Fraud Triangle in Business

Opportunity, pressure, and rationalization are the motives of an individual or group that compel them to conduct fraud. But do you wonder how to spot it and deal with it? Read this article to get the insight in order to prevent your business from any potential fraud.

Smaller businesses are more vulnerable to potential fraud because they don’t have adequate types of equipment to implant measures that spot the fraud beforehand and take prompt measures. The understanding of the fraud triangle is important anyway for the smaller and larger businesses in order to prevent the organization from going through any potential criminal activity by the employers.

Companies should focus on preemptive measures to protect their businesses from fraudulent activities because if they adopt a reactionary approach, they might have to bear a great loss before even realizing the depth of the harm that is caused by their late response. An organization that welcomes the culture of whistleblowing allows employers to be free in raising red flags. Prevents the company from a huge loss as it gains the information beforehand and takes pertinent measures.

What is fraud?

Fraud is an intended deception by an employee or organization for extracting personal gain. In other words, fraud is a deceitful activity that is done to an organization for an unauthorized advantage or to generate illegal profit. In this activity, an illegal act benefits the perpetrators and harms the other party involved. That harm is often financial and illicit in nature.

For example, an employee who pockets cash from the company’s register without getting it in the knowledge of anybody is committing fraud. He would gain the benefit at the expense of giving a loss to the company.

It involves the false representation of the facts that can be done by intentionally withholding information or providing the false information for gaining unauthorized benefits that could have not been gained without applying the deceptive tricks. It is not always the case that the perpetrator is an individual but it can be the whole organization or company that can gamble for gaining a large sum of profit by fraud.

At the heart of this activity, the perpetrator has the information that is used to deceive the victim by taking advantage of information asymmetry as the resource cost of reviewing and verifying the information can be significant enough to create a disincentive to fully invest in fraud prevention.

There can be an innumerable example of frauds happening at the individual, group, and organization levels, some of the examples, however, can be:

  • Forgery or alteration of documents
  • Unauthorized manipulation or alteration of computer files
  • Embezzlement
  • Fraudulent financial reporting
  • Authorization or receipt of payment for goods not received or services not performed
  • Misappropriation or misuse of university resources such as funds, supplies, facilities, equipment, services, inventory, or other assets.
  • Conflict of interests or ethics violation
  • Authorization or receipt of unearned wages or benefits.

Occupational fraud is a serious issue for organizations around the world. Research from the Association of Certified Fraud Examiners states that occupational frauds cost companies 5% of their revenue every year which makes a $4 trillion loss on the global scale. A 2018 study of Global Study on Occupational Fraud and Abuse stated that companies that are at the risk of bearing occupational fraud have failed to carve comprehensive policies to prevent, detect and mitigate fraud.

Gaining insight by understanding the fraud triangle, can help these companies to manage, accountants, and counsel develop proper internal controls to help formulate the strategies that can decrease fraud activities at the workplace.

Fraud Triangle

In order to fight the conduct of fraud, it is not adequate to only know that it is occurring but one has to dive deeper into looking for the causes and methods of its happening so that the policies and strategies made an outcast the issue for the long run. Pertaining to this issue, a well renowned American criminologist Donald R. Cressy developed the “fraud triangle” in his book “Other people’s money; A study in the social psychology of embezzlement”.

He was interested in finding out the circumstance that led the embezzlers to the temptation to go for fraud. His hypothesis was “Trusted persons become trust violators when they conceive of themselves as having a financial problem which is non-shareable, are aware this problem can be secretly resolved by violation of the position of financial trust, and are able to apply to their own conduct in that situation verbalizations which enable them to adjust their conceptions of themselves as trusted persons with their conceptions of themselves as users of the entrusted funds and property”.

He figured out three basic elements:

  • Opportunity
  • Pressure
  • Rationalization

And made a triangle that explains that these are the temptations that justify for the embezzlers to conduct fraud in their capacity.

Opportunity

In the process of theft, there must be something at a place to steal and there will always be a way to steal it. Anything valuable can be a thing to steal and any weakness in the system for example lack of oversight can provide a way to make the job of stealing feasible.

Opportunity is described that weakness in the organization which makes the way easier for the individual to take advantage of. Companies that install strong controls in place limit the opportunities for employers to commit burglary or engage in fraudulent financing reporting. But those companies which do not pay heed to these strict measures leave many loopholes in the system that can be exploited with minimum efforts such as lack of segregation of duties and little supervisory oversight, providing an easy path to perpetrators to plot fraud.

For example, if a company is giving access to open emails from customers, depositing checks, tracking customers’ accounts receivables, and preparing bills, there is a high chance that the employee can deceive his boss as he will find more opportunities to divert funds into his pocket compared to that employee who is segregated duties and responsibilities and often meets with organizational limitations that keep them restricted to their work and not present them the opportunities to commit any fraud.

The organization should also formulate punishable mechanisms if it catches someone guilty. If the alerts are piled up and not made a lesson for the potential violators, they can take it as a route to fly under the radar if they plan anything in the future.

Pressure

Pressure is also called motivation for the individual to commit fraud. Anyways finding the guts for going off the record and putting the effort in doing something which is risky to its core, the perpetrator would definitely have the motivation that overrides all the potential risks. These motives can be personal or occupational. Personal situations that caused an increased demand for money for example vices such as drugs and gambling or merely life problems such as spouse losing job, children needing tuition fee, overwhelming debts, addiction, or divorce. Occupational motives may include the unrealistic performance targets that keep on pushing an individual to go off the board.

Rationalization

Rationalization is the element that pushes the perpetrator to justify his/her act. There can be multiple channels through which he can justify his fraud as not a wrongful activity but as a forceful compensation to him in exchange for the injustice that happened to him. For instance, a person may feel stealing is justifiable because he was not paid his due compensation or management did not care about his overburdening workload.

