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2-1

2-2
2-26
Three common ways that fraudulent financial reporting can be perpetrated include:
Manipulation, falsification or alteration of accounting records or supporting documents
Misrepresentation or omission of events, transactions, or other significant information
Intentional misapplication of accounting principles
Common types of fraudulent financial reporting include:
Improper revenue recognition
Improper deferral of costs and expenses
Improper asset valuation
Concealed liabilities
Misrepresentations or omissions in financial statement footnotes of MD&A
2-27
The reporter’s statement makes sense. Asset misappropriations are much easier to accomplish in
small organizations that don’t have sophisticated systems of internal control. Fraudulent financial
reporting is more likely to occur in large organizations because management often has ownership
of or rights to vast amounts of the company’s stock. As the stock price goes up, management’s
worth also increases. However, the reporter may have the mistaken sense that financial fraud
only occurs rarely in smaller businesses. That is not the case. Many smaller organizations are
also motivated to misstate their financial statements in order to (a) prop up the value of the
organization for potential sale, (b) obtain continuing financing from a bank or other financial
institution, or (c) to present a picture of an organization that is healthy when it may be
susceptible to not remaining a going concern. Finally, smaller organizations may conduct a fraud
of a different sort, i.e., misstating earnings by understating revenue or masking owner
distributions as expenses. This is often done to minimize taxes. It would also be a mistake to
think that asset misappropriations do not happen in larger organizations. Whenever controls are
weak, there is an opportunity for asset misappropriation. When the opportunity is coupled with
motivation and a belief that the fraud could be covered up, some of those opportunities will
result in asset misappropriation.
2-28
a. A Ponzi scheme occurs when the deposits of current investors are used to pay returns on
the deposits of previous investors; no real investment is happening.
b. The key elements of the Bernie Madoff fraud include:
Fabricated “gains” of almost $65 billion
Defrauded thousands of investors
Took advantage of his high profile investment leader status to establish trust in his
victims

2-3
Accomplished the scheme by keeping all the fraudulent transactions off the real financial
statements of the company
Employed a CPA who conducted a sham audit
Led to the PCAOB now having oversight of the audits of SEC-registered brokers and
dealers
c. The Bernie Madoff fraud is primarily a case of asset misappropriation. However, it is
important to note that asset misappropriation then led Madoff to commit fraudulent financial
reporting to hide the asset misappropriation.
2-29
a. Management perpetrated the fraud by filling inside containers with water in the larger
containers filled with oil. Further, they transferred the oil from tank to tank in the order in which
they knew the auditors would proceed through the location.
b. The goal was to overstate inventory assets, thereby understanding cost of goods sold and
overstating income.
c. The Great Salad Oil Swindle is primarily a case of fraudulent financial reporting.
2-30
Incentives relate to the rationale for the fraud, e.g., need for money, desire to enhance stock
price. Opportunities relate to the ability of the fraudster to actually accomplish the fraud, e.g.,
through weak internal controls. Rationalization is the psychological process of justifying the
fraud.
2-31
Common incentives for fraudulent financial reporting include:
Management compensation schemes
Other financial pressures for either improved earnings or an improved balance sheet
Debt covenants
Pending retirement or stock option expirations
Personal wealth tied to either financial results or survival of the company
Greed—for example, the backdating of stock options was performed by individuals who
already had millions of dollars of wealth through stock
2-32
Factors, or red flags, that would be strong indicators of opportunity to commit fraud include:
inadequate segregation of duties
opportunities for management override
absence of monitoring controls
complex organizational structure

2-4
unauthorized access to physical assets
inadequate reconciliations of key accounts, especially bank accounts
access to cash that it not supervised or reconciled by someone else
2-33
The ability to rationalize is important. Unless fraudsters are outright criminals, they will often be
able to come up with an excuse for their behavior. “Accounting rules don’t specifically disallow
it” or “the company owes me” are potential rationales. Other common rationalizations include:
Unfair financial treatment (perceived) in relationship to other company employees
“It is only temporary”, or “it’s a loan from the company”
“I deserve it”
“The company is so big they won’t miss it”
“ The company is unethical”
“The company comes by its profits in a way that exploits people”.
2-34
a. incentive
b. incentive
c. opportunity
d. incentive
e. rationalization
f. opportunity
2-35
Refer to Exhibit 2.3 for brief descriptions.
a. Enron: fraudulent financial reporting
b. WorldCom: fraudulent financial reporting
c. Parmalat: fraudulent financial reporting
d. HealthSouth: fraudulent financial reporting
e. Dell: fraudulent financial reporting
f. Koss Corporation: asset misappropriation
g. Olympus: fraudulent financial reporting
h. Longtop Financial Technologies: fraudulent financial reporting

2-5
i. Peregrine Financial Group: asset misappropriation
j. Sino-Forest Corporation: fraudulent financial reporting
k. Diamond Foods, Inc.: fraudulent financial reporting
2-36
a. Professional skepticism is an attitude that includes a questioning mind and a critical
assessment of audit evidence; requires an ongoing questioning of whether the information and
audit evidence obtained suggests that a material misstatement due to fraud may exist.
b. Professional skepticism is helpful in detecting fraud because without it the external
auditor will be easily convinced of alternative explanations to the fraud that management will
provide to conceal the fraud.
c. The key behaviors necessary to successfully exercise professional skepticism include
validating information through probing questions, critically assessing evidence, and paying
attention to inconsistencies.
d. It is difficult to exercise professional skepticism in practice for a variety of reasons
including, the nature tendency to trust people (especially client personnel with whom you have
worked), lack of repeated exposure to fraud, many repeated exposures to situations that do NOT
involve fraud.
e. Personal characteristics and behaviors that might make you skeptical about an individual
include some of the following:
Providing inaccurate or conflicting evidence
Interacting in a difficult or unhelpful manner
Acting in an untrustworthy fashion
Engaging in conspicuous consumption of material possessions beyond the level to which
their salary would normally make that lifestyle possible.
Publicly available evidence exists that might help you assess whether an individual warrants
increased skepticism. Information can include: tax liens, credit scores, and legal filings.
2-37
a. If a company has good products, it would be expected that it should have comparable
profitability with other industry participants. The fact that it does not have that profitability,
coupled with a weakness in internal controls over disbursements, should lead the auditor to
embrace the idea that there is an opportunity for a disbursements fraud and that such a fraud
could be hurting the reported profitability of the company.

2-6
b. The company is doing better than its competitors and it appears to have achieved these
better results through cost control. While cost control might be a valid explanation, the auditor
should consider other potential explanations such as inappropriately capitalizing expenses,
inappropriately recognizing revenue, etc.
c. The company would appear to be using ‘window dressing’ in order to bypass debt
covenants. It is doing so by sharply discounting current sales. These actions are not necessarily
fraudulent, but they may be created to portray a misleading picture of the current economic
health of the organization.
d. This brief description mirrors that of the Koss case where the CFO was very intimidating,
not a CPA, and possessed limited accounting experience. The company did not increase profit
during her tenure. The external auditor should consider these factors to suggest a heightened risk
of fraud.
2-38
Some of the key findings of the COSO study included:
The amount and incidence of fraud remains high.
The median size of company perpetrating the fraud rose tenfold to $100 million during
the 1998-2007 time period.
There was heavy involvement in the fraud by the CEO and/or CFO.
The most common fraud involved revenue recognition.
Many of the fraud companies changed auditors.
The majority of the frauds took place at companies that were listed on the Over-The-
Counter (OTC) market rather than those listed on the NYSE or NASDAQ.
2-39
a. The various failures and environmental characteristics during the time of the Enron fraud
include:
Weak management accountability.
Weak corporate governance.
Accounting became more rule-oriented and complex.
The financial analyst community was unduly influenced by management pressure.
Bankers were unduly influenced by management pressure.
Arthur Andersen was unduly influenced by management pressure, especially since
consulting revenues at Enron were very high.
b. In terms of the fraud triangle,
Incentives: management was very concerned about managing stock prices through
keeping debt off the balance sheet; the underlying business model of the company was
not working; the company had strayed too far away from its “utility” roots and employees

