1. Controlling Information Systems:
Introduction to Internal Control

2. Learning Objectives
Summarize the eight elements of COSO’s Enterprise Risk Management—Integrated Framework.
Understand that management employs internal control systems as part of organizational and IT governance initiatives.
Describe how internal control systems assist organizations to achieve objectives and respond to risks.
Describe fraud, computer fraud, and computer abuse.
Enumerate control goals for operations and information processes.
Describe the major categories of control plans.

3. Why do we need controls?
(1) to provide reasonable assurance that the goals of each business process are being achieved
(2) to mitigate the risk that the enterprise will be exposed to some type of harm, danger, or loss (including loss caused by fraud or other intentional and unintentional acts)
(3) to provide reasonable assurance that the company is in compliance with applicable legal and regulatory obligations.

4. Organizational Governance
Organizational Process to:
Select Objectives
Determine Processes necessary to Achieve Objectives
Monitor Performance
Includes Internal Control

5. Example: Objective Setting
Mission, vision, purpose: e.g., to be the leading producer of household products in the regions in which we operate
Strategic
objectives
e.g., to be in the
top quartile of
product sales for retailers of our products
Strategy
e.g., expand production
of our top-five selling retail
products to meet increased
demand
Related objectives, e.g.,
increase production of x by 15%
hire 180 qualified new staff
maintain product quality
Source: Adapted from Enterprise Risk Management—Integrated Framework, Application Techniques, p. 20.

6. Enterprise Risk Management
Structured Process for Creating Organization Objectives (i.e. Governance)
Board of Director, Management Initiative
Strategic Outlook
Identify events that might effect organization
Manage risk associated with these events

7. Components of Enterprise Risk Management
Internal Environment
Decisions formulated re:
Integrity, ethical values, risk, risk appetite, oversight functions, organization design, authority and responsibilities set
Objective Setting
Establish Strategies
without which potential events can not be identified
Operating, Reporting and Compliance Objectives
Event Identification
Risk and Opportunities that can effect the Objectives
Risk – Assessment and Response
Opportunities – Feedback to Objective Setting Process

8. Components of Enterprise Risk Management
Risk Assessment
What is the impact of a risk on an Objective
Likelihood – Probability that the risk will occur
Impact - $ Effect of the risk occurring

9. Risk vs. Exposure
Estimate the annual dollar loss that would occur (i.e., the impact) should a costly event, say a destructive fire, take place. For argument sake, say that the estimated loss is –$1,000,000.
Estimate the annual probability that the event will occur (i.e., the likelihood). Suppose the estimate is 5 percent.
Multiply item 1 by item 2 to get an initial expected gross risk (loss) of –$50,000 (–$1,000,000 × 0.05), which is the maximum amount or upper limit that should be paid for controls and the related risk reduction offered by such controls, in a given year. Next, we illustrate a recommendation plan using one corrective control, a fire insurance policy, and one preventive control, a sprinkler system.
Assume that the company would pay $1,000 annually (cost of control) for a $20,000 fire insurance policy (reduced risk exposure due to control). The estimated monetary damage remains at $1 million and expected gross risk (loss) remains at –$50,000, because there is still a 5 percent chance that a fire could occur. But, the company’s residual expected risk exposure is now –$31,000 [–$50,000 + ($20,000 – $1,000)]. Our expected loss is reduced by the amount of the insurance policy (less the cost of the policy).

10. Risk vs. Exposure (Cont.)
Next, you recommend that the company install a sprinkler system with a 5-year annualized cost (net present value) of $10,000 each year to install and maintain (cost of control). At this point you might be tempted to say that the company’s residual expected risk just increased to –$41,000 (–$31,000 – $10,000), but wait! The sprinkler system lowered the likelihood of a damaging fire from 5 to 2 percent. In conjunction with this lower probability, the insurance company agreed to increase its coverage to $30,000 while holding the annual premium constant at $1,000.
Thus, the residual expected risk exposure is –$1,000, calculated as follows: Expected gross risk (–$20,000 or –$1,000,000 × 0.02) plus the insurance policy ($30,000) equals a gain of $10,000, but we must subtract the insurance premium ($1,000) and the sprinkler system ($10,000), leaving the residual expected risk at –$1,000.

