Chapter 11: Introduction to Business Ethics and Fraud

Chapter 11: Introduction to Business Ethics and Fraud
IT Auditing & Assurance, 2e, Hall & Singleton IT Auditing & Assurance, 2e, Hall & Singleton

ETHICS Pertains to the principles of conduct that individuals use in making choices and guiding their behavior in situations that involve the concepts of right and wrong. Business Ethics How do managers decide on what is right in conducting business? Once managers have recognized what is right, how to they achieve it? The necessity to have an articulate foundation for ethics and a consistent application of the ethical standards. Ethics – pertains to the principles of conduct that individuals use in making choices and guiding their behavior in situations that involve the concepts of right and wrong. Business ethics involves finding the answers to two questions. How do managers decide on what is right in conducting their business? Once managers have recognized what is right, how do they achieve it? IT Auditing & Assurance, 2e, Hall & Singleton

Ethical Issues in Business [Table 11-1]
BUSINESS ETHICS Basis of Ethical Standards Religious Philosophical Historical IBM combination of all three Ethical Issues in Business [Table 11-1] Equity Exec. salaries Pricing Rights Health (screening) Privacy Sexual harassment Equal opportunity Whistleblowing Honesty Conflicts of interest Security of data & records Foreign practices [FCPA] Accurate F/S reporting Exercise of Corp. Power PAC, and politics Workplace safety Downsizing, closures Business Ethics can be divided into 4 areas: Equity, Rights, Honesty, Exercise of Corporate Power [Table 11-1] IT Auditing & Assurance, 2e, Hall & Singleton

IMPLEMENTING BUSINESS ETHICS
1990 Business Roundtable Greater commitment of top management Written codes (policy) that clearly communicate standards and expectations Programs to implement ethical guidelines Techniques to monitor compliance Boeing Uses line managers to lead ethics training Toll-free number to report violations General Mills Published guidelines with vendors, competitors, customers Johnson & Johnson Creed integral to its culture Uses surveys to ascertain compliance SAIC Toll-free number, required training, separate dept. HOW SOME FIRMS ADDRESS ETHICAL ISSUES 1. Greater commitment of top management to improving ethical standards 2. Written codes that clearly communicate management expectations 3. Programs to implement ethical guidelines 4. Techniques to monitor compliance EXAMPLES: Boeing uses line managers to lead ethics training; toll-free number to report violations General Mills has published guidelines with vendors, competitors, customers Johnson & Johnson has a creed integral to its culture; uses surveys to ascertain compliance SAIC has toll-free number and separate ethics department to handle reports, questions, and whistleblowers Examples IT Auditing & Assurance, 2e, Hall & Singleton

Role of Management Create and maintain appropriate ethical atmosphere Limit the opportunity and temptation for unethical behavior Management needs a methodology for including lower-level managers and employees in the ethics schema Many times, lower-level managers responsible to uphold ethical standards Poor ethical standards among employees are a root cause of employee fraud and abuses Managers and employees both should be made aware of firm’s code of ethics What if management is unethical? e.g., Enron The Role of Management in Maintaining the Ethical Climate Must create and maintain an appropriate ethical atmosphere; they must limit the opportunity and temptation for unethical behavior within the firm. In many situations it is up lower-level managers to uphold a firm’s ethical standards. Poor ethical standards among employees are a root cause of employee fraud and other abuses. A method needs to be developed for including lower-level mangers and employees in the ethics schema of the firm. Managers and employees alike should be made aware of the firm’s code of ethics. IT Auditing & Assurance, 2e, Hall & Singleton

Reported Abuses Typically junior employees (Wall Street Journal) Half of American workers believe the best way to get ahead is politics and cheating One-third of a group of 9,175 surveyed had stolen property and supplies from employers Ethics Resource Center: 1994 study 41% falsified reports 35% committed theft Reported abuses: · Typically junior employees (WSJ) – in case of frauds, typically male, educated, many years on job, holds some key position · Half of American workers believe the way to get ahead is through politics and cheating · One-third of a group [9,175] surveyed had stolen property and supplies from employers · Ethics Resource Center, 1994 study, falsifying reports (41%) and theft (35%) Ethical Development Figure 11-2 Most individuals develop a code of ethics as a result of their family environment, formal educations, and personal experiences. We all go through several stages of moral evolution before settling on one level of ethical reasoning. Ethical Development Most people develop a personal code of ethics from family, formal education, and personal experience Go through stages of moral evolution [Figure 11-2] IT Auditing & Assurance, 2e, Hall & Singleton