2-7
were taking significant risks in the financial markets that did not yield expected profits,
thereby creating strong incentives for top management to conduct the fraud.
Opportunity: corporate governance and external auditor accountability were lacking.
Rationalization: although not discussed in the text specifically, there have been
speculations in the press that management thought they were smarter than everyone else
and that they were very confident that they could get away with the fraud. It is difficult to
know the internal rationalizations of top management.
2-40
Auditing standards historically have reflected a belief that it is not reasonable for auditors to
detect cleverly implemented frauds. However, it is increasingly clear that the general public, as
reflected in the orientation of the PCAOB, expects that auditors have a responsibility to detect
and report on material frauds. Professional auditing standards do require the auditor to plan and
perform an audit that will detect material misstatements resulting from fraud. As part of that
requirement, auditors will begin an audit with a brainstorming session that focuses on how and
where fraud could occur within the organization. Auditors also need to communicate with the
audit committee and management about the risks of fraud and how they are addressed. The
auditor should then plan the audit to be responsive to an organization’s susceptibility to fraud.
2-41
The three ways in which individuals involved in the financial reporting process, including the
external auditor, can mitigate the risk of fraudulent financial reporting include:
Acknowledging that there needs to exist a strong, highly ethical tone at the top of an
organization that permeates the corporate culture, including an effective fraud risk
management program.
Continually exercising professional skepticism, a questioning mindset that strengthens
professional objectivity, in evaluating and/or preparing financial reports.
Remember that strong communication among those involved in the financial reporting
process is critical.
Will these actions be effective? This should promote a lively debate among students if this
question is discussed in class. Some will argue that frauds happen no matter what, so these types
of actions will be futile. Others will be more optimistic, arguing that these actions, if consistently
applied, could help to mitigate fraud risk.
2-42
a. The financial literacy, integrity, and reputation of Board members enhance credibility of
the regulation and oversight of the auditing profession. Inspections by the PCAOB act as a
highly visible enforcement mechanism, hopefully leading to higher quality audits. Further,

2-8
information that is learned through the inspection process can be used as a basis for modifying
and enhancing auditing standards.
b. These sections improve auditor independence by separating consulting and auditing by
the same audit firm. The partner rotation requirement ensures that a “fresh set of eyes” will be
responsible for oversight on the engagement.
c. The “cooling off” period helps to avoid conflicts of interest between top members of the
engagement team and the client. By requiring a cooling off period, an auditor will not be unduly
influenced (or appear to be unduly influenced) by the possibility of high-level employment with
the client.
d. Audit committees clearly serve the role of the “client” of the auditor. They act as
surrogates for the shareholders who are the actual audit client. They act as the liaison between
management and the external auditor. By being independent, they gain credibility and ensure that
the external auditor can rely on them to perform their governance role. By requiring that audit
committees can hire their own attorneys and by ensuring that they have adequate monetary
resources, the external auditor has confidence that they will act as truly independent monitors of
management.
e. The certification requirements help address the risk of fraud by forcing the CEO and CFO
to take internal controls and high quality financial reporting seriously. By forcing them to sign,
they will likely require individuals below them to provide assurance that those departments or
organizational units are each committed to internal controls and high quality financial reporting
as well. Of course, a signature is just a signature! So, the likelihood that a CFO who is
committing fraud will certify falsely is probably 100%. Thus, this mechanism is not without
practical flaws.
f. It addresses off-balance sheet transactions and special purpose entities, which were the
main mechanisms used to conduct the Enron fraud.
g. A strong internal control system is critical to preventing fraud. These sections of
Sarbanes-Oxley Act mandate the disclosure of weak internal controls, thereby providing a strong
motivation to managers to ensure that controls are effective. By requiring external auditor
assurance on management’s assessment, financial statement users can believe in management’s
assertions about controls.
h. One member of the audit committee needs to be a financial expert to ensure that there is
the knowledge necessary on the audit committee to critically evaluate management’s financial
reporting and internal control choices. Without that knowledge, the committee may be unduly
influenced by management’s preferences.
i. It imposes strict penalties for destroying documents, which was an element in the
downfall of Andersen.

2-9
2-43
No, nonpublic organizations are not required to abide by the Sarbanes-Oxley Act. However,
many organizations view these requirements as “best practice” and so nonpublic organizations
sometimes adhere to certain requirements of the Sarbanes-Oxley Act voluntarily.
2-44
The major parties involved in corporate governance, and their role/activities are as follows:
Party Overview of Responsibilities
Stockholders Broad Role: Provide effective oversight through election of board
members, through approval of major initiatives (such as buying or
selling stock), and through annual reports on management
compensation from the board
Board of
Directors
Broad Role: The major representatives of stockholders;
they ensure that the organization is run according to the
organization's charter and that there is proper accountability.
Specific activities include:
• Selecting management
• Reviewing management performance and determining
compensation
• Declaring dividends
• Approving major changes, such as mergers
• Approving corporate strategy
• Overseeing accountability activities
Management Broad Role: Manage the organization effectively; provide accurate
and timely accountability to shareholders and other
stakeholders
• Formulating strategy and risk management
• Implementing effective internal controls
• Developing financial and other reports to meet public,
stakeholder, and regulatory requirements
• Managing and reviewing operations
• Implementing an effective ethical environment
Audit
Committees of
the Board of
Directors
Broad Role: Provide oversight of the internal and external audit
function and over the process of preparing the annual financial
statements and public reports on internal control
• Selecting the external audit firm
• Approving any nonaudit work performed by the audit firm
• Selecting and/or approving the appointment of the Chief
Audit Executive (Internal Auditor)
• Reviewing and approving the scope and budget of the
internal audit function

2-10
Regulatory
Organizations:
SEC, AICPA,
FASB, PCAOB,
IAASB
• Discussing audit findings with internal and external auditors,
and advising the board (and management) on specific actions that
should be taken
Broad Role: Set accounting and auditing standards dictating
underlying financial reporting and auditing concepts; set the
expectations of audit quality and accounting quality
• Establishing accounting principles
• Establishing auditing standards
• Interpreting previously issued standards
• Enforcing adherence to relevant standards and rules for
public companies and their auditors
2-45
These principles include:
• The board's fundamental objective should be to build long-term sustainable growth in
shareholder value for the corporation.
• Successful corporate governance depends upon successful management of the company, as
management has the primary responsibility for creating a culture of performance with
integrity and ethical behavior.
• Effective corporate governance should be integrated with the company's business strategy and
not viewed as simply a compliance obligation.
• Transparency is a critical element of effective corporate governance, and companies should
make regular efforts to ensure that they have sound disclosure policies and practices.
• Independence and objectivity are necessary attributes of board members; however, companies
must also strike the right balance in the appointment of independent and non-independent
directors to ensure an appropriate range and mix of expertise, diversity, and knowledge on the
board.
2-46
a. Independent directors are more likely to stand up to management and report fraud than
those directors that are not independent.
b. Holding meetings without management present enables a frank and open discussion,
including enabling board members with concerns about potential fraud or weak management to
alert other board members to express those concerns.
c. By having a nominating/corporate governance committee composed of independent
directors, the organization is more likely to attract high quality board members that are not
unduly influenced by management. And by having a corporate governance committee, this
important element of control achieves prominence in the organization and acts as a deterrent to
fraud.

2-11
d. Having a written charter and an annual performance evaluation ensures that the
committee responsibilities are appropriate, and that the responsibilities are actually accomplished
(or shareholders are alerted if they are not accomplished). Accomplishing such activities acts as a
deterrent to fraud.
e. By having an independent compensation committee, top management will be less able to
inappropriately influence compensation decisions for themselves.
f. Having a written charter and an annual performance evaluation ensures that the
deterrent to fraud.
g. This requirement ensures an adequate size and independence of the audit committee,
which acts to strengthen governance and deter fraud.
h. Having a written charter and an annual performance evaluation ensures that the
deterrent to fraud.
i. These requirements encourage a high quality set of corporate governance behaviors,
which taken together act as a deterrent to fraud.
j. By making the ethics issue a prominent disclosure, it encourages management and other
individuals within the organization to take it more seriously. It acts to encourage a high quality
“tone at the top”.
k. By requiring this disclosure, users of the financial statements can evaluate for themselves
whether the foreign companies’ governance is adequate, or gain an appreciation for governance
differences. This knowledge encourages companies to adopt corporate governance mechanisms
that they otherwise may not, thereby affecting the control environment and the opportunity for
fraud. It also helps users know where deficiencies may exist, making them more skeptical.
l. It attempts to ensure that the top-level executives place the appropriate importance on
corporate governance and that they would be required to disclose if their company is not
compliant, which would alert users to heightened fraud risk.
m. An internal audit function is important to the control environment. Having that oversight
internally improves internal control, thereby deterring fraud.
2-47
a. This requirement forces audit committees to take internal controls seriously, and to
consider any potential independence impairments for the external auditor. Both internal controls
and high quality external auditing are critical for the prevention and/or detection of fraud.

