Question

Explain the components of the Fraud Triangle.

Donald R. Cressey, a noted criminologist, is mostly credited with coming up with the concept of a Fraud Triangle. Albrecht points out that, while researching his doctoral thesis in the 1950s, Cressey developed a hypothesis of why people commit fraud. He found that trusted persons become trust violators when they conceive of themselves as having a financial problem that is nonsharable, are aware that this problem can be secretly resolved by violation of the position of financial trust, and are able to apply to their contacts in that situation verbalizations which enable them to adjust their conceptions of themselves as users of the entrusted funds or property.⁶ (Links to an external site.)

Edwin Sutherland, another criminologist, argued that persons who engage in criminal behavior have accumulated enough feelings and rationalizations in favor of law violation that outweigh their pro-social definitions. Criminal behavior is learned and will occur when perceived rewards for criminal behavior exceed the rewards for lawful behavior or perceived opportunity. So, while not directly introducing the Fraud Triangle, Sutherland did introduce the concepts of rationalizations and opportunities. It is interesting to think about how Sutherland’s thesis relies on a utilitarian analysis of harms and benefits of criminal behavior.⁷ (Links to an external site.)

The Fraud Triangle in auditing is discussed in AU-C Section 240. The deception that encompasses fraudulent financial reporting is depicted in Exhibit 5.2 (Links to an external site.).⁸ (Links to an external site.)

Three conditions generally are present when fraud occurs. First, management or other employees have an incentive or are under pressure, which provides the motivation for the fraud. Second, circumstances exist that provide an opportunity for a fraud to be perpetrated. Examples include the absence of, or ineffective, internal controls and management’s override of internal controls. Third, those involved are able to rationalize committing a fraudulent act.

As noted in the auditing standard, some individuals possess an attitude, character, or set of ethical values that allow them to commit a dishonest act knowingly and intentionally. For the most part, this is the exception rather than the rule. However, even honest individuals can commit fraud in an environment that imposes sufficient pressure on them. The greater the incentive or pressure, the more likely that an individual will be able to rationalize the acceptability of committing fraud.⁹ (Links to an external site.)

It is important for students to understand the link between elements of the Fraud Triangle and our earlier discussions about cognitive development. The disconnect between one’s values and actions may be attributable to motivations and incentives to act unethically, perhaps because of a perceived gain or as a result of pressures imposed by others who might try to convince us it is a one-time request or standard practice, or to be loyal to one’s supervisor or the organization. These also become rationalizations for unethical actions invoked by the perpetrator of the fraud.

Incentives/Pressures to Commit Fraud

The incentive to commit fraud typically is a self-serving one. Egoism drives the fraud in the sense that the perpetrator perceives some benefit by committing the fraud, such as a higher bonus or promotion. The fraud may be caused by internal budget pressures or financial analysts’ earnings expectations that are not being met. Personal pressures also might lead to fraud if, for example, a member of top management is deep in personal debt or has a gambling or drug problem. In a “60 Minutes” interview with Dennis Kozlowski, the former CEO of Tyco, Kozlowski said his motivation to steal from the company was to keep up with “the masters of the universe.” This meant keeping up with other CEOs of large and successful companies that had pay packages in the hundreds of millions. Kozlowski was generous with his lieutenants because he thought they would be loyal to the boss. In 2005, a jury found that Kozlowski and ex-CFO Marc Swartz stole about $137 million from Tyco in unauthorized compensation and made $410 million from the sale of inflated stock.

Opportunity to Commit Fraud

The second side of the Fraud Triangle connects the pressure or incentive to commit fraud with the opportunity to carry out the act. Employees who have access to assets such as cash and inventory should be monitored closely through an effective system of internal controls that helps safeguard assets. For example, the company should segregate cash processing responsibilities, including the opening of mail that contains remittance advices, along with checks for the payment of services; the recording of the Page 278receipts as cash and a reduction of receivables; the depositing of the money in the bank; and the reconciling of the balance in cash on the books with the bank statement balance. Obviously, when the fraud is perpetrated by the CEO and CFO, as was the case with Tyco, access is a given. Then, it is just a matter of circumventing the controls or overriding them or, in the case of Kozlowski, enlisting the aid of others in the organization to hide what was going on.

Rationalization for the Fraud

Fraud perpetrators typically try to explain away their actions as acceptable. For corporate executives, rationalizations to commit fraud might include thoughts such as “We need to protect our shareholders and keep the stock price high,” “All companies use aggressive accounting practices,” “It’s for the good of the company,” or “The problem is temporary and will be offset by future positive results.” In the Tyco case, Kozlowski stated in his “60 Minutes” interview that he wasn’t doing anything different from what was done by his predecessor. He took the low road of ethical behavior and rationalized his actions by essentially claiming that everyone (at least at Tyco) did what he did by misappropriating company resources for personal purposes. The fact is he established the culture that condoned such behavior.

Other rationalizations might include “My boss doesn’t pay me enough” or “I’ll pay the money back before anyone notices it’s gone.” The underlying motivation for the fraud in these instances may be dissatisfaction with the company and/or personal financial need. AU-C Section 240 (AU-C 240) provides an extensive list of risk factors that can contribute to the likelihood that fraudulent financial reporting will occur. These are presented in Exhibit 5.3 (Links to an external site.).

1. For discussion purposes: how can the fraud triangle help you identify and prevent fraud?

2. What are the 10-Q and 10-K used to report?

Answer 1

1. The fraud triangle is a theory used in audit at planning stage to understand the 3 sets of angle. Auditors often refer to the fraud triangle while reviewing the risk of fraud in an organization. Fraud triangle consists of-

(a) Incentive

(b) Oppourtunity

(c) Rationalization

Fraud means a deception that is intentional and caused by an employee or organization for personal gain. Simply, fraud is a deceitful activity used to earn illegal profit. In addition, the illegal act benefits the perpetrator and harms other parties involved.

Oppourtunity- refers to situation/circumstance that facilitates fraud-

i. Weak internal control

ii. Ineffective top management

iii. Accounting policies leave too much to desire

iv. Concentration of power

Incentive- Gain which can be made

i. Gain outweighs cost

ii. Outside pressure- analysts or management

iii. Performance linked bonuses

Rationalisation- justification to commit fraud-

i. Ego satisfaction

ii. Learned behaviours

iii. Feeling of hurt or bruises

Fraud triangle helps auditors plan their work effectively and perform satisfactory audit procedures to collect evidences.

2. Form 10K is annual report to be filed and mandatory requirement of US SEC (Security Echange Commission). Companies with more than $10 million in assets and a class of equity securities that is held by more than 2000 owners must file annual and other periodic reports, regardless of whether the securities are publicly or privately traded. This form includes financial information such as company history, organizational structure, executive compensation, equity, subsidiaries, and audited financial statements, among other information.

A Company is required to fileform 10Q quarterly by public companies which contains information of relevant information regarding their financial position. The 10-Q provides investors with the financial position of companies on an ongoing basis.