Articles & Alerts
Understand the Fraud Triangle to Help Combat Occupational Fraud
Occupational fraud costs companies an estimated 5% of their revenue every year. On a global scale, that represents approximately $4 trillion lost annually. Despite these figures from the Association of Certified Fraud Examiners’ 2018 Global Study On Occupational Fraud And Abuse (ACFE Study), many companies fail to incorporate comprehensive policies and procedures to prevent, detect and mitigate fraud. Gaining an understanding of the Fraud Triangle can help management, accountants and counsel develop proper internal controls to help combat fraud in the workplace.
What is the Fraud Triangle?
The concept of the Fraud Triangle is generally credited to American sociologist Donald R. Cressey who worked in the fields of criminology and white-collar crime. The Fraud Triangle outlines three elements that are typically present when an individual commits occupational fraud – Pressure, Opportunity and Rationalization. All of these elements are typically present, so effectively addressing any one of them will help minimize the fraud risk. However, to the extent possible, companies should try to counteract all three factors.
“Pressure” refers to the motivation of the employee – that is, what is driving him or her to commit fraud. These pressures may be unrelated to work, and are rather personal in nature, such as overwhelming debt, addiction, divorce, or other family issues. However, there may also be work-related pressures, such as high demands by supervisors regarding meeting financial targets or performance-related bonuses.
“Opportunity” to commit fraud is a risk factor that is heightened where internal controls are weak or non-existent. Companies with strong controls in place help to limit opportunities for employees to commit larceny or engage in fraudulent financial reporting. Companies with limited or no internal controls, such as lack of segregation of duties and/or little supervisory oversight, provide an easy opening for fraud to be perpetrated. For example, a business is at greater risk of fraud if the same employee is responsible for opening mail from customers, depositing checks, preparing billing and tracking customers’ accounts receivables. In this situation, an employee has more opportunities to divert funds into his or her pocket than an employee at a company that segregates responsibilities among a few employees so that their access to various corporate records and resources is limited, thereby reducing the opportunity to commit fraud.
“Rationalization” is the final factor and it is how the perpetrator justifies his or her fraud. For instance, a person may feel it is permissible to steal because an injustice was done to him or her, such as not getting paid a fair compensation or management not caring about their overburdened workload. Rationalization can also occur if an employee sees his or her superior displaying unethical behavior and getting away with it. In this situation, the employee may feel as though management is not concerned with creating an ethical environment and unethical behavior is tolerated or overlooked.
How can companies prevent and detect fraud?
The Fraud Triangle helps companies understand how and why fraud is committed so they can take proactive measures to address the causes of fraud before it occurs and better detect fraud if and when it does occur.
First, employers can attempt to limit the pressure on employees. It may not be possible to address all pressures on employees, especially if the pressure is from external sources. Yet, appropriate employment policies, such as employee assistance programs and appropriate levels of time off may help. In addition, financial and performance goals should be reviewed to ensure they are reasonably attainable and appropriately communicated to employees.
Next, to address the rationalization aspect, it is important for companies to create a corporate culture that truly values employees, sets proper ethical codes of conduct, and insists on accountability. For example, companies can promote work/life balance, conduct performance reviews, adopt an ethics code, create a hotline for reporting abuses by employees, provide rewards for whistleblowers and thoroughly investigate and respond to complaints. According to the ACFE Study, many of these tactics can have a significant impact on reducing the amount and duration of a fraud.
Last, but critical to limiting risks of fraud, companies should ensure that internal controls are in place and operating effectively to reduce the opportunity to commit fraud. An operational review conducted by an independent third party can help companies identify their risks, evaluate their internal controls and make recommendations on where improvements can be made. The review should be comprehensive involving not just employees with direct access to financial and accounting records, but also employees in operations and other departments, including staff within the company and outside vendors and customers. These reviews should be done periodically to ensure that changes within the company, such as an increase in the volume of business, additional business locations, changes in personnel, changes in the use of technology and other operational changes, have not caused internal controls to erode.
Companies should not only implement strong controls; they should also continually engage in fraud detection. As noted by the ACFE Study, “organizations that do not actively seek out fraud are likely to experience schemes that continue for much longer and at a higher cost.”
The key takeaway is management, with advice from corporate counsel and accountants, has the power to identify and mitigate fraud risks. While there is no action that can completely eliminate fraud, implementing policies that address the three arms of the Fraud Triangle will not only help to reduce the risk of fraud, but will also aid in detecting fraud if it does occur.