Ethical Issues in Accounting

Course Code: ACT 4102

Fraud

Any and all means a person uses to gain an unfair advantage over another
person is called fraud.
a

Two types of frauds that are important to businesses are:

a. Misappropriation of Assets
Misappropriation of assets is the theft of company assets by employees.
Examples include the following:
 Albert Milano, a manager at Reader’s Digest responsible for processing
bills, embezzled $1 million over a five-year period. He forged a
superior’s signature on invoices for services never performed,
submitted them to accounts payable, forged the endorsement on the
check, and deposited it in his account. Milano used the stolen funds to
buy an expensive home, five cars, and a boat.
 A bank vice president approved $1 billion in bad loans in exchange for
$585,000 in kickbacks. The loans cost the bank $800 million and
helped trigger its collapse.
Fraud related to business (Cont.…):

b. Fraudulent Financial Reporting:

The National Commission on Fraudulent Financial Reporting (the
Treadway Commission) defined fraudulent financial reporting as
intentional or reckless conduct, whether by act or omission, that results in
materially misleading financial statements. Management falsifies financial
statements to deceive investors and creditors, increase a company’s stock
price, meet cash flow needs, or hide company losses and problems.
a

The Treadway Commission recommended four actions to reduce

fraudulent financial reporting:
1. Establish an organizational environment that contributes to the
integrity of the financial reporting process.
2. Identify and understand the factors that lead to fraudulent financial
reporting.
3. Assess the risk of fraudulent financial reporting within the company.
4. Design and implement internal controls to provide reasonable
assurance of preventing fraudulent financial reporting.
The Auditor’s Responsibility to Detect Fraud:

i) Understand fraud: Because auditors cannot effectively audit

something they do not understand, they must understand fraud and
how and why it is committed.
ii) Discuss the risks of material fraudulent misstatements: While
planning the audit, team members discuss among themselves how
and where the company’s financial statements are susceptible to
fraud.
iii) Obtain information: The audit team gathers evidence by looking for
fraud risk factors; testing company records; and asking management,
the audit committee of the board of directors, and others whether
they know of past or current fraud. Because many frauds involve
revenue recognition, special care is exercised in examining revenue
accounts.
iv) Identify, assess, and respond to risks: The evidence is used to
identify, assess, and respond to fraud risks by varying the nature,
timing, and extent of audit procedures and by evaluating carefully the
risk of management overriding internal controls.
Why Perpetrates do Fraud?
a

1) Pressure-Employee pressure triangle (Financial, emotional and

lifestyle) and FSs pressure triangle (Financial, management characteristics
and industry conditions)
2) Opportunity—(Commit, convert and conceal)
3) Rationalization—(Attitude, Justification and lack of personal integrity)

Fraud triangle-3 components

1. Pressures:

A pressure is a person’s incentive or motivation for committing fraud.

Three types of pressures that lead to misappropriations:

1.1 Employee Pressure

1.1.a) Financial pressure 1.1.b) Emotional pressure 1.1.c) Lifestyle pressure
1 Living beyond one’s means 1 Excessive greed, ego, pride, ambition 1 Gambling habit
2 High personal debt/expenses 2 Performance not recognized 2 Drug or alcohol
3 “Inadequate” salary/income 3 Job dissatisfaction 3 Addiction
4 Poor credit ratings 4 Fear of losing job 4 Sexual relationships
5 Heavy financial losses 5 Need for power or control 5 Family/peer pressure
6 Bad investments 6 Overt, deliberate nonconformity
7 Tax avoidance 7 Inability to abide by or respect rules
8 Unreasonable quotas/goals 8 Challenge of beating the system
9 Envy or resentment against others
10 Need to win financial one-upmanship
competition
11 Coercion by bosses/top management
Pressures (Cont.…):

