Chapter 6: Ethics, Internal Control, and IFRS
Discussion Questions: Key Points
1. Many would argue that our ethics are established well before we reach college. While it is
true that our upbringing has an indelible impact on our morality, this is not to say that we are
not capable of moral development throughout our lives. As our worlds expand, so do our
opportunities to develop and refine our sense of right and wrong. Indeed, as we move beyond
our teenage years in which right and wrong is often excessively influenced by peer group
norms, we begin to understand the importance of ethical conduct of citizens in society. A
college classroom that ignores its responsibility to teach the ethical implications of decisions
associated with its subject area is failing in one of its primary obligations to society.
2. This is a subject that has been debated extensively. While it is doubtful that a person of low
morality will conduct himself or herself with high standards in a professional setting, most
would argue that they are distinctly different concepts. The implication is that because our
professional lives are just beginning (or have not yet begun), we have a tremendous
opportunity for moral development at this point.
3. Management fraud involves manipulation of financial statements so that users will alter
decisions about the company. Sometimes management fraud is called fraudulent financial
reporting. Employee fraud is theft or misuse of company assets. Sometimes employee fraud
is called misappropriation of assets. The frauds at Enron and WorldCom were examples of
management fraud. The executives at the company misstated financial statements so that
others would think that the company was profitable when, in fact, it had been suffering huge
losses. Employee fraud can range from cashiers stealing from the company to cases of
unauthorized use of corporate resources. Some may recall the stories of the Tyco executive
who used company money to throw a multi-million dollar birthday party for his wife.
4. The three components of the fraud triangle are perceived pressure, rationalization, and
perceived opportunity. It is helpful to be able to recognize the warning signs of fraud
associated with each of these categories. It is also helpful to know that it takes all three
elements in order for fraud to occur. Managers tend to emphasize the restriction of
opportunity to commit fraud, but they would also be well advised to look at the other
elements as well. If management behaves with poor integrity in dealing with others, for
example, employees will be more likely to rationalize dishonest behavior.
5. Management fraud risk factors are typically broader in scope. Employee fraud risk factors are
typically more personal. Lifestyle changes and personal attitudes toward the company are
employee fraud risk factors. Management fraud risk factors tend to focus more on the
company’s financial position and other macro-level factors.
6. The control environment is the tone at the top of the organization. It has a significant effect
throughout the organization. If management communicates a lack of personal integrity, it will
be much more likely that individuals throughout the organization will demonstrate lack of
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integrity in their professional interactions. Students may relate a variety of situations in
which the tone at the top filtered down throughout the organization.
7. The perceived opportunity corner of the fraud triangle is most closely associated with a
company’s control activities. For example, if a company segregates duties more effectively
or establishes responsibility more clearly, an employee will perceive less opportunity to
engage in fraudulent behavior.
8. It should make management more aware of the importance of the other two elements of the
fraud triangle. Given that perceived opportunity can never be completely limited due to
inherent limitations of internal control, management should realize that pressures and
rationalization could make the difference in preventing fraud. Management should pay
attention to all corners of the fraud triangle.
9. The Sarbanes-Oxley Act of 2002 decentralized power within the organization. While a good
CEO is still crucial to an organization, the CEO should be less likely to be able to impose his
or her will on the organization through domineering behavior.
10. A rules-based system tends to attempt to anticipate any problems that could arise and have a
rule to establish legal boundaries. A principles-based system tends to establish ideals toward
which all individuals should strive without attempting to anticipate every situation. When
individuals buy into the principles and are aware that they are expected to strive toward
fulfilling those principles, this set of standards may be preferable. When individuals are
expected to act in a self-interested way, it may be necessary to have a more rules-based
system. IFRS is generally regarded to be more principles-based than U.S. GAAP.
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Short Exercises
(5–10 min.) S 6-1
1
F
2
CR
3
B
4
F
5
E
(5–10 min.) S 6-2
1
P
2
P
3
R
4
O
5
P
(5–10 min.) S 6-3
Student answers will vary.
1. It can be argued that any one of the four objectives is the most important. However,
many students feel that the safeguarding of assets is the most important. In fact, all of the
objectives are equally important.
2. In order for the business to survive in the long run, each of the objectives must be
accomplished. The failure to accomplish any of the objectives can leave the business
susceptible to such things as erroneous financial reporting, theft, or fraud. Any one of
these may harm the company to the extent that its survival is in jeopardy.
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(5–10 min.) S 6-4
1
ADR
2
RA
3
PA
4
RA
5
SD
(10–15 min.) S 6-5
Student answers will vary.
