CHAPTER 3 Ethics, Fraud and Internal Control

Objectives for Chapter 3Discuss the broad issues pertaining to business ethics.Have a basic
understanding of ethical issues related to the use of information technology.Distinguish
between management fraud and employee fraud.Enumerate the common types of fraud
scheme.Discuss the fraud schemes of bribery, illegal gratuities and economic
extortion.Explain the problems associated with lack of auditor and director
independence.Give an example of preventive, detective and corrective control.Discuss the
six broad classes of physical control activities defined by COSO.
ETHICAL ISSUES IN BUSINESS - Ethical standards are derived from societal mores
and deep-rooted personal beliefs about issues of right and wrong that are not universally
agreed upon.What Is Business Ethics? - Ethics pertains to the principles of conduct that
individuals and business managers use in guiding their behavior and choices. It involves
not only knowing what is right but also knowing how to achieve what is right.
Making Ethical Decisions - Business organizations have conflicting responsibilities to
their employees, shareholders, customers and the public. Every major decision has
consequences that potentially harm or benefit these constituents.PROPORTIONALITY -
The benefit from a decision must outweigh the risks. Furthermore, there must be no
alternative decision that provides the same or greater benefit with less risk. JUSTICE -
benefits should be distributed fairly to those who share the risks. MINIMIZE RISK -
decision should be implemented to minimize all of the risks Ethics in business can be
divided into four areas:
1. Equity (fairness and lawful practices in the marketplace),

2. Rights (individual employee rights),

3. Honesty (behavior), and

4. Exercise of corporate power (working condition choices).

Ethical behavior is a necessary but not sufficient condition for business success in the long
run.Management is responsible to maintain an ethical environment, to limit opportunity and
temptation for unethical behavior within the company. A company’s commitment to ethics
should be above their commitment to short-term profits and efficiency.
KOHLBERG’S STAGES OF MORAL DEVELOPMENTKohlberg’s model was
created specifically for the framework of child development and has been widely criticized
for promoting the inherent value system of its author. The original Kohlberg model
organized a child’s values development from parental punishment/rewards to organizational
belonging/success (local maximization) to greater social contracts/justice (forgoing one’s
individual gains for the sake of societal gain).
The representation in the Hall textbook is an interpretation of the Kohlberg model. Stage 1
(lowest): Punishment orientation: obey rules to avoid punishmentStage 2: Reward
orientation: obey rules to obtain the rewardStage 3: Good boy/girl orientation: obey rules
to receive approvalStage 4: Authority orientation: obey rules to be perceived as performing
one’s dutyStage 5: Social contract orientation: obey rules to obtain the respect of peers and
​ aintain self-respectStage 6 (highest): Ethical Principle Orientation: rules are guided by
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self- selected ethical principles that promote self-esteem. Every business decision has
ethical ​risks and benefits. Your ethical responsibility is the balancing between these
consequences.
What is Computer Ethics? Computer Ethics is the analysis of the impact of computer
technology and the policies for the ethical use of such technology. It involves software,
hardware, and network behaviors.Three levels of computer ethics: •Pop ethics: staying
current with the media.•Para ethics: having real interest and acquiring some skill and
knowledge in the field.
•Theoretical ethics: multidisciplinary application of ethical theories to computer science.
The following issues of concern involve computer ethics and may generate class
discussions:Privacy: how much information about you is available to others? How much
information about yourself do you really own?Security (Accuracy and Confidentiality):
How can you avoid authorized/unauthorized individuals accessing or changing
your computerized information? Where is the balance between safe data and
open shared resources?
Ownership of Property: Can an individual own ideas? Media? Source or object code?
Do copyright laws and patents restrict the progress of technology?
The following issues of concern involve computer ethics and may generate class
discussions:Equity in Access: Does the economic status of an individual restrict him/her
from access to a career in information technology?
•Environmental Issues: Do high-speed printers cause less responsibility for
reducing paper waste?
•Artificial Intelligence: Who is responsible for the decisions that an expert system or
a bot might make on behalf of a business?
•Unemployment and Displacement: When a business downsizes employees because
a computer now performs their jobs is that business responsible to retrain the
displaced employees?•Misuse of Computers: How do you feel about copying
software, MP3 music files, snooping through other people’s files, or using a business’
computer for personal purposes?- Managers must establish and maintain a system of
internal controls to ensure the integrity and reliability of their data.
SARBANES-OXLEY ACT AND ETHICAL ISSUES•Ethical misconduct and fraudulent
acts spurred Congress into passing the American Competitiveness and Corporate
Accountability Act of 2002.•This legislation, more commonly known as the
Sarbanes-Oxley Act (SOX), is the most significant securities law since the SEC Act of
1933 and 1934. •SOX has many provisions designed to deal with specific problems relating
to capital markets, corporate governance and the auditing professions.
SARBANES-OXLEY ACT Section 406 addresses the following issues:•Conflict of
Interest•Full and Fair Disclosures•Legal Compliance•Internal Reporting of Code
Violations•Accountability
FRAUD AND ACCOUNTANTS - Fraud is a false representation of a material fact made
by one party to another party with the intent to deceive and to induce the other party to rely
on the fact to his or her detriment. Many times, alleged fraud is just poor management
decisions or adverse business conditions.

Common law asserts that for an act to be considered fraudulent, it must meet five
requirements:1. There must be a false representation, statement or a nondisclosure.2.
There must be a material fact, a substantial factor in inducing someone to act.3.
There must be intent to deceive.4. The misrepresentation must have resulted in
justifiable reliance causing someone to act.5. The deception must have caused injury
or loss to the victim of the fraud.
Business fraud is an intentional deception, misappropriation of assets, or
manipulation of financial data to the advantage of the perpetrator. Two types of fraud
discussed in this chapter are employee fraud and management fraud.1. Employee fraud is
committed by non-management personnel and usually consists of an employee taking
cash or other assets for personal gain and concealing their actions.2. Management fraud
is committed at higher levels and usually does not involve the direct theft of an asset.The
Fraud Triangle - This consists of three factors that contribute to or are associated with
management and employee fraud.•situational pressures (high) - includes personal or job
related stresses that coerce an individual act dishonestly•opportunity (high) - involves
direct access to assets and/or access to information that controls assets.•personal
characteristics/ethics(low) - which pertains to one’s character and degree of moral
opposition to acts of dishonesty.