1.2 Pressures That Can Lead to Financial Statement Fraud

1.2.a) Management Characteristics 1.2.c) Financial
1 Questionable management ethics, management style, 1 Intense pressure to meet or exceed earnings
and track record expectations
2 Unduly aggressive earnings forecasts, performance 2 Significant cash flow problems; unusual difficulty
standards, accounting methods, or incentive programs collecting receivables, paying payables
3 Significant incentive compensation based on 3 Heavy losses, high or undiversified risk, high
achieving unduly aggressive goals dependence on debt, or unduly restrictive debt
4 Management actions or transactions with no clear covenants
business justification 4 Heavy dependence on new or unproven product
5 Oversensitivity to the effects of alternative accounting lines
treatments on earnings per share 5 Severe inventory obsolescence or excessive
6 Strained relationship with past auditors inventory build up
7 Failure to correct errors on a timely basis, leading to 6 Economic conditions (inflation, recession)
even greater problems 7 Litigation, especially management vs. shareholders
8 High management/employee turnover 8 Impending business failure or bankruptcy
9 Unusual/odd related-party relationships 9 Problems with regulatory agencies
10 High vulnerability to rise in interest rates
1.2.b) Industry conditions 11 Poor or deteriorating financial position
1 Declining industry 12 Unusually rapid growth or profitability compared to
2 Industry or technology changes leading to declining companies in same industry
demand or product obsolescence 13 Significant estimates involving highly subjective
3 New regulatory requirements that impair financial judgments or uncertainties
stability or profitability
4 Significant competition or market saturation, with
declining margins
5 Significant tax changes or Adjustments
2. Opportunities:

Opportunity is the condition or situation, including one’s personal

abilities, that allows a perpetrator to do three things:
a. Commit the fraud: The theft of assets is the most common type of
misappropriation. Most instances of fraudulent financial reporting involve
overstatements of assets or revenues, understatements of liabilities, or
failures to disclose information.
a

2. Conceal the fraud: To prevent detection when assets are stolen or

financial statements are overstated, perpetrators must keep the
accounting equation in balance by inflating other assets or decreasing
liabilities or equity. Concealment often takes more effort and time and
leaves behind more evidence than the theft or misrepresentation. Taking
cash requires only a few seconds; altering records to hide the theft is more
challenging and time-consuming.
Example:
i) One way for an employee to hide a theft of company assets is to charge
the stolen item to an expense account. The perpetrator’s exposure is
limited to a year or less, because expense accounts are zeroed out at the
end of each year. Perpetrators who hide a theft in a balance sheet account
must continue the concealment.
.
Opportunities (Cont.…):

Example:
ii) Another way to hide a theft of company assets is to use a lapping
scheme. In a lapping scheme, an employee of Company Z steals the cash or
checks customer A mails in to pay the money it owes to Company Z. Later,
the employee uses funds from customer B to pay off customer A’s balance.
Funds from customer C are used to pay off customer B’s balance, and so
forth. Because the theft involves two asset accounts (cash and accounts
receivable), the cover-up must continue indefinitely unless the money is
replaced or the debt is written off the books.
a

3. Convert the theft or misrepresentation to personal gain: In a

misappropriation, fraud perpetrators who do not steal cash or use the
stolen assets personally must convert them to a spendable form. For
example, employees who steal inventory or equipment sell the items or
otherwise convert them to cash. In cases of falsified financial statements,
perpetrators convert their actions to personal gain through indirect
benefits; that is, they keep their jobs, their stock rises, they receive pay
raises and promotions, or they gain more power and influence.
Opportunities Permitting Employee and Financial
Statement Fraud:
Internal Control Factors Other Factors
i) Failure to enforce/monitor internal i) Large, unusual, or complex
controls transactions
ii) Management override of controls ii) Related-party transactions
iii) Dominant and unchallenged iii) Incompetent personnel
management
iv) Ineffective oversight by board of iv) Rapid turnover of key employees
directors
v) Insufficient separation of v) Close association with
authorization, custody, and record- suppliers/customers
keeping duties
vi) Too much trust in key employees vi) Questionable accounting practices
vii) Inadequate supervision  
viii) Unclear lines of authority  
ix) Lack of proper authorization  
procedures
x) Inadequate system for safeguarding  
assets
3. Rationalization:

A rationalization allows perpetrators to justify their illegal behavior.

