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CHAPTE R 3 Ethics, Fraud, and Internal Control 117

ACCOUNTABILITY. An effective ethics program must take appropriate action when code violations
occur. This will include various disciplinary measures, including dismissal. Employees must see an em-
ployee hotline as credible, or they will not use it. Section 301 directs the organization’s audit committee to
establish procedures for receiving, retaining, and treating such complaints about accounting procedures and
internal control violations. Audit committees will also play an important role in the oversight of ethics
enforcement activities.

Fraud and Accountants

Perhaps no major aspect of the independent auditor’s role has caused more controversy than their respon-
sibility for detecting fraud during an audit. In recent years, the structure of the U.S. financial reporting
system has become the object of scrutiny. The SEC, the courts, and the public, along with Congress, have
focused on business failures and questionable practices by the management of corporations that engage in
alleged fraud. The question often asked is, ‘‘Where were the auditors?’’
The passage of SOX has had a tremendous impact on the external auditor’s responsibilities for fraud
detection during a financial audit. It requires the auditor to test controls specifically intended to prevent or
detect fraud likely to result in a material misstatement of the financial statements. The current authorita-
tive guidelines on fraud detection are presented in Statement on Auditing Standards (SAS) No. 99, Con-
sideration of Fraud in a Financial Statement Audit. The objective of SAS 99 is to seamlessly blend the
auditor’s consideration of fraud into all phases of the audit process. In addition, SAS 99 requires the audi-
tor to perform new steps such as a brainstorming during audit planning to assess the potential risk of ma-
terial misstatement of the financial statements from fraud schemes.

DEFINITIONS OF FRAUD
Although fraud is a familiar term in today’s financial press, its meaning is not always clear. For example,
in cases of bankruptcies and business failures, alleged fraud is often the result of poor management deci-
sions or adverse business conditions. Under such circumstances, it becomes necessary to clearly define
and understand the nature and meaning of fraud.
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. Accord-
ing to common law, a fraudulent act must meet the following five conditions:
1. False representation. There must be a false statement or a nondisclosure.
2. Material fact. A fact must be a substantial factor in inducing someone to act.
3. Intent. There must be the intent to deceive or the knowledge that one’s statement is false.
4. Justifiable reliance. The misrepresentation must have been a substantial factor on which the injured
party relied.
5. Injury or loss. The deception must have caused injury or loss to the victim of the fraud.

Fraud in the business environment has a more specialized meaning. It is an intentional deception, mis-
appropriation of a company’s assets, or manipulation of its financial data to the advantage of the perpetra-
tor. In accounting literature, fraud is also commonly known as white-collar crime, defalcation,
embezzlement, and irregularities. Auditors encounter fraud at two levels: employee fraud and manage-
ment fraud. Because each form of fraud has different implications for auditors, we need to distinguish
between the two.
Employee fraud, or fraud by nonmanagement employees, is generally designed to directly convert
cash or other assets to the employee’s personal benefit. Typically, the employee circumvents the com-
pany’s internal control system for personal gain. If a company has an effective system of internal control,
defalcations or embezzlements can usually be prevented or detected.
Employee fraud usually involves three steps: (1) stealing something of value (an asset), (2) converting
the asset to a usable form (cash), and (3) concealing the crime to avoid detection. The third step is often