ACCOUNTING INFORMATION SYSTEM REVIEWER

CHAPTER 1

The Information System: An Accountant’s

Perspective
THE INFORMATION ENVIRONMENT
Information is a business resource that:
 needs to be appropriately managed
 is vital to the survival of contemporary
businesses

Business organization divided horizontally into

several levels of Activity. (3) Internal and external information flows.

A third flow of information depicted in Figure 1-1

represents exchanges between the organization
and users in the external environment.

External users fall into two groups: trading

partners and stakeholders

Information Requirements

 Each user group has unique information

requirements.
(1) Business operations form the base of the  The higher the level of the organization, the
pyramid greater the need for more aggregated
(2) The three management tiers: operations information and less need for detail.
management, middle management, and WHAT IS A SYSTEM?
top management.
SYSTEM
Horizontal flows of information used primarily at A group of interrelated multiple components or
the operations level to capture transaction and subsystems that serve a common purpose.
operations data  NATURAL SYSTEMS
Vertical flows of information - ALL LIFE FORMS
- Plant and animal, are examples of natural
 downward flows — instructions, quotas, systems.
and budgets
 upward flows — aggregated transaction  ARTIFICIAL SYSTEMS
and operations data -MAN-MADE
-These systems include everything from
clocks to submarines and social systems to
information systems.

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System or subsystem? System Decomposition vs. System

 A system is called a subsystem when it is Interdependency
viewed as a component of a larger system.
SYSTEM DECOMPOSITION. Decomposition is the
 A subsystem is considered a system when it is
process of dividing the system into smaller sub-
the focus of attention.
system parts. This is a convenient way of
representing, viewing, and understanding the
ELEMENTS OF A SYSTEM
relationships among subsystems.
Regardless of their origin, all systems possess
some common elements. SUBSYSTEM INTERDEPENDENCY.
A system is a group of two or more interrelated
 distinct parts are not self-contained
components or subsystems that serve a common
 they are reliant upon the functioning of the
purpose.
other parts of the system
 MULTIPLE COMPONENTS. A system must  all distinct parts must be functioning or the
contain more than one part. system will fail
 RELATEDNESS. A common purpose relates
An Information System Framework
the multiple parts of the system.
 SYSTEM VERSUS SUBSYSTEM. A system is What is an Information System?
called a subsystem when it is viewed in
The information system is the set of formal
relation to the larger system of which it is a
procedures by which data are collected, processed
part. Likewise, a subsystem is called a
into information, and distributed to users.
system when it is the focus of attention.
 PURPOSE. A system must serve at least one AIS versus MIS?
purpose, but it may serve several. Whether
a system provides a measure of time,
electrical power, or information, serving a
purpose is its fundamental justification.
When a system ceases to serve a purpose, it
should be replaced.

An Example of an Artificial System

Let’s assume that the automobile system serves

only one purpose: providing conveyance. Transactions:

A transaction is a business event.

 Financial transactions
- economic events that affect the assets and
equities of the organization
- e.g., purchase of an airline ticket

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 Nonfinancial transactions • nonfinancial transactions that are not

- all other events processed by the normally processed by traditional AIS; e.g.,
organization’s information system tracking customer complaints
- e.g., an airline reservation — no
Management often requires information that
commitment by the customer
goes beyond the capability of AIS

AIS SUBSYSTEMS

• Transaction Processing System

(supports daily business operations)

The TPS is central to the overall function of the

information system by converting economic
What is Accounting Information System?
events into financial transactions, recording
Accounting is an information system. financial transactions in the accounting records
(journals and ledgers), and distributing essential
 It identifies, collects, processes, and
financial information to operations personnel to
communicates economic information about a
support their daily operations.
firm using a wide variety of technologies.
 It captures and records the financial effects of • General Ledger/Financial Reporting Systems
the firm’s transactions. (produces financial statements and reports)
 It distributes transaction information to
The general ledger system (GLS) and the financial
operations personnel to coordinate many key
reporting system (FRS) are two closely related
tasks.
subsystems. However, because of their
AIS versus MIS operational interdependency, they are generally
viewed as a single integrated system—the
Accounting Information Systems (AIS) process
GL/FRS.
• financial transactions; e.g., sale of goods
• nonfinancial transactions that directly affect
the processing of financial transactions; e.g.,
addition of newly approved vendors
• Management Reporting System
Management Information Systems (MIS) process

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(produces special-purpose reports for internal • External financial transactions are the most
use) common source of data for most
organizations. These are economic exchanges
The MRS provides the internal financial with other business entities and individuals
information needed to manage a business. outside the firm.
Managers must deal immediately with many day- - E.g., sale of goods and services,
to-day business problems, as well as plan and purchase of inventory, receipt of cash,
control their operations. and disbursement of cash (including
payroll)
A GENERAL MODEL FOR AIS
• Internal financial transactions involve the
exchange or movement of resources within
the organization.
- E.g., movement of raw materials into
work-in-process (WIP), application of
labor and overhead to WIP, transfer of
WIP into finished goods inventory, and
depreciation of equipment.

