Task 1:

FUNDAMENTAL ACCOUNTING CONCEPTS:

Qualitative Characteristics of Financial Statements
Qualitative characteristics are the attributes that make the information provided in financial statement; useful to users. The four principal qualitative characteristics arc understandability, relevance, reliability and comparability.

Understandability
An essential quality of the information provided in financial statements is that it is readily understandable by users. For this purpose, users arc assumed to have a reasonable knowledge of. business and economic activities and accounting and a willingness to study the information with reasonable diligence. However, information about complex matters that should be included in me financial statements because of its relevance to the economic decision-making needs of users should not be excluded merely on the grounds that it may be too difficult for certain users to understand.

Relevance
To be useful, information must be relevant to me decision-making needs of users. Information has the quality of relevance when it influences the economic decisions of users by helping them evaluate past, present or future events confirming, or correcting, their past evaluations.

Reliability
To be useful, information must also be reliable. Information has the quality of reliability when it is free from material error bias. Information may be relevant but so unreliable in nature or representation that its recognition may be potentially misleading. For example, if the validity and amount of a claim for damages under a legal action are disputed, it may be inappropriate for the enterprise to recognise the fall amount of the claim in the balance sheet, although it may be appropriate to disclose the amount and circumstances of the claim.

Comparability
Users must be able to compare the financial statements of' an enterprise through time in order to identify trends in its financial position and performance. Users must also be able to compare the financial statements of different enterprises in order to evaluate their relative financial position, performance and changes in financial position. Hence, the measurement and display of the financial effect of like transactions and other events must be carried out in a consistent way throughout .an enterprise and over time for that enterprise and in a consistent way for different enterprises.

Faithful Representation
To be reliable, information must represent faithfully die .transactions and other events it either purports to represent or could reasonably be expected to represent. Thus, for example, a balance sheet should represent faithfully the transactions and other events that result in assets & liabilities expects to be represented.

Substance Over Form

If information is to represent faithfully the transactions and other events that it purports to represent, it is necessary that they are accounted for and presented in accordance with their substance and economic reality and not merely their legal form. the substance of transactions or other events is not always consistent with that which is apparent from their legal or contrived form. for example, an enterprise may dispose of an asset to another party in such a way that the documentation purports to pass legal ownership to that party; nevertheless, agreements may exist that ensure that the enterprise continues to enjoy the future economic benefits embodied in the asset. In such circumstances, the reporting of a sale would not represent faithfully the transaction entered into (if indeed there was a transaction).

Neutrality
To be reliable, the information contained in financial statements must be neutral, that is, free from bias. Financial statements are not neutral if, by the selection or presentation, they influence the making of a decision or judgment in order to achieve a predetermined result or outcome.

Prudence
The preparers of financial statements do, however, have to contend with the uncertainties that inevitably surround many events and circumstances, such as the collect ability of doubtful

receivables, the probable useful life of plant and equipment and the number of warranty claims that may occur. Such uncertainties are recognized by the disclosure of their nature and extent and by the exercise of prudence in the preparation of the financial statements. Prudence is the inclusion of a degree of caution in the exercise of judgments needed in making the estimates required under conditions of uncertainty, such that assets or income are not overstated and liabilities or expenses are not understated. However, the exercise of prudence does not allow, for example, the creation of hidden reserves or excessive provisions, the deliberate understatement of assets or income, or the deliberate overstatement of liabilities or expenses,, because the financial statements would not be neutral and, therefore, not have the quality of reliability.

Completeness
To be reliable, the information in financial statement must be complete within the bounds of materiality and cost. An omission can cause information to be false or misleading and thus unreliable and deficient in terms of its relevance.

Constraints on Relevant and Reliable Information Timeliness

If there is undue delay in the reporting of information it may lose its relevance. Management may need to balance the relative merits of timely reporting and the provision of reliable information. To provide information on a timely basis it may often be necessary to report before all aspects of a transaction or other .event are known, thus impairing reliability. Conversely, if reporting is delayed until all aspects are known, the information may be highly reliable but of little use to users who have had to make decisions in me interim. In achieving a balance between relevance and reliability, the overriding consideration is how best to satisfy the economic decision-making needs of users.

Balance between Benefit and Cost

The balance between benefit and cost is a pervasive constraint rather than a qualitative characteristic. The benefits derived from information should exceed the cost of providing it. The evaluation of benefits and costs is, however, substantially a judgmental process. Furthermore, the costs do not necessarily fall or those users who enjoy the benefits. Benefits may also be enjoyed by users other than those for whom the information is prepared; for example, the provision of further information to lenders may reduce the borrowing costs of an enterprise. For these reasons, it is difficult to apply a cost-benefit test in any ' particular case. Nevertheless, standardsetters in particular, as well as the preparers and users of financial statements, should be aware of this constraint.

Balance between Qualitative Characteristics

In practice a balancing, or trade-off, between qualitative characteristics is often necessary. Generally the aim is to achieve an appropriate balance among the characteristics in order to meet the objective of financial statements. The relative importance of the characteristics in different cases is a matter of professional judgment.