Making Ethical Decisions Business schools can and should be involved in ethical development of future managers Business programs can teach students analytical techniques to use in trying to understand and properly handle a firm’s conflicting responsibilities to its employees, shareholders, customers, and the public Every ethical decision has risks and benefits. Balancing them is the manager’s ethical responsibility: Ethical Principles Making Ethical Decisions Business schools can and should be involved in the ethical development of future managers. Business programs can teach students analytical techniques to use in trying to understand and put into perspective a firm’s conflicting responsibilities to its employees, shareholders, customers, and the public. Every ethical decision has both risks and benefits. The balance between these consequences is the managers’ ethical responsibility. The following ethical principles provide some guidance in the discharge of this responsibility. Proportionality – the benefit from a decision must outweigh the risks. With alternatives of equal or greater benefits, choose one with least risk. Justice – the benefits of the decision should be distributed fairly to those who share the risks. Those who do not benefit should not carry the burden of risk. Minimize Risk – the decision should be implemented so as to minimize all of the risks and avoid any unnecessary risks. Proportionality: Benefits of a decision must outweigh the risks. Choose least risky option. Justice: Distribute benefits of decision fairly to those who share risks. Those who do not benefit should not carry any risk Minimize Risk: Minimize all risks. IT Auditing & Assurance, 2e, Hall & Singleton

Levels of Computer Ethics
The analysis of the nature and social impact of computer technology and the corresponding formulation and justification of policies for the ethical use of such technology. Levels of Computer Ethics POP: the exposure to stories and reports in popular media PARA: taking a real interest in computer ethics cases and acquiring some level of skill and knowledge THEORETICAL: multi-disciplinary researchers who apply the theories of philosophy, sociology, and psychology to computer science, intending to bring some new understanding to the field. That is, ethics research. WHAT IS COMPUTER ETHICS “The analysis of the nature and social impact of computer technology and the corresponding formulation and justification of policies for the ethical use of such technology.” Three levels of computer ethics: Pop – computer ethics is simply the exposure to stories and reports found in the popular media regarding the good or bad ramifications of computer technology (e.g., reporting of viruses) Para - computer ethics involves taking a real interest in computer ethics cases and acquiring some level of skill and knowledge in the field. Theoretical – computer ethics is of interest to multidisciplinary researchers who apply the theories of philosophy, sociology, and psychology to computer science with the goal of bringing some new understanding to the field IT Auditing & Assurance, 2e, Hall & Singleton

COMPUTER ETHICS A new problem or just a new twist to an old problem?
Although computer programs are a new type of asset, many believe that they should not be considered as different form other forms of property; i.e., intellectual property is the same as real property and the rights associated with real property. A New Problem or Just a New Twist on an Old Problem? Although computer programs are a new type of asset, many believe that they should not be considered as different from other forms of property. That is, is intellectual property the same as real property and the rights concomitant with real property. IT Auditing & Assurance, 2e, Hall & Singleton

COMPUTER ETHICAL ISSUES
Privacy: Ownership of personal information Policies Security: Systems attempt to prevent fraud and abuse of computer systems, furthering the legitimate interests of firm Shared databases have potential to disseminate inaccurate info to authorized users Ownership of Property: Federal copyright laws Race: African-Americans and Hispanics constitute 20% of population but 7% of MIS professionals Privacy – “… is a matter of restricted access to persons or information about persons.” People prefer to be in full control of what and how much information about themselves is available to others, and to whom it is available. The creation and maintenance of huge, shared databases makes it necessary to protect people from the potential misuse of data. That raises the issue of ownership in the personal information industry. Security (Accuracy and Confidentiality) – computer security is an attempt to avoid such undesirable events as a loss of confidentiality or data integrity. Security systems attempt to prevent fraud and other misuse of computer systems; they act to protect and further the legitimate interests of the system’s constituencies. The ethical issues involving security arise from the emergency of shared, computerized databases that have the potential to cause irreparable harm to individuals by disseminating inaccurate information to authorized users. Ownership of Property – laws designed to preserve real property rights have been extended to cover what is referred to as intellectual property – SOFTWARE. Copyright laws have been invoked in an attempt to protect those who develop software from having it copied. Race – African Americans and Hispanics constitute about 20 percent of the U.S. population, they make up only 7 percent of management information systems (MIS) professionals. Should something special be done in this situation? IT Auditing & Assurance, 2e, Hall & Singleton