Transforming the Data into Information

1. End Users
Functions for transforming data into information
End users fall into two general groups:
according to the general AIS model:
• External users include creditors,
stockholders, potential investors, 1. Data Collection
regulatory agencies, tax authorities, is the first operational stage in the
suppliers, and customers information system. The objective is to
• Internal users include management at ensure that event data entering the
every level of the organization, as well system are valid, complete, and free from
as operations personnel. material errors.
2. Data • Capturing transaction data
are facts, which may or may not be processed • Recording data onto forms
(edited, summarized, or refined) and have no • Validating and editing the data
direct effect on the user.
3. Information 2. Data Processing
is data that have been organized and • Classifying
processed to provide meaning and improve • Transcribing
the decision-making process • Sorting
• Batching
Data Sources
• Merging
are financial transactions that enter the
• Calculating
information system from internal and external
• Summarizing
sources.
• Comparing

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3. Data Management 4. Information Generation

The organization’s database is its physical Information generation is the process of
repository for financial and nonfinancial compiling, arranging, formatting, and
data. presenting information to users.
Information can be an operational
• It can be a filing cabinet or a computer document such as a sales order, a
disk. Regardless of the database’s structured report, or a message on a
physical form, we can represent its computer screen
contents in a logical hierarchy. The
Characteristics of Useful Information
levels in the data hierarchy— attribute,
record, and file—are illustrated in Regardless of physical form or technology, useful
Figure 1-6. information has the following characteristics:

• Relevance: serves a purpose

• Timeliness: no older than the time
period of the action it supports
• Accuracy: free from material errors
• Completeness: all information essential
to a decision or task is present
• Summarization: aggregated in
accordance with the user’s needs

Feedback

• Feedback is a form of output that is sent back

to the system as a source of data. Feedback
may be internal or external and is used to
initiate or alter a process
• DATA ATTRIBUTE. The data attribute • For example, an inventory status report
is the most elemental piece of potentially signals the inventory control clerk that items
useful data in the database. An attribute is of inventory have fallen to, or below, their
a logical and relevant characteristic of an minimum allowable levels.
entity about which the firm captures data. • Internal feedback from this information will
The attributes shown in Figure 1-6 are initiate the inventory ordering process to
logical because they all relate sensibly to a replenish the inventories. Similarly, external
common entity—accounts receivable (AR). feedback about the level of uncollected
customer accounts can be used to adjust the
• Database management involves three organization’s credit-granting policies
fundamental tasks: storage, retrieval,
and deletion

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Information System Objectives in a Business Backbone systems consist of a basic system

Context structure on which to build.

Each organization must tailor its information Vendor-supported systems are custom (or
system to the needs of its users. Therefore, customized) systems that client organizations
specific information system objectives may differ purchase commercially rather than develop in-
from firm to firm. Three fundamental objectives house.
are, however, common to all systems:
Organizational Structure
1. To support the stewardship function of The structure of an organization helps to allocate
management. Stewardship refers to • responsibility
management’s responsibility to properly • authority
manage the resources of the firm. The • accountability
information system provides information
Segmenting by business function is a very
about resource utilization to external users via
common method of organizing
traditional financial statements and other
mandated reports. Internally, management
receives stewardship information from various
responsibility reports.
2. To support management decision making.
The information system supplies managers
with the information they need to carry out
their decision-making responsibilities.
3. To support the firm’s day-to-day operations.
The information system provides information
to operations personnel to assist them in the
The structure of an organization reflects the
efficient and effective discharge of their daily
distribution of responsibility, authority, and
tasks.
accountability throughout the organization.
ACQUISITION OF INFORMATION SYSTEMS
BUSINESS SEGMENTS
How organizations obtain information systems?
Business organizations consist of functional units
1. They develop customized systems from scratch or segments. Firms organize into segments to
through in-house systems development activities, promote internal efficiencies through the
and specialization of labor and cost-effective resource
allocations.
2. They purchase preprogrammed commercial
systems from software vendors. 1. Geographic Location. Many organizations have
operations dispersed across the country and
Three basic types of commercial software:
around the world.
Turnkey systems are completely finished and
2. Product Line. Companies that produce highly
tested systems that are ready for implementation.
diversified products often organize around
product lines, creating separate divisions for each.

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Product segmentation allows the organization to

devote specialized management, labor, and
resources to segments separately, almost as if they
were separate firms.

3. Business Function. Functional segmentation

divides the organization into areas of specialized
responsibility based on tasks. The functional areas
are determined according to the flow of primary
resources through the firm. Examples of business
function segments are marketing, production,
finance, and accounting.

