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Principles of Accounting, Volume 1: Financial Accounting

8.1 Analyze Fraud in the Accounting Workplace

Principles of Accounting, Volume 1: Financial Accounting8.1 Analyze Fraud in the Accounting Workplace
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  1. Preface
  2. 1 Role of Accounting in Society
    1. Why It Matters
    2. 1.1 Explain the Importance of Accounting and Distinguish between Financial and Managerial Accounting
    3. 1.2 Identify Users of Accounting Information and How They Apply Information
    4. 1.3 Describe Typical Accounting Activities and the Role Accountants Play in Identifying, Recording, and Reporting Financial Activities
    5. 1.4 Explain Why Accounting Is Important to Business Stakeholders
    6. 1.5 Describe the Varied Career Paths Open to Individuals with an Accounting Education
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
  3. 2 Introduction to Financial Statements
    1. Why It Matters
    2. 2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate
    3. 2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses
    4. 2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Analyzing and Recording Transactions
    1. Why It Matters
    2. 3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements
    3. 3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions
    4. 3.3 Define and Describe the Initial Steps in the Accounting Cycle
    5. 3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements
    6. 3.5 Use Journal Entries to Record Transactions and Post to T-Accounts
    7. 3.6 Prepare a Trial Balance
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  5. 4 The Adjustment Process
    1. Why It Matters
    2. 4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries
    3. 4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
    4. 4.3 Record and Post the Common Types of Adjusting Entries
    5. 4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance
    6. 4.5 Prepare Financial Statements Using the Adjusted Trial Balance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  6. 5 Completing the Accounting Cycle
    1. Why It Matters
    2. 5.1 Describe and Prepare Closing Entries for a Business
    3. 5.2 Prepare a Post-Closing Trial Balance
    4. 5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity
    5. 5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  7. 6 Merchandising Transactions
    1. Why It Matters
    2. 6.1 Compare and Contrast Merchandising versus Service Activities and Transactions
    3. 6.2 Compare and Contrast Perpetual versus Periodic Inventory Systems
    4. 6.3 Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System
    5. 6.4 Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System
    6. 6.5 Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods
    7. 6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies
    8. 6.7 Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  8. 7 Accounting Information Systems
    1. Why It Matters
    2. 7.1 Define and Describe the Components of an Accounting Information System
    3. 7.2 Describe and Explain the Purpose of Special Journals and Their Importance to Stakeholders
    4. 7.3 Analyze and Journalize Transactions Using Special Journals
    5. 7.4 Prepare a Subsidiary Ledger
    6. 7.5 Describe Career Paths Open to Individuals with a Joint Education in Accounting and Information Systems
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Fraud, Internal Controls, and Cash
    1. Why It Matters
    2. 8.1 Analyze Fraud in the Accounting Workplace
    3. 8.2 Define and Explain Internal Controls and Their Purpose within an Organization
    4. 8.3 Describe Internal Controls within an Organization
    5. 8.4 Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries
    6. 8.5 Discuss Management Responsibilities for Maintaining Internal Controls within an Organization
    7. 8.6 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries
    8. 8.7 Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  10. 9 Accounting for Receivables
    1. Why It Matters
    2. 9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions
    3. 9.2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
    4. 9.3 Determine the Efficiency of Receivables Management Using Financial Ratios
    5. 9.4 Discuss the Role of Accounting for Receivables in Earnings Management
    6. 9.5 Apply Revenue Recognition Principles to Long-Term Projects
    7. 9.6 Explain How Notes Receivable and Accounts Receivable Differ
    8. 9.7 Appendix: Comprehensive Example of Bad Debt Estimation
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  11. 10 Inventory
    1. Why It Matters
    2. 10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions
    3. 10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method
    4. 10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method
    5. 10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet
    6. 10.5 Examine the Efficiency of Inventory Management Using Financial Ratios
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  12. 11 Long-Term Assets
    1. Why It Matters
    2. 11.1 Distinguish between Tangible and Intangible Assets
    3. 11.2 Analyze and Classify Capitalized Costs versus Expenses
    4. 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs
    5. 11.4 Describe Accounting for Intangible Assets and Record Related Transactions
    6. 11.5 Describe Some Special Issues in Accounting for Long-Term Assets
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Current Liabilities
    1. Why It Matters
    2. 12.1 Identify and Describe Current Liabilities
    3. 12.2 Analyze, Journalize, and Report Current Liabilities
    4. 12.3 Define and Apply Accounting Treatment for Contingent Liabilities
    5. 12.4 Prepare Journal Entries to Record Short-Term Notes Payable
    6. 12.5 Record Transactions Incurred in Preparing Payroll
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  14. 13 Long-Term Liabilities
    1. Why It Matters
    2. 13.1 Explain the Pricing of Long-Term Liabilities
    3. 13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
    4. 13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds
    5. 13.4 Appendix: Special Topics Related to Long-Term Liabilities
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  15. 14 Corporation Accounting
    1. Why It Matters
    2. 14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock
    3. 14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock
    4. 14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits
    5. 14.4 Compare and Contrast Owners’ Equity versus Retained Earnings
    6. 14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  16. 15 Partnership Accounting
    1. Why It Matters
    2. 15.1 Describe the Advantages and Disadvantages of Organizing as a Partnership
    3. 15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries
    4. 15.3 Compute and Allocate Partners’ Share of Income and Loss
    5. 15.4 Prepare Journal Entries to Record the Admission and Withdrawal of a Partner
    6. 15.5 Discuss and Record Entries for the Dissolution of a Partnership
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  17. 16 Statement of Cash Flows
    1. Why It Matters
    2. 16.1 Explain the Purpose of the Statement of Cash Flows
    3. 16.2 Differentiate between Operating, Investing, and Financing Activities
    4. 16.3 Prepare the Statement of Cash Flows Using the Indirect Method
    5. 16.4 Prepare the Completed Statement of Cash Flows Using the Indirect Method
    6. 16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
    7. 16.6 Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  18. Financial Statement Analysis
  19. Time Value of Money
  20. Suggested Resources
  21. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
  22. Index