a

The most frequent rationalizations include the following:

i. I am only “borrowing” it, and I will repay my “loan.”
ii. You would understand if you knew how badly I needed it.
iii. What I did was not that serious.
iv. It was for a good cause (the Robin Hood syndrome: robbing the
rich to give to the poor).
v. In my very important position of trust, I am above the rules.
vi. Everyone else is doing it.
vii. No one will ever know.
viii. The company owes it to me; I am taking no more than is rightfully
mine.
Preventing and Detecting Fraud and Abuse:

A. Make Fraud Less Likely to Occur

1 Create an organizational culture that stresses integrity and commitment to ethical values
and competence.
2 Adopt an organizational structure, management philosophy, operating style, and risk
appetite that minimizes the likelihood of fraud.
3 Require oversight from an active, involved, and independent audit committee of the board
of directors.
4 Assign authority and responsibility for business objectives to specific departments and
individuals, encourage them to use initiative to solve problems, and hold them accountable
for achieving those objectives.
5 Identify the events that lead to increased fraud risk, and take steps to prevent, avoid, share,
or accept that risk.
B. Increase the Difficulty of Committing Fraud
1 Develop and implement a strong system of internal controls.
2 Segregate the accounting functions of authorization, recording, and custody.
3 Implement a proper segregation of duties between systems functions.
4 Restrict physical and remote access to system resources to authorized personnel.
5 Use properly designed documents and records to capture and process transactions.
Preventing and Detecting Fraud and Abuse:

C. Improve Detection Methods

1 Develop and implement a fraud risk assessment program that evaluates both the
likelihood and the magnitude of fraudulent activity and assesses the processes and
controls that can deter and detect the potential fraud.
2 Motivate employees to report fraud by implementing whistleblower rewards and
protections for those who come forward.
3 Employ a computer security officer, computer consultants, and forensic specialists as
needed.
4 Install fraud detection software.
5 Conduct periodic external and internal audits, as well as special network security audits;
these can be especially helpful if
sometimes performed on a surprise basis.
D. Reduce fraud losses
  Maintain adequate insurance.
  Develop comprehensive fraud contingency, disaster recovery, and business continuity
plans.
  Store backup copies of program and data files in a secure off-site location.
  Use software to monitor system activity and recover from fraud.
 Practice

• You were asked to investigate extremely high, unexplained merchandise

shortages at a department store chain. You found the following:
a. The receiving department supervisor owns and operates a boutique
carrying many of the same labels as the chain store. The general manager is
unaware of the ownership interest.
b. The receiving supervisor signs receiving reports showing that the total
quantity shipped by a supplier was received and then diverts 5% to 10% of
each shipment to the boutique.
c. The store is unaware of the short shipments because the receiving report
accompanying the merchandise to the sales areas shows that everything was
received.
d. Accounts Payable paid vendors for the total quantity shown on the
receiving report.
e. Based on the receiving department supervisor’s instructions, quantities on
the receiving reports were not counted by sales personnel.
• Required
Classify each of the five situations as a fraudulent act, a fraud symptom, an
internal control weakness, or an event unrelated to the investigation. Justify
your answers.
 Practice

• For each of the following independent cases of employee fraud,

recommend how to prevent similar problems in the future.
a. Abnormal inventory shrinkage in the audiovisual department at a retail
chain store led internal auditors to conduct an in-depth audit of the
department. They learned that one customer frequently bought large
numbers of small electronic components from a certain cashier. The
auditors discovered that they had colluded to steal electronic
components by not recording the sale of items the customer took from
the store.
b. During an unannounced audit, auditors discovered a payroll fraud
when they, instead of department supervisors, distributed paychecks.
When the auditors investigated an unclaimed paycheck, they discovered
that the employee quit four months previously after arguing with the
supervisor. The supervisor continued to turn in a time card for
the employee and pocketed his check.
c. Auditors discovered an accounts payable clerk who made copies of
supporting documents and used them to support duplicate supplier
payments. The clerk deposited the duplicate checks in a bank account
she had opened using a name similar to that of the supplier.
Enough for Today!!!