Breaking the Fraud Triangle – Keys to Deterrence

By B.J. Hoffman
Special to the Legal

In my past posts, I have made mention of the incredible cost of fraud, waste and abuse, and their presence within many organizations. Understanding the reasons for fraud and the available countermeasures allows for effective risk mitigation.

Fraud investigators and auditors employ the “fraud triangle” concept in assessing the risks of, and the reasons for, fraudulent activity in organizations. Fraud is most likely to occur when three factors are simultaneously present:

• Financial pressure upon an employee
• Rationalization
• Perceived opportunity

Financial pressure: Employees subjected to outside financial pressures are more likely to look for illegal ways to maintain their existing lifestyle. Gambling, drugs and alcohol; family medical problems; infidelity; and overall excessive consumer spending habits can all take their toll on an employee’s financial condition, even in good economic times. Today, the depressed state of the economy only serves to exacerbate financial pressures on many employees. Of course, the employer has very little control over this first point of the fraud triangle.

Rationalization: Not every employee with a pressing financial need will resort to fraud, of course. Studies have shown that given the right set of adverse financial circumstances, a majority of the population would perpetrate a fraudulent scheme out of desperation. Employees in such situations need to convince themselves that a defalcation is morally justifiable, even when outside of their normal character. Common rationalizations include, “It is just a loan and I will pay it back,” or, “I was unjustly passed over for promotion and I deserve these funds,” or, “My employer makes so much money that these funds won’t be missed.” Again, employers have very little control over this second aspect of the fraud triangle.

Perceived Opportunity: Typically, even an employee who is under severe financial pressure and who is able to rationalize a theft will not do so if there is a belief that he or she will be caught. This “perception of detection” is the area of the fraud triangle that employers need to focus on, as it is the component of which they have some degree of control. If an employee perceives that internal controls are weak and that his or her scheme will not be detected in a timely fashion (or at all), the door is wide open to losses.

So, how does an employer effectively manage the perception of detection? It predominantly amounts to adopting an effective system of internal controls and setting the right tone at the top of the company, namely in creating an environment in which it is known that fraud is unacceptable.

Internal control systems seek to segregate duties among staff so that incompatible job functions are not assigned to a single employee. An attempt is made to have asset custody, accounting and authorization functions handled by different individuals within a company. For instance, those with physical access to cash or customer payments ideally should not also be responsible for general accounting and bank reconciliation tasks. The proper checks and balances that an effective internal control system affords tend to alert potential fraudsters that their schemes would be detected promptly. Hence, it is unlikely that an attempt is even initiated by the employee.

When employees are aware that someone is watching, and there are internal controls that management deems fraud intolerable, they are likely to suppress their rationalization of fraud. In addition to effective internal controls, the adoption of fraud policies required to be acknowledged annually by the staff and the implementation of telephone tip lines are all additional measures that help to broadcast management’s resolve against fraud, waste and abuse.

Of course, even good internal controls are not 100 percent effective against fraud, especially if there is collusion among employees, or if company executives are able to override control systems. Still, the adoption of good controls is management’s best tool in attempting to break the fraud triangle that, when unchecked, leads to significant annual losses for businesses throughout the world.

B.J. Hoffman is a certified public accountant and certified fraud examiner for Citrin Cooperman, an accounting, tax and business consulting firm. He is a partner in the Philadelphia office. Hoffman provides clients with a mix of audit, tax and litigation support services. He often works with closely held entities in a variety of industries, including professional service firms and real estate enterprises. He can be reached at [email protected] or 215-545-4800.

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