Separation of duties helps prevent employees from being able to steal assets and then cover up
the theft. This is why it is often referred to as the cornerstone of internal controls over the
safeguarding of assets. If an employee has custody of cash (they make the daily deposits) and
records the daily cash sales, they could steal money from the daily deposit and then alter the
amount of the daily cash sales that were recorded in order to hide the theft.
(5–10 min.) S 6-6
1
R
2
P
3
P
4
O
5
P
6
R
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(5–10 min.) S 6-7
1
A
2
L
3
A
4
O
5
A
6
L
7
O
8
A
9
L
10
0
(5–10 min.) S 6-8
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1
B
2
D
3
A
4
E
5
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(5–10 min.) S 6-9
a. Strength. When an employee is on vacation, errors or irregularities may be detected by
the individual filling in for the employee who is on vacation.
b. Weakness. The accounting department should not be allowed to order merchandise or
approve payment. An accountant could have goods sent to his / her home and then
approve payment for the goods.
c. Strength. By not allowing the sales clerk access to both the cash and the accounting
records, it is more difficult for the clerk to steal cash and hide the theft.
d. Weakness. The officer should examine the payment packet to ensure that the payment is
for the correct amount.
(5–10 min.) S 6-10
a.
Separation of duties (The same person is ordering merchandise and approving payment.)
b.
Separation of duties (The same person is selling tickets and taking tickets.)
c.
Adequate documents and records (No sales receipt is being prepared.)
d.
Proper authorization (No authorization is required for sales returns.)
e.
Adequate documents and records (No receiving report is being prepared.)
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(15–20 min.) S 6-11
Requirement 1
Requirement 2
Requirement 3
Missing Internal
Control
Possible Problem
Solution
a.
Separation of duties
Theft
b.
Audit
Unreliable financial
statements
c.
Documentation
Theft
d.
Separation of duties
Theft
Assign accounting and cash
handling duties to separate
employees.
Have the financial statements
audited. Auditors should be
able to prevent false financial
statements.
Order pre-numbered receipts
from another vendor.
Do not allow cashiers to
record sales in accounting
records.
(20-25 min.) S 6-12
Student answers may vary
The main provisions of the Sarbaynes-Oxley act are:
•
It applies to publicly traded companies.
•
It established the Public Company Accounting Oversight Board (PCAOB).
•
It requires that external auditors report to an audit committee, rather than to an
organization’s management.
Prior to Sarbanes-Oxley, the external auditors often
reported to a company’s upper management.
•
It requires that a company’s Chief Executive Officer (CEO) and Chief Financial Officer
(CFO) certify all annual, or quarterly, reports filed by an organization.
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(20-25 min.) S 6-13
Student answers may vary
US GAAP is primarily only utilized in the US compared to IFRS which is used by many
countries in the world.
US GAAP is a rules based system with numerous rules compared to
IFRS which is a principles based system that utilizes overriding principles and a smaller number
of rules. US GAAP utilizes historical cost as its primary method of valuation compared to IFRS
which utilizes fair market value as its primary method of valuation.
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Ethics in Action
Case # 1
Since so many employees, including upper management, are violating the company’s policies, it
may not seem unethical to Jake to allow his friends into the park without paying. However, Jake
needs to remember that just because others are violating the rules, it doesn’t make it right for him
to do the same. As the old adage goes, “Two wrongs don’t make a right.”
Even though
allowing his friends to enter without paying doesn’t directly steal from the park, it does prevent
the company from potentially earning additional revenue.
Case #2
Marybeth’s actions are unethical because she is knowingly preparing financial statements based
on misleading financial information. She is assuming that the out-of-balance situation is a
simple mistake in recording a journal entry, and due to the time-constraint, she “hides” the
problem in the Inventory account. She is not only covering up a problem, she is adding to the
problem by “plugging” the inventory balance. It is one thing to inadvertently prepare misleading
financial statements; to knowingly do so is unethical.
Case #3
1. Rex has no justification for stealing from the company. If he believes he was unfairly denied
a promotion, he should seek an appropriate appeal. In addition, if he is unable to advance any
further in the company, he may consider another place of employment.
2. Given the current company procedures, Rex’s scheme may go undiscovered. However, the
company would become suspicious if Rex’s store hires employees that provide invalid social
security numbers.
3. The company does not bear any direct responsibility; however, the company should have
some internal control procedures in place. The best controls are preventative. While not all
fraudulent actions can be prevented, procedural policies and related checks and balances can
help to deter fraud.
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4. Direct deposit is a procedural policy to enhance accuracy and efficiency. Given that Rex
created a fictitious employee, he could also open a bank account on behalf of the employee
using fictitious documents and then simply make withdrawals from the account rather than
cashing the actual paycheck.
5. With so many remote locations, management needs to ensure company policies and
procedures are adhered to because a strong internal control environment reduces the potential
for theft and fraud.