11. Components of Enterprise Risk Management
Risk Response (4 Types)
Avoid exposure
Leave risky activity
Reduce exposure
Reduce likelihood or impact
Fire extinguishers
Share exposure
Insurance
Accept exposure
Cost > Benefits of intervention
Control Activities
Procedures in place to make sure Risk Response are carried out

12. Components of Enterprise Risk Management
Information and Communication
Identify, Capture and Communicate
So Decision Makers can carry out responsibilities
Monitoring
Evaluation of overall ERM process

13. Internal Control
Definitions

14. Definition of Internal Control
From SAS 78 (1995) - adopted COSO definition:
INTERNAL CONTROL is a process-effected by a an entity’s board of directors, management, and other personnel-designed to provide reasonable assurance regarding the achievement of objectives in the following categories:
Effectiveness & efficiency of operations
Reliability of financial reporting
Compliance with applicable laws & regulations.

15. Five Interrelated Components of Internal Control
1. Control environment- tone at the top, the foundation
2. Risk assessment - identification/analysis of risks
3. Control activities - policies and procedures
4. Information & communication - processing of info in a form and time frame that enables people to do their jobs
5. Monitoring - process that assess quality of internal control over time

16. COSO Report, SOA, and SAS 94
In the section addressing implementation of the Sarbanes Oxley Act section 404, the SEC used the COSO description of internal control.
It went on to say that management must base its evaluation of the effectiveness of its internal control system on a framework such as COSO
COSO report stresses internal control is a process
A complementary perspective on internal control is found in Statement on Auditing Standards (SAS) 94, entitled “The Effect on Information Technology on the Auditor’s Consideration of Internal Control in a Financial Statement Audit.”
This standard guides auditors in understanding the impact of IT on internal control and assessing IT-related control risks
Further, SAS 94 highlights how IT can be used to strengthen internal control, while at the same time emphasizing how IT can actually weaken some controls

17. Recent Internal Control Legislation
Sarbanes-Oxley Act (SOA) of 2002
Created public company accounting oversight board
Increased accountability for company officers and board of directors
Increased white collar crime penalties
Prohibits audit firms from providing design and implementation of financial information systems

18. Sarbanes-Oxley Act of 2002 (SOA)
Section 302—CEOs and CFOs must certify quarterly and annual financial statements
Section 404—Mandates the annual report filed with the SEC include an internal control report by management which:
Document significant Processes
Flow of transactions
Identify Key Controls
Test Key Controls
Written Assessment
ACG 5405

19. Outline of SOA 2002

20. Fraud and its Relationship to Control
Fraud: deliberate act or untruth intended to obtain unfair or unlawful gain.
Management charged with responsibility to prevent and/or disclose fraud
Control systems enable management to do this job
Management responsible to provide internal control system per the Foreign Corrupt Practices Act of 1977
Section 1102 of the Sarbanes-Oxley Act specifically addresses corporate fraud
Instances of fraud undermine management’s ability to convince various authorities that it is upholding its stewardship responsibility

21. SAS 99
The accounting profession too has been proactive in dealing with corporate fraud, as it has launched an anti-fraud program.
One of the manifestations of this initiative is Statement on Auditing Standards (SAS) Number 99, entitled Consideration of Fraud in a Financial Statement Audit.
SAS 99 has the same title as its predecessor, SAS 82, but the new standard is much more encompassing than the old.
For instance, SAS 99 emphasizes brainstorming fraud risks, increasing professional skepticism, using unpredictable audit test patterns, and detecting management override of internal controls.

22. E&Y Fraud Survey About 85 % of fraud committed by company insiders
About 55% of perpetrators were management employees
More fraud in less-developed countries
Only about 20 % of fraud comes to the public knowledge
About 40% of frauds are known to the public, 20% are kept confidential, and the other 40% are not yet discovered
Best prevention is internal control, management reviews, and internal audits
The #1 fraud worry to executives is asset misappropriation
The #2 fraud worry to executives is computer crime
Most organizations now have formal fraud prevention policies including codes of corporate governance and employee conduct
Most useful fraud prevention techniques are internal controls, management reviews, and internal audits

23. Gelinas and Dull Working Definition of IC: Key Points
A system of internal control is not an end in itself. Rather, it is a means to an end—the end of attaining process objectives
Internal control itself is a system. Therefore, like any system it must
(1) have clearly defined goals and
(2) consist of interrelated components that act in concert to achieve those goals.
We can also say that internal control is a process
Establishing a viable internal control system is management’s responsibility.
The strength of any internal control system is largely a function of the people who operate it.
Internal control cannot be expected to provide absolute, 100% assurance that the organization will reach its objectives. Rather, the operative phrase is that it should provide reasonable assurance
Internal control is not free; controls should be built in and cost effective

24. Gelinas and Dull Working Definition of IC
…a system of integrated elements - people, structure, processes, and procedures - acting in concert to provide reasonable assurance that an organization achieves business process goals. The design and operation of the internal control system is the responsibility of top management and therefore should:

25. (Text definition of IC cont.)
Reflect management’s careful assessment of risks.
Be based on management’s evaluation of costs versus benefits.
Be built on management’s strong sense of business ethics and personal integrity.

