The Fraud Triangle: Three Conditions That Increase the Risk of Fraud
The key to deterring fraud is to understand how and why people commit fraud. Knowing the “how” helps managers and business owners create policies and design internal controls to reduce the occurrence of fraud. The “why” is much more complicated, but just (if not more) important. There are three conditions that, when present in varying degrees, increase the risk of fraud: (1) the pressure to commit fraud, (2) the opportunity to commit fraud, and (3) the rationalization of committing the fraud.
The pressure, or incentive, to commit fraud is the reason why a person commits fraud. There are several reasons a person would feel the need to commit fraud: feelings of resentment toward a manager or the company as a whole, personal financial problems (e.g., mounting medical bills, gambling debts, spouse laid off from their job), employee’s compensation tied to financial performance, and greed among others. The reason the employee commits the fraud can change over time. For example, several of the fraud investigations we have worked on started off as embezzling funds to take care of a personal financial problem and then changed to greed once the financial hardship had been solved. Companies can help alleviate some of this pressure by providing programs where employees can seek anonymous help in their time of need. These programs can range from providing resources for a person battling addiction, to setting achievable, realistic goals for compensation purposes based on input from the employee.
The opportunity to commit fraud is the circumstances that allow fraud to occur and is the only condition over which the company has complete control. For example, an employee who is in a position that gives him or her the ability to add vendors and write checks realizes he or she has the opportunity to write checks to a ghost vendor. Opportunities to commit fraud are more commonly present in organizations that have poor internal controls because it makes it easier for the employee to commit fraud and provide a low-risk environment for getting caught. However, companies with ample internal controls are still susceptible to fraud if controls can be overridden by management. If the internal control system is designed in a way that the risk of getting caught is too high, the employee will likely not exploit the perceived opportunity for his or her personal gain. Without opportunity, fraud generally cannot occur.
Rationalization of committing fraud is the most difficult condition to observe because it takes place in the mind of the perpetrator. Rationalization has to do with justifying the fraud. Since many fraudsters view themselves as honest, ordinary people and not as criminals, they have to come up with some reasoning to make the act of committing fraud more acceptable to them. Some common rationalization statements are “I’ll just take this money now and pay it back later,” “No one will notice,” or “I deserve this after all these years with this company.” Some fraudsters rationalize his or her behavior by reframing their definition of wrongdoing to exclude his or her actions.
All three conditions (i.e., pressure, opportunity and rationalization) must be present in varying degrees in order for fraud to occur. A financially strapped employee is not going to commit fraud if the opportunity is not available, or if the risk of getting caught is too high. Similarly, a person who perceives an opportunity to misrepresent financial statements and has the incentive to commit the fraud is unlikely to do so if he or she cannot rationalize the fraud. However, the more pressure a person feels to commit fraud, the easier he or she can justify it. Being aware of these three conditions can help managers and business owners minimize the risk of fraud in their organizations.
If you have any questions on preventing fraud in your organization, please contact an Anders advisor.