Chapter 3Ethics, Fraud, and Internal Control

Objectives for Chapter 3Broad issues pertaining to business ethicsEthical issues related to the use of information technologyDistinguish between management fraud and employee fraudCommon types of fraud schemesKey features of SAS 78 / COSO internal control frameworkObjects and application of physical controls

Business Ethics Why should we be concerned about ethics in the business world?Ethics are needed when conflicts arisethe need to chooseIn business, conflicts may arise between:employeesmanagementstakeholdersLitigation

Business EthicsBusiness 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 Securityaccuracy and confidentiality Ownership of property Equity in access Environmental issues Artificial intelligence Unemployment and displacement Misuse of computer

Legal Definition of FraudFalse 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 actThe misrepresentation must have caused injury or loss

Factors that Contribute to Fraud

2004 ACFE Study of FraudLoss due to fraud equal to 6% of revenuesapproximately $660 billionLoss by position within the company:

Other results: higher losses due to men, employees acting in collusion, and employees with advance degrees

Enron, WorldCom, AdelphiaUnderlying ProblemsLack of Auditor Independence: auditing firms also engaged by their clients to perform nonaccounting activitiesLack 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 firms long-term health. Inappropriate Accounting Practices: a characteristic common to many financial statement fraud schemes. Enron made elaborate use of special purpose entitiesWorldCom 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 independencemore separation between a firms attestation and non-auditing activities Corporate governance and responsibilityaudit committee members must be independent and the audit committee must oversee the external auditors Disclosure requirementsincrease issuer and management disclosureNew federal crimes for the destruction of or tampering with documents, securities fraud, and actions against whistleblowers

Employee FraudCommitted by non-management personnelUsually consists of: an employee taking cash or other assets for personal gain by circumventing a companys system of internal controls

Management FraudPerpetrated at levels of management above the one to which internal control structure relatesFrequently involves using financial statements to create an illusion that an entity is more healthy and prosperous than it actually isInvolves 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 statementsB. corruptionC. asset misappropriation

A. Fraudulent StatementsMisstating the financial statements to make the copy appear better than it isUsually occurs as management fraudMay be tied to focus on short-term financial measures for successMay also be related to management bonus packages being tied to financial statements

B. CorruptionExamples:briberyillegal gratuitiesconflicts of interesteconomic extortionForeign Corrupt Practice Act of 1977: indicative of corruption in business worldimpacted accounting by requiring accurate records and internal controls

C. Asset MisappropriationMost common type of fraud and often occurs as employee fraudExamples:making charges to expense accounts to cover theft of asset (especially cash)lapping: using customers check from one account to cover theft from a different accounttransaction fraud: deleting, altering, or adding false transactions to steal assets

Computer Fraud SchemesTheft, misuse, or misappropriation of assets by altering computer-readable records and files Theft, misuse, or misappropriation of assets by altering logic of computer softwareTheft or illegal use of computer-readable informationTheft, corruption, illegal copying or intentional destruction of softwareTheft, 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 FraudThis 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 FraudProgram Fraudsaltering programs to allow illegal access to and/or manipulation of data filesdestroying programs with a virusOperations Fraudsmisuse of company computer resources, such as using the computer for personal business

Database Management FraudAltering, deleting, corrupting, destroying, or stealing an organizations dataOftentimes conducted by disgruntled or ex-employee

Information Generation FraudStealing, misdirecting, or misusing computer outputScavengingsearching 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 SASSafeguard assets of the firmEnsure accuracy and reliability of accounting records and informationPromote efficiency of the firms operationsMeasure compliance with managements prescribed policies and procedures

Modifying Assumptions to the Internal Control ObjectivesManagement 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 ControlsPossibility of honest errorsCircumvention via collusionManagement overrideChanging conditions--especially in companies with high growth

Exposures of Weak Internal Controls (Risk)Destruction of an assetTheft of an asset Corruption of information Disruption of the information system

The Internal Controls Shield

Preventive, Detective, and Corrective Controls

SAS 78 / COSODescribes the relationship between the firmsinternal control structure,auditors assessment of risk, andthe planning of audit proceduresHow 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 / COSO1. Control environment2. Risk assessment3. Information and communication4. Monitoring5. Control activities

1: The Control EnvironmentIntegrity and ethics of managementOrganizational structureRole of the board of directors and the audit committeeManagements policies and philosophyDelegation of responsibility and authorityPerformance evaluation measuresExternal influencesregulatory agenciesPolicies and practices managing human resources

2: Risk AssessmentIdentify, analyze and manage risks relevant to financial reporting:changes in external environmentrisky foreign marketssignificant and rapid growth that strain internal controlsnew product linesrestructuring, downsizingchanges in accounting policies

3: Information and CommunicationThe AIS should produce high quality information which:identifies and records all valid transactionsprovides timely information in appropriate detail to permit proper classification and financial reportingaccurately measures the financial value of transactionsaccurately 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: MonitoringThe process for assessing the quality of internal control design and operation [This is feedback in the general AIS model.]Separate procedurestest of controls by internal auditorsOngoing monitoring:computer modules integrated into routine operationsmanagement reports which highlight trends and exceptions from normal performance

[red shows relationship to the general AIS model]

5: Control ActivitiesPolicies and procedures to ensure that the appropriate actions are taken in response to identified risks Fall into two distinct categories:IT controlsrelate specifically to the computer environmentPhysical controlsprimarily pertain to human activities

Two Types of IT ControlsGeneral controlspertain to the entitywide computer environmentExamples: controls over the data center, organization databases, systems development, and program maintenanceApplication controlsensure the integrity of specific systems Examples: controls over sales order processing, accounts payable, and payroll applications

Six Types of Physical ControlsTransaction AuthorizationSegregation of DutiesSupervisionAccounting Records Access Control Independent Verification

Physical ControlsTransaction Authorizationused to ensure that employees are carrying out only authorized transactions general (everyday procedures) or specific (non-routine transactions) authorizations

Physical ControlsSegregation of DutiesIn manual systems, separation between:authorizing and processing a transactioncustody and recordkeeping of the assetsubtasksIn computerized systems, separation between:program codingprogram processingprogram maintenance

Physical ControlsSupervisiona compensation for lack of segregation; some may be built into computer systemsAccounting Recordsprovide an audit trail

Physical ControlsAccess Controlshelp to safeguard assets by restricting physical access to themIndependent Verificationreviewing batch totals or reconciling subsidiary accounts with control accounts

ProcessingCustodyRecordingNested Control Objectives for TransactionsControlObjective 1

ControlObjective 2

Control Objective 3CustodyRecording

Physical Controls in IT ContextsTransaction AuthorizationThe rules are often embedded within computer programs.EDI/JIT: automated re-ordering of inventory without human intervention

Physical Controls in IT ContextsSegregation 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 ContextsSupervision The ability to assess competent employees becomes more challenging due to the greater technical knowledge required.

Physical Controls in IT ContextsAccounting Records ledger accounts and sometimes source documents are kept magneticallyno audit trail is readily apparent

Physical Controls in IT ContextsAccess Control Data consolidation exposes the organization to computer fraud and excessive losses from disaster.

Physical Controls in IT ContextsIndependent 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.

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