Mary the Queen College (Pampanga), Inc.

JASA, San Matias, Guagua, Pampanga

College of Accountancy
Subject Code: AIS Module No.8/Title: 3- Ethics, Fraud, and
Internal Control

Subject Description: ACCOUNTING INFORMATION SYSTEM Period of Coverage: Week 7-8

Introduction: Fraud and Accountants

Objectives:
• Be able to distinguish between management fraud and employee fraud.
• Be familiar with common types of fraud schemes.

Content:

Fraud and Accountants

• Passage of SOX has had tremendous impact on the external auditor’s responsibilities for fraud
detection in a financial audit.
– Objective is to seamlessly blend fraud consideration into all phases of the audit process (SAS
99).
• Fraud denotes a false representation of material fact made with the intent to deceive and induce
another to rely it to their detriment. Act must meet five conditions:
– False representation: false statement or disclosure.
– Material fact: fact must be substantial in inducing someone to act.
– Intent to deceive: must exist or knowledge statement is false.
– Justifiable reliance: misrepresentation must have been relied on.
– Injury or loss: must have been sustained by the victim.

• Fraud in business has a more specialized meaning:

– Intentional deception, asset misappropriation or financial data manipulation to the
advantage of the perpetrator.
– White collar crime, defalcation, embezzlement, and irregularities.

• Auditors encounter two types of fraud:

 – Employee fraud (non-management) generally designed to convert cash or other assets to
the employee’s personal benefit.
– Management fraud does not involve direct theft and is more harmful as it usually involves
material misstatements of financial data.
• Perpetrated at levels of management above internal control structures.
• Frequently involves exaggerated financial statement results.
• Misappropriation of assets often shrouded in complex transactions involving related
third parties.

• The fraud triangle factors that contribute to fraud:

– Situational pressures that coerce an individual to act dishonestly.
– Opportunity through direct access to assets.
– Ethics which relate to one’s character and moral compass.
• A recent study suggests fraud losses equal 5% of revenue.
– Actual cost difficult to quantify and do not include indirect losses.
• Most frauds are committed by employees than managers, the losses are much higher for managers
and owners.
• Collusion in the commission of a fraud is difficult to prevent and detect.

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Fraud and Accountants: Underlying Problems

• Lack of Auditor Independence: Audit firms also engaged by their clients to perform non-accounting activities.
• Lack of Director Independence: Many board of directors are comprised of directors who are not independent.
• Questionable Executive Compensation Schemes: Stock options as compensation result in strategies aimed at
 driving up stock prices at the expense of the firm’s long-term health.
– In extreme cases financial statement misrepresentation has been used to achieve stock prices
needed to exercise options.
• Inappropriate Accounting Practices: Common characteristic to many financial statement fraud schemes.
• SOX establishes a framework for oversight and regulation of public companies. Principal reforms pertain to:
– Creation of the Public Company Accounting Oversight Board (PCAOB) to set standards, inspect
firms, conduct investigations and take regulator actions.
– Auditor independence: More separation between a firm’s attestation and non-auditing activities.
– Corporate governance and responsibility: Audit committee members must be independent and
committee must hire and oversee the external auditors.
– Issuer and management disclosure: Increased requirements.
– Fraud and criminal penalties: New penalties for destroying or tampering with documents, securities
fraud, and taking actions against whistleblowers.

Fraud Scemes
• Skimming involves stealing cash before it is recorded on an organization’s books.
• Cash larceny involves stealing cash after it is recorded.
– Lapping is a common technique.
• Billing schemes (vendor fraud) involves paying false vendors by submitting invoices for fictitious goods.
– A shell company fraud includes a false vendor set-up and false purchase orders.
– A pass through fraud involves both a legitimate and false vendor purchase (at a much higher price).
– A pay-and-return scheme involves double payment with the clerk intercepting the vendor
reimbursement check.
• Check tampering involves altering legitimate checks.
• Payroll fraud is the distribution of fraudulent paychecks.
• Expense reimbursement fraud involve false or inflated expense reimbursements.
• Thefts of cash are schemes that involve the direct theft of cash on hand.
• Non-cash misappropriations involve the theft of noncash assets like inventory or information.
• Computer fraud is discussed in a later chapter.

Evaluation: Class discussions and activity

References: Accounting Information System Book By James A. Hall

Next Lesson: Internal Control Concepts and Techniques

Prepared by: Ma Socorro M Sunglao, CPA Checked by: William I. Asenci, Approved by: Lanie M.
MBA CPA MBA, Dean, College of Galvan, PhD (VPAA)
Accountancy

Defalcation is misappropriation of funds by a person trusted with its charge; also, the act of
misappropriation, or an instance thereof. The term is more specifically used by the United States
Bankruptcy Code to describe a category of acts that taint a particular debt such that it cannot be
discharged in bankruptcy. Wikipedia
30 Mar 2020 — Embezzlement refers to a form of white-collar crime in which a person or entity
misappropriates the assets entrusted to him or her. In this type of fraud, the embezzler attains the
assets lawfully and has the right to possess them, but the assets are then used for unintended
purposes.

The method involves taking a subsequent receivables payment from a

transaction (for example, a sale) and using that to cover the theft. The receivable
from the second transaction is covered by money from the third transaction, and
so on.

skimming fraud is a type of white-collar crime that involves taking the cash of
a business prior to entering it into the accounting system. Skimming is an “off-
book” fraud because the cash theft has occurred before it is entered into
the bookkeeping system. Thus, it is never reported on the company’s
accounting records.
Skimming is an illegal practice used by identity thieves to capture credit card information from a
cardholder surreptitiously. Fraudsters often use a device called a skimmer that can be installed
at gas pumps or ATM machines to collect card data.