True and Fair View/Fair Presentation

Financial statements are frequently described as showing a true and fair view of, or as presenting fairly, the financial position, performance and changes in financial position of an enterprise. Although this Framework does not deal directly with such concepts, the application of the principal qualitative characteristics and of appropriate accounting standards normally results in financial statements that convey what is generally understood as a true and fair view of, or as presenting fairly such information.

Going Concern
When preparing financial statements, management should make an assessment of an enterprise's ability to continue as a going concern. Financial statements should be prepared on a going concern basis unless management either intends to liquidate the enterprise or to cease trading, or has no realistic alternative but to do no. When management is aware, in making its assessment, of Material uncertainties related to events or conditions which may cast significant doubt upon the enterprise's ability to continue as a going concern, those uncertainties should be disclosed. When the financial statements are not prepared on a going concern basis, that fact should be disclosed, together with the basis on which the financial statements are prepared and the reason why the enterprise it not considered to be a going concerns. The financial statements are normally prepared on the assumption that an enterprise is a going concern and will continue in operation for the foreseeable future. Hence, it is assumed that the enterprise has neither the intention nor the need to liquidate or curtail materially the scale of its operations; if such an intention or need exists, the financial statements may have to be prepared on a different basis and, if so, the basis used is disclosed.

Underlying Assumptions Accrual l Basis except Cash Flow

In order to meet their objectives, financial statements ate prepared on the accrual basis of accounting. Under this basis, the effects of transactions and other events are recognized when they occur (and not as cash or its equivalent is received or paid) and they are recorded to the

accounting records and reported in the financial statements of the periods which they relate. Financial statements prepared on the accrual basis inform users not only of past transactions involving the payment and receipt of cash but also of obligations to pay cash in me future and of resources that represent cash to be received in the future. Hence, they provide the type of information about past transactions and other events that is most useful to users in making economic decisions.

Consistency of Presentation (Accounting Assumption)

The presentation and classification of Items in the financial statements should be retained from one period to the next unless: (a) a significant change in the nature of the operations of the enterprise or a review of the financial statement presentation demonstrates that the change will result in a more appropriate presentation of events or transactions; or (b) a change in presentation is required by an International Accounting Standard or an Interpretation of the Standing Interpretations Committee.

Materiality and Aggregation

Each material item should be presented separately, in the financial statements. Immaterial amounts mould be aggregated with amounts of a similar nature or function and need not be presented separately.

Offsetting
Assets and liabilities should not be offset except when offsetting is required or permitted by another International Accounting Standard. Items of income and expense should be offset when, and only when: (a) an International Accounting Standard requires or permits it; or (b) Gain & loss of disposal of Asset, gains, losses and related expenses arising from the same or similar transactions and events are net material.

Purpose of Financial Statements

Financial statements are a structured financial representation of the financial position of and the transactions undertaken by an enterprise. The objective of general purpose financial statements is to .provide information about the financial position, performance and cash flow of an enterprise that is useful to a wide Range of users in making economic decisions. Financial statements also show the results of management's stewardship (how it is running) of the resources entrusted to it.

To meet this objective, financial statements provide information about an enterprise's: (a) assets; (b) liabilities: (c) equity; (d) income and expenses, including gains and losses; and (e) cash flows.

Components of Financial Statements

A complete set of financial statements includes the following components: (a) balance sheet; (b) income statement; (c) a statement showing either: (i) all changes in equity; or (ii) changes in equity other than those arising from capital transactions with owner and distributions to owners; (d) cash flow statement; and (e) accounting policies and explanatory notes.

Responsibility for Financial Statements

The Management of an enterprise is responsible for the preparation of its financial statements. Users and Their Information Needs The users of financial statements include present and potential investors, employers, lenders, suppliers and other trade creditors, customers, governments and their agencies and the public. They use financial statements in order to satisfy some of their different needs for information. These needs include the following:

(a) Investors. The providers of risk capital and their advisers are concerned with the risk inherent in, and return provided by, their investments. They need information to help them determine whether they should buy, hold or sell. Shareholders are also interested in information which enables them to assess the ability of the enterprise to pay dividends.

(b) Employees. Employees and their representative groups are interested in information about the stability and profitability of their employers. They are also interested in information which enables them to assess the ability of the enterprise to provide remuneration, retirement benefits and employment opportunities.

(c) Lenders. Lenders are interested in information that enables them to determine whether their loans, and the interest attaching to them, will be paid when due.

(d) Suppliers and other trade creditors. Suppliers and other creditors are interested in information that enables them to determine whether amounts owing to them will be paid when due. Trade creditors are likely to be interested in an enterprise over a shorter period than lenders unless they are dependent upon the continuation of the enterprise as a major customer.

(e) Customers. Customers have an interest in information about the continuance of an enterprise, especially when they have a long-term involvement with, or are dependent on, the enterprise.