FUNCTIONAL SEGMENTATION

Segmentation by business function is the most

common method of organizing.

‘‘The accounting system is a conceptual flow of

information that represents the physical flows of
personnel, raw materials, machinery, and cash
through the organization.’’ Materials Management

Materials management has three sub functions

• Purchasing is responsible for ordering

inventory from vendors when inventory
levels fall to their reorder points.
• Receiving is the task of accepting the
inventory previously ordered by purchasing.
Receiving activities include counting and

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checking the physical condition of these shipments, or damaged merchandise can result in
items. customer dissatisfaction and lost sales. Ultimately,
• Stores takes physical custody of the success depends on filling orders accurately in the
inventory received and releases these warehouse, packaging goods correctly, and
resources into the production process as shipping them quickly to the customer.
needed.
Personnel
Production
Competent and reliable employees are a valuable
Production activities occur in the conversion cycle
resource to a business. The objective of the
in which raw materials, labor, and plant assets are
personnel function is to effectively manage this
used to create finished products.
resource. A well-developed personnel function
includes recruiting, training, continuing education,
The specific activities are determined by the
counseling, evaluating, labor relations, and
nature of the products being manufactured. In
compensation administration.
general, they fall into two broad classes: (1)
primary manufacturing activities and (2)
Finance
production support activities
The finance function manages the financial
• Production planning involves scheduling the resources of the firm through banking and
flow of materials, labor, and machinery to treasury activities, portfolio management, credit
efficiently meet production needs. evaluation, cash disbursements, and cash receipts.
• Quality control monitors the manufacturing
process at various points to ensure that the THE ACCOUNTING FUNCTION
finished products meet the firm’s quality The accounting function manages the financial
standards. information resource of the firm. In this regard, it
• Maintenance keeps the firm’s machinery plays two important roles in transaction
and other manufacturing facilities in running processing
order. - First, accounting captures and records the
financial effects of the firm’s transactions.
Marketing
- Second, the accounting function
The marketplace needs to know about, and have
distributes transaction information to
access to, a firm’s products. The marketing
operations personnel to coordinate many
function deals with the strategic problems of
of their key tasks.
product promotion, advertising, and market
research. On an operational level, marketing The Value of Information
performs such daily activities as sales order entry
The value of information to a user is determined
by its reliability
Distributions
Distribution is the activity of getting the product to Accounting Independence
the customer after the sale. This is a critical step.
Information reliability rests heavily on the concept
Much can go wrong before the customer takes
of accounting independence. Simply stated,
possession of the product. Excessive lags between
accounting activities must be separate and
the taking and filling of orders, incorrect

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independent of the functional areas that maintain

custody of physical resources.

Information reliability requires accounting

independence.

• Accounting activities must be separate

and independent of the functional areas
maintaining resources.
• Accounting supports these functions with
information but does not actively
participate.
• Decisions makers in these functions
require that such vital information be
supplied by an independent source to
ensure its integrity.

THE INFORMATION TECHNOLOGY FUNCTION

Like accounting, the IT function is associated with

the information resource. Its activities can be
organized in a number of different ways.

One extreme structure is the centralized data

processing approach;

at the other extreme is the distributed data

processing approach. Most organizational
structures fall somewhere between these
extremes and embody elements of both.

The Computer Services Function

Potential Disadvantages of Distributed Data
Processing

• Loss of control
• Mismanagement of company resources
• Hardware and software incompatibility
• Redundant tasks and data
• Consolidating tasks usually segregated
• Difficulty attracting qualified personnel
• Lack of standards

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Potential Advantages of Distributed Data • Data Updating - changes or additions

Processing must be performed multiple times
• Currency of Information - potential
• Cost reductions in hardware and data
problem of failing to update all affected
entry tasks
files
• Improved cost control responsibility
• Task-Data Dependency - user’s inability to
• Improved user satisfaction since control is
obtain additional information as needs
closer to the user level
change
• Backup of data can be improved through
• Data Integration - separate files are
the use of multiple data storage sites
difficult to integrate across multiple users
The Evolution of IS Models
The Database Model
Manual Process Model

Transaction processing, information processing,

and accounting are physically performed by
people, usually using paper documents.

Useful to study because:

• helps link AIS courses to other accounting

courses
• often easier to understand business
REA Model
processes when not shrouded in
technology
• facilitates understanding internal controls

The Flat-File Model

The REA model is an accounting framework for

modeling an organization’s

• economic resources; e.g., assets

• economic events; i.e., affect changes in
resources
Data Redundancy Problems • economic agents; i.e., individuals and
departments that participate in an
• Data Storage - excessive storage costs of economic event
paper documents and/or magnetic form • Interrelationships among resources,
events and agents

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Entity-relationship diagrams (ERD) are often used • Plant Maintenance

to model these relationships. • Production Planning
• Quality Management
• Sales and Distribution
• Inventory Management

Accountants as Information System Users

Accountants must be able to clearly convey their

needs to the systems professionals who design the
system.

