Chapter 5: Fraud and Internal Control
Fraud is an attempt to decieve others for personal gain.
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
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.
1. Incentive: The employee has a reason for committing fraud. Personal financial pressure may lead to asset
- 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.