The three aspects of opportunity, incentive (or pressure), and rationalisation are known as the "fraud triangle" in forensic accounting and criminology. According to the notion, when these three criteria coincide, someone is more likely to participate in fraudulent activity. Organisations can identify possible points of vulnerability and put preventative measures in place to lessen the risk of fraud by understanding the fraud triangle.
Fraud is a serious problem that affects many organisations and individuals. Fraud can be defined as the intentional deception or misrepresentation of facts for personal gain or to cause harm to others.
But what motivates someone to commit fraud? And what factors make fraud more likely to occur? One way to answer these questions is to use the fraud triangle theory.
The fraud triangle theory is a model that explains how three elements of the fraud triangle - pressure, opportunity, and rationalisation - interact to create a situation where fraud can happen.
Understanding the fraud triangle theory can help us identify the signs of fraud, prevent it from happening, and detect it when it occurs.
This blog will explain the fraud triangle's meaning, elements, and theory in detail. We will also provide some examples of how the fraud triangle applies to different types of fraud and how we can use it to protect ourselves and our organisations from fraudsters.
Did you know?
In the 1950s, prominent criminologist Donald Cressey created the fraud triangle theory. Cressey did an in-depth study on embezzlement cases and spoke with many people who had been convicted before putting up the hypothesis as a framework to explain their motivations and actions.
Understanding Fraud Tringle Framework
The theory was developed by Donald Cressey, a criminologist who studied the behaviour of embezzlers. The fraud triangle can be understood through the fraud risk factors.
Fraud risk factors are those that may encourage or prompt fraud inside or outside an organisation.
The following are the elements of the fraud triangle framework:
Incentive or Pressure to Commit Fraud
- The incentive to commit fraud can arise from insufficient internal control in the organisation or where sufficient internal control exists, and it cannot prevent or detect fraud if any arises.
- The pressure to commit fraud can arise from the source inside or outside the organisation to achieve expected earning targets, and the management is under pressure at the reporting date or earning calls to manipulate the accounts and polish the financial reports.
The following are risk factors relating to incentive or pressure to commit fraud:
1. High Degree of Competition: A high degree of competition in the marketplace indicates low-profit margins and poor financial results may pressure the management to commit fraud.
2. Inadequate Accounting Policies: Management biases in selecting and adopting accounting policies may result in better financial reports. In contrast, concise avoidance of accounting policies showing poor financial results may make them susceptible to poor corporate governance, incentivising fraud.
3. Management Poor Ethical Values: Management commitment to ethical values and enforcing high integrity within the organisation and its communication that may arise an organization-wide commitment to high ethical values may create a productive work culture.
Hiring a competent workforce with the requisite skills and knowledge may reduce the incentive to commit fraud.
Following are a few guiding factors for high ethical values:
- Management approach and policies designed to mitigate or manage business risks
- The attitude of management toward financial reporting
- How the management has established authority and responsibility framework for operating activities and whether hierarchies are designed to facilitate the cross-checking of each other work.
- Policies and practices relating to human resources, such as imparting adequate training for the work assigned.
Also Read: Forfaiting: How It Works, Pros and Cons, vs Factoring and Examples
Opportunities to Commit Fraud
Opportunities to commit fraud may arise from the management or others within the organisation believing that the controls can be overridden or the person is in a position of trust and knowledge of the deficiencies of the internal controls.
Opportunity can also arise from weak internal controls, lack of oversight, poor security, or trust and access to information or assets.
The following are the risk factors relating to opportunities to commit fraud:
1. Override of Controls
In an organisation, Management is in the position of most trust and knowledge of all the controls. The policies and the framework for the design and implementation of the controls are prepared by the management, and therefore, they can be easily overridden by the management.
Following are a few techniques through which controls can be overridden:
- Recording fictitious journal entries, particularly on important reporting dates such as quarterly earning calls
- Inappropriate accounting assumptions or judgments in making provisions or making estimates for fair financial reposting
- Altering records and terms of related party transactions or in case of significant unusual transactions
- Counselling or not disclosing a particular fact is significant for the user’s understanding of financial positions.
2. Insufficient Internal Control System
An insufficient internal control system may incentivise employees to commit fraud. A system containing design flaws may provoke those within the organisation to embezzle cash or other assets in the low denomination.
For example - Where scarp assets are sold without issuing any cash receipt voucher.
3. Significant Related Party Transactions
Through the existence of a related party, transactions do not prompt a case of fraud. However, the related party transactions are usually complex and may involve a complex network of transactions to present a polished picture of the company's state of affairs.
The related party transactions are significant fraud risk factors that may provoke an opportunity to commit fraud. For example - Inter-corporate loans or book adjustments between subsidiaries at the end of the financial year.
A person committing fraud may rationalise his act of wrongdoing. Some individuals possess a set of ethical values, character, or an attitude that allows them to commit dishonest acts intentionally.
Even an honest individual can commit fraud if put into an environment that imposes sufficient pressure on them. An organisation needs to hire a committed workforce that believes in the values and objectives of the organisation.
Following are a few fraud risk factors related to Rationalisation:
1. Personal Issues of the Employees
An accountant may be facing personal financial problems due to gambling debts and medical bills. They see an opportunity to embezzle funds from the company by creating false vendors and approving payments to themselves.
They rationalise their fraud by thinking they will pay back the money when they win the lottery or gets a raise.
2. Lack of Proper Checks
A sales manager may be pressured to meet their quota and receive a bonus. They see an opportunity to inflate their sales numbers by creating fake invoices and customers.
They rationalise their fraud by thinking they deserve the bonus and no one will notice their deception.
3. Dissatisfied Workforce
A warehouse supervisor may be unhappy with a low salary and lack of recognition. They see an opportunity to steal inventory from the company by falsifying records and receipts.
They rationalise their fraud by thinking that the company owes them more.
The fraud triangle is a framework that helps to understand the factors that motivate individuals to commit fraud in their workplaces—three components of the fraud triangle: opportunity, incentive/pressure, and rationalisation.
Opportunity refers to the circumstances that allow fraud to occur, such as weak internal controls or poor tone at the top. Incentive or pressure refers to the personal or professional reasons that drive someone to commit fraud, such as financial difficulties or unrealistic targets.
Rationalisation refers to how someone justifies their fraudulent actions, such as feeling entitled or wronged by the organisation. By understanding the fraud triangle, auditors and managers can design and implement measures to prevent, detect, and deter fraud in their organisations.
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