The Fraud Triangle

The research on fraud has identified three key factors that determine whether a person will commit fraud.  The three factors, which comprise the so-called “fraud triangle,” are: 1- perceived pressure facing the person, 2- perceived opportunity to commit fraud, and 3- the person’s rationalization, or integrity.

All three factors are usually necessary for fraud to result.  For example, an unethical person facing financial pressure will have to identify an opportunity to commit fraud to be able to commit it.  Similarly, a person facing financial pressure and in a job position that presents an opportunity to commit fraud will not do so if his personal integrity outweighs the other two factors.  On the other hand, even the second person might commit the fraud if he rationalizes it, for example, by convincing himself that he is only “borrowing” the money and will pay it back.

So understanding the three elements of the fraud triangle will provide the fraud investigator with more angles from which to investigate.  For example, an investigator might determine that several employees in a department had the opportunity to commit fraud there.  Investigation of the employees’ personal lives might reveal that only one of them also faced pressures that would motivate committing fraud.  However, while it is beneficial to consider pressures and opportunities, rationalizations normally are not a focus of the investigation because they are difficult to identify.

Here is some detail about the three factors.

Factor 1 – Perceived pressure facing the person

            a. Financial
            b. Personal habits
            c. Work-related feelings

Pressures that might motivate a person to commit fraud may be financial in nature, relate to a personal habit, or stem from work-related feelings.  Financial pressures include factors, such as debt arising from high medical bills, overuse of credit cards, divorce, investment losses, or sheer greed.  Personal habits such as alcohol, drug, or gambling addiction or an expensive extramarital affair, may result in financial pressures to commit fraud in order to obtain funds to support the habit or pay debts resulting from it.  Work-related factors include feelings of resentment because of being overworked, underpaid, or not promoted, that may prompt a person to “get even” with the employer by committing fraud against the employer.  Family or peer-group expectations also may motivate a person to commit fraud.

For example, Mrs. T, the bookkeeper, was getting a divorce and needed to amass legal fees for the divorce and the related child custody battle.  She also had a gambling habit.

Factor 2 – Perceived opportunity to commit fraud

a.       Level of trust is reached

b.       Internal controls are weak or nonexistent

Opportunities to commit fraud can arise when an employee or manager reaches a level of trust in an organization or when internal controls are weak or nonexistent.  Then the employee or manager will perceive that there is an opportunity to commit fraud, conceal it, and attempt to avoid detection and punishment.  While opportunities to commit fraud in an organization may appear limitless, for any one person fraud opportunities are limited to the means available to him.  For example, a shipping dockworker would not have the opportunity to manipulate accounts receivable in order to steal cash receipts but might have the opportunity to steal inventory.

Good controls are an important means of limiting the opportunity for embezzlement, but even when controls exist, a person in a high enough level of trust or authority may be able to override the controls in order to commit the embezzlement.  For instance, a high level and trusted manager might be able to direct a lower level employee to forgo a control procedure usually performed.

Here are some examples of conditions that can provide an environment for embezzlement in an organization.

a.       Inadequate segregation of duties
b.       Failure to inform employees about company rules and about the
          consequences of violating them
c.       Rapid turnover of employees
d.       Constantly operating under crisis conditions
e.       Absence of mandatory vacations
f.        Failure to uniformly and consistently enforce standards and policies
          or to punish perpetrators

Here are some examples of conditions that can provide an opportunity for embezzlement by management.

a.       Existence of related party transactions
b.       Use of many banks
c.       Inadequate or inexperienced staffing in the accounting department
d.       Weak subordinate personnel
e.       Frequent change of auditors or legal counsel

For example, Mrs. T, was the company’s bookkeeper and office manager.  No one followed up on her activities.  There was no segregation of duties.  She performed all of the billing, collecting, disbursing, banking, and recording of all transactions.  She was always under a lot of pressure and like a good soldier, never took a vacation.  She explained to her boss that she “didn’t need a vacation because there was nowhere to go,” and she said she “loved her work.”

Factor 3 – The person’s rationalization or integrity

a.       Management honesty versus dishonesty

Personal integrity might very well be the most important factor in keeping a person from committing embezzlement.  There are many cases in which individuals with severe financial or personal pressures and the opportunity to misappropriate assets do not do so because of strong personal moral codes.  In a recent survey, auditors ranked “attitude” factors (such as management honesty) as more important than situational factors as indicators of the possibility of embezzlement.  Some investigators believe that a strong moral code can prevent individuals from using rationalizations to justify illicit behavior.  Some typical rationalizations for misappropriation of assets and management fraud include:

a.       I am only borrowing the money and will pay it back.
b.       Nobody will get hurt.
c.       The company treats me unfairly and owes me.
d.       It’s for a good purpose.
e.       It’s only temporary, until my financial position improves.
f.        Everybody’s doing it.
g.       I am not part of a team; I’m just an employee, a peon.

Characteristics of Embezzlers

1 - Demographics are similar (sex, age, religion, and education level).
2 – Personalities are usually not antisocial.
3 – There is not necessarily a past criminal record.
4 – There is usually not a deficient family environment.
5 – There is not necessarily a sporadic job history.

Research into the characteristics of embezzlers shows that they share more demographic characteristics, such as gender, age, religion, and education level with the general population than with other criminals.  White-collar criminals do not usually have antisocial personalities, past criminal records, deficient family environments, or sporadic job histories.

Rather, they are usually older than other criminals, past thirty years of age, are married with stable family situations, and have above average educations.  Seventy percent of embezzlers are male.  The age and gender may be due to the fact that, as one study found, almost one half of all embezzlements are committed by professional and managerial employees.  Senior officers and owners commit ten percent of all embezzlements.  Until recently it was the older male who has attained that level of trust and authority that provides an opportunity for embezzling.  However, the study found that clerical and other employees commit thirty percent of embezzlements.  Moreover, as the percentage of females in positions of authority and responsibility over assets increases, it is believed by law enforcement authorities that the percentage of female embezzlers will increase proportionately.

Next time I will explain the “Detection and Prevention of Embezzlement.”