In this chapter, one of the major issues examined is the concept of fraud. Fraud can be defined in many ways, but for the purposes of this course we define it as the act of intentionally deceiving a person or organization or misrepresenting a relationship in order to secure some type of benefit, either financial or nonfinancial. We initially discuss it in a broader sense and then concentrate on the issue of fraud as it relates to the accounting environment and profession.

Workplace fraud is typically detected by anonymous tips or by accident, so many companies use the fraud triangle to help in the analysis of workplace fraud. Donald Cressey, an American criminologist and sociologist, developed the fraud triangle to help explain why law-abiding citizens sometimes commit serious workplace-related crimes. He determined that people who embezzled money from banks were typically otherwise law-abiding citizens who came into a “non-sharable financial problem.” A non-sharable financial problem is when a trusted individual has a financial issue or problem that he or she feels can't be shared. However, it is felt that the problem can be alleviated by surreptitiously violating the position of trust through some type of illegal response, such as embezzlement or other forms of misappropriation. The guilty party is typically able to rationalize the illegal action. Although they committed serious financial crimes, for many of them, it was their first offense.

The fraud triangle consists of three elements: incentive, opportunity, and rationalization (Figure 8.2). When an employee commits fraud, the elements of the fraud triangle provide assistance in understanding the employee’s methods and rationale. Each of the elements needs to be present for workplace fraud to occur.

Four triangles are grouped together to form a large triangle. The middle one is “FRAUD,” surrounded by the top one, “Perceived Opportunity,” the bottom right one, “Rationalization,” and the bottom left one, “Incentive.”
Figure 8.2 Fraud Triangle. The three components identified in the fraud triangle are perceived opportunity, incentive, and rationalization. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Perceived opportunity is when a potential fraudster thinks that the internal controls are weak or sees a way to override them. This is the area in which an accountant has the greatest ability to mitigate fraud, as the accountant can review and test internal controls to locate weaknesses. After identifying a weak, circumvented, or nonexistent internal control, management, along with the accountant, can implement stronger internal controls.

Rationalization is a way for the potential fraudster to internalize the concept that the fraudulent actions are acceptable. A typical fraudster finds ways to personally justify his or her illegal and unethical behavior. Using rationalization as a tool to locate or combat fraud is difficult, because the outward signs may be difficult to recognize.

Incentive (or pressure) is another element necessary for a person to commit fraud. The different types of pressure are typically found in (1) vices, such as gambling or drug use; (2) financial pressures, such as greed or living beyond their means; (3) work pressure, such as being unhappy with a job; and (4) other pressures, such as the desire to appear successful. Pressure may be more recognizable than rationalization, for instance, when coworkers seem to be living beyond their means or complain that they want to get even with their employer because of low pay or other perceived slights.