2-12
b. This requires the audit committee to be engaged and informed about financial accounting
at the company; being engaged and informed enhances the ability of the audit committee to
detect fraud.
c. Analyst interactions and the pressure to meet their expectations provide incentives for
fraud. By requiring that the audit committee discuss the earnings release process, audit
committees have more control over what and how management engages with analysts, and that
control should assist in deterring fraud.
d. Understanding risk assessment and risk management should alert the audit committee to
weaknesses therein, thereby encouraging positive change, which should thereby deter fraud.
e. Meeting separately with these groups encourages frank conversations about concerns,
and such communication is helpful to deterring or detecting fraud.
f. By understanding the nature of any problems that the external auditor is having with
management, the audit committee gets a good sense of potential management aggressiveness,
and the sources of disagreement between the auditor and management. In addition, this
requirement gives the external auditor someone to turn to in reporting fraud on the part of
management.
g. By setting hiring policies regarding employees of the external audit firm, the audit
committee can ensure that management is not exerting undue influence over the members of the
audit team by possibly promising them employment at the company.
h. By reporting regularly to the board of directors, the audit committee is put in a position of
power in the organization, thereby giving them the clout necessary to oversee management and
deter fraud.
2-48
a. The audit committee must be comprised of “outside” independent directors, one of whom
must be a financial expert. The audit committee now has the authority to hire and fire the
external auditor, and will therefore serve as the auditor’s primary contact, especially for
accounting and audit related issues. In addition, at many organizations the audit committee sets
the scope for and hires internal auditors. They would also review the work of both internal and
external auditors.
b. The audit committee certainly takes on much more responsibility with the new
regulation. They will now be much more informed about the audit function and financial
reporting processes within their company. The auditor must report all significant problems to the
audit committee. For auditors, the reporting relationship should reinforce the need to keep the
third-party users in mind in dealing with reporting choices.

2-13
c. The audit committee is basically in a position of mediator, but not problem solver. One
member must be a financial expert, but all members must be well versed in the field. This
financial knowledge can help the audit committee to understand the disagreement. Ultimately,
the company would like to receive an unqualified audit opinion. If the external auditor believes a
certain accounting treatment to be wrong, they do not have to give an unqualified opinion. The
audit committee’s responsibility is to assist in resolution of the dispute so that financial reporting
is accurate. Skills of audit committee members that would assist in this type of situation include
interpersonal skills, negotiation skills, and communication skills.
2-49
Factors Explain Your Reasoning and the Implications of Poor
Governance
a. The company is in the
financial services sector and has
a large number of consumer
loans, including mortgages,
outstanding.
This is not necessarily poor governance. However, the auditor
needs to determine the amount of risk that is inherent in the
current loan portfolio and whether the risk could have been
managed through better risk management by the organization.
The lack of good risk management by the organization
increases the risk that the financial statements will be misstated
because of the difficulty of estimating the allowance for loan
losses.
b. The CEO’s and CFO’s
compensation is based on three
components: (a) base salary, (b)
bonus based on growth in assets
and profits, and (c) significant
stock options.
This is a rather common compensation package and, by itself, is
not necessarily poor corporate governance. However, in
combination with other things, the use of ‘significant stock
options’ may create an incentive for management to potentially
manage reported earnings in order to boost the price of the
company’s stock. The auditor can determine if it is poor
corporate governance by determining the extent that other
safeguards are in place to protect the company.
c. The audit committee meets
semi-annually. It is chaired by a
retired CFO who knows the
company well because she had
served as the CFO of a division
of the firm before retirement. The
other two members are local
community members – one is the
President of the Chamber of
Commerce and the other is a
retired executive from a
successful local manufacturing
firm.
This is a strong indicator of poor corporate governance. If the
audit committee meets only twice a year, it is unlikely that it is
devoting appropriate amounts of time to its oversight function,
including reports from both internal and external audit.
There is another problem in that the chair of the audit
committee was previously employed by the company and
would not meet the definition of an independent director.
Finally, the other two audit committee members may not have
adequate financial experience.
This is an example of poor governance because (1) it signals
that the organization has not made a commitment to

Factors Explain Your Reasoning and the Implications of Poor
Governance
independent oversight by the audit committee, (2) the lack of
financial expertise means that the auditor does not have
someone independent that they can discuss controversial
accounting or audit issues that arise during the course of the
audit. If there is a disagreement with management, the audit
committee does not have the expertise to make independent
judgments on whether the auditor or management has the
appropriate view of the accounting or audit issues.
d. The company has an internal
auditor who reports directly to
the CFO, and makes an annual
report to the audit committee.
The good news is that the organization has an internal audit
function. However, the reporting relationship is not ideal.
Further, the bad news is that a staff of one isn’t necessarily as
large or as diverse as it needs to be to cover the major risks of
the organization.
e. The CEO is a dominating
personality – not unusual in this
environment. He has been on the
job for 6 months and has decreed
that he is streamlining the
organization to reduce costs and
centralize authority (most of it in
him).
A dominant CEO is not especially unusual, but the
centralization of power in the CEO is a risk that many aspects
of governance, as well as internal control could be overridden.
The centralization of power in the CEO is a risk that many
aspects of governance, as well as internal control could be
overridden, which of course increases the risk of fraud and the
risk faced by the external auditor.
f. The Company has a loan
committee. It meets quarterly to
approve, on an ex-post basis all
loans that are over $300 million
(top 5% for this institution).
There are a couple of elements in this statement that yield great
risk to the audit and to the organization, and that are indicative
of poor governance. First, the loan committee only meets
quarterly. Economic conditions change more rapidly than once
a quarter, and thus the review is not timely. Second, the only
loans reviewed are (a) large loans that (b) have already been
made. Thus, the loan committee does not act as a control or a
check on management or the organization. The risk is that
many more loans than would be expected could be delinquent,
and need to be written down.
g. The previous auditor has
resigned because of a dispute
regarding the accounting
treatment and fair value
assessment of some of the loans.
This is a very high risk indicator that is indicative of poor
governance. The auditor would look extremely bad if the
previous auditor resigned over a valuation issue and the new
auditor failed to adequately address the same issue. Second, this
is a risk factor because the organization shows that it is willing
to get rid of auditors with whom they do not agree. This is a
problem of auditor independence and coincides with the above
identification of the weakness of the audit committee.
2-14

2-15
Fraud Focus: Contemporary and Historical Cases
2-50
a. Management at Koss may have placed a high level of trust in Sachdeva because they
knew her for a long period of time and she did not exhibit behaviors that caused concern.
Further, management at the company was reportedly quite relaxed in its approach to monitoring
and control. These behaviors led to a lack of professional skepticism on the part of management.
b. Grant Thornton was obligated to uncover the fraud in the sense that they ignored red
flags (weakening financial condition, poor internal control and monitoring) that should have
alerted them to problems in the company. Grant Thornton experienced an audit failure because
they issued unqualified audit opinions on materially misstated financial statements. It appears
that they may not have employed an appropriate level of professional skepticism.
c. Sachdeva’s lavish lifestyle should have raised suspicions because her level of
conspicuous consumption far exceeded her apparent ability to pay given her relatively modest
salary. However, her lifestyle may have been explained away or ignored because of her
husband’s prominent medical practice. People likely assumed that her lifestyle was none of their
business and that she simply used her family’s joint money to fund her lavish purchases. Even
when confronted with a known fraud, individuals that know a fraudster often have difficulty
believing that it is true – denial is a common factor even in the face of seemingly obvious signs
of fraud.
d. Management and the audit committee should have been skeptical of Sachdeva because of
the weak internal controls in place, coupled with deteriorating financial conditions at the
company. The auditors should have been more skeptical of her explanations for the financial
condition of the company. The auditors should have collected more audit evidence to better
understand the increase in cost of goods sold. The auditors should have realized that there was a
risk of fraud given the lack of monitoring and the high level access to corporate bank accounts
that Sachdeva had.
e. The audit committee plays an important oversight role in any organization. The benefit of
the audit committee should be that they are independent from the daily operations of the
organization, and should therefore be in a position to more critically evaluate the personalities
and behaviors of senior management, including the CFO in this particular case. Further, audit
committees of public companies are required to have at least one financial expert, and it is the
obligation of that individual to consider and initiate investigation of anomalies in the financial
statements. Clearly this oversight did not occur in the case of Koss.
f. Whenever an organization uses corporate credit cards, there should be controls over their
use. Most typically, such controls involve review and approval of payment by a senior official. In
Sachdeva’s case, senior management allowed her to use the credit cards without review, and she
was the individual in charge of making payments on the cards. Thus, basic controls involving
review and segregation of duties were not used at Koss.

