CHAPTER ONE

 INTRODUCTION

1.1 Back ground of the study

Recent reported cases of multibillion-dollar fraudulent corporate accounting and reporting scandal have refueled public policy debates on Internal control (IC). It is an issue of considerable interest to policy makers involved in corporate governance issues. IC in essence is intertwined with and directly affected by the dynamics of corporate governance. IC is intended to assure that if it is properly designed and implemented it helps the companies can achieve their objectives and they become prevented from accounting frauds.

Prior studies on IC have supported the relevance of IC disclosures as a monitoring tool on IC for shareholders and have focused on two dimensions: examining the substance and variety of voluntary IC disclosures in annual reports; and determining the usefulness of IC disclosures to users of financial statements (El-Gazzar and Fornaro, 2003; O‘Reilly-Allen and McMullen,

2002; Hermanson, 2000). For example, Deumes and Knechel (2005), Willis and Lightle (2000) and El-Gazzar and Fornaro (2003) analyzed the different types of assertions contained in IC disclosures. Wallace (1981) analyzed the content of IC disclosures of municipal government reports. Hermanson (2000) analyzed the demand for IC disclosures by surveying disparate user groups. He found that IC disclosures might serve to motivate both management and the audit committee to focus their attention on enhancing IC. Wallace and White (1996) found that senior management at companies with an internal audit function (IAF) focused primarily on aspects of financial controls (versus operational controls) and those at larger firms were more likely to publish IC disclosures. McMullen et al. (1996) found that although smaller firms had a higher incidence of financial reporting problems than larger firms, the incidence was lower when senior management at such companies published IC reports. IC disclosure is risky but the risk varies inversely with the level of IC attained (Root, 1998). For a company that has attained a high level of IC, such disclosure is an opportunity to showcase that quality.

Although larger businesses are more likely to experience economic crime, fraud may be more costly for small businesses (Thomas and Gibson, 2003; Price Waterhouse Coopers (PWC), 2003). The average small business fraud amounted to $98,000 per occurrence compared to $105,500 per incident for large companies (Association of Certified Fraud Examiners, 2004). On a per employee basis, losses from fraud can be as much as 100 times greater at small firms than large firms (Association of Certified Fraud Examiners, 2004; Wells, 2003). In addition, the damage inflicted by fraud goes beyond direct monetary loss. Collateral damage may include harm to external business relationships, employee morale, firm reputation, and branding (Price Waterhouse Coopers (PWC), 2003). In fact, some of the collateral effects of fraud, such as damage to firm reputation, can be long-term (PWC, 2003). Despite the increased incidence of fraud and enactment of new anti-fraud laws, many organizational anti-fraud efforts are not current and are somewhat superficial (Andersen, 2004). Hence, many entities are trying new and different steps to combat fraud (Price Waterhouse Coopers (PWC), 2003).

1.2 Statement of problem

The Company‘s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company‘s internal control over financial reporting includes those policies and procedures that: (I) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company‘s assets; (II) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that the Company‘s receipts and expenditures are being made only in accordance with authorizations of the Company‘s management and directors; and (III) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company‘s assets that could have a material effect on the Company‘s financial statements.

Management, including the Company‘s Chief Executive Officer (CEO) and Chief Financial Officer (CEO), does not expect that the company‘s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Poor controls lead to losses, scandals, and failures and damage the reputation of organizations in whatever sector they are from (Picket, 2005).

However, despite the existence of certain possible inherent weaknesses that would exist in almost every system, howsoever perfect in design, the corrective action taken for rectification by

the management and its periodic assessment through the Systems Control Evaluation method adopted in Systems Based Audit 1 enables the fulfillment of the principal objectives of establishing and effectively operating internal control procedures.

Once the financial statement fraud has been committed it is difficult to stop, as most fraud techniques involve ―borrowing‖ from one period and ―loaning‖ to another period. With the passage of time, the amounts and numbers of people involved grow and the perpetrators can only continue to try hiding the fraud.

All the above discussed inherent limitations and problems about the internal control and the nature and type of fraud along with the gap in the literature with respect to impact of internal control over accounting frauds, in developing countries, Ethiopia in particular, call for undertaking such types of extensive research to tackle the issues.

1.3 Objectives of study

The purpose of research is to discover answers to questions through the application of scientific procedures. The main aim of research is to find out the truth which is hidden and which has not been discovered as yet (Kothari, 1985). Before establishing the aims and objectives of the substantive research problem, a comprehensive review of existing literature pertaining to internal control and accounting frauds was undertaken. Therefore, after careful consideration of research problem, the following objectives of the study are determined.

The main objective of the research paper is to assess the impacts of strong and effective internal control in alleviating accounting frauds (i.e. fraudulent financial reporting and defalcations).

The specific objective of this thesis includes:

1.    To examine the current internal accounting control of each organization ;

2.      To enumerate and discuss which accounting frauds are committed inside the organization;

3.      To dig out what factors will contribute to individuals to commit fraud;

4.      To investigate what ethical consideration should be followed by employee of the organization on top of the company internal control to overcome fraud related problems.

1.4 Research questions:

The study will try to answer the following questions:

RQ 1:     Do those public enterprises which are found in Nigeria have strong internal control?

RQ 2:     Do factors explained in Donald Cressey fraud triangle (i.e. Incentive, pressure and rationalization) motivate selected organization peoples to commit fraud?

RQ 3: What ethical value do the organization employees must follow to combat accounting fraud?

1.5 Significance of the study

The researcher believes that the result of this research project will have the following significances:

1)      This research paper could be used as an initiation (an eye opener) for those who are interested to conduct a detailed and comprehensive study regarding the impacts of internal control over accounting frauds in public enterprises.

2)      Moreover, it will provide constructive feedback about the efficiency and effectiveness of the existing internal control practice of those public enterprises in Nigeria  administration.

3)      What is more, the results of the study can prove to be of great importance to public organizations to gain a clearer insight onto how design, implement and finally evaluate internal control so that in turn alleviate the potential accounting frauds inside the organization and to the whole country by large.

1.6 Scope and Limitation of the study

Although internal control have a direct impact on reduction of management fraud which is committed by management at all levels and other types of fraud, this study is restricted to

exploring the internal control impacts on accounting fraud among selected public enterprises . Hence no attempt is made to explore the fender-bender of internal control in reducing management fraud and other types of frauds such as consumer fraud, mortgage fraud, and banking fraud.

The study, as already indicated, has basic purpose of investigating the impacts of internal control over accounting frauds in selected public enterprises. However, due to the basic fact that the subjects of the study only account for a limited proportion of the total public organization in the Nigeria, the generalizability of results that may be obtained from this study is limited.

In this regard a full picture of existing organizations internal control and their impact on overcoming accounting related fraud can be developed through a comprehensive study, which among other things, encompasses all public enterprises in the Nigeria as its subjects.

Nevertheless, it is beyond doubt that any research paper undertaken has no resource constraints. This study cannot be an exception to this fact. Moreover, it is hardly ever possible to get all relevant information from concerned respective public enterprises due to the organization bureaucratic response to the researcher, and individual refusal to cooperate to fill the questionnaire and to be interviewed. Besides, lack of research studies and availability of sufficient current literature in country context on the subject of impact of internal control over accounting frauds are some limiting constraints.

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