Typically, all three elements of the triangle must be in place for an employee to commit fraud, but companies usually focus on the opportunity aspect of mitigating fraud because, they can develop internal controls to manage the risk. The rationalization and pressure to commit fraud are harder to understand and identify. Many organizations may recognize that an employee may be under pressure, but many times the signs of pressure are missed.

Virtually all types of businesses can fall victim to fraudulent behavior. For example, there have been scams involving grain silos in Texas inflating their inventory, the sale of mixed oils labeled as olive oil across the globe, and the tens of billions of dollars that Bernie Madoff swindled out of investors and not-for-profits.

To demonstrate how a fraud can occur, let’s examine a sample case in a little more detail. In 2015, a long-term employee of the SCICAP Federal Credit Union in Iowa was convicted of stealing over $2.7 million in cash over a 37-year period. The employee maintained two sets of financial records: one that provided customers with correct information as to how much money they had on deposit within their account, and a second set of books that, through a complex set of transactions, moved money out of customer accounts and into the employee’s account as well as those of members of her family. To ensure that no other employee within the small credit union would have access to the duplicate set of books, the employee never took a vacation over the 37-year period, and she was the only employee with password-protected access to the system where the electronic records were stored.

There were, at least, two obvious violations of solid internal control principles in this case. The first was the failure to require more than one person to have access to the records, which the employee was able to maintain by not taking a vacation. Allowing the employee to not share the password-protected access was a second violation. If more than one employee had access to the system, the felonious employee probably would have been caught much earlier. What other potential failures in the internal control system might have been present? How does this example of fraud exhibit the three components of the fraud triangle?

Unfortunately, this is one of many examples that occur on a daily basis. In almost any city on almost any day, there are articles in local newspapers about a theft from a company by its employees. Although these thefts can involve assets such as inventory, most often, employee theft involves cash that the employee has access to as part of his or her day-to-day job.

Accountants, and other members of the management team, are in a good position to control the perceived opportunity side of the fraud triangle through good internal controls, which are policies and procedures used by management and accountants of a company to protect assets and maintain proper and efficient operations within a company with the intent to minimize fraud. An internal auditor is an employee of an organization whose job is to provide an independent and objective evaluation of the company’s accounting and operational activities. Management typically reviews the recommendations and implements stronger internal controls.

Another important role is that of an external auditor, who generally works for an outside certified public accountant (CPA) firm or his or her own private practice and conducts audits and other assignments, such as reviews. Importantly, the external auditor is not an employee of the client. The external auditor prepares reports and then provides opinions as to whether or not the financial statements accurately reflect the financial conditions of the company, subject to generally accepted accounting principles (GAAP). External auditors can maintain their own practice, or they might be employed by national or regional firms.

Ethical Considerations

Internal Auditors and Their Code of Ethics

Internal auditors are employees of an organization who evaluate internal controls and other operational metrics, and then ethically report their findings to management. An internal auditor may be a Certified Internal Auditor (CIA), an accreditation granted by the Institute of Internal Auditors (IIA). The IIA defines internal auditing as “an independent, objective assurance and consulting activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance processes.”2

Internal auditors have their own organizational code of ethics. According to the IIA, “the purpose of The Institute’s Code of Ethics is to promote an ethical culture in the profession of internal auditing.”3 Company management relies on a disciplined and truthful approach to reporting. The internal auditor is expected to keep confidential any received information, while reporting results in an objective fashion. Management trusts internal auditors to perform their work in a competent manner and with integrity, so that the company can make the best decisions moving forward.

One of the issues faced by any organization is that internal control systems can be overridden and can be ineffective if not followed by management or employees. The use of internal controls in both accounting and operations can reduce the risk of fraud. In the unfortunate event that an organization is a victim of fraud, the internal controls should provide tools that can be used to identify who is responsible for the fraud and provide evidence that can be used to prosecute the individual responsible for the fraud. This chapter discusses internal controls in the context of accounting and controlling for cash in a typical business setting. These examples are applicable to the other ways in which an organization may protect its assets and protect itself against fraud.

Footnotes

  • 2 The Institute of Internal Auditors (IIA). “Code of Ethics.” n.d. https://na.theiia.org/standards-guidance/mandatory-guidance/Pages/Code-of-Ethics.aspx
  • 3 The Institute of Internal Auditors (IIA). “Code of Ethics.” n.d. https://na.theiia.org/standards-guidance/mandatory-guidance/Pages/Code-of-Ethics.aspx
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