2-16
g. Top-level managers should have been skeptical about the reasons for Sachdeva’s
behavior. In retrospect, it seems that she was purposely trying to intimidate her subordinates
through this dominating behavior. Management may have questioned why she was trying to
intimidate her subordinates. Was there something that she was trying to cover up? This tactic
was also used at Enron, whereby top-level management would explicitly indicate that any
questioning of its actions (from employees, external analysts, etc.) was an indication of how
dense the questioner was. Top-level managers should have wondered why she felt the need to
behave in this manner, and they should have objected to it in person or at least told her in private
to eliminate the behavior if for no other reason than to establish and maintain a more professional
tone in the workplace. This kind of behavior puts subordinates in a very awkward position. In
Sachdeva’s case, she reportedly acted dominating to the vast majority of her subordinates. In
such a setting where one individual is not singled out, it should be easier for the group to act
cohesively and approach senior management privately to complain about the situation. In a
setting where one individual is singled out, that individual should consider finding a formal or
informal mentor to help them decide how to garner the support to approach senior management
with their concerns.
2-51
a. Yes, the members of the audit committee appear to be professionally qualified. They
have all held financially responsible leadership positions at large companies in industries similar
to those as Koss Corporation. The committee meets less frequently than quarterly, which is fairly
infrequent. Prior to SOX, this level of audit committee involvement was common, but it is now
more common for audit committees of public companies to meet at least bi-monthly, if not
monthly. Without frequent meetings, committee members are not able to generate sufficient
questions and then gather sufficient evidence in order to develop a professionally skeptical view
of the true situation at the company, and that is what appears to have happened at Koss. You
might consider gathering evidence to support your conclusions about the professional
qualifications of audit committee members. For example, you might observe the questions that
they ask during meetings, and their level of preparedness. You might inquire about their
continuing professional education and experiences. You will obtain this information in various
ways, but personal observation will likely be very important.
b. Lawrence Mattson is the audit committee financial expert. He is a retired president of a
large consumer products company, which should make him financially knowledgeable.
However, the fact that he has clearly been retired for quite some time (he is in his late 70’s) calls
into question whether he is currently “up to speed” on the financial reporting demands faced by a
public company. Without adequate financial knowledge, it is nearly impossible to exercise
adequate professional skepticism – knowledge is one of the bases upon which skepticism rests.
Financial expertise is important for audit committee members because they play a significant
role in corporate governance over financial matters – they are a key defense in potential
problems with financial reporting.
c. Their compensation is very low given the important role that they play in the company,
and the fact that this is a public board. Further, many audit committee members at public
companies receive stock options or stock grants to align their interests with the long-term goals

2-17
of stockholders. These audit committee members receive no stock options, and hold very few (if
any) shares.
d. Theodore Nixon is the only audit committee member who is still an active, working
financial professional. The other members of the audit committee are relatively older, and are no
longer working in the public sector. This certainly does not disqualify them, but coupled with the
relatively few meetings that the committee has, it calls into the question whether the audit
committee is really functioning in a strong oversight capacity. The responsibilities that the proxy
statement outlines seem reasonable, but it seems impossible that an audit committee with these
characteristics could carry out those responsibilities in so few meetings.
2-52
This exercise is based on an article in the Wall Street Journal (Dell Investors Protest CEO in
Board Vote, by: Joann S. Lublin and Don Clark, Aug 18, 2010). The article provides more
details on shareholder voting for directors if the instructor is interested in pursuing that aspect of
governance. In terms of the specific questions:
a. The following are the corporate governance principles presented in the chapter. Students
could argue that many of the principles could be in question at Dell. Of great concern is that
management has a great deal of control over the governance and there are questions about
management’s ethics and integrity. If the financial statements were intentionally misstated, this
calls into question the company’s commitment to transparency. Further, given Mr. Dell’s roles,
there are questions about the independence of the board.
The Board’s fundamental objective should be to build long-term sustainable growth in
shareholder value for the corporation
Successful corporate governance depends upon successful management of the company, as
management has the primary responsibility for creating a culture of performance with
integrity and ethical behavior
Good corporate governance should be integrated with the company's business strategy and
not viewed as simply a compliance obligation.
Transparency is a critical element of good corporate governance, and companies should
make regular efforts to ensure that they haves sound disclosure policies and practices.
Independence and objectivity are necessary attributes of board members; however,
companies must also strike the right balance between the appointment of independent and
non-independent directors to ensure that there is an appropriate range and mix of expertise,
diversity and knowledge on the board.
b. The discussion in part a. suggests that Dell’s auditors should have some concerns about
the quality of governance at Dell. And this in turn suggests that the audit might have heightened
risk.
c. Dell’s auditor can respond in various ways. At the extreme, the auditor may decide to not
retain Dell as a client. Another approach would be to increase the audit work and audit rigor to
mitigate any risks that may be associated with the lower quality governance. However, if the

2-18
governance is really poor, extra audit work may not be sufficient. Further, if the auditors have
reason to question the integrity and ethics of Mr. Dell it could be hard to “audit around that.”
This is a setting where it is important that the auditors employ an appropriate level of
professional skepticism.
d. In general, having an independent board chair would improve governance. Given the
alleged behavior of Mr. Dell, it may be even more important at Dell, Inc. Recall however that no
individual or company admitted wrongdoing in this case.
e. Removing Mr. Dell from his CEO position may not be as likely as removing him from
his board position. Student discussion will likely not come to a consensus on this point.
Application Activities
2-53
a. The skepticism continuum is founded on the belief that professional skepticism is related
to a questioning mind, and that an individual may range from a neutral mindset, to a presumptive
doubt mindset, to complete doubt. Complete trust would be outside the range on the continuum
of professional skepticism. The continuum then relates to evidence collection, whereby lower
skepticism is associated with less audit evidence and documentation and higher skepticism is
associated with more audit evidence and documentation.
b. Threats to individual auditor professional skepticism include judgment biases, lack of
knowledge and expertise, deadline pressures, auditor character/personal attributes, cultural
attributes, and performance incentives. Mitigating factors include professional education and
licensing requirements, supervision, review, performance metrics that reward the auditor for
quality work, effective recruiting requirements, effective engagement partner leadership, and
training.
c. Common human judgment tendencies that can weaken individual auditor professional
skepticism include the following:
Overconfidence. The tendency of individuals to overestimate their own abilities.
Overconfidence can lead the auditor to not spend enough time critically thinking about
client-related facts that would otherwise raise red flags.
Confirmation. The tendency of individuals to seek information and evidence that supports
their initial beliefs or preferences. If the individual auditor does not seek contradictory
evidence, their professional skepticism is not heightened because the auditor does not
detect discrepancies.
Anchoring. The tendency of individuals to evaluate information from a starting point and
then not adjusting sufficiently away from that starting point despite evidence to the
contrary. For example, the individual auditor may anchor on last year’s account balance
or procedures used last year and insufficiently adjust for new information.
Availability. The tendency of individuals to consider information that is more easily
available from memory to be more likely, relevant, or important. By focusing on more

2-19
readily available information, the individual auditor may not make the effort to engage in
critical thinking about patterns available in audit evidence.
2-54
This research question asks students to summarize the PCAOB’s concerns with respect to
problems their inspection teams have noted in auditors’ performance in each of the following
areas.
a. Auditors’ overall approach to the detection of fraud
Problems noted:
1. auditors often document their consideration of fraud merely by checking off items
on standard audit programs and checklists rather than by considering unique features
of their individual clients
2. lack of involvement by senior members of the engagement team
3. failure to expand audit procedures despite recognition of heightened fraud risk
b. Brainstorming sessions
Problems noted:
1. Engagement teams have been found not to conduct brainstorming sessions
2. Brainstorming sessions were sometimes conducted AFTER audit evidence
collection had begun, rather than as an integral part of the planning process
3. Key members of the engagement team did not attend the brainstorming session.
c. Auditors’ responses to fraud risk factors
Problems noted:
1. Auditors sometimes do not address known fraud risk factors via evidence.
2. Auditors sometimes collect evidence, but do not tie it to specific known fraud risk
factors.
d. Financial statement misstatements
Problems noted:

2-20
1. Failure to appropriately determine whether items are material or not.
2. Failure to investigate known departures from GAAP to determine if those
departures were indicative of fraud.
3. Failure to post material items to a summary sheet indicating material
misstatements, or inappropriately netting misstatements. This causes senior
engagement personnel and audit committee members to be unaware of problems that
engagement teams encountered on the engagement that could be indicative of fraud.
e. Risk of management override of controls
Problems noted:
1. Failure to evaluate the risk of management override of controls.
2. Failure to evaluate the fraud risk potential associated with end of period journal
entries or accounting estimates.
3. Failure to document or test management’s assumptions about accounting estimates.
f. Other areas to improve fraud detection
Problems noted:
1. Improper use of analytical procedures in fraud detection.
2. Failure to adequately audit accounts receivables, which are related to revenue
recognition (an area in which auditors are supposed to presume fraud)
3. Failure to determine that interim audit testing appropriately rolled forward to apply
to end of year conclusions.
2-55
a. The PCAOB sets standards for audits of public companies and defines the auditing
profession’s responsibilities for detecting fraud and other financial misdeeds. They also establish
and test quality control guidelines for external audit firms that audit public companies. The
inspection process keeps the external audit profession acutely alert to its responsibilities of

