RISKS AND CONTROLS IN CAPITAL AND INVESTMENT PROCESSES (STUDY OBJECTIVE 4)
For both source of capital processes and investment processes, the important control is the specific authorization and oversight by top management. The very close supervision of these transactions helps prevent risks of theft or misuse of the cash related to capital and investment processes. In addition, the large sums of money involved in capital and investment decisions usually dictates that the cash not be handled by regular company employees. For example, a stock sale to raise capital might result in millions or billions of dollars in proceeds. Company employees are not likely to handle any cash from the result of a stock sale. Instead, the funds would probably be transferred electronically. The broker would electronically transfer funds to the company bank account.
Since these transactions are authorized by top management and the funds are not necessarily handled by employees, the underlying risks are not the same as other processes. Generally, the risks are not related to employee fraud, but are instead related to management fraud. That is, top management is much more likely to conduct fraud by manipulating capital or investment processes. Internal controls aimed at preventing and detecting employee fraud are not as effective in capital and investment decisions. This does not mean that typical internal controls should be ignored, but that in addition to any regular controls in place, the company must carefully examine risks related to its capital and investment processes and implement relevant controls aimed at prevention and detection of management fraud.
THE REAL WORLD
In the early 2000s, the Securities and Exchange Commission investigated Nathan A. Chapman, Jr., and three of his companies. One of the companies, echapman.com, was scheduled to sell stock through an initial public offering (IPO). In an IPO, the company offering stock must explain to potential investors the manner in which funds from the IPO will be used.
The SEC found that Chapman lied about the use of IPO funds. Chapman was actually using proceeds from the sale of new stock to buy more of his own stock. These purchases were only intended to show a larger volume of sales of the stock, thereby making it look like a more attractive stock. He was attempting to artificially pump up the price of the stock through these purchases of his own stock. To conceal this fraud, his company falsified the financial statements.
In this case, typical internal controls such as segregation of duties and reconciliations would not likely prevent or detect these frauds. The more important controls of specific authorization by top management and close scrutiny by the internal and external auditors are especially important in capital and investment processes.