Chapter 7 Controlling Information Systems: Introduction to Enterprise Risk Management and Internal Control

Accounting Information Systems 7e

Ulric J. Gelinas and Richard Dull

Copyright 2008 Thomson Southwestern, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license.

Learning Objectives
Summarize the eight elements of COSOs Enterprise Risk ManagementIntegrated Framework. Understand that management employs internal control systems as part of organizational and IT governance initiatives. Describe how internal control systems assist organizations to achieve objectives and respond to risks. Describe fraud, computer fraud, and computer abuse. Enumerate control goals for operations and information processes. Describe the major categories of control plans.
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Organizational Governance
Select Objectives Establish processes to achieve objectives Monitor performance toward objectives

Objective Setting
Mission, vision, purpose: e.g., to be the leading producer of household products in the regions in which we operate

Strategic objectives e.g., to be in the top quartile of product sales for retailers of our products

Strategy e.g., expand production of our top-five selling retail products to meet increased demand

Related objectives, e.g., increase production of x by 15% hire 180 qualified new staff maintain product quality

Source: Adapted from Enterprise Risk ManagementIntegrated Framework, Application Techniques, p. 20. 4

Why do we need controls?

(1) to provide reasonable assurance that the goals of each business process are being achieved (2) to mitigate the risk that the enterprise will be exposed to some type of harm, danger, or loss (including loss caused by fraud or other intentional and unintentional acts) (3) to provide reasonable assurance that the company is in compliance with applicable legal and regulatory obligations.
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Components of Enterprise Risk Management

Internal Environment The internal environment encompasses the tone of an organization, and sets the basis for how risk is viewed and addressed by an entitys people, including risk management philosophy and risk appetite, integrity and ethical values, and the environment in which they operate. Objective Setting Objectives must exist before management can identify potential events affecting their achievement. Enterprise risk management ensures that management has in place a process to set objectives and that the chosen objectives support and align with the entitys mission and are consistent with its risk appetite. Event Identification Internal and external events affecting achievement of an entitys objectives must be identified, distinguishing between risks and opportunities. Opportunities are channeled back to managements strategy or objective-setting processes. Risk Assessment Risks are analyzed, considering likelihood and impact, as a basis for determining how they should be managed. Risks are assessed on an inherent and a residual basis.
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Risk vs. Exposure

1. 2. 3. Estimate the annual dollar loss that would occur (i.e., the impact) should a costly event, say a destructive fire, take place. For argument sake, say that the estimated loss is $1,000,000. Estimate the annual probability that the event will occur (i.e., the likelihood). Suppose the estimate is 5 percent. Multiply item 1 by item 2 to get an initial expected gross risk (loss) of $50,000 ($1,000,000 0.05), which is the maximum amount or upper limit that should be paid for controls and the related risk reduction offered by such controls, in a given year. Next, we illustrate a recommendation plan using one corrective control, a fire insurance policy, and one preventive control, a sprinkler system. Assume that the company would pay $1,000 annually (cost of control) for a $20,000 fire insurance policy (reduced risk exposure due to control). The estimated monetary damage remains at $1 million and expected gross risk (loss) remains at $50,000, because there is still a 5 percent chance that a fire could occur. But, the companys residual expected risk exposure is now $31,000 [ $50,000 + ($20,000 $1,000)]. Our expected loss is reduced by the amount of the insurance policy (less the cost of the policy).
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4.

Risk vs. Exposure (Cont.)

4. Next, you recommend that the company install a sprinkler system with a 5-year annualized cost (net present value) of $10,000 each year to install and maintain (cost of control). At this point you might be tempted to say that the companys residual expected risk just increased to $41,000 ($31,000 $10,000), but wait! The sprinkler system lowered the likelihood of a damaging fire from 5 to 2 percent. In conjunction with this lower probability, the insurance company agreed to increase its coverage to $30,000 while holding the annual premium constant at $1,000. Thus, the residual expected risk exposure is $1,000, calculated as follows: Expected gross risk ($20,000 or $1,000,000 0.02) plus the insurance policy ($30,000) equals a gain of $10,000, but we must subtract the insurance premium ($1,000) and the sprinkler system ($10,000), leaving the residual expected risk at $1,000.
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5.

Components of Enterprise Risk Management (Continued)

Risk Response Management selects risk responses avoiding, accepting, reducing, or sharing risk developing a set of actions to align risks with the entitys risk tolerances and risk appetite. Control Activities Policies and procedures are established and implemented to help ensure the risk responses are effectively carried out. Information and Communication Relevant information is identified, captured, and communicated in a form and timeframe that enable people to carry out their responsibilities. Effective communication also occurs in a broader sense, flowing down, across, and up the entity. Monitoring The entirety of enterprise risk management is monitored and modifications made as necessary. Monitoring is accomplished through ongoing management activities, separate evaluations, or both.