2-21
assuring audit quality, i.e., the threat of inspection should lead to more consistently high audit
quality on all engagements even though not all engagements will actually be inspected.
b. The rationale for the requirement was probably to get people from diverse disciplines to
comprise the Board. This way, more thoughts are generated. Congress probably was under the
impression that CPA’s tend to think alike. The disadvantage to having only two CPA’s on the
board is that they do not form a majority and that the board may not have a sufficient level of
accounting and auditing expertise. The Board sets standards for an industry made up almost
entirely of CPA’s, yet the strongest voice may not be that of a CPA.
c. No, the audit standards promulgated by the PCAOB apply only to public listed
companies in the U.S. However, many of the auditing standards that have been adopted by the
PCAOB include U.S. audit standards originally developed by the Auditing Standards Board of
the AICPA.
2-56
a. Shareholders would normally not know what qualifications are important for their
external auditors. If the CEO or CFO had these responsibilities, the auditor would be more likely
to bend to their wishes rather than take the hard stances that may be required for fair financial
reporting. Part of the purpose of designating the audit committee to oversee the audit is to have
an advocate for the stockholders of the company.
b. Factors to consider in evaluating the external auditor’s independence include:
The nature and extent of non-audit services provided to the client.
The policies and procedures the external auditor’s firm has to assure independence.
The lengths of time individuals have been in charge of the audit.
c.
Any pending or completed investigations by the SEC or PCAOB of the firm.
This part of the problem will vary based upon the company that each student selected.
This is a good problem to assign if you feel that your students are unfamiliar with locating basic
public company filings using the SEC online data system.
2-57
The purpose of this project is to get students familiar with resources related to businesses and
acquaint them with the process of gathering evidence about corporate governance and evaluating
the effectiveness of corporate governance. Another alternative is to discuss what students have
observed in their part-time jobs.
2-58
The goal of this exercise is to allow the student to see how audit committees really function in
the “real world.” The differences between the various companies will likely indicate that audit
committees, charters, and company goals differ across organizations.

2-22
2-59
This exercise illustrates that the issue of corporate governance is a global issue. The insights the
students will obtain will depend, in part, on the countries selected for research. For example, a
report on Turkey would likely point out that: (1) there have been recent efforts to improve
governance, in part, due to Turkey’s efforts to join the European Union, (2) the concepts of
transparency and disclosure are not well accepted by many companies because of their “family
business” nature, etc.
Academic Research Cases
2-60
a. The issue being addressed is the role that risk, internal controls, and risk management
within a company has on external audit demand and therefore, audit fees. Much research has
been done on factors that may have an effect on audit fees. Some research has indicated that
audit fees are affected by the size of the company, inherent risks such as receivables and
litigation risk attributable to the auditor. Other research has indicated that these results are not
consistent. Specifically, this research focuses on four risk issues that may affect audit fees. The
risks that confront the stakeholders of a company may affect audit demand as each stakeholder
may face different risks. Risk associated with the amount of internal controls, as well as whether
the controls in place are voluntary or mandatory, in a company may also affect the need for
external auditing. The level of corporate governance in a company may also have an effect on
the level of necessity for auditing services, thus affecting fees.
b. The research indicated that there is a positive association between internal control/ risk
management in an organization and audit fees as well as corporate governance and audit fees. In
an organization with multiple stakeholders, the stakeholders are able to share control costs and
therefore more apt to lead to an increased voluntary demand for levels of control. Audit fees are
higher when a company has an audit committee, discloses a high level of financial risk
management, and has a larger proportion of independent Board Members. Audit fees are lower
when a company does not have an audit committee, has a smaller portion of independent board
members, and discloses a relatively high level of compliance risk management, which is
consistent with the theory that mandated internal controls lower audit fees.
c. Companies with greater corporate governance and voluntary controls have an increased need
and desire for external audit assurance. This would also imply that these companies expect a
higher quality audit, but they are more willing to pay for the higher quality audit. Companies
with less corporate governance and only mandatory controls are more willing to sacrifice audit
quality to reduce audit fees for the company.
d. Data was gathered using companies in Belgium as Belgium has an environment where
stakeholders other than shareholders have a significant effect on corporate behavior. The
researchers contacted 102 individual companies and requested disclosure of total fees paid for
statutory audits of 2001 accounts. Information about corporate governance was also requested.

2-23
Only 50 companies elected to provide all information necessary to complete the research. Risk
and risk-management data for these companies was hand-collected from the 2001 annual reports.
Estimation models were used to determine the effect of risk variables, governance variables, and
the joint effect of these risks. Risk variables were given a score of 1 to 5 and included disclosures
about management of financial risk, disclosures about management of compliance risk,
disclosures about management of environmental risk, disclosures about management of
technology risk, and disclosures about management of internal process risk as well as disclosure
about management of change management risk. Dummy variables include a variable equal to 1 if
the company has an internal auditor and 0 if not as well as a variable equal to 1 if the company
has a formal model of risk management and 0 if not. The standard risk measures of net income
and receivables average of total assets was also used in the research. Governance variables
included if external auditors were part of the Big 5, if the company has an audit committee,
number of non-execs on the board, percentage of board members that are non-execs, number of
independent board members, percentage of board members that were independent, total number
of board members, and if the CEO was chairperson on the board.
e. The research is somewhat limited due to a relatively small sampling of companies being
used. Also, the risk and risk management data was retrieved from the 2001 annual reports.
Therefore, there is the risk that the companies used for this research may have had incentives for
disclosing or not disclosing information that affect management actions. Also, the Belgian
economy and market is unique so it is not clear how these results would apply to a more market-
driven economy like the United States.
2-61
a. The issue being addressed is the need for an internal audit report (IAR) to increase
governance transparency for external stakeholders. Governance transparency is defined as the
availability and extent of governance-related disclosures. The internal audit function is critical to
the corporate governance of a company, as it provides assurance and ongoing assessments of the
company’s risk management processes and systems of internal control. Internal stakeholders
have access to the information provided by internal audit. However, external stakeholders do not.
This asymmetry raises the concern that corporate governance is not transparent to the external
stakeholders and that this may represent an information risk to them. A commitment to an
increase in the transparency of corporate governance is believed to result in an increase in trust
and confidence with shareholders and stakeholders. This research is being performed to
determine if the external stakeholders would benefit from additional information that could be
provided to them in an IAR, what information they would benefit from, and if the benefit
received would outweigh the cost of providing such information.
The legal liability for internal auditors may increase as a result of the potential to become more
accountable for the performance of an internal audit. Additional requirements for performance of
the audit could result in loss of flexibility in determining the scope of the internal audit as
necessary for a specific company. The IAR would not only highlight the work that the internal
auditor is doing, but it would also highlight what internal audit is not doing. However, the
requirement of an IAR could also provide the internal audit profession additional leverage that

2-24
would increase internal auditor value within the corporate world, as well as the audit profession
itself.
b. The results of the interviews that were conducted definitely indicate that an IAR has the
potential to improve external stakeholder understanding of the internal audit function and
corporate governance. As a result, corporate governance would be more transparent to the
external stakeholders. The interview results indicate that increased transparency may lead to
increased quality standardization of and investment in internal audit activities. The IAR would
provide the external stakeholders with information about what is and is not being audited within
the company. This would provide external stakeholders with an increased confidence in the
information that they are being provided.
Increased cost considerations determined in the interviews included increased legal exposure for
internal auditors as they would be held more accountable for their performance as well as more
accountable for financial reporting failures. This increased liability could affect availability of
qualified auditors as well as their desired compensation as a result of the increased liability.
Increased information load for users is another cost concern. The corporate disclosure is already
lengthy and complex; the concern was expressed that users may not be able to fully understand
the report. Additional reporting costs were not viewed as being a major issue if the internal
auditor is doing a thorough job already but that there was the concern of increased risk due to
limitations on audit scope as a result of not wanting to disclose results.
The IAR should include information that will provide valuable insight of the internal audit
function to the external stakeholders. Some of the suggested information that should be included
is the composition of the internal audit department, as well as their responsibilities,
accountability, activities, and resources. The majority of the interviewees did not feel that an
actual audit opinion was necessary as it would basically be the same as the opinion over internal
controls.
c. An internal audit report supplied to external stakeholders could have several implications on
audit quality. The report would potentially increase the accountability of the internal auditor,
providing the auditor an incentive to apply more diligent care to the audit itself, therefore
increasing the quality of the audit. The increased accountability and public review could provide
the internal audit group with leverage for asking for critical resources and access within the
company. Management would potentially have more incentive to provide the additional support
and access that is requested. Another implication to the audit quality would be that the increase
in accountability may lead the auditor to limit the scope of their audits due to having to disclose
the results which would result in a decrease in audit quality. Further, as the quality of the internal
audit function is affected, there are implications for external auditors who may choose to rely on
the work of the internal auditors when performing the financial statement audit.
d. Data was gathered by conducting 18 semi-structured interviews, which averaged 20
minutes in length. A semi-structured interview format was used to allow new topics and
questions to be introduced by the interviewees. The interviewees were selected using a
convenience sampling. The interviewees consisted of four audit committee members (including 2
audit committee chairs), three analysts from investment firms, five internal auditors (including