(f) Governments and their agencies. Governments and their agencies are interested in the allocation of resources and, therefore, the activities of enterprises. They also require information in order to regulate the activities of enterprises, determine taxation policies and as the basis for national income and similar statistics.

(g) Public. Enterprise affect members of the public in a variety of ways. For example, enterprises may a substantial contribution to the local economy fin many ways including the number of people they employ and their patronage of local suppliers. Financial statement may assist the public by providing information about the trends and recent developments in the prosperity of the enterprise and the range of its activities.

(a) Historical Cost. Assets are recorded at the amount of each or cash equivalents paid or tin; lair value of the consideration given to acquire them at the time of their acquisition. Liabilities are recorded at the amount of proceeds received in exchange for the obligation, or in some circumstances (for example, income taxes), at the amounts of cash or cash equivalents expected to be paid to satisfy the liability in the normal course of business. Asset Valuation Alternates:

(b) Realisable (settlement) value. Assets are carried at the amount of cash or cash equivalents that could currently be obtained by selling the asset in an orderly disposal. Liabilities are carried at their settlement values; that is, the undiscounted amounts of cash or cash equivalents expected to be paid Hi satisfy the liabilities in the normal course of business.

(c) Currant cost. Assets are carried at the amount of cash or cash equivalents that would have to be paid if the same or an equivalent asset was acquired currently, Liabilities are carried at the undiscounted amount of cash or cash equivalents that would be required to settle the obligation currently. Sale, turnover, gross receipt, Revenue is the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an enterprise when those inflows result in increases in equity, other than increases relating to contributions from equity participants.

Measurement of Revenue
Revenue should be measured at the fair value of the. consideration received or receivable. The amount of revenue arising on a transaction is usually determined by agreement between the enterprise and the buyer or user of the asset. It is measured at the fair value of the consideration received or receivable taking into account the amount of any trade discounts and volume rebates allowed by the enterprise. In most cases, the consideration is in the form of cash or cash equivalents and the amount of revenue is the amount of cash or cash equivalents received or receivable. However, where the inflow of cash or cash

Accrual Basis of Accounting

An enterprise should prepare its financial statements, except for cash flow information, under the accrual basis of accounting. Under the accrual basis of accounting, transactions and events are recognized when they occur (and not as cash or its equivalent is received or paid) and they are recorded in the accounting records and reported in the financial statements of the periods to which they relate. Expenses arc recognized in the income statement on the basis of a direct association between the costs

incurred and th; earning of specific items of income (matching). However the application of the matching concept does not allow the- recognition of items in the balance sheet winch do not meet the definition of assets or liabilities.

Comparative Information
Unless an International Accounting Standard permits or requires otherwise, comparative information should he disclosed in respect of the previous period for all numerical information in the financial statements. Comparative information should be included in narrative and descriptive information when it is relevant to an understanding of the current periods financial statements.

Materiality
The relevance of information is affected by its nature and materiality. In some cases, the nature of information alone is sufficient to determine its relevance. For example, the reporting of a new segment may affect the assessment of the risks and opportunities facing the enterprise irrespective of the materiality of the results achieved by the new segment in the reporting period. In other cases, both the nature and materiality are important, for example, the amounts of inventories^ held in each of the main categories that are appropriate to me business. Information is material if its omission or misstatement could influence the economic decisions of users taken on the basis of the financial statements. Materiality depends on the size of the item or error judged in the particular circumstances of its omission or misstatement. Thus, materiality provides a threshold or cut-off point rather than being a primary qualitative characteristic which information must have if it is to be useful.

The Objective of Financial Statements

The objective of financial statements to provide information about the financial positron, performance and changes in financial position of an enterprise that is useful to a wide range of users in making economic decisions.

Sale of Goods
Revenue from the sale of goods should be recognised when all the following conditions haw been satisfied:

(a) the enterprise has transferred to the buyer the significant risks and rewards of ownership of the goods. (b) the enterprise retains neither continuing managerial involvement to the degree usually associated with ownership nor effective control over the goods sold. (c) the amount of revenue can he measured reliably;

(d) it is probable that the economic benefits associated with the transaction will flow to the enterprise; and (e) the costs incurred or to be incurred it respect of the transaction can be measured reliably.

Rendering of Services
When the outcome of a transaction involving the rendering of services can be estimated reliably, revenue associated with the transaction should be recognized by reference to the stage of completion of the transaction at the balance sheet date. The outcome of a transaction can be estimated reliably when all the following conditions are satisfied: (a) the amount of revenue can be measured reliably; (b) it is probable that the economic benefits associated with the transaction will flow to the enterprise; (c) the stage of completion of the transaction at the balance sheet date can be measured reliably; and (d) the costs incurred for the transaction and the costs to complete the transaction can be measured reliably.

Interest, Royalties and Dividends

Revenue arising the use by others of enterprise assets yielding interest, royalties and dividends should be recognized on the bases set out in paragraph 30 when: (a) it is probable that the economic benefits associated with the transaction will flow to the enterprise; and (b) the amount of the revenue can be measured realibly.