The accountant should actively participate in

systems development projects to ensure
appropriate systems design.

The accounting function is responsible for the

conceptual system, while the computer function is
responsible for the physical system.

The conceptual system determines the nature of

the information required, its sources, its
destination, and the accounting rules that must be
applied.

• External Auditors
ENTERPRISE RESOURCE PLANNING SYSTEMS - attest to fairness of financial
statements
Enterprise resource planning (ERP) is an - assurance service: broader in scope
information system model that enables an than traditional attestation audit
organization to automate and integrate its key • IT Auditors
business processes. - evaluate IT, often as part of external
ERP breaks down traditional functional barriers by audit
facilitating data sharing, information flows, and • Internal Auditors
the introduction of common business practices - in-house IS and IT appraisal services
among all organizational users.

ERP packages are sold to client organizations in

modules that support standard processes. Some
common ERP modules include:

• Asset Management
• Financial Accounting
• Human Resources
• Industry-Specific Solutions

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CHAPTER 2 • financial component (cash receipts)

Introduction to Transaction Processing Accounting Records (Manual System)

A Financial Transaction is... Document

an economic event that affects the assets and • Source Documents - used to capture and
equities of the firm, is reflected in its accounts, formalize transaction data needed for
and is measured in monetary terms. transaction processing
• Product Documents - the result of transaction
similar types of transactions are grouped together
processing
into three transaction cycles:
• Turnaround Documents - a product document
• the expenditure cycle of one system that becomes a source
• the conversion cycle document for another system
• the revenue cycle
Creation of A Source Documents

A Product Document
Each Cycle has Two Primary Subsystems

Expenditure Cycle: time lag between the two due

to credit relations with suppliers:

• physical component (acquisition of goods)

• financial component (cash disbursements to
the supplier)

Conversion Cycle:

• the production system (planning, scheduling,

and control of the physical product through
the manufacturing process)
• the cost accounting system (monitors the flow
of cost information related to production)

Revenue Cycle: time lag between the two due to

credit relations with customers:

• physical component (sales order processing)

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A Turnaround Document Accounting Records

Audit Trail

Journals and Ledgers

• Journals - a record of chronological entry

• special journals - specific classes of
transactions that occur in high Accountants should be able to trace in both
frequency directions. Sampling and confirmation are two
• general journal - nonrecurring, common techniques
infrequent, and dissimilar transactions Example of Tracing an Audit Trail
• Ledger - a book of financial accounts
• general ledger - shows activity for each
account listed on the chart of accounts
• subsidiary ledger - shows activity by detail
for each account type

Sales Order Recorder in Sales Journal

Flow of Information from Economic Event into Computer-Based Systems

the General Ledger
Types of Files in Computer-Based Systems

1. Master File – Stores account balances,

similar to general and subsidiary ledgers.
(e.g., accounts receivable, inventory).
2. Transaction File – Temporarily holds
transaction data before updating the
master file. (e.g., sales orders, cash
receipts).

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3. Reference File – Contains standards or these to transactions in the sales journal (archive
guidelines for processing transactions. file).
(e.g., tax tables, price lists, customer credit
4. From these journal entries, identify source
limits).
documents that can be pulled from their files and
4. Archive File – Stores past transactions for
verified. If necessary, confirm these source
audit and reference. (e.g., past payroll
documents by contacting the customers.
records, prior-period ledgers)
Introduction to Transaction Processing
Entity Relationship Diagram (ERD)
Cardinalities
A documentation technique to represent the
relationship between entities in a system. Represent the numerical mapping between
entities:
The REA model version of ERD is widely used in
AIS. REA uses 3 types of entities: • one-to-one
• one-to-many
• resources (cash, raw materials)
• many-to-many
• events (release of raw materials into the
production process)
• agents (inventory control clerk, vendor,
production worker)

Accounting Records in a Computer-Based System

Documentation Techniques

Data Flow Diagrams (DFD)

• use symbols to represent the processes,

data sources, data flows, and entities in a
system
• represent the logical elements of the
EXPLANATION OF STEPS IN FIGURE: system
1. Compare the AR balance in the balance sheet • do not represent the physical system
with the master file AR control account balance. Data Flow Diagram Symbols
2. Reconcile the AR control figure with the AR
subsidiary account total.