2-25
three CAE’s), two members from the AICPA, 2 members from HA, and 2 members from the
SEC. All participants had a minimum of ten years of experience with governance and audit
related issues.
The authors also reviewed relevant literature to gain insights on issues related to disclosures
made via an IAR.
e. The research for this paper did not consider the extent to which external stakeholders
deduce adequate information about the internal audit function from current governance
disclosures. Additional research is also needed to determine the costs and benefits derived from
various wordings on an IAR within a mandatory versus voluntary environment.
2-62
a. The authors examine newsworthy cases in the pre-SOX era to identify the correlation
between audit committee (AC) characteristics (independence and financial expertise including
both accounting and non-accounting financial expertise) and the occurrence of misappropriation
of assets. They are particularly interested in how AC financial expertise and independence relate
to the incidence of misappropriation of assets in publicly-held companies.
Accounting expertise described AC members with prior roles as CPAs, auditors, or other major
accounting positions. Non-accounting financial expertise referred to AC members with prior
roles as CEO, president, chair of the board, or other major roles in the financial services industry.
The distinction between accounting and non-accounting expertise is intentionally made to
measure the efficacy of SOX’s broad definition of financial expert which lacks a requirement for
accounting expertise (a condition formerly proposed by the initial exposure draft). An underlying
objective in this study is to contribute to the ongoing debate as to the appropriateness of the
definition of financial expert (e.g., whether SOX’s broad definition of financial expert could be
improved).
b. Companies whose AC members were independent and possessed non-accounting
financial expertise had a reduced likelihood for the occurrence of misappropriation of assets. The
presence of a financial expert was especially necessary (even with accounting expertise, but to a
lesser extent than non-accounting), as ACs with independence but no financial expertise were not
significant in reducing the occurrence.
Without considering AC independence, overall financial expertise (comprised of both accounting
and non-accounting financial expertise) and non-accounting financial expertise were both
significantly and negatively correlated to the occurrence of misappropriation of assets.
Accounting expertise was not significantly related to the occurrence of asset misappropriation.
The authors suggest that this finding is possibly due to overreliance on the expert by other
members or because the AC spends very little time actually reviewing financial statements.
c. When assessing the internal controls of a company, the auditor should not automatically
assume an increased control risk solely due to lack of accounting expertise on the AC. As shown

2-26
by this study, non-accounting financial expertise is actually correlated with a stronger control
environment that deters instances of fraud. So, auditors need not be overly-skeptical of (nor
overly-reliant upon) the company’s internal controls based on the background of the financial
expert.
d. A sample of 28 companies experiencing incidents of misappropriation of assets during
1987-1998 was compared to a set of 28 control companies without asset misappropriation
(similar size, industry, time period) to determine the association between AC characteristics and
the occurrence of asset misappropriation.
e. Sample size was a limiting factor, as only 56 companies were analyzed. Further, the time
period examined could be a limitation. Because the years sampled encompass a pre-SOX era, the
results may be somewhat dated. Since 1998, there has been heightened emphasis on internal
controls and increased public scrutiny of audits. Therefore, the ACs may currently devote
additional time to reviewing financial statements, possibly increasing the value of accounting
financial experts.
Ford and Toyota
2-63
Note to instructor: The solutions based upon the FYE 2012 annual reports for Ford and Toyota are posted
at the Cengage web site for the 9th
edition of this text. The solutions for FYE 2014 will be posted at the
Cengage web site for the 10th
edition of this text.
Ford and Toyota Semester Project: Using these instructional resources based on Ford and
Toyota, students will have the opportunity to apply the concepts from each chapter within the
context of two actual companies. We have used these types of exercises in our undergraduate
and graduate auditing classes . In the undergraduate classes, the authors used these types of
materials as the basis for in-class group activities. In the graduate classes, the instructors used
these types of materials as the basis for both in-class group activities, and out-of-class small
group cases and projects.
If you are looking for a semester project using these materials, one of the authors always assigns
a semester paper that is completed in small groups (with 15 minutes of class time used each
class period for group discussion, along with the expectation that groups will also meet
periodically outside of class). For this project, the author assigns each of the questions for the
chapters that are covered in the syllabus. Below, we reproduce the grading criteria and student
instructions related to that project. Perhaps you will find this useful as a basis for constructing a
similar project of your own.
FORD AND TOYOTA GROUP PAPER DESCRIPTION
The purpose of this group paper is to summarize your in-class discussions of the Ford and
Toyota materials. The case is worth 100 points and will be due the last day of class. Note the
following:
1. There is no page limit. Simply type up your answers (single space text is

2-27
appropriate, and please use 12cpi font) to each class assignment as we proceed
throughout the course. Keep them in a file and hand them in at the end of the course.
2. Your group will have three to five members.
3. Start a new class day/assignment on a new page of paper.
4. The text of your responses should address the assigned questions. Assign one
group member per class day/assignment to be a note-taker, and that person will also be
responsible for updating the “master” file.
Note: The questions are located at the end of selected chapters in the book, immediately
following the homework problems.

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The practicability of establishing
telegraphs on the electric principle is no
longer a question. Wheatstone, of London,
and his associates, have been more
fortunate than our American inventor, in
procuring the means to put his ingenious
system into practical use for two or three
hundred miles, in Great Britain; and the
movements of the cars on the Blackwall rail
road are at this time directed with great
economy, and perfect safety to life and
property, by means of his magnetic needle
telegraph. If a system more complicated and
less efficient than the American telegraph is
operated for great distances in England,
with such eminent success and advantage,
there can be no reasonable doubt that, if
the means be furnished for putting in
operation the system of Professor Samuel F.
B. Morse, of New York, the original inventor
of the electro-magnetic telegraph, the same,
if not greater success, will be the result.
Your committee are of opinion that it is but
justice to Professor Morse, who is alike
distinguished for his attainments in science
and excellence in the arts of design, and
who has patiently devoted many years of
unremitting study, and freely spent his
private fortune, in inventing and bringing to
perfection a system of telegraphs which is
calculated to advance the scientific
reputation of the country, and to be
eminently useful, both to the Government
and the people, that he should be furnished
with the means of competing with his
European rivals.

Professor Morse bases his system upon
the two following facts in science:
First. That a current of electricity will
pass to any distance along a conductor
connecting the two poles of a voltaic battery
or generator of electricity, and produce
visible effects at any desired points on that
conductor.
Second. That magnetism is produced in a
piece of soft iron (around which the
conductor, in its progress, is made to pass)
when the electric current is permitted to
flow, and that the magnetism ceases when
the current of electricity is prevented from
flowing. This current of electricity is
produced and destroyed by breaking and
closing the galvanic circuit at the pleasure of
the operator of the telegraph, who in this
manner directs and controls the operation of
a simple and compact piece of mechanism,
styled the register, which, at the will of the
operator at the point of communication, is
made to record, at the point of reception,
legible characters, on a roll of paper put in
motion at the same time with the writing
instrument. These characters the inventor
has arranged into a conventional alphabet,
and which is capable of being learned and
used with very little practice.
Professor Morse has submitted his
telegraphic plan to the severe scrutiny of
European criticism; and the Academy of
Sciences, of Paris, the highest scientific
tribunal in the world, hailed it with

enthusiasm and approbation, when its
operation was exhibited, and its principles
explained by their distinguished perpetual
secretary, M. Arago.
It appears, from documents produced by
Professor Morse, that the thanks of several
learned bodies in France were voted to him
for his invention, and the large medal of
honor was awarded to him by the Academy
of Industry. It further appears, that several
other systems of telegraphs on the electric
plan (among which were Wheatstone’s, of
London, Steinheil’s, of Munich, and
Masson’s, of Caen) had been submitted at
various times for the consideration of the
French Government, who appointed a
commission to examine and report on them
all, at the head of which commission was
placed the administrator-in-chief of the
telegraphs of France, (M. Foy,) who, to a
note to Professor Morse, thus writes:
“I take a true pleasure in confirming to
you in writing that which I have already had
the honor to say to you viva voce—that I
have prominently presented to Monsieur the
Minister of the Interior your electro magnetic
telegraph, as being the system which
presents the best chance of a practical
application; and I have declared to him that,
if some trials are to be made with electric
telegraphs, I do not hesitate to recommend
that they should be made with your
apparatus.”