Recent Internal Control Legislation

Sarbanes-Oxley Act (SOA) of 2002
Created public company accounting oversight board Increased accountability for company officers and board of directors Increased white collar crime penalties Prohibits audit firms from providing design and implementation of financial information systems
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Sarbanes-Oxley Act of 2002 (SOA)

Section 302CEOs and CFOs must certify quarterly and annual financial statements Section 404Mandates the annual report filed with the SEC include an internal control report

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Outline of SOA 2002

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Definition of Internal Control

From SAS 78 (1995) - adopted COSO definition:
INTERNAL CONTROL is a process-effected by a an entitys board of directors, management, and other personnel-designed to provide reasonable assurance regarding the achievement of objectives in the following categories:
Effectiveness & efficiency of operations Reliability of financial reporting Compliance with applicable laws & regulations.

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General Control Model

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Five Interrelated Components of Internal Control

1. 2. 3. 4. Control environment- tone at the top Risk assessment - identification/analysis of risks Control activities - policies and procedures Information & communication - processing of info in a form and time frame to enable people to do their jobs 5. Monitoring - process that assess quality of internal control over time
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 In the section addressing implementation of the Sarbanes Oxley Act section 404, the SEC used the COSO description of internal control.
It went on to say that management must base its evaluation of the effectiveness of its internal control system on a framework such as COSO COSO report stresses internal control is a process

COSO Report, SOA, and SAS 94

A complementary perspective on internal control is found in Statement on Auditing Standards (SAS) 94, entitled The Effect on Information Technology on the Auditors Consideration of Internal Control in a Financial Statement Audit.
This standard guides auditors in understanding the impact of IT on internal control and assessing IT-related control risks Further, SAS 94 highlights how IT can be used to strengthen internal control, while at the same time emphasizing how IT can actually weaken some controls
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Fraud and its Relationship to Control

Fraud: deliberate act or untruth intended to obtain unfair or unlawful gain.
Management charged with responsibility to prevent and/or disclose fraud
Control systems enable management to do this job Management responsible to provide internal control system per the Foreign Corrupt Practices Act of 1977 Section 1102 of the Sarbanes-Oxley Act specifically addresses corporate fraud Instances of fraud undermine managements ability to convince various authorities that it is upholding its stewardship responsibility

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SAS 99
The accounting profession too has been proactive in dealing with corporate fraud, as it has launched an anti-fraud program. One of the manifestations of this initiative is Statement on Auditing Standards (SAS) Number 99, entitled Consideration of Fraud in a Financial Statement Audit.
SAS 99 has the same title as its predecessor, SAS 82, but the new standard is much more encompassing than the old. For instance, SAS 99 emphasizes brainstorming fraud risks, increasing professional skepticism, using unpredictable audit test patterns, and detecting management override of internal controls.

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E&Y Fraud Survey

About 85 % of fraud committed by company insiders About 55% of perpetrators were management employees More fraud in less-developed countries About 40% of frauds are known to the public, 20% are kept confidential, and the other 40% are not yet discovered The #1 fraud worry to executives is asset misappropriation The #2 fraud worry to executives is computer crime Most organizations now have formal fraud prevention policies including codes of corporate governance and employee conduct Most useful fraud prevention techniques are internal controls, management reviews, and internal audits

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2006 Report on Fraud by Assoc. of CFE

Median loss $159,000 One quarter at least $1 million Typical organization loses 5% of revenue to fraud Detected more likely by tips than internal controls Frauds by employees:
30% by accounting department employees 20% by upper management
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Preview of some Computer Crime

Salami slicing - rounding Back door non-secured access point Trojan horse code in harmless looking program Logic bomb go off on event occurrence Worm network invasion Zombie takes over another computer
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Ethics and Controls

COSO report stresses ethics as part of control environment (tone at the top) AICPA has built ethics issues into CPA exam The Institute of Management Accountants has a code of ethics which is also tested on both the CMA and CFM exams Internal Auditing has ethics articles

Many corporations have developed Codes of Conduct

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Business Process Control Plans

Business Process Control Plans - reflect information processing policies and procedures that assist in accomplishing control goals
The Control Environment The fact that the control environment appears at the top of the hierarchy illustrates that the control environment comprises a multitude of factors that can either reinforce or mitigate the effectiveness of the pervasive and application control plans. Pervasive control plans also relate to a multitude of goals and processes Like the control environment, they provide a climate or set of surrounding conditions in which the various business processes operate. They are broad in scope and apply equally to all business processes, hence they pervade all systems. Business process control plans relate to those controls particular to a specific process or subsystem, such as billing or cash receipts, or to a particular technology used to process the data.
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Business Process Control Goals