Equity in Access: Some barriers are avoidable, some are not Factors: economic status, affluence of firm, documentation language, cultural limitations Environmental Issues: Should firms limit non-essential hard copies? What is non-essential? Disposal of equipment and supplies (toner) Artificial Intelligence: Who is responsible for faulty decisions from an Expert System? What is the extent of AI/ES in decision-making processes? Equity in Access – some barriers to access are intrinsic to the technology of information systems, but some are avoidable through careful system design. Factors that limit access to computing technology: The economic status of the individual, the affluence of an organization, documentation in only one language, other cultural limitations. Environmental Issues – computers with high-speed printers allow for the production of printed documents faster than ever before. Should organizations limit nonessential hard copies? What is nonessential definition? Artificial Intelligence – a new set of social and ethical issues has arisen out of the popularity of expert systems. Both knowledge engineers and domain experts must be concerned about their responsibility for faulty decisions, incomplete or inaccurate knowledge bases, and the role given to computers in the decision-making process. This has the potential to cause a displacement of “experts” b/c expert systems attempt to clone a manger’s decision-making style. IT Auditing & Assurance, 2e, Hall & Singleton

Unemployment & Displacement: Computers and technology sometimes replace jobs (catch-22, productivity) Some people unable to change with IT, get displaced and find it difficult to obtain new job Misuse of Computer: Copying proprietary software Using a firm’s computers for personal benefit Snooping through firm’s files Internal Control Responsibility: Unreliable information leads to bad decision, possible financial distress Management must establish and maintain a system of appropriate internal controls to ensure integrity and reliability of data (antithetical) IS professionals and accountants are central to adequate internal controls Unemployment and Displacement – many jobs have been and are being changed as a result of the availability of computer technology. People unable or unprepared to change are displaced and are finding it difficult to obtain new jobs. Misuse of Computers – computers can be misused in many ways. Examples: Copying proprietary software, using a company’s computer for personal benefit, snooping through other people’s files, and using company systems for personal pleasure or business during company time (or not?). Internal Control Responsibility – a business cannot meet its financial obligations or achieve the objectives if its information is unreliable. Managers must establish and maintain a system of appropriate internal controls to ensure that integrity and reliability of their data. Information systems professionals and accountants are central to ensuring control adequacy. IT Auditing & Assurance, 2e, Hall & Singleton

IT Auditing & Assurance, 2e, Hall & Singleton
FRAUD & ACCOUNTANTS The lack of ethical standards* is fundamental to the occurrence of business fraud. No major aspect of the independent auditor’s role has caused more difficulty for public accounting than the responsibility for detection of fraud during an audit. [article] This issue has gathered momentum outside the accounting profession to the point where the profession faces a crisis in public confidence in its ability to perform independent attest functions. [SAS 82] 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 justifiably rely on the fact to his/her detriment, i.e., his/her injury or loss. Synonyms: White-collar crime, defalcation, embezzlement, irregularities. FRAUD The lack of ethical standards is fundamental to business fraud. No major aspect of the independent auditor’s role has caused more difficulty for the public accounting profession than the responsibility for the detection of fraud during an audit. The issue of the auditor’s role in detecting fraud has gathered momentum to the point where the public accounting profession today faces a crisis in public confidence in its ability to perform the independent attestation function. [SAS 82] From SEC, Congress, public press. 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 justifiably rely on the fact to his or her detriment. Also known as white-collar crime, defalcation, embezzlement, and irregularities. * See Messina et al. research into Ethics and Actual Frauds (coops) IT Auditing & Assurance, 2e, Hall & Singleton

