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 firms 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 Information & Communication

Control Environment

Risk Assessment

Control Activities

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

Highlights of CE Components - I
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 - 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?
Figure 7-2 Continued

Highlights of CE Components - III

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?

Figure 7-2 Continued

Highlights of CE Components - IV
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?

Figure 7-2 Continued

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 firms 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 banks consumer loan managers 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.

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 Figure 7-4

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 firms data or its assets or to commit destructive acts Acts of Nature or Accidents, such as floods, fires, and equipment breakdowns
Figure 7-4 Continued

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 companys 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

Manual System Computer-based System

Characteristics

Characteristics

Risk Exposures

Compensating Controls

Data recorded in paper source documents

Data sometimes captured without use of source documents

Audit trail may be partially lost

Printed copies of source documents prepared by computer systems

Data reviewed for Data often not errors by clerks subject to review by clerks

Errors, accidental Edit checks or deliberate, may performed by be entered for computer system processing

Figure 7-6

Control Problems Caused by Computerization: Data Processing

Manual System Computer-based System

Characteristics

Characteristics

Risk Exposures

Compensating Controls
Outputs reviewed by users of computer system; carefully developed computer processing programs Restricted access to computer facilities; clear procedure for authorizing changes to programs Printed journals and other analyses

Processing steps performed by clerks who possess judgment

Processing steps performed by CPU blindly in accordance with program instructions Processing steps Processing steps among various clerks in concentrated within separate departments computer CPU

Errors may cause incorrect results of processing

Unauthorized manipulation of data and theft of assets can occur on larger scale Audit trail may be partially lost

Processing requires use Processing does not of journals and ledgers require use of journals

Processing performed relatively slowly

Processing performed very rapidly

Effects of errors may spread rapidly through files

Editing of all data during input and processing steps

Figure 7-6 Continued

Control Problems Caused by Computerization: Data Storage & Retrieval

Manual System
Characteristics Characteristics

Computer-based System
Risk Exposures Compensating Controls Security measures at points of access and over data library Data files printed periodically; backup of files; protection against sudden power losses Security measures at points of access

Data stored in file drawers throughout the various departments Data stored on hard copies in human- readable form

Data compressed on magnetic media (e.g., tapes, disks) Data stored in invisible, eraseable, computer-readable form Stored data often readily accessible from various locations via terminals

Data may be accessed by unauthorized persons or stolen Data are temporarily unusable by humans, and might possibly be lost Data may be accessed by unauthorized persons

Stored data accessible on a piece-meal basis at various locations

Figure 7-6 Continued

Control Problems Caused by Computerization: Information Generation

Manual System Computer-based System

Characteristics

Characteristics

Risk Exposures

Compensating Controls

Outputs Outputs generated generated quickly and neatly, laboriously and often in large usually in small volumes volumes Outputs usually in Outputs provided hard-copy form in various forms, including soft-copy displays and voice responses

Inaccuracies may be buried in impressive-looking outputs that users accept on faith Information stored on magnetic media is subject to modification (only hard copy provides permanent record)

Reviews by users of outputs, including the checking of amounts Backup of files; periodic printing of stored files onto hard-copy records

Figure 7-6 Continued

Control Problems Caused by Computerization: Equipment

Manual System Computer-based System

Characteristics

Characteristics

Risk Exposures

Compensating Controls

Relatively simple, inexpensive, and mobile

Relatively complex, expensive, and in fixed locations

Business operations may be intentionally or unintentionally interrupted; data or hardware may be destroyed; operations may be delayed through inefficiencies

Figure 7-6 Continued

Backup of data and power supply and equipment; preventive maintenance of equipment; restrictions on access to computer facilities; documentation of equipment usage and processing procedures

Accounting Information Systems: Essential Concepts and Applications

Fourth Edition by Wilkinson, Cerullo, Raval, and Wong-On-Wing

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