Chapter 7: Risk Exposures and the Internal Control Structure · Internal Control Internal Control is a state that management strives to achieve to provide reasonable assurance that

Accounting Information Systems:

Essential Concepts and Applications

Fourth Edition by Wilkinson, Cerullo, Raval,

and Wong-On-Wing

Chapter 7: Risk Exposures

and the Internal Control

Structure

Slides Authored by Somnath Bhattacharya, Ph.D. Florida Atlantic University

Internal Control

Internal Control is a state that management strives to achieve to provide reasonable assurance that the firm’s objectives will be achieved

These controls encompass all the measures and practices that are used to counteract exposures to risks

The control framework is called the Internal Control Structure

Objectives of the Internal

Control Structure

Promoting Effectiveness and Efficiency of Operations

Reliability of Financial Reporting

Safeguarding assets

Checking the accuracy and reliability of accounting data

Compliance with applicable laws and regulations

Encouraging adherence to prescribed managerial policies

Components and Major

Considerations of the IC Structure

Internal Control

Structure

Control

Environment

Risk

Assessment

Control

Activities

Information &

Communication Monitoring

Activities related to Financial Reporting

Activities related to Information

Processing

General

Controls

Application

Controls

Figure 7-1

Control Environment

The Control Environment establishes the tone of a company, influencing the control consciousness of its employees

It is comprised of seven components: • Management philosophy and operating style

• Integrity and ethical values

• Commitment to competence

• The Board of Directors and the Audit Committee

• Organizational Structure

• Assignment of authority and responsibility

• Human resources policies and practices

• External Influences

Management Philosophy and Operating Style Does management emphasize short-term

profits and operating goals over long-term goals? Is management dominated by one or a few

individuals? What type of business risks does

management take and how are these risks managed? Is management conservative or aggressive

toward selecting from available alternative accounting principles?

Figure 7-2

Highlights of CE Components - I

Figure 7-2 Continued

Highlights of CE Components - II

Organization Structure Is an up-to-date organization chart prepared,

showing the names of key personnel?

Is the information systems function separated from incompatible functions?

How is the accounting department organized?

Is the internal audit function separate and distinct from accounting?

Do subordinate managers report to more than one supervisor?

Assignment of Authority and Responsibility Does the company prepare written employee

job descriptions defining specific duties and reporting relationships? Is written approval required for changes

made to information systems? Does the company clearly delineate

employees and managers the boundaries of authority-responsibility relationships? Does the company properly delegate

authority to employees and departments?


Highlights of CE Components - III

Human Resource Policies and Practices Are new personnel indoctrinated with respect to

Internal Controls, Ethics Policies, and Corporate Code of Conduct? Is the company in compliance with the ADA? The

EEOA? Are Grievance Procedures to manage conflict in force? Does the company maintain a sound Employee

Relations program? Do employees work in a safe, healthy environment? Are Counseling Programs available to employees? Are proper Separation Programs in force for

employees who leave the firm? Are critical employees Bonded?


Highlights of CE Components - IV

Key Functions Performed

by Audit Committees

Establish an Internal Audit Department Review the Scope and Status of Audits Review Audit Findings with the Board and

ensure that Management has taken proper action recommended in the Audit Report and Letter of Reportable Conditions Maintain a direct Line of Communication

among the Board, Management, External and Internal Auditors, and periodically arrange Meetings among the parties

Figure 7-3

Key Functions Performed

by Audit Committees

Review the Audited Financial Statements with the Internal Auditors and the Board of Directors Require periodic Quality Reviews of the

operations of the Internal Audit Departments to identify areas needing improvement Supervise special investigations, such as

Fraud Investigations Assess the performance of Financial

Management Require the Review of Compliance with

Laws and Regulations and with Corporate Codes of Conduct

Figure 7-3

Risk Assessment

Top management must be directly involved in Business Risk Assessment.

This involves the Identification and Analysis of Relevant Risks that may prevent the attainment of Company-wide Objectives and Objectives of Organizational Units and the formation of a plan to determine how to manage the risks.

