Chapter 5 Fraud and Internal Control

Chapter 5: Fraud and Internal Control Fraud is an attempt to decieve others for personal gain. Employee Fraud 1. Corruption: misusing an individuals position for inappropriate personal gain. (bribery) - A former mayor from Detroit was sentenced to 28 years in federal prison for corruption after he accepted payments from people seeking to do business with the city and was awarded contracts to a friend who redirected money to him. 2. Asset misappropriation: Theft embezzlement, cash is usually the target, but other assets can be misappropriated. - A vice president of product development at Tiffany & Co. Admitted to stealing and reselling $1.3 million of jewelry that belonged to her employer. The company discovered the pieces missing when counting its inventory. 3. Financial Statement Fraud: Involves misreporting amounts in the financial statements, usually to portray more favorable financial results than what actually exists. - The most famous cases occurred at Enron (now bankrupt) and WorldCom (now part of Verizon). WorldCom violated GAAP by recording $11 billion of expenses as assets, the result of which was larger total assets on the balance sheet and more net income on the income statement. Fraud Triangle 1. Incentive: The employee has a reason for committing fraud. Personal financial pressure may lead to asset misappropriation. - In financial statement fraud cases, the incentive can be to make the business appear successful, so it attracts investors, business partners, or meet loan requirements. - Loan covenants in lending agreements may require the company to achieve financial targets, such as maintaining specific levels of assets or stockholders' equity. If loan covenants are not met, the lender may require the company to pay higher interest rates, repay their loan balance on demand, or put up extra collateral to secure the loan. 2. Opportunity: The employee has a means of committing fraud. Opportunities to commit fraud usually stem from weak internal controls. - Covering up thefts committed by not requiring proper authorization for journal entries recorded. 3. Rationalization: The employee perceives the misdeed as unavoidable or justified. - In the Koss case, the defense attorney argued that the VP suffered from addiction and mental illness, which led to uncontrollable compulsive behavior. In many other cases, fraudsters rationalize their actions through a feeling of personal entitlement, which outweighs moral principles, such as honesty and concern for others. These types of employees often feel they are underpaid, so fraud is their way to get even and paid what they think they deserve. The Sarbanes-Oxely Act: A set of laws established to strengthen corporate reporting in the United States. Key requirements of the SOX Act: -All companies that trade on U.S. stock exchanges must comply with requirements of SOX. 1. Counteract incentives: Those who willfully misrepresent financial results will face stiff penalties.
- including fines up to $5 million plus repayment of any fraud proceeds. Maximum jail sentences have been increased to 20 years, which can add up to more depending on the violations committed. 2. Reduce opportunities: This is the part of the fraud triangle that is most affected by SOX. To reduce fraud opportunities and improve companies' internal control over financial reporting, SOX requires all public companies to... - Establish an audit committee of independent directors. Ensures the company's accounting and internal control and audit functions are effective. - Evaluate and report on the effectiveness of internal control over financial reporting. 3. Encourage honesty: Some parts of SOX help honest employees confront those inclines to rationalize and conceal fraud. - public companies must have tip lines that allow their employees to secretly submit concerns about questionable accounting or auditing practices. These laws are put in place if you tattle on your boss for committing fraud, you cannot be fired for it. Internal Control consists of the actions taken by people at every level of an organization to achieve its objectives relating to... 1. Operations: focus on completing work efficiently and effectively and protecting assets by reducing the risk of fraud. 2. Reporting: producing reliable and timely accounting information for use by people internally and externally to the organization. 3. Compliance: focuses on adhering to laws and regulations. Most organizations use the following control components as a framework when analyzing their internal control systems... 1. Control environment: refers to the attitude people in an organization hold regarding internal control. Influenced by the policies a company's board of directors and senior managers set, their demonstrated commitment to integrity and ethical values, the character of the people they hire, and how they evaluate others. 2. Risk assessment: managers should continuously assess the potential for fraud and other risks that could prevent the company from achieving its objectives. 3. Control activities: include various work responsibilities and duties completed by employees to reduce risks to an acceptable level.
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