FRAUD A fraudulent act must meet the following 5 conditions:
False representation Material fact Intent Justifiable reliance Injury or loss A fraudulent act must meet the following 5 conditions: False representation Material fact Intent Justifiable Reliance Injury or loss Forensic Accounting · Investigation · Evidence for court · Litigation · CFE – Association of Certified Fraud Examiners [see newsletter sample] IT Auditing & Assurance, 2e, Hall & Singleton

FRAUD TREE Asset misappropriation fraud Stealing something of value – usually cash or inventory (i.e., asset theft) Converting asset to usable form Concealing the crime to avoid detection Usually, perpetrator is an employee Financial fraud Does not involve direct theft of assets Often objective is to obtain higher stock price (i.e., financial fraud) Typically involves misstating financial data to gain additional compensation, promotion, or escape penalty for poor performance Often escapes detection until irreparable harm has been done Usually, perpetrator is executive management Source: ACFE Corruption fraud Bribery, etc. IT Auditing & Assurance, 2e, Hall & Singleton

FRAUD SCHEMES Fraudulent financial statements {5%} Corruption {10%} Bribery Illegal gratuities Conflicts of interest Economic extortion Asset misappropriation {85%} Charges to expense accounts Lapping Kiting Transaction fraud FRAUD SCHEMES ACFE 2002 Report to the Nation Fraudulent Financial Statements {5%} Corruption {10%} Bribery Illegal gratuities Conflicts of interest Economic extortion Asset Misappropriation {85%} Charges to Expense Accounts {??} Lapping {??} Kiting {??} Transaction Fraud {??} IT Auditing & Assurance, 2e, Hall & Singleton

EMPLOYEE FRAUD Employee Theft Theft of asset Conversion of asset (to cash, to fraudster) Concealment of fraud Employee fraud – done by non-management employees are generally designed to directly convert cash or other assets to the employee’s personal benefit. Employee fraud usually involves 3 steps: stealing something of value, converting the asset to a usable form, and concealing the crime to avoid detection. Management fraud – often escapes detection until irreparable damage has been done. Does not involve the direct theft of assets. Management may engage in fraudulent activities to obtain a higher price from a stock or debt offering or just to meet the expectations of investors. May typically involve materially misstating financial data and reports to gain additional compensation, to garner a promotion, or to escape the penalty for poor performance. IT Auditing & Assurance, 2e, Hall & Singleton

MANAGEMENT FRAUD Special Characteristics: Perpetrated at levels of management above the one where internal controls relate Frequently involves using the financial statements to create false image of corporate financial health If fraud involves misappropriation of assets, it frequently is shrouded in a complex maze of business transactions, and often involves third parties. [e.g., ZZZZ Best fraud] Three special characteristics: · Perpetrated at levels of management above the one where internal controls relate · Frequently involves using the financial statements to create illusions about corporate financial health · If fraud involves misappropriation of assets, it frequently is shrouded in a complex maze of business transactions, and often involves third parties IT Auditing & Assurance, 2e, Hall & Singleton

FRAUD TRIANGLE People engage in fraudulent activities as a result of forces within the individual (their ethical system) and without (from temptation and/or stress from the external environment) Situational Pressures Opportunity Rationalization A person with a high level of personal ethics and limited pressure and opportunity to commit fraud is most likely to behave honestly [Figure 11-2] A person with low level of integrity, and moderate to high pressures, and moderate to high opportunity is most likely to commit fraud Auditors can develop a “red flag” checklist to detect possible fraudulent activity A questionnaire approach could be used to help auditors uncover motivations for fraud Factors that Contribute to Fraud People engage in fraudulent activities as a result of an interaction of forces both within the individual’s personality and the external environment. Three major categories: Situational Pressures, Opportunity, Rationalization. A person with a high level of personal ethics and limited pressure and opportunity to commit fraud is most likely to behave honestly. An individual with less personal integrity, when placed in situations with increasing pressure and given the opportunity, is most likely to commit fraud. Auditors can develop a red flag checklist to detect possible fraudulent activity. A questionnaire approach could be used to help external auditors uncover motivations for committing fraud. IT Auditing & Assurance, 2e, Hall & Singleton

