Question

Kruger Financing is a boutique investment firm with big ambitions. Masai, their CFO has been featured in multiple financial magazines and newspapers because the company has grown its investment revenues by an average of 25% in the past three years, while the industry average is about 7%.

On April 1, you read an article in the Financial Post Magazine in which Masai explains that he has been able to achieve this level of growth by providing a lot of autonomy to his sales staff. He says, “they are the people on the ground, talking to the clients, and they understand what they need. Businesses these days move fast; waiting a month for a loan to be disbursed could mean a lost opportunity for the businesses and for us. This is why our salespeople have the autonomy to disburse loans of up to $500,000 without going through our central credit department. I hire only the best, and I trust them to know a good opportunity when they see one. The small business loan has actually proven to be one of our most lucrative products.”

Masai goes on to explain that he motivates his sales staff by providing them with a large bonus incentive. For example, a salesperson at his company makes on average $68,000 of base salary, which is much lower than the industry average of $105,000. However, Kruger Financing has a very generous bonus system where employees receive a percentage of the fees earned on each financing transaction they close. With this, a salesperson could have a bonus of up to $150,000, while other companies in the industry normally cap bonuses at $40,000. The bonuses are paid out one month after year-end when all the results for the year have been reviewed.

On July 5, the cover of the Business Journal has a headline “Kruger Financing reports third-quarter loss due to internal fraud.” The article goes on to say that 20 Kruger Financing salespeople had issued loans in the range of $200,000 - $499,000 to themselves and close family members. The default rate on these loans was very high, so Kruger Financing has to take a write-down for its small business loans receivable.

A salesperson in the article was quoted as saying, “It was just hard sometimes to make it through the year on our base salary. You know you have all this money coming with your bonus at year-end, so you think you will just borrow the money and pay it back when you get your bonus. But then the bonus comes and you decide to keep it as you already spent the amount you borrowed and realize you need the bonus money for other expenses. If taking out a small business loan for yourself was so bad, why was it so easy to do?”

Required:

1.       Based on the fraud triangle, explain how each of the three factors (incentive, opportunity, and rationalization) were present, allowing a fraud to take place.

2.       What are some potential strategies and measures that Masai could put in place to reduce the risk of such occurrences happening again?

Answer 1

Solution:

1. The fraud triangle consists of three components; Incentive , Opportunity , and Rationalization .

Incentive, such as a financial need, may often provide a motive for committing the fraud. Examples of incentive that commonly lead to fraud include the need to meet earnings expectations to sustain investors confidence , the need to meet productivity targets at work, or simply the inability to pay one's bills. Opportunity, or perceived opportunity , defines the method by which the crime can be committed. The individual fraudster must see some way he or she can use his or her position of trust to solve the financial problem with a perceived risk of geting caught. For instance , an individual committing a fraud sees an internal control weakness and, believing no one will notice if funds are taken, begins the fraud with a small amount of money. If no one notices, the amount taken usually grows.

Finally, rationalization involves the individual fraudster justifying the crime to him or herself in a way that makes it an acceptable or justifiable act.Common rationalizations an individual may use include ; " i was underpaid; my employer cheated me" or " i was entitled to the money " or " i was only borrowing the money".