Your committee, in producing further
evidence of the approbation by the scientific
world of the system of Professor Morse,
would cite the letter of Professor Henry, of
Princeton College, well known for his
eminent attainments in electrical science,
(marked 11,) in the appendix of this report.
More recently, a committee, consisting of
some of our most distinguished scientific
citizens, was appointed by the American
Institute of New York, to examine and report
upon this telegraph, who made the report
(12) in the appendix. In compliance with the
recommendation of this report, the Institute
awarded to Professor Morse the gold medal.
Besides the evidence these testimonials
furnish of the excellence of Professor
Morse’s system, your committee, as well as
the greater part of the members of both
Houses of Congress, have had a practical
demonstration of the operation of the
electro magnetic telegraph, and have
witnessed the perfect facility and
extraordinary rapidity with which a message
can be sent by means of it from one
extremity of the capitol to the other. This
rapidity is not confined in its effects to a few
hundred feet, but science makes it certain
that the same effects can be produced, at
any distance on the globe, between any two
given points connected by the conductors.
Your committee have alluded to other
electric telegraphs; for, as is not uncommon
in the birth of great inventions, scientific

minds have, at nearly the same period of
time, in various parts of Europe, conceived
and planned electric telegraphs; but it is a
matter of national pride, that the invention
of the first electro magnetic telegraph, by
Professor Morse, as well as the first
conception of using electricity as the means
of transmitting intelligence, by Doctor
Franklin, is the offspring of American genius.
Your committee beg leave to refer to the
letter of Professor Morse, (marked 13,) in
the appendix, to C. G. Ferris, one of the
committee, giving, at his request a brief
history of the telegraph since it was before
Congress, in 1838, for some interesting
information concerning it, and for Professor
Morse’s estimate of the probable expense of
establishing his system of telegraphs for
thirty or forty miles.
They would also refer to the House
document, No. 15, (December 6, 1837,) and
to House report, No. 753, (April 6, 1838,) for
valuable information on the subject of
telegraphs.
Your committee invite special attention to
that part of Professor Morse’s letter which
details the plan of a revenue which may be
derived from his telegraphic system, when
established to an extent sufficient for the
purposes of commercial and general
intelligence. From these calculations, made
upon safe data, it is probable that an income
would be derived from its use by merchants
and citizens more than sufficient to defray

the interest of the capital expended in its
establishment. So inviting, indeed, are the
prospects of profit to individual enterprise,
that it is a matter of serious consideration,
whether the Government should not, on this
account alone, seize the present opportunity
of securing to itself the regulation of a
system which, if monopolized by a private
company, might be used to the serious
injury of the Post Office Department, and
which could not be prevented without such
an interference with the rights of the
inventor and of the stockholders as could
not be sustained by justice or public opinion.
After the ordeal to which the electro
magnetic telegraph system has been
subjected, both in Europe and in America,
and the voice of the scientific world in its
favor, it is scarcely necessary for your
committee to say that they have the fullest
confidence in Professor Morse’s plan, and
they earnestly recommend the adoption of it
by the Government of the United States.
They deem it most fortunate that no definite
system of telegraphs should hitherto have
been adopted by the Government, since it
enables them to establish this improved
system, which, in the opinion of your
committee, is decidedly superior to any
other now in use, possessing an advantage
over telegraphs depending on vision,
inasmuch as it may be used both by night
and day, in all weathers, and in all seasons
of the year, with equal convenience; and,
also, possessing an advantage over electric

telegraphs heretofore in use, inasmuch as it
records, in permanent legible characters on
paper, any communication which may be
made by it, without the aid of any agent at
the place of recording, except the apparatus
which is put in motion at the point of
communication. Thus, the recording
apparatus, called the register, may be left in
a closed chamber, where it will give notice of
its commencing to write, by a bell, and the
communication may be found, on opening
the apartment. Possessing these great
advantages, and the means of
communication not being liable to
interruption by the ordinary contingencies
which may impede or prevent the successful
action of other telegraphs, the advantages
to be derived from it will soon be apparent
to the community, and it will become the
successful rival of the Post Office, when
celerity of communication is desired, and
create a revenue from which this system of
telegraphs may be extended and ramified
through all parts of the country, without
imposing any burden upon the people or
draughts on the treasury, beyond the outlay
for its first establishment.
As a first step towards the adoption of
this system of telegraphs by the
Government, your committee recommend
the appropriation of thirty thousand dollars
to be expended under the direction of the
Postmaster General, in constructing a line of
electro magnetic telegraphs, under the
superintendence of Professor Sam’l F. B.

Morse, of such length and between such
points as shall fully test its practicability and
utility; and for this purpose they respectfully
submit the following bill:
A bill to test the Practicability of Establishing
a System of Electro Magnetic Telegraphs by
the United States.
Be it enacted by the Senate and House
of Representatives of the United States in
Congress assembled, That the sum of thirty
thousand dollars be, and is hereby,
appropriated, out of any moneys in the
treasury not otherwise appropriated, for
testing the capacity and usefulness of the
system of electro magnetic telegraphs
invented by Samuel F. B. Morse, of New
York, for the use of the Government of the
United States, by constructing a line of said
electro magnetic telegraphs, under the
superintendence of Professor Samuel F. B.
Morse, of such length and between such
points as shall fully test its practicability and
utility; and that the same shall be expended
under the direction of the Postmaster
General, upon the application of said Morse.
Sec. 2. And be it further enacted, That
the Postmaster General be, and he is
hereby, authorized to pay, out of the
aforesaid thirty thousand dollars, to the said
Samuel F. B. Morse, and the persons
employed under him, such sums of money
as he may deem to be a fair compensation
for the services of the said Samuel F. B.
Morse and the persons employed under him,

in constructing and in superintending the
construction of the said line of telegraphs
authorized by this bill.
No. 11.
Letter from Professor Henry to Professor
Morse.
Princeton College, February 24, 1842.
My dear Sir: I am pleased to learn that
you have again petitioned Congress in
reference to your telegraph, and I most
sincerely hope that you will succeed in
convincing our representatives of the
importance of the invention. In this you
may, perhaps, find some difficulty, since, in
the minds of many, the electro magnetic
telegraph is associated with the various
chimerical projects constantly presented to
the public, and particularly with the
schemes, so popular a year or two ago, for
the application of electricity as moving
power in the arts. I have asserted, from the
first, that all attempts of this kind are
premature, and made without a proper
knowledge of scientific principles. The case
is, however, entirely different in regard to
the electro magnetic telegraph. Science is
now fully ripe for this application, and I have
not the least doubt, if proper means be
afforded, of the perfect success of the
invention.
The idea of transmitting intelligence to a
distance by means of electrical action, has

been suggested by various persons, from
the time of Franklin to the present; but until
within the last few years, or since the
principal discoveries in electro magnetism,
all attempts to reduce it to practice were
necessarily unsuccessful. The mere
suggestion, however, of a scheme of this
kind is a matter for which little credit can be
claimed, since it is one which would
naturally arise in the mind of almost any
person familiar with the phenomena of
electricity; but the bringing it forward at the
proper moment when the developments of
science are able to furnish the means of
certain success, and the devising a plan for
carrying it into practical operation, are the
grounds of a just claim to scientific
reputation as well as to public patronage.
About the same time with yourself,
Professor Wheatstone, of London, and Dr.
Steinheil, of Germany, proposed plans of the
electro magnetic telegraph, but these differ
as much from yours as the nature of the
common principle would well permit; and
unless some essential improvements have
lately been made in these European plans, I
should prefer the one invented by yourself.
With my best wishes for your success, I
remain, with much esteem yours, truly,
JOSEPH HENRY.
Professor Morse.

No. 12.
Report of the American Institute on the
Electro Magnetic Telegraph.
New York, September 12, 1842.
The undersigned, the committee of arts
and sciences of the American Institute,
respectfully report:
That, by virtue of the power of adding to
their numbers, they called to their aid the
gentlemen whose names are hereunto
annexed, with those of the original members
of the committee, and proceeded to
examine Professor Morse’s electro magnetic
telegraph.
Having investigated the scientific
principles on which it is founded, inspected
the mechanism by which these principles are
brought into practical operation, and seen
the instruments in use in the transmission
and return of various messages, they have
come to the conclusion that it is admirably
adapted to the purposes for which it is
intended, being capable of forming words,
numbers, and sentences, nearly as fast as
they can be written in ordinary characters,
and of transmitting them to great distances
with a velocity equal to that of light. They,
therefore, beg leave to recommend the
telegraph of Professor Morse for such
testimonials of the approbation of the
American Institute as may in its judgment
be due to a most important practical
application of high science, brought into

successful operation by the exercise of much
mechanical skill and ingenuity.
All which is respectfully submitted.
JAMES RENWICK, LL. D.,
Prof. Chem. and Nat. Phil., Columbia Col.,
N. Y.
JOHN W. DRAPER, M. D.,
Prof. Chem. and Min., University, city of
New York.
WILLIAM H. ELLET, M. D.
Prof. Chem., &c. Col. of Columbia, S. C.
JAMES R. CHILTON, M. D.,
Chem., &c., New York.
G. C. SCHAEFFER,
Associate Prof. Chem., Columbia Col., N. Y.
EDWARD CLARK.
CHARLES A. LEE, M. D.
Extract from the minutes of the Institute:
Resolved, That the report be accepted,
adopted, and referred to the premium
committee, and that the recording secretary
be directed to publish the same, at the
expense of the Institute.
No. 13.
Letter from S. F. B. Morse to the Hon. C. G.
Ferris.

