CH 3 Ethics, Fraud, and Internal Control

business ethics

involves finding answers to:

1. how do managers decide on what is right in conducting their business

2. once managers have recognized what is right, how do they achieve it

4 main areas of business ethics

1. equity

2. rights

3. honesty

4. exercise of corporate power

computer ethics

concerns social impact of computer technology

main components of computer ethics issue

● Privacy

● Security—accuracy and confidentiality

● Ownership of property

● Equity in access

● Environmental issues

● Artificial intelligence

● Unemployment and displacement

● Misuse of computer

false representation

false statement or disclosure

material fact

a fact must be substantial in inducing someone to act

justifiable reliance

misrepresentation must have resulted in _______ upon information, which caused someone to act

injury or loss

misrepresentation must have caused ____

lack of auditor independence

auditing firms also engaged by their clients to perform nonaccounting 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 t he firm's long-term health

inappropriate accounting practices

a characteristic common to many financial statement fraud schemes

employee fraud

• committed by non-management personnel

• 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

1. fraudulent statements

2. corruption

3. asset misappropriation

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

corruption

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

asset misappropriation

most common type of employee fraud

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

management responsibility

establishment and maintenance of a system of internal control is the responsibility of the management

reasonable assurance

cost of achieving objectives of internal control should not outweigh its benefits

methods of data processing

techniques 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

1. destruction of an asset

2. theft of an asset

3. corruption of an information

4. disruption of information system

SAS 78/COSO

Describes the relationship between the firm's internal control structure, auditor's assessment of risk, and the planning of audit procedures

weaker - higher

The _________ the internal control structure, the____ the assessed level of risk; the higher the risk, the more auditor procedures applied in the audit.

5 internal control components

1. Control Environment

2. Risk Assessment

3. Control Activities

4. Information and Communication

5. Monitoring

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

risk assessment

Identify, analyze and manage risks relevant to financial reporting

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

monitoring

process for assessing quality of internal control design and operation

control activities

policies and procedures to ensure that the appropriate actions are taken in response to identified risks

2 categories of control activities

it controls and physical controls

2 types of it controls

general and application

general controls

entity wide computer environment

application controls

ensure integrity of specific systems

6 types of physical controls

● Transaction Authorization

● Segregation of Duties

● Supervision

● Accounting Records

● Access Control

● Independent Verification

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