What Is the Triangle of Fraud?
You’ll hear auditors referring to the triangle of fraud. That’s because in most fraudulent acts, three circumstances lead to the commission of fraud: the incentive to commit fraud, the opportunity to carry out the fraudulent act, the ability to rationalize or justify the fraud.
For fraud to occur, all three sides of the triangle must be present.
Management employees may perpetrate fraud differently from non-management employees. However, overlap between the two groups may exist. A manager, for example, may commit fraud based on an incentive listed in the upcoming non-management list.
Incentives to commit fraud that apply to all employees
Incentives exist when an employee has an overriding reason to steal from the company. Sometimes the employee has bills he can’t pay or a money-sucking addiction. Of course, the incentive could merely be greed.
Here are some red flags to consider when looking for fraud among management and non-management employees:
The employee’s spouse has lost a job.
The employee is divorced and has expensive child or spousal support payments.
The employee or his spouse or child is involved in civil or criminal proceedings.
The employee has a drug, alcohol, or gambling problem.
The employee purchased a new home with an accelerating variable rate mortgage.
The employee never takes a vacation (in an attempt to conceal the fraud).
To identify at-risk employees, consider whose paychecks are being garnished by the court system in order to pay for child support or alimony. Also, look at payroll records to see who has accrued substantial vacation or sick leave. (Reporting the accrual is required by GAAP.)
Management incentives to commit fraud
Managers are often motivated to commit fraud because of the way they’re compensated. For example, a department manager may be angling for a higher raise at year’s end. How well each department performs could be senior management’s method of allocating available bonuses to the managers. A common performance measure is comparing actual department expenses to the budget.
Suppose the department manager artificially forces expenses to stay under budget to get a bigger bonus. For example, she may fail to book reasonable warranty estimates. Booking warranty estimates takes place whenever a company sells a product with a warranty. The company has to recognize the estimated repair expense it may incur to fix the product over the life of the warranty. Low-balling the estimate reduces expenses.
Other methods of deflating expenses include manipulating inventory and purchase expenses. Higher inventory figures reduce the cost of goods sold expense. Waiting to record current purchases until after the end of the year also serves to reduce expenses.
What about fraud among senior management? What would be the incentive? People in senior management often have a relatively low salary with the bulk of their compensation coming from bonuses tied to company results.
Under these circumstances, strong motivation exists to do things to increase net income, such as book revenue before it’s earned. This fraud takes place if the revenue is recorded in the books prior to making the good or service available to the customer.
Another senior-management incentive is pressure from outside sources, such as the board of directors or shareholders. Shareholders, who are interested in protecting their investments, want to see positive numbers on the financial statements. Keeping the board of directors happy is in the best interest of senior management, and some managers may believe that pleasing the board is more important than acting with integrity.
Opportunities for fraud
Regardless of the strength of the incentive, fraud can take place only if the opportunity is present. The opportunity for fraud can come in many forms. Here are some examples of circumstances that can open the door to fraudulent transactions:
Weak internal controls: Strong internal controls are a business’s first line of defense. For example, a billing department has an internal control to establish and enforce a mandatory credit limit for new customers.
No segregation of duties: An employee has an opportunity for fraud when the company has no segregation of duties; that is, one employee handles several related tasks. Lack of shared responsibility combined with incentive can make the temptation to steal overwhelming.
Indifferent management: Sometimes management doesn’t enforce the internal controls set in place. For example, many companies require that department heads approve any purchases over a certain dollar amount. Poor managers approve any and all purchases without asking why the purchases are needed, because they’re too lazy to get involved.
Ineffective monitoring of management: This takes place when the company is small and has few managers. If the corporate structure is one officer — the president — with all employees reporting directly to that person, the head honcho has ample opportunity for fraud.
Rationalizing the fraudulent act
Employees go through a thought process to justify fraud — at least to themselves. In some cases, the employee’s rationale is that he works harder than the owner. In the employee’s eye, the owner is vastly overpaid, and, therefore, a little fraud on the part of the employee levels the playing field.
A major red flag of rationalization on the part of management is firing or forcing an auditor to withdraw from the engagement. When the company starts telling the auditor how to do the job, that’s the ultimate in rationalization. That’s why you must request a potential client’s permission to speak with the predecessor auditor. If the predecessor auditor parted ways because of fraud, run away from this company.
Keep in mind that the employee could also have some sort of psychiatric illness or personality disorder that prevents him from being able to control his actions. Or the employee may lack the ability to realize or care that his actions are inappropriate. Nor does the worker stop to consider the consequences of his actions. In these truly sad situations, the employee is very likely to be caught.