3. Select a sample of update entries made to

accounts in the AR subsidiary ledger and trace

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System Flowcharts Modern Systems versus Legacy Systems

• illustrate the relationship among processes • Modern systems characteristics:

and the documents that flow between them o client-server based and process
• contain more details than data flow diagrams transactions in real time
• clearly depict the separation of functions in a o use relational database tables
system o have high degree of process integration
• are used to represent the relationship and data sharing
between the key elements--input sources, o some are mainframe based and use batch
programs, and output products--of computer processing
systems • Some firms employ legacy systems for certain
• depict the type of media being used (paper, aspects of their data processing.
magnetic tape, magnetic disks, and o Accountants need to understand legacy
terminals) systems.
• in practice, not much difference between • Legacy systems characteristics:
document and system flowcharts o mainframe-based applications
Symbol Set for Representing Manual Procedures o batch oriented
o early legacy systems use flat files for data
storage
o later legacy systems use hierarchical and
network databases
o data storage systems promote a single-
user environment that discourages
information integration

Record Structures for Sales, Inventory, and

Accounts Receivable Files

Symbol Set for Representing Computer Processes

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Database Backup Procedures Computer-Based Accounting Systems (Batch

Processing/ Sequential File)

• Destructive updates leave no backup.

• To preserve adequate records, backup
procedures must be implemented, as shown
below:
o The master file being updated is copied as
a backup. Steps in Batch Processing /Sequential File
o A recovery program uses the backup to
• Keystroke - source documents are
create a pre-update version of the master
transcribed by clerks to magnetic tape for
file.
processing later
Computer-Based Accounting Systems • Edit Run - identifies clerical errors in the
batch and places them into an error file
Two broad classes of systems:
• Sort Run - places the transaction file in the
• batch systems same order as the master file using a primary
• real-time systems key
• Update Run - changes the value of
Batch Processing
appropriate fields in the master file to reflect
• A batch is a group of similar transactions that the transaction
are accumulated over time and then • Backup Procedure - the original master
processed together. continues to exist and a new master file is
• The transactions must be independent of one created
another during the time period over which
Real-Time Systems
the transactions are accumulated in order for
batch processing to be appropriate. • process transactions individually at the
• •A time lag exists between the event and the moment the economic event occurs
processing. • have no time lag between the economic
event and the processing
• generally require greater resources than
batch processing since they require dedicated
processing capacity; however, these cost
differentials are decreasing

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• oftentimes have longer systems • Track each transaction processed

development time • Identify any out-of-sequence documents
• Disadvantages:
o arbitrary information
o hard to make changes and insertions

Block Codes

• Represent whole classes by assigning each

class a specific range within the coding
scheme
• Used for chart of accounts
o The basis of the general ledger
• Allows for the easy insertion of new codes
within a block
Why Do So Many AIS Use Batch Processing? o Don’t have to reorganize the coding
structure
• AIS processing is characterized by high- • Disadvantage:
volume, independent transactions, such are o arbitrary information
recording cash receipts checks received in the
mail. Group Codes
• The processing of such high-volume checks • Represent complex items or events involving
can be done during an off-peak computer two or more pieces of data using fields with
time. specific meaning
• This is one reason why batch processing • For example, a coding scheme for tracking
maybe done using real-time data collection. sales might be 04-09-476214-99, meaning:
Data Coding Schemes o Store Number 04 09
o Dept. Number 476214
Uses of Coding in AIS o Item Number Salesperson 99
• Concisely represent large amounts of • Disadvantages:
complex information that would otherwise o arbitrary information
be unmanageable o overused
• Provide a means of accountability over the
Mnemonic Codes
completeness of the transactions processed
• Identify unique transactions and accounts • Alphabetic characters used as abbreviations,
within a file acronyms, and other types of combinations
• Support the audit function by providing an • Do not require users to memorize the
effective audit trail meaning since the code itself is informative –
and not arbitrary
Sequential Codes
o NY = New York
• Represent items in sequential order • Disadvantages:
• Used to prenumber source documents o limited usability and availability

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CHAPTER 3 • Environmental issues

• Artificial intelligence
Ethics, Fraud, and Internal Control
• Unemployment and displacement
Business Ethics • Misuse of computer

Business ethics involves finding the answers to SARBANES-OXLEY ACT AND ETHICAL ISSUES
two questions:
Section 406—Code of Ethics for Senior Financial
• How do managers decide on what is right in Officers
conducting their business?
A public company may disclose its code of ethics in
• Once managers have recognized what is right,
several ways: PCAOB = PICPA
how do they achieve it?
SOX LAW
Four Main Areas of Business Ethics
• included as an exhibit to its annual report
• as a posting to its Web site
• by agreeing to provide copies of the code
upon request.

The SEC has ruled that compliance with Section

406 necessitates a written code of ethics that
addresses the following ethical issues.