26. Ethics and Controls
COSO report stresses ethics as part of control environment (tone at the top)
AICPA has built ethics issues into CPA exam
The Institute of Management Accountants has a code of ethics which is also tested on both the CMA and CFM exams
Internal Auditing has ethics articles
Many corporations have developed Codes of Conduct

27. Business Process Control Goals
Control Goals - ends to be obtained
Control goals of operations processes
Control goals of information processes
See Table 7.1 Control Goals (page 230)

28. Control Goals of the Operations Process
Ensure effectiveness of operations
Process is achieving it’s objective
Ensure efficient employment of resources
Benefits > Cost
Ensure security of resources
Resources and Information

29. Control Goals of Operations Process
Ensure effectiveness of operations
A measure of success in meeting one or more operations process goals which reflect the criteria used to judge the effectiveness of various business processes
Ex. Deposit cash receipts on the day received
Ensure efficient employment of resources
A measure of the productivity of the resources applied to achieve a set of goals
Ex. What is the cost of people, computers, and other resources to deposit cash on the day received
Ensure security of resources
Protecting an organization’s resources from loss, destruction, disclosure, copying, sale, or other misuse
Ex. Are cash and information resources available when required?
Are they put to authorized use?

30. Control Goals of the Information Process
For business event inputs, ensure
Input validity
Input completeness
Input accuracy
For master data, ensure
Update completeness
Update accuracy

31. Control Goals of Information Process
Input validity
Input data is approved and represents actual economic events and objects
Ex. Are all cash receipts input into the process supported by valid/authorized customer payments
Input completeness
Requires that all valid events or objects be captured and entered into the system
Ex. Are all valid customer payment captured on a customer remittance advice (RA) and entered into the process?
Input Accuracy
Requires that events be correctly captured and entered into the system (correctly)
Ex. Is correct payment amount and customer number on the RA?
Ex. Is the correct payment amount and customer number keyed into the system?

32. Control Goals of Information Process
Master Update Information Processing Activity
Merge new data (from Input’s) with existing Master data
Update completeness
Requires all events entered into the computer are reflected in their respective master data
Ex. Are all input cash receipts recorded in the AR master data?
Update accuracy
Requires that data entered into a computer are reflected correctly in their respective master data
Ex. Are all input cash receipts correctly recorded in the AR master data?
Potential Problems
Programming Errors
Operational Errors
What happens in Real-Time Processing Environments?

33. Master Updates

34. Control Goals Map

35. Lenox Company Systems Flowchart

36. Control Goals for the Lenox Cash Receipts Process
Control Goals of the Lenox Cash Receipts Business Process
Control goals of the operations process
Control goals of the information process
Ensure effectiveness of operations
Ensure efficient employment of resources (e.g., people and computers)
Ensure security of resources (e.g., checks and AR master data)
For the remittance advice inputs, ensure:
For the AR master data, ensure: A B IV IC IA UC UA
Effectiveness goals include:
A – Timely deposit of checks
B – Comply with compensating balance agreements with the depository bank
IV = Input validity
IC = Input completeness
IA = Input accuracy
UC = Update completeness
UA = Update accuracy

37. Business Process Control Plans
Business Process Control Plans - reflect information processing policies and procedures that assist in accomplishing control goals
The Control Environment The fact that the control environment appears at the top of the hierarchy illustrates that the control environment comprises a multitude of factors that can either reinforce or mitigate the effectiveness of the pervasive and application control plans.
Pervasive control plans also relate to a multitude of goals and processes
Like the control environment, they provide a climate or set of surrounding conditions in which the various business processes operate.
They are broad in scope and apply equally to all business processes, hence they pervade all systems.
Business process control plans relate to those controls particular to a specific process or subsystem, such as billing or cash receipts, or to a particular technology used to process the data.

39. Other Classifications of Control Plans
Preventive Controls: Issue is prevented from occurring – cash receipts are immediately deposited to avoid loss
Detective Controls: Issue is discovered – unauthorized disbursement is discovered during reconciliation
Corrective Controls: issue is corrected – erroneous data is entered in the system and reported on an error and summary report; a clerk re-enters the data