Chapter 3

Ethics, Fraud, and Internal Control

Objectives for Chapter 3
 Broad issues pertaining to business ethics
 Ethical issues related to the use of information
technology
 Distinguish between management fraud and
employee fraud
 Common types of fraud schemes
 Key features of SAS 78 / COSO internal control
framework
 Objects and application of physical controls

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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

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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.

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Limitations of Internal Controls
 Possibility of honest errors

 Circumvention via collusion

 Management override

 Changingconditions--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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The Internal Controls Shield

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Preventive, Detective, and
Corrective Controls

Figure 3-3
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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,
[red disclosures,
shows relationship to the and estimates
general [output]
AIS model]
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 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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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 entity-wide 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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 Nested Control Objectives for
Transactions
Control
Objecti Authorization Processing
ve 1

Control Authorization Custody Recording

Objecti
ve 2

General
Journals Ta 1 Subsidiary
Ledgers Ledger
Control
Objecti
Figure 3-4
ve 3 23
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

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.

Access Control
Data consolidation exposes the organization to computer
fraud and excessive losses from disaster

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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Thank you for listening

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