In: Accounting
Briefly define each of the three elements of the fraud triangle and the fourth element of the fraud diamond.
The fraud triangle is used to explain the motivation behind a fraud. However, what exactly is fraud?
Fraud refers to a deception that is intentional and caused by an employee or organization for personal gain. In other words, fraud is a deceitful activity used to gain an advantage or generate an illegal profit. In addition, the illegal act benefits the perpetrator and harms other parties involved.
For example, an employee that pockets cash from the company’s register is committing fraud. The employee would benefit from getting additional cash at the expense of the company.
Below, we discuss the components in the fraud triangle that contribute to increasing the risk of fraud.
The Fraud Triangle components
Opportunity
Opportunity refers to circumstances that allow fraud to occur. In the fraud triangle, it is the only component that a company exercises complete control over. Examples that provide opportunities for committing fraud include:
1. Weak internal controls
Internal controls are processes and procedures implemented to ensure the integrity of accounting and financial information. Weak internal controls such as poor separation of duties, lack of supervision, and poor documentation processes give rise to opportunities for fraud.
2. Poor tone at the top
Tone at the top refers to upper management and board of directors’ commitment towards being ethical, showing integrity, and being honest. A poor tone at the top results in a company that is more susceptible to fraud.
3. Inadequate accounting policies
Accounting policies refer to how items on the financial statements are recorded. Poor (inadequate) accounting policies may provide an opportunity for employees to manipulate numbers.
Incentive
Incentive, alternatively called pressure, refers to an employee’s mindset towards committing fraud. Examples of things that provide incentives for committing fraud include:
1. Bonuses based on a financial metric
Common financial metrics used to assess the performance of an employee are revenues and net income. Bonuses that are based on a financial metric creates pressure for employees to meet targets which, in turn, may cause them to commit fraud to achieve the objective.
2. Investor and analyst expectations
The need to meet or exceed investor and analyst expectations can create pressure to commit fraud.
3. Personal incentives
Personal incentives may include wanting to earn more money, the need to pay personal bills, a gambling addiction, etc.
Rationalization
Rationalization refers to an individual’s justification for committing fraud. Examples of common rationalizations that fraud committers use include:
1. “They treated me wrong”
An individual may be spiteful towards their manager or employer and believe that committing fraud is a way of getting payback.
2. “Upper management is doing it as well”
A poor tone at the top may cause an individual to follow in the footsteps of those higher in the corporate hierarchy.
3. “There is no other solution”
An individual may believe that they might lose everything (for example, losing a job) unless he or she commits fraud.
Now the fourth element of Fraud Diamond is
Capacity
A person’s position or function within a company may give him or her the ability to create or exploit an opportunity for fraud not available to others. According to Wolfe and Hermanson (2004), the fraudster also has the necessary traits and abilities to be the right person to pull it off, and that this person has recognized this particular fraud opportunity and can turn it into reality. Wolfe and Hermanson identified important observable traits related to individuals’ capacity to commit fraud. Those threats include: (a) authoritative position or function within the organization; for example, a CEO might have the ability to influence and perpetuate frauds due to his or her position within the organization; (b) intelligence to exploit the accounting and internal control systems’ weaknesses to the greatest advantage and have the ability to understand how the system works; (c) ego and confidence that fraudulent behaviors will not be detected, which will have an impact on their decision-making process; thus, the more confident they are, the greater chance that they will commit fraud; and (d) capability to effectively deal with stress due to the risk of getting caught and manage the fraud over a long period of time. That person also must effectively and consistently lie to avoid detection and may even have to persuade others to believe that fraud does not take place.