Control Activities - I

Control Activities as related to Financial Reporting may be classified according to their intended uses in a system:

• Preventive Controls block adverse events, such as errors or losses, from occurring

• Detective Controls discover the occurrence of adverse events such as operational inefficiency

• Corrective controls are designed to remedy problems discovered through detective controls

• Security Measures are intended to provide adequate safeguards over access to and use of assets and data records

Control Activities - II

Control Activities relating to Information Processing may also be classified according to where they will be applied within the system

• General controls are those controls that pertain to all activities involving a firm’s AIS and assets

• Application controls relate to specific accounting tasks or transactions

The overall trend seems to be going from specific application controls to more global general controls

Control Activities - III

Performance Reviews

Comparing Budgets to Actual Values

Relating Different Sets of Data-Operating or Financial-to one another, together with Analyses of the relationships and Investigative and Corrective Actions

Reviewing Functional Performance such as a bank’s consumer loan manager’s review of reports by branch, region, and loan type for loan approvals and collections

Information & Communication

All Transactions entered for processing are Valid and Authorized

All valid transactions are captured and entered for processing on a Timely Basis and in Sufficient Detail to permit the proper Classification of Transactions

The input data of all entered transactions are Accurate and Complete, with the transactions being expressed in proper Monetary terms

All entered transactions are processed properly to update all affected records of Master Files and/or Other Types of Data sets

All required Outputs are prepared according to Appropriate Rules to provide Accurate and Reliable Information

All transactions are recorded in the proper Accounting Period

Risk

Business firms face risks that reduce the chances of achieving their control objectives.

Risk exposures arise from internal sources, such as employees, as well as external sources, such as computer hackers.

Risk assessment consists of identifying relevant risks, analyzing the extent of exposure to those risks, and managing risks by proposing effective control procedures.

Figure 7-4

Some Typical Sources of Risk - I

Clerical and Operational Employees, who process transactional data and have access to Assets

Computer Programmers, who have knowledge relating to the Instructions by which transactions are processed

Managers and Accountants, who have access to Records and Financial Reports and often have Authority to Approve Transactions


Some Typical Sources of Risk - II

Former Employees, who may still understand the Control Structure and may harbor grudges against the firm Customers and Suppliers, who generate many

of the transactions processed by the firm Competitors, who may desire to acquire

confidential information of the firm Outside Persons, such as Computer Hackers and

Criminals, who have various reasons to access the firm’s data or its assets or to commit destructive acts Acts of Nature or Accidents, such as floods,

fires, and equipment breakdowns

Types of Risks

Unintentional errors

Deliberate Errors (Fraud)

Unintentional Losses of Assets

Thefts of assets

Breaches of Security

Acts of Violence and Natural Disasters

Factors that Increase Risk

Exposure

Frequency - the more frequent an occurrence of a transaction the greater the exposure to risk

Vulnerability - liquid and/or portable assets contribute to risk exposure

Size of the potential loss - the higher the monetary value of a loss, the greater the risk exposure

Problem Conditions

Affecting Risk Exposures

Collusion (both internal and external), which is the cooperation of two or more people for a fraudulent purpose, is difficult to counteract even with sound control procedures

Lack of Enforcement Management may not prosecute wrongdoers because of the potential embarrassment

Computer crime poses very high degrees of risk, and fraudulent activities are difficult to detect

Computer Crime

Computer crime (computer abuse) is the use of a computer to deceive for personal gain.

Due to the proliferation of networks and personal computers, computer crime is expected to significantly increase both in frequency and amount of loss.

It is speculated that a relatively small proportion of computer crime gets detected and an even smaller proportion gets reported.

Examples of Computer

Crime

Theft of Computer Hardware & Software

Unauthorized Use of Computer Facilities for Personal Use

Fraudulent Modification or Use of Data or Programs

Reasons Why Computers

Cause Control Problems

Processing is Concentrated

Audit Trails may be Undermined

Human Judgment is bypassed

Data are stored in Device-Oriented rather than Human-Oriented forms Invisible Data

Stored data are Erasable

Data are stored in a Compressed form

Stored data are relatively accessible

Computer Equipment is Powerful but Complex and Vulnerable

Feasibility of Controls

Audit Considerations

Cost-Benefit Considerations Determine Specific Computer Resources Subject to Control

Determine all Potential Threats to the company’s Computer System

Assess the Relevant Risks to which the firm is exposed

Measure the Extent of each Relevant Risk exposure in dollar terms

Multiply the Estimated Effect of each Relevant Risk Exposure by the Estimated Frequency of Occurrence over a Reasonable Period, such as a year

Compute the Cost of Installing and Maintaining a Control that is to Counter each Relevant Risk Exposure

Compare the Benefits against the Costs of Each Control

Legislation

The Foreign Corrupt Practices Act of 1977

Of the Federal Legislation governing the use of computers, The Computer Fraud and Abuse Act of 1984 (amended in 1986) is perhaps the most important This act makes it a federal crime to intentionally

access a computer for such purposes as: (1) obtaining top-secret military information, personal, financial or credit information

(2) committing a fraud

(3) altering or destroying federal information

Methods for Thwarting

Computer Abuse

Enlist top-management support so that awareness of computer abuse will filter down through management ranks.