Control Goals - ends to be obtained
Control goals of operations processes Control goals of information processes

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Control Goals of the Operations Process Ensure effectiveness of operations Ensure efficient employment of resources Ensure security of resources

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Control Goals of Operations Process

Ensure effectiveness of operations (including compliance)
A measure of success in meeting one or more operations process goals which reflect the criteria used to judge the effectiveness of various business processes Ex. Deposit cash receipts on the day received

Ensure efficient employment of resources

A measure of the productivity of the resources applied to achieve a set of goals Ex. What is the cost of people, computers, and other resources to deposit cash on the day received

Ensure security of resources

Protecting an organizations resources from loss, destruction, disclosure, copying, sale, or other misuse Ex. Are cash and information resources available when required? Are they put to authorized use?
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Control Goals of the Information Process For business event inputs, ensure Input validity Input completeness Input accuracy For master data, ensure update completeness update accuracy
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Control Goals of Information Process

Input validity
Input data approved and represent actual economic events and objects Ex. Are all cash receipts input into the process supported by customer payments

Input completeness
Requires that all valid events or objects be captured and entered into the system Ex. Are all valid customer payments captured on a customer remittance advice (RA) and entered into the process?

Input Accuracy
Requires that events be correctly captured and entered into the system Ex. Is correct payment amount and customer number on the RA? Ex. Is the correct payment amount and customer number keyed into the system?

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Control Goals of Information Process

Update completeness
Requires all events entered into the computer are reflected in their respective master data Ex. Are all input cash receipts recorded in the AR master data?

Update accuracy
Requires that data entered into a computer are reflected correctly in their respective master data Ex. Are all input cash receipts correctly recorded in the AR master data?

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Lenox Company Systems Flowchart

M AILROOM ACCOUNTS RECEIVABLE COM PUTER CASHIER Customer RAs Verify, log event on cash receipts event data, update AR, notify clerk Key customer number,invoice number,amount and check number Cash receipts event data A RAs Checks Endorsed Checks Print deposit slip Temp file "Accepted and processed" Endorsed Checks Accounts receivable master data At end of day Endorsed Checks Error routine not shown Filed until deposit slip is received

Endorse checks

A Compare

Endorsed Checks 1 Deposit slip

RA = Remittance advice

Deposit slip Deposit slip

2 1

Bank

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Control Goals for the Lenox Cash Receipts Process

Control Goals of the Lenox Cash Receipts Business Process Control goals of the operations process Ensure effectiveness of operations Ensure efficient employment of resources (e.g., people and computers) Ensure security of resources (e.g., checks and AR master data) Control goals of the information process For the remittance advice inputs, ensure: For the AR master data, ensure:

IV

IC

IA

UC

UA

Effectiveness goals include: A Timely deposit of checks B Comply with compensating balance agreements with the depository bank

IV = Input validity IC = Input completeness IA = Input accuracy UC = Update completeness UA = Update accuracy

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Other Classifications of Control Plans

Preventive Controls: Issue is prevented from occurring cash receipts are immediately deposited to avoid loss Detective Controls: Issue is discovered unauthorized disbursement is discovered during reconciliation Corrective Controls: issue is corrected erroneous data is entered in the system and reported on an error and summary report; a clerk re-enters the data 33

Gelinas and Dull Working Definition of IC: Key Points

A system of internal control is not an end in itself. Rather, it is a means to an endthe end of attaining process objectives Internal control itself is a system. Therefore, like any system it must
(1) have clearly defined goals and (2) consist of interrelated components that act in concert to achieve those goals. We can also say that internal control is a process

Establishing a viable internal control system is managements responsibility. The strength of any internal control system is largely a function of the people who operate it. Internal control cannot be expected to provide absolute, 100% assurance that the organization will reach its objectives. Rather, the operative phrase is that it should provide reasonable assurance Internal control is not free; controls should be built in and cost effective

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Gelinas and Dull

Working Definition of IC
INTERNAL CONTROL is a process-effected by a an entitys board of directors, management, and other personneldesigned to provide reasonable assurance regarding the achievement of objectives in the following categories:
Effectiveness & efficiency of operations Reliability of reporting Compliance with applicable laws & regulations.
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Chapter Important Points

Need for controls ERM components COSO components Definition of controls Need to avoid fraud Pervasive versus process controls Process control goals (operations and information) Preventive, detective, and corrective controls
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