organization
In business, conflicts may arise
between:
employees
management
stakeholders
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?
Legal Definition of Fraud
It’s the crime of getting money by deceiving other people.
Fraud in the business environment can be defined
“an intentional deception, misappropriation of company’s asset,
or manipulation of it’s financial data to the advantage of
perpetrator”
Fraud also know as “white collar crime,
crime defalcation,
defalcation and
embezzlement”
embezzlement
Fraudulent Act must meet the
following five conditions
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
2008 ACFE Study of Fraud
Loss due to fraud equal to 7% of
revenues—approximately $994 billion

Other results: higher losses due to men,


employees acting in collusion, and
employees with advance degrees
Types of Fraud
1. 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
2. Management Fraud
deceives 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.
Frequently misappropriates assets and then
shrouded with 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
Corruption can took place both the
managerial or employee level of the
organization in collusion with an outsider.

Examples:
bribery
illegal gratuities
conflicts of interest
economic extortion
C. Asset Misappropriation
The assets of the business are either directly
or indirectly diverted to the proprietor’s
benefit.
It’s the most common type of fraud and often
occurs as employee fraud.

Types of Asset Misappropriation fraud


1.Cash Misappropriation
2.Non Cash Misappropriation
Cash Misappropriation Frauds
1. Skimming: stealing cash from the organization before it’s
recorded on the organizations books.
2. Lapping: Cash receipts are stolen from the organization after
they have been recorded in the organizations books and
records.
3. Billing Schemes: also know as vendor fraud, are perpetrated
by employees who cause their employer to issue a payment to
a false supplier
A. Shell Company
B. Pass through Fraud
C. Pay and Return
4. Check Tempering: forging or changing a check that the
organization has written to a legitimate payee.
5. Payroll Fraud: distribution of paycheck to non existing or
already left employee.
6. Expense Reimbursement Fraud: an employee makes a claim of
inflated business expense
7. Direct Theft of Cash in the organization
Non Cash Misappropriation Fraud
Involves the theft or misuse of the organization’s non cash
assets.
Ex: store manger who steals inventory, customer service clerk
who sells confidential company information to third party.
Internal Control Objectives
The internal control system comprises policies,
practices employed by the organization in order
to achieve these objectives.

1.Safeguard assets of the firm.


2.Ensure accuracy and reliability of
accounting records and information.
3.Promote efficiency of the firm’s operations
Limitations of Internal Controls
Possibility of honest errors
Personnel may avoid the sys via collusion
Management is in the position to override
internal control procedures
Conditions may change over time so that so
that existing controls may become ineffectual.
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
Internal Control Vs Auditor’s Assessment Vs Audit Procedures
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.
Six Types of Physical Controls
Transaction Authorization
Segregation of Duties
Supervision
Accounting Records
Access Control
Independent Verification
Physical Controls
1. Transaction Authorization
used to ensure that employees are carrying
out only authorized transactions
general (everyday procedures) ex: purchase
of inventory from specified vendor.
Specific (non-routine transactions)
authorizations ex: increase credit limit for
specific customer needs management
responsibility
Physical Controls
2. Segregation of Duties
In manual systems, separation between:

authorizing and processing a transaction


custody and recordkeeping of the asset
subtasks
Physical Controls
3. Supervision
Establishing managerial span of control
where a single manager supervises a
several employees
4. Accounting Records
The accounting records of the organization
consist of source documents, journals, and
ledgers.
These records provide an audit trail of an
economic event
Physical Controls
5. Access Controls

The purpose of access control is to ensure


that only authorized personnel have access
to the firms asset.
Un authorized access exposes assets to
misappropriation, damage and theft.
Access control play an important in
safeguarding the asset
6. Independent Verification
Are independent checks of the accounting system to identify
error and misrepresentation.
Verification is different from supervision, because it takes
place after the fact.
Examples:
reconciling subsidiary accounts with control accounts
Comparing physical assets with accounting records.
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

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