What is the Fraud Triangle Theory?

The fraud triangle theory is used by auditors to find out why employees commit fraud within an organization. It is an effective way to inspect and analyse the root cause through a  fraud triangle audit and necessary measures are taken to curb the risk of any fraud activity.

Fraud Triangle

Who created the Fraud Triangle?

Donald Cressey created the concept of the Fraud Triangle. The formulation of the theory required Cressey to interview about 200 convicted embezzlers around the Midwest, which he dubbed “trust violators.” The people that had entered the workplace with no intention to steal picked his interest.

Also, See: 3 Different Types Of Managers & What They Do

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Businesses still need to work more to lessen the financial pressures and diminish the rationalizations that drive to fraud. The FERF (Financial Executives Research Foundation) recently published the results of its studies of financial officials, managers, and employees. The article, Breaking the Cycle of Fraud, recommends strategies and policies to mitigate the issues in two sections of the fraud triangle that is most closely connected to ethical matters: rationalization and financial pressure.

What brings us to the next question, What is Pressure in the fraud triangle?

The pressure here rightly states the need to have done a fraud. For example, if an employee has a huge debt or is involved in irrational activities like gamble or bet. It could potentially be a state of mind where it affects the performance of an employee due to society or peer pressure.

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The fraud triangle was formed by criminology researchers Donald Cressey and Edwin Sutherland to explain the three elements that come collectively when an individual commits fraud:

  • Rationalization: People with weak ethics, has the mind-set of the fraudster that justifies the crime.
  • Opportunity: Weak internal controls support the fraud to occur.
  • Financial pressure: Is the recognized need for committing the fraud

How does the Fraud Triangle help us?

By imposing stronger internal controls and processes, organizations can take definite, visible action to lessen the risk of opportunity. However, rationalization and financial pressure together include individuals’ moral framework and organizational culture, and those are much more challenging to influence overtly and directly.

 

List and briefly discuss the three major components of the fraud triangle

Financial Pressure

Breaking the Cycle reemphasizes the broadly described significance of a positive tone at the top of the company in mitigating financial pressure. The report details various historical examples where a pressured corporate culture brought to demolish. In such cases, to manage short-term financial performance targets for bonus purpose was given far higher priority by senior managers than to act ethically and consider the long term sustainability of the company.

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There are few lower-level executives and employees in an organization that likely do almost anything to please their managers and bosses even if it violates provisions in the company’s code of conduct as well as their ethical standards.

However, it is noted that businesses are now focussed on deeply investigating the fraud triangle internal controls to avoid such kind of activity within an enterprise.

In the year 2015, the SEC declared a proposed rule to require corporations to publish the connection between executive pay and an organization’s financial performance. The new law intends to support stakeholders to receive notifications clearly while electing directors and vote on proper compensation.

The metric defined to represent organization performance implies total stakeholder return calculated every year and compared to the total stakeholder return of a peer group of organizations. However, this rule will only reinforce the current focus on short-term financial targets and goals. Performance measurements for satisfying senior managers and others should expand to include and embrace the accomplishment of a more ethics-based subject. This will in turn reduce the act to control a fraud triangle opportunity. 

Rationalisation

The FERF report lists several essential features of an efficient, ethical environment that strengthens and encourages efforts to avoid the rationalization of improper conduct.

It includes practical ethics training tailored to the organization, yearly surveys of workers’ opinions, and useful whistleblowing applications. The training should include all managers’ levels of the company. And include real-time world examples of the adverse outcomes of unethical behaviour. And also be based on the company’s code of ethics, and involve true-to-life applications. A few types of research have shown that one on one training is likely to be very effective and fruitful.

The year-end reviews of employee perspectives and evaluations of the noble spirit recommended by Breaking the Cycle must be professionally planned to avoid driving questions. Investigations must also be delivered anonymously to encourage accurate responses that will help assess the ethical environment of the organization and the effectiveness of the ethics program. Otherwise, the effort might not be sufficient and result in the perceived opportunity fraud triangle.

If administered correctly, helpline programs or whistleblowers are compelling and essential in detecting and deterring unethical conduct in the company.

Encourage Whistleblowing

In 2014, the Anti-Fraud collaboration reported that many employees are reluctant to report wrongdoing internally using their business reporting method.

The reason for not mentioning is the fear of retaliation. The reason for not saying is the fear of reprisals. In an organization, employees assume that senior-level management becomes connected and won’t take any effective action to prevent unethical conduct. There are few legal protections for whistleblowers in some states and some businesses. This is why the IMA Statement recommends that employees who an ethical dispute should consult directly to the management.

 

Ethics training should involve motivation for each and everyone in the company. As well as distributors, to use the helpline when sanctioned. Some of the highlights of an adequately designed whistleblower helpline include comprehensive passage with worldwide language ability and adaptation to local cultures. And also protocols to handle any reports professionally, if necessary; a single helpline for all ethics-related concern; methods for confidential reporting of results; including documented formal processes for timely investigation and legal information security and document maintenance policies.

The IMA Statement of Ethical Professional Practice requires that all members shall encourage others within their company to act. In accordance with its stated principles: Fairness, Responsibility, Objectivity, and Honesty.

Combating Occupational Fraud

People will always continue to find ways to steal and deceive. But I genuinely think that all actions that take place in the dark will one day come to light. The best way to stop employee fraud is to embrace practices that will decrease or lessen opportunity and incentive. Lack of or readily overridden controls, absence of management review and strategy. And also incompetent auditing is a common factor that allows fraud to occur.

Another important factor that the fraud triangle applies to is Capability. A person who commits any fraud is asserted by a few or several traits like pride, weakness, greed or dishonesty to carry out one such action. Perhaps, the basic knowledge of processes and controls i.e. the ability to conduct the fraud also adds to the list. 

Recent research conducted by a market research company states the 10-80-10 to be a new characteristic rule that defines workplace employee behaviour.
As per the research, 10% of the population will never have an intention to commit any fraud
80% might give in to the idea to do a fraud based on the 3 components discussed – pressure, rationalization and opportunity.
The remaining 10% are likely to find new methods to commit fraud more securely.

Have you done your share of encouragement lately? Let us know in the comments below.

ALSO READ, 3 Different Types Of Managers & What They Do

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