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Chapter 7 Controlling Information Systems:

Introduction to Enterprise Risk Management and Internal Control

Accounting Information Systems 7eUlric 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.

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Learning Objectives

• Summarize the eight elements of COSO’s Enterprise Risk Management—Integrated 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

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

Strategicobjectivese.g., to be in thetop quartile ofproduct sales for retailers of our products

Strategye.g., expand productionof our top-five selling retailproducts to meet increaseddemand

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

Source: Adapted from Enterprise Risk Management—Integrated Framework, Application Techniques, p. 20.

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Why do we need controls?

• (1) to provide reasonable assurance that the goals of each business process are being achieved-(achieve obj)

• (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)-(avoid risk)

• (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 (ERM)

• Internal Environment – Encompasses the tone of an organization.

– Sets the basis for how risk is viewed and addressed by an entity’s people.

– Includes 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.

– ERM ensures management has a process in place to set objectives and that the objectives support and align with the entity’s mission and are consistent with its risk appetite.

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Components of ERM (Cont’d.)• Event Identification

– Internal and external events affecting achievement of an entity’s objectives must be identified, distinguishing between risks and opportunities.

– Opportunities are channeled back to management’s 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.

• Risk Response

– Management selects risk responses – avoiding, accepting, reducing, or sharing risk – developing a set of actions to align risks with the entity’s risk tolerances and risk appetite.

Components of ERM (Cont’d.)• 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

to enable people to carry out their responsibilities.

– Effective communication also occurs in a broader sense, flowing down, across and up the entity.

• Monitoring– Enterprise risk management is monitored and modifications are

made as necessary.

– Monitoring is accomplished through ongoing management activities, separate evaluations, or both.

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Risk vs. Exposure

1. 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.

2. Estimate the annual probability that the event will occur (i.e., the likelihood). Suppose the estimate is 5 percent.

3. 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.

4. 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 company’s 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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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 company’s 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.

5. 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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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 302—CEOs and CFOs must certify quarterly and annual financial statements

• Section 404—Mandates 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

entity’s 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. Control environment- tone at the top

2. Risk assessment - identification/analysis of risks

3. Control activities - policies and procedures

4. 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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COSO Report, SOA, and SAS 94

• 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 • A complementary perspective on internal control is found in

Statement on Auditing Standards (SAS) 94, entitled “The Effect on Information Technology on the Auditor’s 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 management’s 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 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 organization’s 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

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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

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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