Revenue should be recognized on the fallowing bases:

(a) interest should be recognised on a time proportion basis, that takes into account the effective yield on the asset; (b) royalties should be recognised on an accrual basis in accordance with the substance of the relevant agreement; and (c) dividends should be recognised when the shareholders right to receive payment is established.

Disclosure
An enterprise should disclose:

(a) the accounting policies adapted for the recognition of revenue including the methods adopted to determine the stage of completion of transactions involving the tendering of services.

(b) the amount of each significant category of revenue recognised during the period including revenue arising from:

(i) the sale of goody; (ii) the rendering of services; (iii) interest; (iv) royalties; (v) dividends; and (vi) the amount of revenue arising from exchanges of goods or services included in each significant category of revenue. When the outcome of the transaction involving the rendering of services cannot be estimated reliably, revenue should be recognized only to the extent of the expenses recognized are recoverable.

TASK 2:
An accounting system consists of the personnel, procedures, technology, and records used by an organization (1) To develop accounting information and (2) To communicate this information to decision makers. The design and capabilities of these systems vary greatly from one organization to another. In small businesses, accounting systems may consist of little more than a cash register, a checkbook, and an annual trip to an income tax preparer. In large businesses, accounting systems include computers, highly trained personnel, and accounting reports that affect the daily operations of every department. But in every case, the basic purpose of the accounting system remains the same: to meet the organizations needs for information as efficiently as possible. Many factors affect the structure of the accounting system within a particular organization. Among the most important are (1) The companys needs for accounting information and (2) The resources available for operation of the system. Describing accounting as an information system focuses attention on the information accounting provides, the users of the information, and the support for financial decisions that is provided by the information. These relationships are depicted in Exhibit 12. While some of the terms may not be familiar to you at this early point in your study of business and accounting, you will be

introduced to them more completely as we proceed through this textbook and as you undertake other courses in business and accounting. Observe, however, that the information system produces the information presented in the middle of the diagramfinancial position, profitability, and cash flows. This information meets the needs of users of the information investors, creditors, managers, and so onand supports many kinds of financial decisions performance evaluation and resource allocation, among others. These relationships are consistent with what we have already learnednamely, that accounting information is intended to be useful for decision-making purposes.

ACCOUNTING AS AN INFORMATION SYSTEM

DETERMINING INFORMATION NEEDS:The types of accounting information that a company develops vary with such factors as the size of the organization, whether it is publicly owned, and the information needs of management. The need for some types of accounting information may be prescribed by law. For example, income tax regulations require every business to have an accounting system that can measure the companys taxable income and explain the nature and source of every item in the companys income tax return. Federal securities laws require publicly owned companies to prepare financial statements in conformity with generally accepted accounting principles. These statements must be filed with the Securities and Exchange Commission, distributed to stockholders, and made available to the public. Other types of accounting information are required as matters of practical necessity. For example, every business needs to know the amounts owed to it by each customer and the amounts owed by the company to each creditor, and uses generally accepted accounting principles for financial reporting. Although much accounting information clearly is essential to business operations, management still has many choices as to the types and amount of accounting information to be developed. For example, should the accounting system of a department store measure separately the sales of each department and of different types of merchandise? The answer to such questions depends on how useful management considers the information to be and the cost of developing the information.

THE COST OF PRODUCING ACCOUNTING INFORMATION

Accounting systems must be cost-effectivethat is, the value of the information produced should exceed the cost of producing it. Management has no choice but to produce the types of accounting reports required by law or contract. In other cases, however, management may use cost-effectiveness as a criterion for deciding whether or not to produce certain information. In recent years, the development and installation of computer-based information systems have increased greatly the types and amount of accounting information that can be produced in a costeffective manner.

BASIC FUNCTIONS OF AN ACCOUNTING SYSTEM

In developing information about the activities of a business, every accounting system performs the following basic functions: Interpret and record the effects of business transactions. Classify the effects of similar transactions in a manner that permits determination of the various totals and subtotals useful to management and used in accounting reports. Summarize and communicate the information contained in the system to decision makers. The differences in accounting systems arise primarily in the manner, frequency, and speed with which these functions are performed. In our illustrations, we often assume the use of a simple manual accounting system. Such a system is useful in illustrating basic accounting concepts, but it is too slow and cumbersome to meet the needs of most business organizations. In a large business, transactions may occur at a rate of several hundred or several thousand per hour. To keep pace with such a rapid flow of information, these companies must use accounting systems that are largely computerbased. The underlying principles within these systems are generally consistent with the basic manual system we frequently refer to in this text. Some small businesses that continue to use manual accounting systems modify these systems to meet their needs as efficiently as possible. Understanding manual systems allows users to understand the needs that must be met in a computerized system.

WHO DESIGNS AND INSTALLS ACCOUNTING SYSTEMS? The design and installation of large accounting systems is a specialized field. It involves not just accounting, but expertise in management, information systems, marketing, andin many casescomputer programming. Thus accounting systems generally are designed and installed by a team of people with many specialized talents.