Verify employee identification: Knowing that the company did not immediately verify the
legitimacy of new employees, Rex used this to perpetrate his fraud. The company should
verify the social security number immediately with the Social Security Administration to
reduce the possibility for fictitious employees.

Corporate management models behavior: It is important to set a good example. If store
managers know that the corporate headquarters is inefficient and careless, then there will
be a perception of oversight or proper governance. This can encourage unethical
behavior.

Random audits and unannounced visits: Since there are numerous remote locations,
random audits and regular visits to each store should be a part of the operating
procedures. Unannounced store visits by corporate management can include observations
of employees. These visits signal employees that corporate management does not tolerate
fraud.

Interview employees: Further, even asking an employee about his or her manager or other
employees may provide valuable information.

Hot-tip line: In addition, providing employees and customers with a toll free corporate
telephone number that they can anonymously call anytime to report any problems can
also provide insight information.
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Case #4
1. Yes, one could argue that Sam’s behavior is unethical. His scheme is clearly for personal
gain and others stand to be harmed by Sam’s actions. He was very focused on reporting
increased sales because the growth fueled the increase in the stock price. Sam’s profit was
two-fold: (1) he received stock through the bonus plan as a result of the reported sales
performance, and (2) he was able to sell the stock at the inflated stock price.
Sam’s scheme results in fraudulent financial reporting. Even though the contractors are
taking possession of the alarm systems, RAS is overstating revenue by overstating
receivables that will not be collected in cash. When the company buys back the alarm
systems, the receivable is cleared by an offsetting increase to inventory. This process allows
RAS to record the revenue from the sale of the same alarm systems (inventory) over and
over.
2. There are typically more people affected in situations where there is unethical behavior than
might be expected. Following are those, in addition to Sam and the contractors, who could
be harmed in this situation:
(a) Members of the management team who are drawn into this scheme and could suffer
damage to their reputations.
(b) The investors who paid inflated amounts for the company’s stock.
(c) RAS, Inc. may end up being sued by stockholders who made investment
decisions based on the fraudulent financial statements.
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Case #5

Even though Mary is the new manager and has no reason to distrust her employees, she
also has no reason to trust them. This is really an issue of a preventative internal control
over cash. Considering that Mary cannot constantly monitor each cashier and each
cashier has contact with cash, it is reasonable to test the honesty of each cashier.

Mary has a fiduciary responsibility to oversee and manage the store’s assets and related
operations. Part of that responsibility is to safeguard and protect all the assets, including
cash. Simply checking the integrity of each cashier is not unethical. Mary is not singling
out a specific cashier but rather testing every employee who has contact with cash.
Furthermore, to be effective, it has to be done without their knowledge. Otherwise, she
could not realistically test the employee if they know that they are being tested.
Accordingly, her conduct is not unethical.

