Chapter 14 Internal Control and the Prevention of Fraud

Topics to be Discussed Introduction Fraud Causes of Fraud

Introduction Reasons for increased risk of fraud: The size of corporations Globalization Reduced stability in the workforce Reduction in corporate loyalty Increased computerization of accounting systems Growing reliance on the Internet as a sales tool

Fraud Common law requirements for fraud include a false representation of a material fact made by one party to another party with the intent to deceive and induce the other party to justifiably rely on the fact to his or her detriment.

Fraud Key Concept Fraud is more narrowly defined in a business context than in common law.

Fraud In business, fraud may include: Internal deceptions by management Manipulation of financial data Misappropriation of the organization’s assets Falsifying documents or accounting records

Management Fraud Management fraud typically involves misstating financial statements in order to mislead readers of those statements or to take advantage of incentives or other benefits tied to earnings.

Management Fraud Typically the result of pressure on management to report good operating results. Commonly involves improper revenue recognition, overstating assets or understating liabilities.

Management Fraud Key Concept Management fraud can be very difficult to detect.

Management Fraud Performance Fraud The manipulation of financial information designed to inflate earnings or to cover up a decline in financial position. Can cause irreparable damage to the financial position of a company.

Management Fraud Pause and Reflect How might companies reduce the risk of management fraud?

Earnings Management GAAP leaves considerable leeway to managers to make choices that can impact earnings. These and other choices provide management with ample opportunities to manage earnings. Used to “smooth” earnings from quarter to quarter or to otherwise manipulate financial results for a variety of reasons.

Earnings Management Microsoft was accused of setting aside revenue not needed to make current sales and profit targets as a “reserve” that could be used to increase revenue and earnings in the future. The SEC considers this to be a manipulation of financial statements.

Earnings Management Pause and Reflect How do you feel about “earnings management”? Which stakeholders should management consider in making decisions to smooth earnings? Is earnings management ethical?

Employee Fraud Typically involved the theft of cash or other assets of the organization. Almost always carried out for the personal benefit of the employee(s). Thefts must be concealed to avoid detection.

Employee Fraud Key Concept Good internal control systems can usually detect and prevent most types of employee fraud.

Causes of Fraud People engage in fraudulent activity as a result of an interaction of forces both within an individual’s personality and the external environment. Combinations of high situational pressure, high opportunity, and low ethical standards are likely to lead to fraud.

Causes of Fraud Key Concept Individuals engage in fraudulent activity as a result of situational pressures, opportunity, and personal characteristics.

Causes of Fraud Just as fraudulent activities have increased in business, fraudulent activities like cheating and plagiarism are rampant in many colleges and universities. What are some possible causes of fraudulent activities in an academic setting?

Role of the Internal Audit Department Develop internal control systems that reduce situational pressures and opportunities for fraudulent behavior. Responsible for the design and maintenance of an internal control system. Conduct periodic audit procedures to ensure that errors and irregularities in financial information are detected.

Role of the Internal Audit Department Operational Audits: the evaluation of the effectiveness and efficiency of operations of various departments and divisions of the company.

Role of the External Auditor To attest to the fairness of a company’s financial statements and to report any discovered fraud or irregularities to shareholders.

Internal Control Topics Internal Control Systems and the Prevention of Fraud Internal Control Procedures Common Frauds and Effective Internal Controls Behavioral Implications of Internal Control Systems Internal Control in an E-business Environment

Internal Control Systems and the Prevention of Fraud Internal Control: a process, effected by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in the following categories: Reliability of financial reporting Compliance with applicable laws and regulations Effectiveness and efficiency of operations

Internal Control Systems and the Prevention of Fraud Key Concept The internal control system’s impact on promoting effective and efficient operations is perhaps even more important than detecting fraudulent activity.

Designs of Internal Control Systems The need for internal control systems is predicated on the assumption that managers and employees of a company will not always exhibit behavior that is in the best interest of the owners or shareholders of the company. Remember Amber Valley Ski Resort which has dozens of managers and hundreds of employees?

Designs of Internal Control Systems Pause and Reflect What types of fraudulent activities might the employees of Amber Valley undertake?

Characteristics of an Internal Control System What should we consider for a good internal control system? The organizational environment in which the system exists. The risks that affect the ability of a company to meet its objectives and the activities a company uses to control its risks. The methods and procedures a company uses to communicate and to monitor its internal control system.

Organizational Environment Key Concept Upper-level management sets the tone of ethical behavior and the overall ethical atmosphere of the organization.

Organizational Environment CPAs are governed by a code of ethical conduct that spells out ethical responsibilities to their clients. Garcia and Buffett does not allow partners or other employees to own stock or have any financial interest in an audit client of the firm.

Organizational Environment Pause and Reflect Why would owning stock in an audit client raise concerns about independence?

Risk Assessment and Risk Control Risk assessment and control involves identifying potential risks to the organization and ways to minimize or manage those risks.

Communication and Monitoring Procedures Internal Control Procedures are also impacted by the methods, records, and reports a company uses to communicate with employees and external decision makers, and the procedures a company uses to monitor its internal control system to make sure it is functioning properly.

Internal Control Procedures Internal Control Procedures: are used to address areas of risk identified during the risk assessment process. They are designed to focus on activities that are determined to increase the risk of management or employee fraud.

Reviewing Financial Reports that Compare Actual Results to Budgeted Amounts Big Al’s projects selling 2,000 pizzas per week but actually sells 3,000 pizzas per week. Internal Auditors should expect variable costs to be 50% higher than budgeted in the static budget at the beginning of the year. If the numbers do not compare, what could have caused the variance?

Other Internal Control Procedures Checking the Accuracy of Recorded Transactions Segregation of Duties Securing Assets Comparing Financial Data with Other Supporting Data

Behavioral Implications of Internal Control Systems Well-designed internal control systems can detect many types of fraudulent activity. The real goal of an internal control system is to prevent the fraudulent activity in the first place.

Behavioral Implications of Internal Control Systems Key Concept To be effective, internal control systems must be communicated throughout an organization and modified as new risks are identified.

Behavioral Implications of Internal Control Systems Threats in an E-business Environment Internet (E-business) False Web sites posing as selling agents Inside perpetrators Perpetrators intercepting credit card information, messages, company data Perpetrators sending false messages Data destruction, viruses, rerouting messages, altering data False customers posing as legitimate customers

Behavioral Implications of Internal Control Systems Key Concept E-business activities entail new risks and require new internal control procedures.

End of Chapter 14 Now tell me, Why do you think this company would need any Internal Controls?