Large businesses have a staff of systems analysts, internal auditors, and other professionals who work full-time in designing and improving the accounting system. Medium-size companies often hire a CPA firm to design or update their systems. Small businesses with limited resources often purchase one of the many packaged accounting systems designed for small companies in their line of business. These packaged systems are available through office supply stores, computer stores, and software manufacturers.

COMPONENTS OF INTERNAL CONTROL In developing its accounting system, an organization also needs to be concerned with developing a sound system of internal control. Internal control is a process designed to provide reasonable assurance that the organization produces reliable financial reports, complies with applicable laws and regulations, and conducts its operations in an efficient and effective manner. A companys board of directors, its management, and other personnel are charged with developing and monitoring internal control. The five components of internal control, as discussed in Internal Control-Integrated Framework (Committee of Sponsoring Organizations of the Treadway Commission), are the control environment, risk assessment, control activities, information and communication, and monitoring. An organizations control environment is the foundation for all the other elements of internal control, setting the overall tone for the organization. Factors that affect a companys control environment are: (1) The integrity, ethical values, and competence of the companys personnel, (2) Managements philosophy and operating style, (3) Managements assignment of authority and responsibility, (4) Procedures for the hiring and training of personnel, and (5) Oversight by the board of directors. The control environment is particularly important because fraudulent financial reporting often results from an ineffective control environment. Risk assessment involves identifying, analyzing, and managing those risks that pose a threat to the achievement of the organizations objectives. For example, a company should assess the risks that might prevent it from preparing reliable financial reports and then take steps to minimize those risks. Control activities are the policies and procedures that management puts in place to address the risks identified during the risk assessment process. Examples of control activities include approvals, authorizations, verifications, reconciliations, reviews of operating performance, physical safeguarding of assets, and segregation of duties.

Information and communication involves developing information systems to capture and communicate operational, financial, and compliance-related information necessary to run the business. Effective information systems capture both internal and external information. In addition, an effective control system is designed to facilitate the flow of information downstream (from management to employees), upstream (from employees to management), and across the organization. Employees must receive the message that top management views internal control as important, and they must understand both their role in the internal control system and the roles of others. All internal control systems need to be monitored. Monitoring enables the company to evaluate the effectiveness of its system of internal control over time. Monitoring is generally accomplished through ongoing management and supervisory activities, as well as by periodic separate evaluations of the internal control system. Most large organizations have an internal audit function, and the activities of internal audit represent separate evaluations of internal control.

TASK 3
Macro Risk Levels
On a macro (large-scale) level there are two main types of risk, these are systematic risk and unsystematic risk.

Systematic risk is the risk that cannot be reduced or predicted in any manner and it is almost impossible to predict or protect yourself against this type of risk. Examples of this type of risk include interest rate increases or government legislation changes. The smartest way to account for this risk, is to simply acknowledge that this type of risk will occur and plan for your investment to be affected by it. Unsystematic risk is risk that is specific to an assets features and can usually be eliminated through a process called diversification (refer below). Examples of this type of risk include employee strikes or management decision changes.

MICRO RISK LEVELS: While the above risk types are the macro scale levels of risk, there are also some more important micro (small-scale) types of risks that are important when talking about the valuation of a stock or bond. These include:

Business Risk - The uncertainty of income caused by the nature of a companys business measured by a ratio of operating earnings (income flows of the firm). This means that the less certain you are about the income flows of a firm, the less certain the income will

flow back to you as an investor. The sources of business risk mainly arises from a companys products/services, ownership support, industry environment, market position, management quality etc. An example of business risk could include a rubbish company that typically would experience stable income and growth over time and would have a low business risk compared to a steel company whereby sales and earnings fluctuate according to need for steel products and typically would have a higher business risk. Liquidity Risk The uncertainty introduced by the secondary market for a company to meet its future short-term financial obligations. When an investor purchases a security, they expect that at some future period they will be able to sell this security at a profit and redeem this value as cash for consumption this is the liquidity of an investment, its ability to be redeemable for cash at a future date. Generally, as we move up the asset allocation table the liquidity risk of an investment increases. Financial Risk - Financial risk is the risk borne by equity holders (refer Shares section) due to a firms use of debt. If the company raises capital by borrowing money, it must pay back this money at some future date plus the financing charges (interest etc charged for borrowing the money). This increases the degree of uncertainty about the company because it must have enough income to pay back this amount at some time in the future. Exchange Rate Risk - The uncertainty of returns for investors that acquire foreign investments and wish to convert them back to their home currency. This is particularly important for investors that have a large amount of over-seas investment and wish to sell and convert their profit to their home currency. If exchange rate risk is high even though a substantial profit may have been made overseas, the value of the home currency may be less than the overseas currency and may erode a significant amount of the investments earnings. That is, the more volatile an exchange rate between the home and investment currency, the greater the risk of differing currency value eroding the investments value. Country Risk - This is also termed political risk, because it is the risk of investing funds in another country whereby a major change in the political or economic environment could occur. This could devalue your investment and reduce its overall return. This type of risk is usually restricted to emerging or developing countries that do not have stable economic or political arenas. Market Risk - The price fluctuations or volatility increases and decreases in the day-today market. This type of risk mainly applies to both stocks and options and tends to perform well in a bull (increasing) market and poorly in a bear (decreasing) market (see bull vs bear). Generally with stock market risks, the more volatility within the market, the more probability there is that your investment will increase or decrease.