Mary should not inform the employees of her test. Once an employee found out, they
would quickly tell others and soon every current and future employee would know and
thus could not be tested by baiting the cash drawer.

Again, there is nothing unethical about Mary testing any employee that has contact with
cash, even the assistant manager.
Case #6
1. Assuming no other changes, the $45,000 decrease in the amount of recorded depreciation
expense would result in an increase in earnings.
2. The ethical issue in this case is not difficult to identify – Is it ethical for you to follow
Karen’s instructions and change the amount of the depreciation expense knowing that
the change is being made to manage the company’s earnings?
3. To resolve this dilemma, you should first consider your alternatives:
A) Record the entry as requested by Karen.
B) Explain your position to Karen and refuse to make the entry.
C) Talk to a person in authority within the company above the CFO about the
situation.
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D) Quit working for the company.
E) Report the situation to the external auditors and/or SEC.
Each of these alternatives includes a potential consequence:
A) You are likely to receive good evaluations for cooperation and perhaps a salary increase.
B) Karen may say she will make the entry herself, or conversely, she may get angry and
write you up as being insubordinate.
C) The person in authority may take what you have to say very seriously, thank you for
your courage, and take appropriate actions to monitor the situation. Conversely, they
may not be at all interested in what you have to say, and can not wait for you to leave so
they can speak to the CFO and/or Karen about dismissing you.
D) If you quit – you are out of work, at least temporarily.
E) This is a serious step. Be sure that you are confident enough with your position that you
would be willing to defend it in a court of law.
In the end, you are the one that must decide on the appropriate alternative after considering
your ethical values and the likely consequences of each alternative.
It is important, however, to avoid the temptation to rationalize unethical behavior.
4. The following are common pitfalls used to rationalize unethical behavior:
(A)
(B)
(C)
(D)
Everybody does it.
If it’s legal, it’s ethical.
It’s unlikely that anyone will ever know.
If someone finds out, the consequences (penalty) are minimal.
Case #7
1. In this case, Marvin has made himself an unauthorized, interest-free loan at the expense of is
employer. His rationalization for this unethical behavior is that he is just borrowing the
money and will pay it back before anyone notices. Marvin never considers that the company
is being harmed by his actions – the company does not have use of the $2,500 that Marvin
has taken for his personal use.
2. The lack of proper segregation of duties made it very easy for Marvin to take the cash and
cover his tracks by overstating inventory. In a good internal control system, cash-handling
and cash-recording activities should be separated to remove the opportunity for theft of cash
and cover-up by altering the records. Although Marvin considers himself a “true company
man” and has been loyal to his employer for a number of years, when a person is faced with
the right pressures and presented with the right opportunities, fraud is likely to occur.
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Case #8
1. There are two basic accounting issues related to Chuck’s request:
(a) Proper cutoff of the accounting period: Only transactions for the current accounting
period should be included in the current year’s operating results. Since CrystalClean has
a December 31 year-end, the major contract to be signed on January 2 should be
accounted for in the subsequent year.
(b) Revenue recognition: Revenue should not be reported until it is earned. In this case, the
revenue will not be earned until the cleaning services for the contract are provided.
2. The ethical issue in this case involves delaying the closing process knowing this delay is a
deliberate attempt to misrepresent the current year’s operating results.
3. The appropriate course of action would be for you to make every effort to explain to Chuck
the importance of preparing the financial statements in accordance with GAAP, especially
since the banker is going to be relying on information in the financial statements. If you are
unable to convince Chuck to do the right thing, you should refuse to go along with his
request. Many frauds start out by slightly bending the rules, but then escalate to larger and
more dishonest acts. You do not want to allow yourself to get caught up in this situation. Of
course, you need to be prepared to look for another job since Chuck will probably fire you.
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Financial Analysis
1. Management is responsible for the information in the Annual Report. The Audit Committee
is responsible for recommending the independent accountants to the Board of Directors.
2. The independent auditors were Deloitte & Touche LLP. They conducted their audit in
accordance with the standards of the United States Public Company Accounting Oversight
Board (PCAOB).
3.
Their opinion was that the financial statements present fairly, in all material respects, the
financial position of Columbia Sportswear as of December 31, 2008, and 2007, and the
results of their operations and their cash flows for each of the three years in the period ended