CONFLICTS OF INTEREST. The company’s code of

ethics should outline procedures for dealing with
actual or apparent conflicts of interest between
personal and professional relationships.
Computer Ethics
is ‘‘the analysis of the nature and social impact of FULL AND FAIR DISCLOSURES. This provision
computer technology and the corresponding states that the organization should provide full,
formulation and justification of policies for the fair, accurate, timely, and understandable
ethical use of such technology disclosures in the documents, reports, and
financial statements that it submits to the SEC and
Three levels of computer ethics: pop, para, and to the public.
theoretical
LEGAL COMPLIANCE. Codes of ethics should
concerns the social impact of computer require employees to follow applicable
technology (hardware, software, and governmental laws, rules, and regulations.
telecommunications).
INTERNAL REPORTING OF CODE VIOLATIONS. The
What are the main computer ethics issues? code of ethics must provide a mechanism to
• Privacy permit prompt internal reporting of ethics
• Security—accuracy and confidentiality violations.
• Ownership of property
• Equity in access

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ACCOUNTABILITY. An effective ethics program (1) situational pressure, which includes

must take appropriate action when code violations personal or job-related stresses that could
occur. coerce an individual to act dishonestly.
(2) opportunity, which involves direct access
Fraud
to assets and/or access to information
Fraud and Accountants that controls assets.
(3) ethics, which pertains to one’s character
Statement on Auditing Standards (SAS) No. 99,
and degree of moral opposition to acts of
Consideration of Fraud in a Financial Statement
dishonesty
Audit. The objective of SAS 99 is to seamlessly
blend the auditor’s consideration of fraud into all
phases of the audit process. In addition, SAS 99
requires the auditor to perform new steps such as
a brainstorming during audit planning to assess
the potential risk of material misstatement of the
financial statements from fraud schemes.

Legal Definition of Fraud

Fraud denotes 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
To provide insight into these factors, auditors
justifiably rely on the fact to his or her detriment.
often use a red-flag checklist consisting of the
According to common law, a fraudulent act must
following types of questions:
meet the following five conditions:
• Do key executives have unusually high
• False representation - false statement or
personal debt?
disclosure
• Do key executives appear to be living
• Material fact - a fact must be substantial in
beyond their means?
inducing someone to act
• Do key executives engage in habitual
• Intent to deceive must exist
gambling?
• The misrepresentation must have resulted in
• Do key executives appear to abuse alcohol
justifiable reliance upon information, which
or drugs?
caused someone to act
• Do any of the key executives appear to lack
• The misrepresentation must have caused
personal codes of ethics?
injury or loss
• Are economic conditions unfavorable within
Fraud Triangle the company’s industry?
• Does the company use several different
The fraud triangle consists of three factors that
banks, none of which sees the company’s
contribute to or are associated with management
entire financial picture?
and employee fraud
• Do any key executives have close
associations with suppliers?

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• Is the company experiencing a rapid • Age. Older employees tend to occupy higher-
turnover of key employees, either through ranking positions and therefore generally have
resignation or termination? greater access to company assets.
• Do one or two individuals dominate the
company? • Education. Generally, those with more education
occupy higher positions in their organizations and
Studies therefore have greater access to company funds
2008 ACFE Study of Fraud (Association of Certified and other assets.
Fraud Examiners) THE PERPETRATORS OF FRAUDS
• Collusion. One reason for segregating
• Loss due to fraud equal to 7% of revenues— occupational duties is to deny potential
approximately $994 billion perpetrators the opportunity they need to commit
fraud. When individuals in critical positions
• Loss by position within the company:
collude, they create opportunities to control or
Position % of Loss $ gain access to assets that otherwise would not
Frauds exist
Owner/Executive 23% $834,000
Manager 37% 150,000 Underlying Problems
Employee 40% 70,000
• Lack of Auditor Independence: auditing firms
• Other results: higher losses due to men, also engaged by their clients to perform non
employees acting in collusion, and employees with accounting activities
advance degrees
• Lack of Director Independence: directors who
THE PERPETRATORS OF FRAUDS also serve on the boards of other companies, have
a business trading relationship, have a financial
• Fraud Losses by Position within the
relationship as stockholders or have received
Organization
personal loans, or have an operational relationship
• Fraud Losses and the Collusion Effect
as employees
• Fraud Losses by Gender
• Fraud Losses by Age • Questionable Executive Compensation
• Fraud Losses by Education Schemes: short-term stock options as
compensation result in short-term strategies
Conclusions
aimed at driving up stock prices at the expense of
• Position. Individuals in the highest positions the firm’s long-term health
within an organization are beyond the internal
• Inappropriate Accounting Practices: a
control structure and have the greatest access to
characteristic common to many financial
company funds and assets.
statement fraud schemes
• Gender. Women are not fundamentally more
o Enron made elaborate use of special
honest than men, but men occupy high corporate
purpose entities.
positions in greater numbers than women. This
affords men greater access to assets.

