SOX - Fraud Triangle

Sarbanes-Oxley Act and Ethical Issues
- Public outcry surrounding ethical misconduct and fraudulent acts by executives of Enron, Global Crossing, Tyco,
Adelphia, WorldCom
- Provisions designed to deal with specific problems relating to capital markets, corporate governance, and the auditing
profession
Section 406 of SOX
- requires public companies to disclose to the SEC whether they have adopted a code of ethics that applies to the
organization’s CEO, CFO, controller, or persons performing similar functions
- If the company has not adopted such a code, it must explain why
Ways of Disclosing the Code of Ethics
1. Included as an exhibit to its annual report

2. as a posting to its Web site
3. by agreeing to provide copies of the code upon request
Code of Ethics
- should apply equally to all employees

- Top management’s attitude toward ethics sets the tone for business practice
- Lower-level managers and non-managers has the responsibility to uphold a firm’s ethical standards
Ethical Issues that Should be Addressed in the Written Code of Ethics
1. Conflicts of Interest
- outline procedures for dealing with actual or apparent conflicts of interest between personal and professional
relationships
- Focus on dealing with conflicts of interest, not prohibiting them.
- Whereas avoidance is the best policy, sometimes conflicts are unavoidable.
- Provide decision models, and participate in training programs that explore conflict of interest issues
2. Full and Fair Disclosures

- organizations should provide full, fair, accurate, timely, and understandable disclosures in the documents, reports, and financial
statements that it submits to the SEC and to the public.
Note:
- Overly complex and misleading accounting techniques were used to camouflage questionable activities that lie at the
heart of many recent financial scandals.
- The objective of this rule is to ensure that future disclosures are candid, open, truthful, and void of such deceptions.
3. Legal Compliance
- require employees to follow applicable governmental laws, rules, and regulations
- doing the right thing requires sensitivity to laws, rules, regulations, and societal expectations
- provide employees with training and guidance
4. Internal Reporting of Code Violations

- provide a mechanism to permit prompt internal reporting of ethics violations.
- Employee ethics hotlines are emerging as the mechanism for dealing with these related requirements.
- Outsource employee hotline service to independent vendors (for confidentiality)
5. Accountability.
- must take appropriate action when code violations occur
- implementing various disciplinary measures
FRAUD AND ACCOUNTANTS

Fraud
- denotes a false representation of a material fact made by one party to another party with the intent to
deceive and induce the other party to justifiably rely on the fact to his or her detriment.
Five Conditions for Fraud

1. False representation
2. Material fact
3. Intent
4. Justifiable reliance
5. Injury or loss
Notes:
1. False representation - false statement or a nondisclosure

2. Material fact - must be a substantial factor in inducing someone to act
3. Intent - intent to deceive or the knowledge that one’s statement is false
4. Justifiable reliance - the misrepresentation have been a substantial factor on which the injured party relied.
5. Injury or loss - must have caused injury or loss to the victim of the fraud
Fraud in the Business Environment
- intentional deception, misappropriation of a company’s assets, or manipulation of its financial data to the advantage of
the perpetrator
Two Levels of Fraud in the Business Environment
I. Employee Fraud
- fraud by nonmanagement employees,

- designed to directly convert cash or other assets to the employee’s personal benefit
- If a company has an effective system of internal control, defalcations or embezzlements can usually be prevented or
detected
3 Steps of Employee Fraud
1. Stealing something of value (an asset)
2. Converting the asset to a usable form (cash)
3. Concealing the crime to avoid detection
II. Management Fraud
- more insidious than employee fraud because it often escapes detection until the organization has suffered
irreparable damage or loss
Top management fraud
Performance fraud
- involves deceptive practices to inflate earnings or to forestall the recognition of either insolvency or a
decline in earnings
Example: fraudulent activities to drive up the market price of the company’s stock
- to meet investor expectations or
- to take advantage of stock options that have been loaded into the manager’s compensation package
Lower-level management fraud

- involves materially misstating financial data and internal reports to gain additional compensation, to garner
a promotion, or to escape the penalty for poor performance
Three Special Characteristics of Management Fraud

1. The fraud is perpetrated at levels of management above the one to which internal control structures generally
relate.
2. The fraud frequently involves using the financial statements to create an illusion that an entity is healthier and
more prosperous than, in fact, it is.
3. If the fraud involves misappropriation of assets, it frequently is shrouded in a maze of complex business
transactions, often involving related third parties.
Note: management can often perpetrate irregularities by overriding an otherwise effective internal control structure
that would prevent similar irregularities by lower-level employees.
The Fraud Triangle

The fraud triangle consists of three factors that contribute to or are associated with management and employee
fraud.
1. Situational Pressure
- includes personal or job-related stresses that could coerce an individual to act dishonestly
2. Opportunity
- involves direct access to assets and/or access to information that controls assets
3. Ethics
- pertains to one’s character and degree of moral opposition to acts of dishonesty
- auditor’s evaluation of fraud is enhanced when the fraud triangle factors are considered
Red-flag Checklist for Matters of Ethics and Personal Stress

• Do key executives have unusually high personal debt?
• Do key executives appear to be living beyond their means?
• Do key executives engage in habitual gambling?
• Do key executives appear to abuse alcohol or drugs?
• Do any of the key executives appear to lack personal codes of ethics?
• Are economic conditions unfavorable within the company’s industry?
• Does the company use several different banks, none of which sees the company’s
entire financial picture?
• Do any key executives have close associations with suppliers?
• Is the company experiencing a rapid turnover of key employees, either through
resignation or termination?
• Do one or two individuals dominate the company?

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Sarbanes-Oxley Act and Ethical Issues

Section 406 of SOX

Ways of Disclosing the Code of Ethics

1. Included as an exhibit to its annual report

- should apply equally to all employees

Ethical Issues that Should be Addressed in the Written Code of Ethics

2. Full and Fair Disclosures

4. Internal Reporting of Code Violations

FRAUD AND ACCOUNTANTS

Five Conditions for Fraud

1. False representation - false statement or a nondisclosure

Fraud in the Business Environment

Two Levels of Fraud in the Business Environment

- fraud by nonmanagement employees,

3 Steps of Employee Fraud

1. Stealing something of value (an asset)

2. Converting the asset to a usable form (cash)

3. Concealing the crime to avoid detection

II. Management Fraud

Lower-level management fraud

Three Special Characteristics of Management Fraud

The Fraud Triangle

Red-flag Checklist for Matters of Ethics and Personal Stress

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