Implement and enforce control procedures.

Increase employee awareness in the seriousness of computer abuse, the amount of costs, and the disruption it creates.

Establish a code of conduct.

Be aware of the common characteristics of most computer abusers.

Methods for Thwarting

Computer Abuse

Recognize the symptoms of computer abuse such as:

behavioral or lifestyle changes in an employee

accounting irregularities such as forged, altered or destroyed input documents or suspicious accounting adjustments

absent or ignored control procedures

the presence of many odd or unusual anomalies that go unchallenged

Encourage ethical behavior

Control Problems Caused by

Computerization: Data Collection

Characteristics Characteristics Risk Exposures CompensatingControls

Data recorded inpaper sourcedocuments

Data sometimescaptured withoutuse of sourcedocuments

Audit trail may bepartially lost

Printed copies ofsource documentsprepared bycomputer systems

Data reviewed forerrors by clerks

Data often notsubject to reviewby clerks

Errors, accidentalor deliberate, maybe entered forprocessing

Edit checksperformed bycomputer system

Manual System Computer-based System

Figure 7-6


Computerization: Data Processing



Processing stepsperformed by clerkswho possess judgment

Processing stepsperformed by CPU“blindly” in accordancewith programinstructions

Errors may causeincorrect results ofprocessing

Outputs reviewed byusers of computersystem; carefullydeveloped computerprocessing programs

Processing stepsamong various clerks inseparate departments

Processing stepsconcentrated withincomputer CPU

Unauthorizedmanipulation of dataand theft of assets canoccur on larger scale

Restricted access tocomputer facilities;clear procedure forauthorizing changes toprograms

Processing requires useof journals and ledgers

Processing does notrequire use of journals

Audit trail may bepartially lost

Printed journals andother analyses

Processing performedrelatively slowly

Processing performedvery rapidly

Effects of errors mayspread rapidly throughfiles

Editing of all dataduring input andprocessing steps


Control Problems Caused by Computerization:

Data Storage & Retrieval



Data stored in filedrawersthroughout thevariousdepartments

Data compressedon magneticmedia (e.g.,tapes, disks)

Data may beaccessed byunauthorizedpersons or stolen

Security measuresat points of accessand over datalibrary

Data stored onhard copies inhuman- readableform

Data stored ininvisible,eraseable,computer-readableform

Data aretemporarilyunusable byhumans, andmight possibly belost

Data files printedperiodically;backup of files;protection againstsudden powerlosses

Stored dataaccessible on apiece-meal basisat variouslocations

Stored data oftenreadily accessiblefrom variouslocations viaterminals

Data may beaccessed byunauthorizedpersons

Security measuresat points of access


Control Problems Caused by Computerization:

Information Generation



Outputsgeneratedlaboriously andusually in smallvolumes

Outputs generatedquickly and neatly,often in largevolumes

Inaccuracies maybe buried inimpressive-lookingoutputs that usersaccept on faith

Reviews by usersof outputs,including thechecking ofamounts

Outputs usually inhard-copy form

Outputs providedin various forms,including soft-copydisplays and voiceresponses

Information storedon magneticmedia is subject tomodification (onlyhard copyprovidespermanent record)

Backup of files;periodic printing ofstored files ontohard-copy records



Computerization: Equipment Manual System Computer-based System


Relatively simple,inexpensive, andmobile

Relativelycomplex,expensive, and infixed locations

Businessoperations may beintentionally orunintentionallyinterrupted; dataor hardware maybe destroyed;

operations may bedelayed throughinefficiencies

Backup of dataand power supplyand equipment;preventivemaintenance ofequipment;restrictions on

access tocomputerfacilities;documentation ofequipment usageand processingproceduresFigure 7-6 Continued

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Accounting Information Systems:

Essential Concepts and Applications

Fourth Edition by Wilkinson, Cerullo,

Raval, and Wong-On-Wing

Documents

Chapter 7: Risk Exposures and the Internal Control Structure · Internal Control Internal Control is a state that management strives to achieve to provide reasonable assurance that