Chapter 3 Ethics, Fraud, and Internal Control

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
Ethical Issues in Business
Executive Salaries
Equity Corporate Worth
Product Pricing
Corporate Due Process
Employee Health Screening
Employee Privacy
Rights Sexual Harassment
Diversity
Equal Employment Opportunity
Whist;e-Blowing
Employee and Management Conflict
Security of Organization Data and Records
Honesty Misleading Advertising
Questionable business practices in Foreign Countries
Accurate Reporting of Shareholders Interest
Political Action Committees
Workplace Safety
Product Safety
Exercise of Corporate Power Environmental Issues
Divestment Of Interest
Corporate Political Contribution
Downsizing and Plant Closures

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 comp
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.

2008 ACFE Study of Fraud

▪ Loss due to fraud equal to 7% of revenues—
approximately $994 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 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 whistle-blowers.

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
▪ 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
 Preventive, Detective, and Corrective Controls

SAS 109 / 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 109 / COSO
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 entity wide 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

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
 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.
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

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.
Application Controls
▪ Risks within specific applications
▪ Can affect manual procedures (e.g., entering data) or embedded (automated) procedures
▪ Convenient to look at in terms of:
▪ input stage
▪ processing stage
▪ output stage
Application Input Controls
▪ Goal of input controls - valid, accurate, and complete input data
▪ Two common causes of input errors:
▪ transcription errors – wrong character or value
▪ transposition errors – ‘right’ character or value, but in wrong place
▪ Check digits – data code is added to produce a control digit
▪ especially useful for transcription and transposition errors
▪ Missing data checks – control for blanks or incorrect justifications
▪ Numeric-alphabetic checks – verify that characters are in correct form
▪ Limit checks – identify values beyond
▪ Range checks – identify values outside upper and lower bounds
▪ Reasonableness checks – compare one field to another to see if relationship is appropriate
▪ Validity checks – compares values to known or standard values
▪ Programmed processes that transform input data into information for output
▪ Three categories:
▪ Batch controls
▪ Run-to-run controls
▪ Audit trail controls
▪ Batch controls - reconcile system output with the input originally entered into the system
▪ Based on different types of batch totals:
▪ total number of records
▪ total dollar value
▪ hash totals – sum of non-financial numbers
▪ Run-to-run controls - use batch figures to monitor the batch as it moves from one programmed procedure (run) to another
▪ Audit trail controls - numerous logs used so that every transaction can be traced through each stage of processing from its
economic source to its presentation in financial statements

Transaction Log to Preserve the Audit Trail

Master File Backup Controls

▪ Sequential master file system
▪ GFS Backup Technique
▪ Batch system using direct access files
▪ Destructive update approach calls for
▪ Separate master back up procedure
▪ Real-time system master file backup
▪ Processed continuously, therefore
▪ Backup at pre-specified intervals through the day

Application Output Controls

▪ Goal of output controls is to ensure that system output is not lost, misdirected, or corrupted, and that privacy is not violated.
▪ In the following flowchart, there are exposures at every stage

Stages in the Output Process

Application Controls Output
▪ Output spooling – creates a file during the printing process that may be inappropriately accessed
▪ Printing – create two risks:
▪ production of unauthorized copies of output
▪ employee browsing of sensitive data
▪ Waste – can be stolen if not properly disposed of, e.g., shredding
▪ Report distribution – for sensitive reports, the following are available:
▪ use of secure mailboxes
▪ require the user to sign for reports in person
▪ deliver the reports to the user

▪ End user controls – end users need to inspect sensitive reports for accuracy
▪ shred after used
▪ Controlling digital output – digital output message can be intercepted, disrupted, destroyed, or corrupted as it passes along
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