POSSIBLE QUESTIONNAIRE
Do key executives have unusually high personal debt? Do key executives appear to be living beyond their means? Do key executives engage in habitual gambling? Do key executives appear to abuse alcohol or drugs? Do key executives appear to lack personal codes of ethics? Do key executives appear to be unstable (e.g., frequent job or residence changes, mental or emotional problems)? Are economic conditions unfavorable within the company’s industry? Does the company use several different banks, none of which sees the company’s entire financial picture? Do key executives have close associations with suppliers? Do key executives have close associations with members of the Audit Committee or Board? Is the company experiencing a rapid turnover of key employees, either through quitting or being fired? Do one or two individuals dominate the company? Does anyone never take a vacation? SAMPLES: Do key executives have unusually high personal debt? Do key executives appear to be living beyond their means? Do key executives engage in habitual gambling? Do key executives appear to abuse alcohol or drugs? Do key executives appear to lack personal codes of ethics? Do key executives appear to be unstable (e.g., frequent job or residence changes, mental or emotional problems)? Are economic conditions unfavorable within the company’s industry? Does the company use several different banks, none of which sees the company’s entire financial picture? Do key executives have close associations with suppliers? Do key executives have close associations with members of the Audit Committee or Board? Is the company experiencing a rapid turnover of key employees, either through quitting or being fired? Do one or two individuals dominate the company? IT Auditing & Assurance, 2e, Hall & Singleton

FINANCIAL LOSSES FROM FRAUD
1996, 2002, and 2004 study by Association of CFE (“Report to the Nation”) estimated losses from fraud and abuse at 6% of annual revenues! Based on GDP in 2002, that would be $600B, and in 2004 $660B in losses. Actual cost is difficult to quantify because: All fraud is not detected Of ones detected, not all are reported In many cases, incomplete information is gathered Information is not properly distributed to management or law enforcement authorities Too often, business organizations decide to take no civil or criminal action against the perpetrator of fraud Organizations with 100 or fewer employees were the most vulnerable to fraud SEC fraud violations reported in COSO “Landmark Study” 1998 FINANCIAL LOSSES FROM FRAUD 1996 study by Association of CFE estimated losses from fraud and abuse at 6% of annual revenues. 1) All fraud is not detected 2) Of ones detected, not all are reported 3) In many cases, incomplete information is gathered 4) Information is not properly distributed to management or law enforcement authorities 5) Too often, business organizations decide to take no civil or criminal action against the perpetrator(s) of fraud Organizations with 100 or fewer employees were the most vulnerable to fraud. 1998 COSO Landmark Study found similar results to ACFE Report to the Nation regarding smaller firms having higher risks. It also found problems with executives, independence, and audit committees which were addressed in Sarbanes-Oxley Act of 2002. IT Auditing & Assurance, 2e, Hall & Singleton

FINANCIAL LOSSES FROM FRAUD
Profile of perpetrator: By position – Table 11-3 By gender – Table 11-5 By age – Table 11-6 By Education – Table 11-7 Conclusions about profile? Fraudsters do not look like crooks! Collusion – Table 11-4 Significant reason to adhere to segregation of duties Risks associated with a key position held by a trusted employee who unknowingly has weak ethics IT Auditing & Assurance, 2e, Hall & Singleton

UNDERLYING PROBLEMS Lack of auditor independence Lack of director independence Questionable executive compensation schemes Inappropriate accounting practices IT Auditing & Assurance, 2e, Hall & Singleton

SARBANES-OXLEY ACT PCAOB Auditor independence List of services considered non-independent Corporate governance Issuer and management disclosure Fraud and criminal penalties IT Auditing & Assurance, 2e, Hall & Singleton

ANTI-FRAUD PROFESSION
Fraud auditors Forensic accountants Association of Certified Fraud Examiners Certified Fraud Examiner certification – Forensic Accounting Investigation Evidence for court Litigation CFE – Association of Certified Fraud Examiners See newsletter sample at ACFE web site IT Auditing & Assurance, 2e, Hall & Singleton

Chapter 11: Introduction to Business Ethics and Fraud
IT Auditing & Assurance, 2e, Hall & Singleton IT Auditing & Assurance, 2e, Hall & Singleton

Chapter 11: Introduction to Business Ethics and Fraud

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