Control system in a business:

Internal control can be described as any action taken by an organization to help enhance the likelihood that the objectives of the organization will be achieved. The definition of internal control has evolved over recent years as different internal control models have been developed. This article will describe these models, present the definitions of internal control they provide,

and indicate the components of internal control. Various parties responsible for and affected by internal control will also be discussed. THE COSO MODEL In the United States many organizations have adopted the internal control concepts presented in the report of the Committee of Sponsoring Organizations of the Tread way Commission (COSO). Published in 1992, the COSO report defines internal control as: a process, effected by 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 and efficiency of operations, reliability of financial reporting, and compliance with applicable laws and regulations. COSO describes internal control as consisting of five essential components. These components, which are subdivided into seventeen factors, include: 1. The control environment 2. Risk assessment 3. Control activities 4. Information and communication 5. Monitoring The COSO model is depicted as a pyramid, with control environment forming a base for control activities, risk assessment, and monitoring. Information and communication link the different levels of the pyramid. As the base of the pyramid, the control environment is arguably the most important component because it sets the tone for the organization. Factors of the control environment include employees' integrity, the organization's commitment to competence, management's philosophy and operating style, and the attention and direction of the board of directors and its audit committee. The control environment provides discipline and structure for the other components. Risk assessment refers to the identification, analysis, and management of uncertainty facing the organization. Risk assessment focuses on the uncertainties in meeting the organization's financial, compliance, and operational objectives. Changes in personnel, new product lines, or rapid expansion could affect an organization's risks. Control activities include the policies and procedures maintained by an organization to address risk-prone areas. An example of a control activity is a policy requiring approval by the board of directors for all purchases exceeding a predetermined amount. Control activities were once thought to be the most important element of internal control, but COSO suggests that the control environment is more critical since the control environment fosters the best actions, while control activities provide safeguards to prevent wrong actions from occurring.

Information and communication encompasses the identification, capture, and exchange of financial, operational, and compliance information in a timely manner. People within an organization who have timely, reliable information are better able to conduct, manage, and control the organization's operations. Monitoring refers to the assessment of the quality of internal control. Monitoring activities provide information about potential and actual breakdowns in a control system that could make it difficult for an organization to accomplish its goals. Informal monitoring activities might include management's checking with subordinates to see if objectives are being met. A more formal monitoring activity would be an assessment of the internal control system by the organization's internal auditors.

OTHER CONTROL MODELS Some users of the COSO report have found it difficult to read and understand. A model that some believe overcomes this difficulty is found in a report from the Canadian Institute of Chartered Accountants, which was issued in 1995. The report, Guidance on Control, presents a control model referred to as Criteria of Control (CoCo). The CoCo model, which builds on COSO, is thought to be more concrete and user-friendly. CoCo describes internal control as actions that foster the best result for an organization. These actions, which contribute to the achievement of the organization's objectives, center around: Effectiveness and efficiency of operations Reliability of internal and external reporting Compliance with applicable laws and regulations and internal policies. CoCo indicates that control comprises: those elements of an organization (including its resources, systems, processes, culture, structure and tasks) that, taken together, support people in the achievement of the organization's objectives. CoCo model recognizes four interrelated elements of internal control, including purpose, capability, commitment, and monitoring and learning. An organization that performs a task is guided by an understanding of the purpose (the objective to be achieved) of the task and supported by capability (information, resources, supplies, and skills). To perform the task well over time, the organization needs a sense of commitment. Finally, the organization must monitor task performance to improve the task process. These elements of control, which include twenty specific control criteria, are seen as the steps an organization takes to foster the right action. In addition to the COSO and CoCo models, two other reports provide internal control models. One is the Institute of Internal Auditors Research Foundation's Systems Auditability and Control (SAC), which was issued in 1991 and revised in 1994. The other is the Information Systems Audit and Control Foundation's COBIT (Control Objectives for Information and Related Technology), which was issued in 1996.

The Institute of Internal Auditors issued SAC to provide guidance to internal auditors on internal controls related to information systems and information technology (IT). The definition of internal control included in SAC is: a set of processes, functions, activities, sub-systems, and people who are grouped together or consciously segregated to ensure the effective achievement of objective and goals. COBIT focuses primarily on efficiently and effectively monitoring information systems. The report emphasizes the role and impact of IT control as it relates to business processes. This control model can be used by management to develop clear policy and good practice for control of IT. The following COBIT definition of internal control was adapted from COSO: The policies, procedures, practices, and organizational structures are designed to provide reasonable assurance that business objectives will be achieved and that undesired events will be prevented or detected and corrected. While the specific definition of internal control differs across the various models, a number of concepts are very similar across these models. In particular, the models emphasize that internal control is not only policies and procedures to help an organization accomplish its objectives but also a process or system affected by people. In these models, people are perceived to be central to adequate internal control. These models also stress the concept of reasonable assurance as it relates to internal control. Internal control systems cannot guarantee that an organization will meet its objectives. Instead, internal control can only be expected to provide reasonable assurance that a company's objectives will be met. The effectiveness of internal controls depends on the competency and dependability of the organization's people. Limitations of internal control include faulty human judgment, misunderstanding of instructions, errors, management override of controls, and collusion. Further, because of cost-benefit considerations, not all possible controls will be implemented. Because of these inherent limitations, internal controls can not guarantee that an organization will meet its objectives.

