This article is part of a larger series on Bookkeeping.
Designed by well-known criminologist Donald R. Cressey, the fraud triangle is a model for identifying the existence of fraud as exhibited in three risk factors: incentives, opportunities, and rationalization. It’s a guide for small business owners and managers to assess the possible areas in the business where fraud might exist.
In the accounting process, we don’t look at fraud as if we’re about to prosecute someone in court. Rather, we look at fraud in accounting as a causative factor that causes material misstatements in the accounting records and financial statements and how we can prevent it from happening.
1. Incentives or Pressures
Fraud may start when there are incentives at stake or pressures from the business owners. Examples of incentives include promotions, performance bonuses, salary increases, and fringe benefits. However, achieving certain performance goals and expectations is requisite before getting these incentives.
Employees who desperately want to receive incentives may resort to fraud if performance goals aren’t met. Aside from incentives, pressure from top management or business owners to perform or be disciplined can be a root cause of fraud.
For example, a sales manager might be under constant pressure from top management to exceed sales forecasts amid reluctant consumer buying behavior due to rising prices. Moreover, unrealistic management expectations or threats can be a source of pressure. Setting unrealistic goals that are hard to achieve can drive employees to commit fraud to save their jobs or prevent them from being demoted.
Business owners should set practical, realistic goals to keep employees motivated without applying undue pressure.
Opportunities to commit fraud exist when small business internal controls are non-existent or weak. There is an opportunity to commit fraud if an employee believes that they can override internal controls or take advantage of its weaknesses. The lack of owner participation can also contribute to an opportunity to commit fraud. If the business owner doesn’t actively participate in daily operations, such as approving large expenses and signing checks, employees with financial problems might see an opportunity to steal money from the business.
The lack of physical controls can also be an opportunity to commit fraud. For example, giving all employees access to the inventory storage unit gives rise to the opportunity to steal goods, especially if there are no security personnel or closed-caption TV (CCTV) cameras in place.
Small business owners are often shocked when their most trusted employee steals from them, but it’s often the most trusted employee that is given the most opportunity to steal.
3. Attitudes or Rationalization
The attitude of the small business owner or top management toward business operations and financial reporting is a risk factor. It is always the “tone at the top” that sets the company culture and ethics. If the owner brags about hiding income from the IRS, what effect might that have on the behavior of their employees? Hence, a business owner with unethical business practices should expect the same from their employees.
Besides attitudes, some employees try to rationalize fraud. The rationalization of fraud arises from inadequacies within the business or personal problems. For example, employees who steal money from the company often rationalize this act as a way of getting back at their employers for giving them low salaries. Moreover, an employee who is heavy in debt can use this reason to steal money.
“No one would know/see” is the common rationalization for fraud, especially if the employee is handling incompatible duties like recording payments in the accounting records and accepting cash from customers. Proper segregation of duties or active participation of the small business owner can eliminate possibilities of fraud only up to a certain extent. Since fraud is an act with an intention to conceal, collusions among employees with the same rationalizations to commit fraud can be hard to detect.
4. Kinds of Business Fraud
There are two types of business fraud applicable to every business, fraudulent financial reporting and misappropriation of assets. These can exist regardless of the business size and anywhere in the bookkeeping process.
1. Fraudulent Financial Reporting
Also known as financial statement fraud, fraudulent financial reporting involves the intentional manipulation of financial statement information through misstatements and omissions of information. Below are some of the precursors of fraudulent financial reporting using the fraud triangle model:
2. Misappropriation of Assets
Asset misappropriation involves theft and unauthorized use of company assets. Lower level employees can do it in small or immaterial amounts, but top management can also misappropriate assets in large amounts by concealing them. Here are some examples of asset misappropriation using the fraud triangle model:
Establishing a good internal control system can mitigate the risks of fraud, but only up to a certain level. Business owners and leaders should create a good working relationship and environment for employees to prevent them from resorting to fraudulent acts. Keeping employees happy and providing them with growth opportunities will help them align personal goals with business goals.