Chapter 3

Ethics, Fraud, and Internal Control

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

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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?

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Four Main Areas of Business Ethics

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 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 computer
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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

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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 whistleblowers

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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

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 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

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Fraud Schemes
Three categories of fraud schemes according to the Association of
Certified Fraud Examiners:
A. fraudulent statements
B. corruption
C. asset misappropriation

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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

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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

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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

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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

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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. 15
Limitations of Internal Controls
• Possibility of honest errors
• Circumvention via collusion
• Management override
• Changing conditions--especially in companies with high growth

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

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 SAS 78 / 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.
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Five Internal Control
Components: SAS 78 / COSO
1. Control environment
2. Risk assessment
3. Information and communication
4. Monitoring
5. Control activities

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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

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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

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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

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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] 23

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

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[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

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 Two Types of IT Controls
• General controls—pertain to the entitywide 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

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Six Types of Physical Controls
• Transaction Authorization
• Segregation of Duties
• Supervision
• Accounting Records
• Access Control
• Independent Verification

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Physical Controls
Transaction Authorization
• used to ensure that employees are carrying out only authorized
transactions
• general (everyday procedures) or specific (non-routine
transactions) authorizations

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Physical Controls
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

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Physical Controls
Supervision
• a compensation for lack of segregation; some may be built into
computer systems
Accounting Records
• provide an audit trail

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Physical Controls
Access Controls
• help to safeguard assets by restricting physical access to them

Independent Verification
• reviewing batch totals or reconciling subsidiary accounts with
control accounts

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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

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Physical Controls in IT Contexts
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.

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

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Physical Controls in IT Contexts
Accounting Records
• ledger accounts and sometimes source documents are kept
magnetically
• no audit trail is readily apparent

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

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Physical Controls in IT Contexts
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.

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