PARTIES RESPONSIBLE FOR AND AFFECTED BY INTERNAL CONTROL While all of an organization's people are an integral part of internal control, certain parties merit special mention. These include management, the board of directors (including the audit commit tee), internal auditors, and external auditors. The primary responsibility for the development and maintenance of internal control rests with an organization's management. With increased significance placed on the control environment, the focus of internal control has changed from policies and procedures to an overriding philosophy and operating style within the organization. Emphasis on these intangible aspects highlights the importance of top management's involvement in the internal control system. If internal control is not a priority for management, then it will not be one for people within the organization either.

As an indication of management's responsibility, top management at a publicly owned organization will include in the organization's annual financial report to the shareholders a statement indicating that management has established a system of internal control that management believes is effective. The statement may also provide specific details about the organization's internal control system. Internal control must be evaluated in order to provide management with some assurance regarding its effectiveness. Internal control evaluation involves everything management does to control the organization in the effort to achieve its objectives. Internal control would be judged as effective if its components are present and function effectively for operations, financial reporting, and compliance. The board of directors and its audit committee have responsibility for making sure the internal control system within the organization is adequate. This responsibility includes determining the extent to which internal controls are evaluated. Two parties involved in the evaluation of internal control are the organization's internal auditors and their external auditors. Internal auditors' responsibilities typically include ensuring the adequacy of the system of internal control, the reliability of data, and the efficient use of the organization's resources. Internal auditors identify control problems and develop solutions for improving and strengthening internal controls. Internal auditors are concerned with the entire range of an organization's internal controls, including operational, financial, and compliance controls. Internal control will also be evaluated by the external auditors. External auditors assess the effectiveness of internal control within an organization to plan the financial statement audit. In contrast to internal auditors, external auditors focus primarily on controls that affect financial reporting. External auditors have a responsibility to report internal control weaknesses (as well as reportable conditions about internal control) to the audit committee of the board of directors.

TASK 4

Assessing Fraud Risk BY JOSEPH T. WELLS AND JOHN D. GILL OCTOBER 2007 Every organization faces some risk of fraud from within. Fraud exposure can be classified into three broad categories: asset misappropriation, corruption and fraudulent financial statements. Answering the following 15 questions is a good starting point for sizing up a companys vulnerability to fraud and creating an action plan for lessening the risks. The questions are based on information from the 2007 edition of the Fraud Examiners Manual published by the Association of Certified Fraud Examiners.

1. Do one or two key employees appear to dominate the company? If control is centered in the hands of a few key employees, those individuals should be under heightened scrutiny for compliance with internal controls and other policies and procedures. 2. Do any key employees appear to have a close association with vendors? Employees with a close relationship to a vendor should be prohibited from approving transactions with that vendor. Alternatively, transactions between these parties should be reviewed on a regular basis for compliance with internal controls. 3. Do any key employees have outside business interests that might conflict with their job duties? Take the example of a 32-year-old sales representative who started a software company using his employers time, equipment and facilities. The software company he worked for discovered that the employee demonstrated his own products to the companys customers. Ultimately, the employee diverted $500,000 in business away from his employer. The example illustrates why key employees should provide annual financial disclosures that list outside business interests. Many companies, particularly publicly traded companies, require such disclosures. Interests that conflict with the organizations interests should be prohibited. Organizations should implement an explicit policy that forbids employee business activities that directly compete with the operations of the organization. Employees who have something to hide may lie or omit key facts on the disclosure form, but requiring the step still has advantages, such as making it easier to fire workers who fail to reveal potential conflicts. If an employer can show that an employee had such an interest and failed to disclose it on an annual reporting form, the employee can be fired simply for failing to follow company policy. 4. Does the organization conduct pre-employment background checks to identify previous dishonest or unethical behavior? Organizations should conduct pre-employment background checks before offering employment to any key applicant. The scope of a background check varies by position, but a general list to consider includes: criminal records and convictions; Social Security number verification; credit history; previous employment; employment references; personal references; education verification; professional license verification; drivers license verification and driving history check; and civil records and judgments. Employers should ensure that legal requirements are met for the use of and access to the information. For companies that have failed to do background checks, post-hire screenings may be appropriate in some cases, but should be conducted on the advice of legal counsel. A number of legal issues come into play when employers consider screening workers who are already on the job.

