To deter, detect and investigate fraud, business leaders must understand how and why people commit fraud. Knowing the “how” helps managers and business owners create policies and design internal controls to reduce fraud risks. The “why” is more nuanced, but it is just as important in understanding fraud.
The fraud triangle has endured through the decades as a metaphorical diagram to help business owners understand and analyze fraud. The concept states that there are three factors which, together, lead to fraudulent behavior. They are (1) a perceived un-shareable financial need (motive/pressure), (2) a perceived opportunity to commit fraud, and (3) the rationalization of committing fraud.
The “How”
The “opportunity” element of the fraud triangle refers to the circumstances that allow fraud to occur. Without it, fraud becomes impossible. This is the only portion of the fraud triangle over which a business has control.
According to the ACFE’s 2020 Report to the Nations, 32% of reported fraud cases arise in organizations that lack internal controls. However, even in organizations with a robust control environment, fraud is possible if employees circumvent controls. This is accomplished in a number of ways, including collaboration by multiple employees or a lack of management review.
Far too many fraud cases come to us where an employee was placed in a position of complete trust that they then betrayed. A well-designed system of internal controls paired with strong “tone at the top” and management oversight are the best ways for a company to reduce fraud opportunities. And remember, trust is NOT an internal control! The next section explains why.
The “Why”
Whether referred to as pressure, motive, or incentive, another key element of fraud is a perceived financial need on the part of the fraud perpetrator. It is the reason why a person commits fraud.
There is a nearly endless list of reasons a person would feel the need to commit fraud. It can be personal financial problems, such as mounting medical bills, gambling debts or a spouse laid off from their job, employee’s compensation tied to financial performance, or good old-fashioned greed. The reason the employee commits fraud may also evolve over time. For example, several of the fraud investigations we have worked on began with employee embezzling funds to take care of a personal financial problem and then changed to greed once the financial hardship has been resolved.
Companies help alleviate some of this pressure by providing programs where employees seek anonymous help in their time of need. These programs range from providing resources for a person battling addiction, to setting achievable, realistic goals for compensation purposes based on input from the employee. Management should always seek to be in-tune with the needs of their employees as much as possible.
How Do Fraudsters Sleep at Night?
Rationalization of committing fraud is the most difficult condition to observe because it takes place in the mind of the perpetrator. Rationalization involves fabricating a moral excuse to justify the fraud. Many fraudsters view themselves as honest, ordinary people and not as criminals, so they have to come up with some reasoning to reconcile the act of committing fraud with their own personal code of ethics.
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 fraudulent activities by re-framing their definition of wrongdoing to exclude his or her actions. In certain rare cases, fraudsters seem to abandon their moral code entirely.
The Perfect Storm
The convergence of these three conditions: pressure, opportunity and rationalization, form a high-risk environment ripe for fraud. Each element interacts with the others. While an employee may have a high degree of financial pressure, they won’t commit fraud if there is no perceived opportunity or if the risk of detection is too high. Meanwhile a sufficiently compensated, content employee with little financial pressure is not likely to commit fraud, even if they may have the opportunity to do so. 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 knows it is wrong and cannot rationalize the fraud. However, as the pressure to commit occupational fraud increases, a potential fraudster may begin to see more opportunities to circumvent weak internal controls and may begin to rationalize these behaviors in their head. Keeping the components of the fraud triangle in mind helps managers and business owners minimize the risk of fraud in their organizations and design procedures to reduce financial losses.
An Intro to Fraud Prevention
There’s no time to wait when it comes to fraud prevention. Fraudsters quickly take advantage of businesses if they see a way to commit fraud and the right pressures are in place. The first strategy your business should put in place is segregation of duties. Small and medium-sized organizations often struggle with implementing proper segregation of duties due to limited staff, resulting in one or two individuals managing the entire accounting process. If this is a problem for your business, consider outsourcing accounting functions or having a business leader oversee certain cash management tasks to prevent corruption.
Next, access to accounting systems should also be restricted when possible. Open access allows employees to manipulate financial data and commit fraud. Assigning different access levels or outsourcing accounting functions with administrative controls significantly reduces the risk of fraudulent activity.
Payroll departments are another area vulnerable to fraud, such as inflated timesheets or payments to fictitious employees. Small and medium-sized companies that manage payroll internally face a higher risk of such issues. Outsourcing payroll introduces stronger controls and oversight, including time tracking systems reviewed by external accountants.
If you suspect internal fraud, a forensic accountant can perform a fraud examination to determine if there are indications of fraudulent activity. Do you have additional questions on fraud protection or suspect fraud may have already occurred at your organization? Contact an Anders advisor below. Learn more about Anders Forensic, Valuation and Litigation services.