New York, December 6, 1842.
Dear Sir: In compliance with your
request, I give you a slight history of my
electro magnetic telegraph, since it was
presented for the consideration of Congress,
in the year 1838.
During the session of the 25th Congress,
a report was made by the Committee on
Commerce of the house, which concluded by
unanimously submitting a bill appropriating
$30,000 for the purpose of testing my
system of electro magnetic telegraphs. The
pressure of business at the close of that
session prevented any action being taken
upon it.
Before the session closed, I visited
England and France, for the double purpose
of submitting my invention to the test of
European criticism, and to secure to myself
some remuneration for my large
expenditures of time and money in
elaborating my invention. In France, after a
patent had been secured in that country, my
telegraph first attracted the attention of the
Academy of Sciences, and its operation was
shown, and its principles were explained, by
the celebrated philosopher, Arago, in the
session of that distinguished body of learned
men, on September 10, 1838. Its reception
was of the most enthusiastic character.
Several other societies, among which were
the Academy of Industry and the
Philotechnic Society, appointed committees
to examine and report upon the invention,

from all which I received votes of thanks,
and from the former the large medal of
honour. The French Government at this time
had its attention drawn to the subject of
electric telegraphs, several systems having
been presented for its consideration, from
England, Germany and France. Through the
kind offices of our minister at the French
Court, General Cass, my telegraph was also
submitted; and the Minister of the Interior
(M. Montalivet) appointed a commission, at
the head of which was placed M. Alphonse
Foy, the administrator-in-chief of the
telegraphs of France, with directions to
examine and report upon all the various
systems which had been presented. The
result of this examination (in which the
ingenious systems of Professor Wheatstone,
of London, of Professor Steinheil, of Munich,
and Professor Masson, of Caen, passed in
review) was a report to the Minister in favor
of mine. In a note addressed to me by M.
Foy, who had expressed his warmest
admiration of my telegraph in my presence,
he thus writes:
“I take a true pleasure in confirming to
you in writing that which I have already had
the honor to say to you viva voce, that I
have prominently presented (signalé) to
Monsieur the Minister of the Interior your
electro magnetic telegraph, as being the
system which presents the best chance of a
practical application; and I have stated to
him that if some trials are to be made with
electric telegraphs, I hesitate not to

recommend that they should be made with
your apparatus.”
In England, my application for a patent
for my invention was opposed before the
Attorney General by Professor Wheatstone
and Mr. Davy, each of whom had systems
already patented, essentially like each other,
but very different from mine. A patent was
denied me by the Attorney General, Sir John
Campbell, on a plea which I am confident
will not bear a legal examination. But there
being no appeal from the Attorney General’s
decision, nor remedy, except at enormous
expense, I am deprived of all benefit from
my invention in England. Other causes than
impartial justice evidently operated against
me. An interest for my invention, however,
sprung up voluntarily, and quite
unexpectedly, among the English nobility
and gentry in Paris, and, had I possessed
the requisite funds to prosecute my rights
before the British Parliament, I could
scarcely have failed to secure them, so
powerfully was I supported by this interest
in my favour; and I should be ungrateful did
I not take every opportunity to acknowledge
the kindness of the several noblemen and
gentlemen who volunteered to aid me in
obtaining my rights in England, among the
foremost of whom were the Earl of Lincoln,
the late celebrated Earl of Elgin, and the
Hon. Henry Drummond.
I returned to the United States in the
spring of 1839, under an engagement
entered into in Paris with the Russian

Counsellor of State, the Baron Alexandre de
Meyendorff, to visit St. Petersburg with a
distinguished French savant, M. Amyot, for
the purpose of establishing my telegraphic
system in that country. The contract,
formally entered into, was transmitted to St.
Petersburg, for the signature of the Emperor,
which I was led to believe would be given
without a doubt; and, that no time should
be lost in my preparations, the contract, duly
signed, was to be transmitted to me in in
New York, through the Russian ambassador
in the United States, in four or five weeks, at
farthest, after my arrival home.
After waiting, in anxious suspense, for as
many months, without any intelligence, I
learned indirectly that the Emperor, from
causes not satisfactorily explained, refused
to sign the contract.
These disappointments, (not at all
affecting the scientific or practical character
of my invention,) combined with the
financial depression of the country,
compelled me to rest a while from further
prosecuting my enterprise. For the last two
years, however, under many discouraging
circumstances, from want of the requisite
funds for more thoroughly investigating
some of the principles involved in the
invention, I have, nevertheless, been able to
resolve all the doubts that lingered in my
own mind, in regard to the perfect
practicability of establishing my telegraphic
system to any extent on the globe. I say,
“doubts that lingered in my own mind;” the

principle, and, indeed, the only one of a
scientific character, which at all troubled me,
I will state, and the manner in which it has
been resolved:
At an early stage of my experiments, I
found that the magnetic power produced in
an electro magnet, by a single galvanic pair,
diminished rapidly as the length of the
conductors increased. Ordinary reasoning on
this fact would lead to a conclusion fatal to
the whole invention, since at a great
distance I could not operate at all, or, in
order to operate, I should be compelled to
make use of a battery of such a size as
would render the whole plan in effect
impracticable. I was, indeed, aware, that by
multiplying the pairs in the battery—that is,
increasing the intensity of its propulsive
power, certain effects could be produced at
great distances, such as the decomposition
of water, a visible spark, and the deflection
of the magnetic needle. But as magnetic
effects, except in the latter case, had not, to
my knowledge been made the subject of
careful experiment, and as these various
effects of electrical action seemed, in some
respects, to be obedient to different laws, I
did not feel entirely assured that magnetism
could be produced by a multiplication of
pairs sufficiently powerful at a great distance
to effect my purpose. From a series of
experiments which I made, in conjunction
with Professor Fisher, during the last
summer, upon 33 miles of wire, the
interesting fact so favorable to my

telegraphic system, was fully verified, that
while the distance increased in an
arithmetical ratio, an addition to the series
of galvanic pairs of plates increased the
magnetic power in a geometric ratio. Fifty
pairs of plates were used as a constant
power. Two miles of conductors at a time,
from two to thirty-three, were successively
added to the distance. The weight upheld by
the magnet from the magnetism produced
by 50 pairs, gradually diminished up to the
distance of 10 miles; after which, the
addition of miles of wire up to 33 miles (the
extent to which we were able to try it)
caused no further visible diminution of
power. The weight then sustained was a
constant quantity. The practical deduction
from these experiments is the fact that with
a very small battery all the effects I desire,
and at any distance, can be produced. In
the experiments alluded to, the fifty pairs
did not occupy a space of more than 8 cubic
inches, and they comprised but 50 square
inches of active surface.
The practicability of establishing my
telegraphic system is thus relieved from all
scientific objections.
Let me now turn your attention, sir, one
moment to a consideration of the telegraph
as a source of revenue. The imperfections of
the common systems, particularly their
uselessness, on account of the weather,
three quarters of the time, have concealed
from view so natural a fruit of a perfected
telegraphic system. So uncertain are the

common telegraphs as to time, and so
meager in the quantity of intelligence they
can transmit under the most favorable
circumstances, that the idea of making them
a source of revenue would not be likely to
occur. So far, indeed, from being a source of
revenue, the systems in common use in
Europe are sustained at great expense; an
expense which, imperfect as they are, is
justified, in the view of the Government, by
the great political advantages which they
produce. Telegraphs with them are a
Government monopoly, and used only for
Government purposes. They are in harmony
with the genius of those Governments. The
people have no advantage from them,
except indirectly as the Government is
benefitted. Were our mails used solely for
the purpose of the Government, and private
individuals forbidden to correspond by them,
they would furnish a good illustration of the
operation of the common European
telegraphic systems.
The electro magnetic telegraph, I would
fain think, is more in consonance with the
political institutions under which we live, and
is fitted, like the mail system, to diffuse its
benefits alike to the Government and to the
people at large.
As a source of revenue, then, to the
Government, few, I believe, have seriously
computed the great profits to be derived
from such a system of telegraphs as I
propose; and yet there are sure data already

obtained by which they can be
demonstrated.
The first fact is, that every minute of the
24 hours is available to send intelligence.
The second fact is, that 12 signs, at
least, can be sent in a minute,
instantaneously, as any one may have proof
by actual demonstration of the fact on the
instrument now operating in the capitol.[15]
There can be no doubt that the cases,
where such speedy transmission of
intelligence from one distant city to another
is desirable, are so numerous, that when
once the line is made for such transmission,
it will be in constant use, and a demand
made for a greater number of lines.
The paramount convenience, to
commercial agents and others, of thus
corresponding at a distance, will authorize a
rate of postage proportionate to the
distance, on the principle of rating postage
by the mails.
To illustrate the operation of the
telegraph in increasing the revenue, let us
suppose that but 18 hours of the 24 are
efficiently used for the actual purposes of
revenue; that 6 hours are allowed for
repetitions and other purposes, which is a
large allowance. This would give, upon a
single circuit, 12,960 signs per day, upon
which a rate of postage is to be charged.
Intelligence of great extent may be
comprised in a few signs. Suppose the

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