5. Does the organization educate employees about the importance of ethics and anti-fraud programs? All employees should receive training on the ethics and anti-fraud policies of the organization. The employees should sign an acknowledgement that they have received the training and understand the policies. 6. Does the organization provide an anonymous way to report suspected violations of the ethics and anti-fraud policies? Organizations should provide employees, vendors and customers with a confidential system for reporting suspected violations of the ethics and anti-fraud policies. According to the 2006 ACFE Report to the Nation on Occupational Fraud and Abuse , frauds are most commonly detected by a tip. The greatest percentage of those tips comes from employees of the victim organization. In one instance, an anonymous tip received by a fraud hotline thwarted a fraud scheme that had drained approximately $580,000 from a business. The caller reported that the companys accounts payable manager was approving fictitious invoices from his own outside company. The tip clued in company management to the scheme and brought an abrupt end to the managers windfall. The fraudster was terminated and arrested. The company ultimately recouped most of its losses. 7. Is job or assignment rotation mandatory for employees who handle cash receipts and accounting duties ? Job or assignment rotation should be considered for employees who work with cash receipts and accounting duties. The frequency of the rotation depends on the individuals responsibilities and the number of people available for the revolving duties. 8. Has the company established positive pay controls with its bank by supplying the bank with a daily list of checks issued and authorized for payment? One method for a company to help prevent check fraud is to establish positive pay controls by supplying its banks with a daily list of checks issued and authorized for payment. Banks verify items presented for payment against the companys list and reject items that dont appear on the list. The use of those controls foiled a fraud attempt by an employee and his accomplice, who worked for a check-printing company. The accomplice printed blank checks with the account number belonging to the perpetrators employer. The perpetrator then wrote more than $100,000 worth of forgeries on the counterfeit checks. When the checks were presented to the bank for payment, they did not appear on the organizations list of expected payments. The bank refused to cash them. The organization was notified, and the fraudsters were arrested.

9. Are refunds, voids and discounts evaluated on a routine basis to identify patterns of activity among employees, departments, shifts or merchandise? Companies should routinely evaluate those transactions to search for patterns of activity that might signal fraud. 10. Are purchasing and receiving functions separate from invoice processing, accounts payable and general ledger functions? Segregation of duties is an important control. The failure to segregate these duties allowed one large, publicly traded company to be duped by a member of its managerial staff. The individual managed a remote location of the company and was authorized to order supplies and approve vendor invoices for payment. For more than a year, the manager routinely added personal items and supplies for his own business to orders made on behalf of his employer. The orders often included a strange mix of items. For instance, technical supplies and home furnishings were purchased in the same order. In addition to ordering personal items, the employee changed the delivery address for certain supplies so they were shipped directly to his home or side business. Because the manager was in a position to approve his own purchases, he could get away with such blatantly obvious frauds. The scheme cost his employer approximately $300,000 in unnecessary purchases. 11. Is the employee payroll list periodically reviewed for duplicate or missing Social Security numbers? Organizations should check the employee payroll list periodically for duplicate or missing Social Security numbers that may indicate a ghost employee or overlapping payments to current employees. 12. Are there policies and procedures addressing the identification, classification and handling of proprietary information? To help prevent the theft and misuse of intellectual property, the company should implement policies and procedures addressing the identification, classification and handling of proprietary information. 13. Do employees who have access to proprietary information sign nondisclosure agreements? All employees who have access to proprietary information should sign nondisclosure agreements. It is easier to sue for breach of a nondisclosure agreement than it is to sue for theft of information. Nondisclosure agreements afford companies legal options for the use of nonpublic information, not simply for information that is considered a trade secret. In most states, companies without nondisclosure agreements may be limited to suing for theft of trade secret information.

14. Is there a company policy that addresses the receipt of gifts, discounts and services offered by a supplier or customer? Organizations should implement a policy that sets ground rules about employees accepting gifts, discounts and services offered by a supplier or customer. If no explicit policy is in place, employees may find themselves in ambiguous situations without clear ethical guidelines. For example, a city commissioner negotiated a land development deal with a group of private investors. After the deal was approved, the commissioner and his wife were rewarded by one of the investors with an all-expenses-paid international vacation. While the promise of the trip may have influenced the commissioners negotiations, this would be difficult to prove. However, had a clear policy regarding the receipt of gifts been implemented and enforced, the commissioner would have known that accepting the free vacation was a violation of the rules. The ambiguity of the situation would have been avoided. 15. Are the organizations financial goals and objectives realistic ? Closely monitor compliance with internal controls over financial reporting if the financial goals and objectives appear to be unrealistic. Establish realistic financial goals and objectives for the organization. Common justifications for financial statement fraud include a desire to obtain bonuses linked to goals or frustration with objectives that were unachievable through normal means.

http://www.qwoter.com/college/Understanding-the-Risks/24.html http://www.enotes.com/internal-control-systems-reference/internal-control-systems http://www.journalofaccountancy.com/Issues/2007/Oct/AssessingFraudRisk.htm