Chapter 3: Ethics, Fraud, & Internal Control Flashcards
Why should we be concerned about ethics in the business world?
Ethics are needed when conflicts arise—the
people need to choose
In business, conflicts may arise between:
● employees
● management
● stakeholders
● Litigation
____ ____ 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?
Business ethics
concerns the social impact of computer technology (hardware,
software, and telecommunications).
Computer Ethics…
What are the main computer ethics issues?
▪ Privacy
▪ Security—accuracy and confidentiality
▪ Ownership of property
▪ Environmental issues
▪ Artificial intelligence
▪ Unemployment and displacement
▪ Misuse of computer
Legal Definition of Fraud
● False representation
● Material fact-
● 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
Legal Definition of Fraud
false statement or disclosure
False representation
Legal Definition of Fraud
a fact must be substantial in inducing someone to act
Material fact-
Legal Definition of Fraud
______ must exist
Intent to deceive
Legal Definition of Fraud
The misrepresentation must have resulted in
______ ______ upon information, which
caused someone to act
justifiable reliance
Legal Definition of Fraud
The misrepresentation must have caused
______ or ____
injury or loss
Fraud Triangle
Enron, WorldCom, Adelphia Underlying Problems
• Lack of Auditor Independence:
● Lack of Director Independence
● Questionable Executive Compensation Schemes:
● Inappropriate Accounting Practices
Enron, WorldCom, Adelphia Underlying Problems
Auditing firms also engaged by their clients to perform nonaccounting activities
Lack of Auditor Independence:
Enron, WorldCom, Adelphia Underlying Problems
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
Lack of Director Independence
Enron, WorldCom, Adelphia Underlying Problems
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.
Questionable Executive Compensation Schemes:
Enron, WorldCom, Adelphia Underlying Problems
: 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
Inappropriate Accounting Practices
Employee Fraud
Committed by _______
non-management personnel/employee
T or F?
Employee Fraud usually consists of: an employee taking cash or other assets for personal gain by circumventing a company’s system of internal controls
T
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
Management Fraud
T or F?
Management Fraud involves misappropriation of assets, it frequently is shrouded in a maze of complex business transactions
T
Fraud Schemes
Three categories of fraud schemes according to the
Association of Certified Fraud Examiners:
A. fraudulent statements
B. corruption
C. asset misappropriation
● 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
Fraudulent Statements
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
Most common type of fraud and often occurs as
employee fraud
Asset Misappropriation
making charges to expense accounts to cover theft of asset (especially cash)
Asset Misappropriation
using customer’s check from one account to
cover theft from a different account
Asset Misappropriation
lapping:
deleting, altering, or adding false
transactions to steal assets
Asset Misappropriation
transaction fraud:
Internal Control Objectives According to AICPA SAS
- Safeguard assets of the firm
- Ensure accuracy and reliability of accounting
records and information - Promote efficiency of the firm’s operations
- Measure compliance with management’s
prescribed policies and procedures
Modifying Assumptions to the Internal
Control Objectives
- Management Responsibility
- Reasonable Assurance
- Methods of Data Processing
The establishment and maintenance of a system of internal control is the responsibility of management
Management Responsibility
The cost of achieving the objectives of internal control should not outweigh its benefits.
Reasonable Assurance
The techniques of achieving the objectives will vary with different types of technology
Methods of Data Processing
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)
● ____ of an asset
● ____ of an asset
● ____ of information
●_____ of the information system
● Destruction of an asset
● Theft of an asset
● Corruption of information
● Disruption of the information system
The Internal Controls Shield
Undesirable Events
1 Access
2 Fraud
3. Errors
4. Mischief
SAS 78 / COSO
Describes the relationship between the firm’s…
● internal control structure,
● auditor’s assessment of risk, and
● the planning of audit procedures
T or F?
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.
T
Five Internal Control Components: SAS 78 / COSO
- Control environment
- Risk assessment
- Information and communication
- Monitoring
- Control activities
● 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
The Control Environment
● Identify, analyze and manage risks relevant to
financial reporting which includes:
● changes in external environment
● risky foreign markets
● significant and rapid growth that strain internal
controls
● new product lines
● restructuring, downsizing
● changes in accounting policies
Risk Assessment
● 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
Information and Communication
The process for assessing the quality of internal control
design and operation
Accomplished by :
● 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
Monitoring
● 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
Control Activities
Control Activities
Fall into two distinct categories:
______ —relate specifically to the computer
environment
IT controls
Control Activities
Fall into two distinct categories:
_____ —primarily pertain to human
activities
Physical controls
Two Types of IT Controls
- General controls
- Application controls
________ _____ —pertain to the entitywide
computer environment
● Examples: controls over the data center, organization
databases, systems development, and program
maintenance
General controls
____ ___ —ensure the integrity of
specific systems
● Examples: controls over sales order processing,
accounts payable, and payroll applications
Application controls
Six Types of Physical Controls
● Transaction Authorization
● Segregation of Duties
● Supervision
● Accounting Records
● Access Control
● Independent Verification
Physical Controls
● used to ensure that employees are carrying out
only authorized transactions
● general (everyday procedures) or specific (non-
routine transactions) authorizations
Transaction Authorization
Physical Controls
● 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
Segregation of Duties
Physical Controls
● a compensation for lack of segregation; some may be built into computer systems
Supervision
Physical Controls
● provide an audit trail
Accounting Records
Physical Controls
● help to safeguard assets by restricting physical
access to them
Access Controls
Physical Controls
● reviewing batch totals or reconciling subsidiary
accounts with control accounts
Independent Verification
Physical Controls in IT Contexts
● The rules are often embedded within computer
programs.
● EDI/JIT: automated re-ordering of inventory
without human intervention
Transaction Authorization
Physical Controls in IT Contexts
● A computer program may perform many tasks that are
deemed incompatible.
● Thus the crucial need to separate program development,
program operations, and program maintenance.
Segregation of Duties
Physical Controls in IT Contexts
● The ability to assess competent employees becomes
more challenging due to the greater technical
knowledge required.
Supervision
Physical Controls in IT Contexts
● ledger accounts and sometimes source documents are
kept magnetically
● no audit trail is readily apparent
Accounting Records
Physical Controls in IT Contexts
● Data consolidation exposes the organization to
computer fraud and excessive losses from disaster.
Access Control
Physical Controls in IT Contexts
● 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.
Independent Verification