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o WorldCom transferred transmission line Management Fraud

costs from current expense accounts to
capital accounts. three special characteristics

Sarbanes-Oxley Act of 2002 • Perpetrated at levels of management above

the one to which internal control structure
Its principal reforms pertain to: relates
• Frequently involves using financial
• Creation of the Public Company Accounting statements to create an illusion that an
Oversight Board (PCAOB) entity is more healthy and prosperous than
• Auditor independence—more separation it actually is
between a firm’s attestation and non- • Involves misappropriation of assets, it
auditing activities frequently is shrouded in a maze of complex
• Corporate governance and responsibility— business transactions
audit committee members must be
independent and the audit committee must Fraud Schemes
oversee the external auditors
• Disclosure requirements—increase issuer Three categories of fraud schemes according to
and management disclosure the Association of Certified Fraud Examiners:
• Fraud and Criminal Penalties - SOX imposes
a range of new criminal penalties for fraud
A. Fraudulent Statements
and other wrongful acts. In particular, the
• Misstating the financial statements to
act creates new federal crimes relating to
make the copy appear better than it is
the destruction of documents or audit work
• Usually occurs as management fraud
papers, securities fraud, tampering with
• May be tied to focus on short-term
documents to be used in an official
financial measures for success
proceeding, and actions against whistle-
• May also be related to management
blowers.
bonus packages being tied to financial
Employee Fraud statements

• Committed by non-management personnel B. Corruption

• Usually consists of: an employee taking cash • Corruption involves an executive,
or other assets for personal gain by manager, or employee of the organization
circumventing a company’s system of in collusion with an outsider.
internal controls • four principal types of corruption: bribery,
• Employee fraud usually involves three steps: illegal gratuities, conflicts of interest, and
(1) stealing something of value (an asset), economic extortion.
(2) converting the asset to a usable form o BRIBERY. Bribery involves giving,
(cash), and (3) concealing the crime to avoid offering, soliciting, or receiving things
detection of value to influence an official in the
performance of his or her lawful
duties.

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o ILLEGAL GRATUITIES. An illegal and cashes a check from Customer A. To

gratuity involves giving, receiving, conceal the accounting imbalance caused
offering, or soliciting something of by the loss of the asset, Customer A’s
value because of an official act that account is not credited. Later (the next
has been taken billing period), the employee uses a check
o CONFLICTS OF INTEREST. Every received from Customer B and applies it to
employer should expect that his or Customer A’s account. Funds received in
her employees will conduct their the next period from Customer C are then
duties in a way that serves the applied to the account of Customer B, and
interests of the employer. so on.
o ECONOMIC EXTORTION. Economic
extortion is the use (or threat) of • Billing schemes, also known as vendor
force (including economic sanctions) fraud, are perpetrated by employees who
by an individual or organization to causes their employer to issue a payment
obtain something of value. to a false supplier or vendor by submitting
invoices for fictitious goods or services,
C. Asset Misappropriation inflated invoices, or invoices for personal
• Most common type of fraud and often purchase.
occurs as employee fraud
• Examples: Three examples of billing scheme
o making charges to expense accounts o A shell company fraud first requires
to cover theft of asset (especially cash) that the perpetrator establish a false
o lapping: using customer’s check from supplier on the books of the victim
one account to cover theft from a company.
different account o A pass through fraud is similar to the
o transaction fraud: deleting, altering, shell company fraud with the
or adding false transactions to steal exception that a transaction actually
assets takes place.
• Skimming involves stealing cash from an o A pay-and-return scheme is a third
organization before it is recorded on the form of vendor fraud. This typically
organization’s books and records. One involves a clerk with check writing
example of skimming is an employee who authority who pays a vendor twice
accepts payment from a customer but for the same products (inventory or
does not record the sale (example is mail supplies) received
room fraud )
• Cash larceny involves schemes in which • Check Tampering involves forging or changing in
cash receipts are stolen from an some material way a check that the organization
organization after they have been has written to a legitimate payee
recorded in the organization’s books and
• Payroll fraud is the distribution of fraudulent
records, An example of this is lapping, in
paychecks to existent and/or nonexistent
which the cash receipts clerk first steals
employees.

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• Expense reimbursement frauds are schemes in • REASONABLE ASSURANCE the cost of

which an employee makes a claim for achieving improved control should not
reimbursement of fictitious or inflated business outweigh its benefits
expenses. • METHODS OF DATA PROCESSING The
control techniques used to achieve these
• Thefts of cash are schemes that involve the objectives will, however, vary with
direct theft of cash on hand in the organization. different types of technology.
• LIMITATIONS.
• Non-cash fraud schemes involve the theft or
misuse of the victim organization’s non-cash Limitations of Internal Controls
assets.
• Possibility of honest errors
• Computer Fraud. Because computers lie at the • Circumvention via collusion
heart of modern accounting information systems, • Management override
the topic of computer fraud is of importance to • Changing conditions--especially in
auditors. Although the fundamental structure of companies with high growth
fraud is unchanged by computers— fraudulent
statements, corruption, and asset The Internal Controls Shield
misappropriation—computers do add complexity
to the fraud picture.