December 31, 2008, in conformity with accounting principles generally accepted in the
United States of America
3. Management is responsible for both establishing and maintaining the internal control
procedures of the company. The effectiveness of the internal controls is assessed by
management and audited by the independent auditors. Internal control procedures are very
important. While these procedures cannot guarantee that all misstatements will be prevented
or detected, they are extremely important to ensure that the overall financial statement
content represents the financial results of the business.
4. The auditors not only audit the management assessment of internal controls but also obtain
an understanding of the internal controls over financial reporting by testing and evaluating
the design and operating effectiveness of the existing internal controls. The auditor’s opinion
was that Columbia Sportswear maintained, in all material respects, effective internal control
over financial reporting as of December 31, 2008.
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Industry Analysis
Although there are a lot of differences between these two reports concerning their disclosure of
internal control procedures, there are many similarities also. Mostly the similarities are in the
wording of the two reports. Since much of the wording for these reports is suggested by GAAP,
you’ll find some of the same phrases in each report. Essentially, they are telling the readers of
the financial statements that management is responsible for establishing and maintaining
adequate internal control over financial reporting for the company. They go on to say that the
system has been assessed or evaluated as part of the engagement to prepare these audited
financial statements. The one thing that Columbia Sportswear does that Under Armour does not
do is to actually include the report on internal controls that was prepared by the independent
auditing firm.
Small BusinessAnalysis
It certainly does appear that Joe is involved in something that is affecting your cash. However,
you should proceed slowly and cautiously in your analysis of the situation. Your main objective
is to safeguard your assets and not necessarily to do all the investigative work to build a case
against Joe. Come in several evenings and analyze some of Joe’s transactions. That might give
you more direction.
If Joe is involved in some fraudulent activity, it appears that he is committing what is known as
Employee Embezzlement. It would also appear that maybe his uncle’s company is involved.
Perhaps the double billing to his uncle last year was just the tip of the iceberg. This is similar to
establishing a fake company talked about in the text, but in this case, the company is not fake. It
actually exists, and it appears that Joe has an accomplice in his embezzlement scheme, that being
his uncle.
The element of internal control that is being violated here is part of the control activities, or more
precisely, separation of duties. Joe handles the billing and the collections. Regardless of whether
or not it is convenient for one person to perform both functions, it should never happen. In a
small office where it is difficult to delegate duties involving cash to other people, the best person
to get involved is the owner!
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Written Communication
Students’ responses will vary since there is not a lot of information given regarding the office
and the personnel involved. However, some key points should be covered. A suggested report
might be as follows:
Control activities are one of the five key elements that affect an organization’s internal control
system. Control activities themselves have two important elements: policies establishing what
should be done and the procedures that should be followed to implement the policies. Since the
types of control activities used by an organization vary from company to company, our activities
will be unique to our circumstances. Some examples of common control activities include:







Employment of competent as well as trustworthy personnel.
Separation of duties: responsibility for more than one of the following functions should
not be given to any one employee.
Mandatory Vacations – while the employee is away, another employee should perform
their duties.
Restricted access: Limit the number of employees who have access to company assets.
Security measures: Proper security measures should be implemented to deter theft.
Proper authorization: Requiring proper authorization for all sales returns can help prevent
improper refunds from being issued.
Maintain adequate documents and records: A trail of business documents and records,
called an audit trail, should be maintained.
Our operations seem to be adequate in most of these areas. We try to employ competent
personnel that we consider to be trustworthy. Even though our office is small in terms of
personnel, separation of duties can be obtained by having the owner involved in as many of the
accounting functions as possible. I suggest we strengthen the mandatory vacation rule, that we
further restrict access to some of the company assets, and we review our security measures
currently in place. Regarding proper authorization, we should also have that in place for all
disbursements and credit corrections. And last but not least, the procedures for establishing our
audit trail should be reviewed periodically.
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