Internal Control

Internal Control Objectives According to AICPA

SAS (American Institute of Certified Public
Accountants, Statements on Auditing Standard)

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 Exposures of Weak Internal Controls (Risk)
prescribed policies and procedures
The absence or weakness of a control is called an
Modifying Assumptions exposure. A weakness in internal control may
expose the firm to one or more of the following
Inherent in these control objectives are four
types of risks:
modifying assumptions that guide designers and
auditors of internal controls. • Destruction of an asset
• Theft of an asset
• MANAGEMENT RESPONSIBILITY. This
• Corruption of information
concept holds that the establishment and
• Disruption of the information system
maintenance of a system of internal
control is a management responsibility

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Preventive, Detective, and Corrective Controls • External influences—regulatory agencies

• Policies and practices managing human
resources
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
SAS 78 /COSO
• restructuring, downsizing
Committee of Sponsoring Organizations of the • changes in accounting policies
Treadway Commission (COSO)
SAS 78/COSO requires that auditors obtain
Describes the relationship between the firm’s... sufficient knowledge of the organization’s risk
assessment procedures to understand how
• internal control structure, management identifies, prioritizes, and manages
• auditor’s assessment of risk, and the risks related to financial reporting.
• the planning of audit procedures

How do these three interrelate? 3. Information and communication

The weaker the internal control structure, the The AIS should produce high quality information
higher the assessed level of risk; the higher the which:
risk, the more auditor procedures applied in the
audit. • identifies and records all valid transactions
• provides timely information in appropriate
Five Internal Control Components: SAS 78/COSO detail to permit proper classification and
financial reporting
1. Control environment • accurately measures the financial value of
transactions
Important elements of the control environment
• accurately records transactions in the
are:
time period in which they occurred
• Integrity and ethics of management
Auditors must obtain sufficient knowledge of the
• Organizational structure
IS to understand:
• Role of the board of directors and the
audit committee • the classes of transactions that are
• Management’s policies and philosophy material
• Delegation of responsibility and authority
• Performance evaluation measures

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o how these transactions are initiated • Physical controls—primarily pertain to

[input] human activities
o the associated accounting records and
accounts used in processing [input] Two Types of IT Controls
• the transaction processing steps involved
• General controls—pertain to the entity wide
from the initiation of a transaction to its
computer environment
inclusion in the financial statements
[process] o Examples: controls over the data center,
• the financial reporting process used to organization databases, systems
compile financial statements, disclosures, development, and program maintenance
and estimates [output]
• Application controls—ensure the integrity of
4. Monitoring specific systems

The process for assessing the quality of internal o Examples: controls over sales order
control design and operation processing, accounts payable, and payroll
applications
[This is feedback in the general AIS model.]
Six Categories of Physical Controls
• Separate procedures—test of controls by
internal auditors 1. Transaction Authorization
• Ongoing monitoring:
o computer modules integrated into • used to ensure that employees are carrying
routine operations out only authorized transactions
o management reports which highlight • general (everyday procedures) or specific
trends and exceptions from normal (non-routine transactions) authorizations
performance
2. Segregation of Duties
[red shows relationship to the general AIS
model]
• In manual systems, separation between:
o authorizing and processing a
5. Control activities
transaction
o custody and recordkeeping of the
Policies and procedures to ensure that the
appropriate actions are taken in response to asset
identified risks o subtasks
• In computerized systems, separation
between:
o program coding
Fall into two distinct categories: o program processing
o program maintenance
• IT controls—relate specifically to the
computer environment Control Objectives for Transactions

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• The rules are often embedded within

computer programs.
o EDI/JIT: automated re-ordering of
inventory without human
intervention

2. Segregation of Duties

• A computer program may perform many

tasks that are deemed incompatible.
3. Supervision • Thus the crucial need to separate program
development, program operations, and
• a compensation for lack of segregation;
program maintenance.
some may be built into computer systems
3. Supervision
4. Accounting Records
• The ability to assess competent employees
• provide an audit trail
becomes more challenging due to the
5. Access Controls greater technical knowledge required.

• help to safeguard assets by restricting 4. Accounting Records

physical access to them
• ledger accounts and sometimes source
6. Independent Verification documents are kept magnetically
o no audit trail is readily apparent
• Reconciling batch totals at points during provide an audit trail
transaction processing.
• Comparing physical assets with accounting 5. Access Controls
records.
• Data consolidation exposes the
• Reconciling subsidiary accounts with
organization to computer fraud and
control accounts.
excessive losses from disaster.
• Reviewing management reports (both
computer and manually generated) that
6. Independent Verification
summarize business activity.
• 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.

Physical Controls in IT Contexts

1. Transaction Authorization

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