The other way of justifying the wrongful act is by seeing the superiors at the organization showing unethical behavior and getting away with it. In this scenario, the employee may feel that the management does not care about the wrongful behavior conducted by other workers and this behavior is not only tolerated but overlooked. So he can assume that he can also get away with it.

The fraudsters often use these sentences to justify what they are doing is not a big deal:

  • Everyone skims a little off the top
  • We waste so much anyway, why shouldn’t I benefit from it?
  • They expect you to do this, it is one of the perks of the job
  • Our company is so huge, if I’m taking a little, it won’t be missed

In order to prevent these little but constant mistakings and misgivings, the companies should champion transparency in their finances. If it explains that a holiday bonus depends on the company’s specific financial target, they would probably better realize the value of some dollars here and there.

Also, companies should make preemptive policies rather than responsive ones. Such as management should have knowledge about the people working at the firm. There should be programs that can alleviate pressure from the workers, for example, these programs should help the workers at the time of need. If they are battling addiction or other family issues, they should be provided anonymous help where they turn around when they need it.

Management should remain “in-tune” with the needs of their employees so that they can have the knowledge of the people working for them to achieve greater success. If they can win their trust, they will surely be paid off in long run.

Red flags for frauds

It is the responsibility of the manager and employers to watch out for the people working under the organization. They should be aware of the red flags for fraud as these are the warning signs that the risk is higher. One or two signs should not be taken as a grim concern but if they are occurring quite often, it is better to contact the Internal Audit Department.

Here are examples of employee red flags:

  • Significant debt and credit problems
  • Employee lifestyle changes: expensive cars, jewelry, clothes, homes
  • High employee turnover: especially in those areas which are vulnerable to fraud
  • Behavioral changes: alcohol, drugs, gambling, or just fear of losing a job
  • Lack of segregation of duties in vulnerable areas
  • Refusal to take sick leaves or vacation

Red flags for management

  • Management frequently overrides internal controls
  • Managers showing significant disrespect for regulatory bodies
  • Weak internal control environment
  • Accountant personnel are lax or inexperienced in their duties
  • Policies and procedures are not documented or enforced
  • Decentralization without adequate monitoring
  • High employee rate turnover; low employee morale
  • Refusal to use the serial numbered documented (receipts)
  • Compensation program that is out of proportion
  • Excessive number of checking accounts; frequent changes in bank accounts
  • Photocopied or missing documents
  • Excessive number of the year-end transaction; unnecessarily convoluted transactions
  • Management decisions are dominated by an individual or small group
  • Reluctance to provide information to, or engage in frequent disputes with auditors

Types of fraud

The Association of Certified Fraud Examiners states in their study that organizations around the world lose 5% of their revenue on fraud that occurs inside their place. Although the percentage seems least by summing it up, it makes a whopping $3.7 trillion annually. And does not even count the effects of the loss that the company has to face as the result of this fraud which also renders more money loss such as negative reputation and company morale.

So, companies have to watch out for their employers’ conduct at the office and take measures to prevent that from happening in frequent ways. Below is the list of common types of fraud that organizations around the world have to cater to.

Payroll fraud

There are multiple ways through which employers get to do scams on payroll such as:

  • Lying about their productivity, sales, and working hours to get a higher pay
  • Requesting for an advance payroll without having any intention of giving it back on time
  • En-listing a co-worker to manipulate their attendance record by clocking in and out for them
  • Falsely claiming expenses to be reimbursed without having the right to do so such as a meal with friends and family as a business expense
  • Falsifying pay rates by internal collusion between employee and payrolls department whereby additional funds are allocated, paid out, and then divided between the two parties.
  • Unjustly receiving commissions and funds from employees.

Studies suggest that Payroll frauds are likely to occur within small businesses as they don’t have advanced anti-fraud measures and systems.

How to avoid it: Do background checks on a frequent basis on every employee and if you suspect anyone in the office, ask your managers to have a close watch over his/her activities. Also, you should ask your managers to closely watch timesheets and use a secure system of payroll service. If there is any misfortune event happening at the place by anybody try to take strict action against him so that others in the organization get a lesson for the future.

Invoice fraud schemes

Invoice fraud occurs when an employee, usually from sales and accounting, creates fake invoices for the products and services that were never bought in order to steal money from the organization for his own unlawful benefit. He can also create a fake supplier or shell to funnel money to, or award or inflated rewards to his friends and family. Hence abusing his power to hoard money for personal benefit.

How to avoid it: Cross-check every invoice that is produced by the team in order to confirm that it only mentions the goods and services that are bought. Do comprehensive background checks before approving a new supplier.

Asset misappropriation

This type of fraud happens by the employees who are most trusted in the organization as they hold and manage the assets and interests of an organization. Typically the fraud includes cash or cash equivalents such as vouchers and credit notes but it can extend to include company data and intellectual property.

The fraud may occur by an employee lying about his/her qualifications to get the job or it can be done by an organized crime group who manage to infiltrate the organization and take advantage of the weak process and inadequate security system and controls.

How to avoid it: Keep rotating cash-handling staff and never entrust all financial tasks to just one employee. Also, if you suspect that the fraud is going on right now, you should contact the police to start a criminal investigation. If you have found out the employee(s), fire them immediately and look for others to identify whether there is any kind of systematic failure across your organization in order to prevent this from happening again.

Financial statement fraud

This type of fraud happens by fudging important facts such as revenues, assets, sales, liabilities in order to deceive investors or the public, manipulate stock or bonuses. The fraud is usually done to quietly fix the business problem that prevents them from achieving the expected profit or complying with loan covenants. It is also the case that they do it to obtain or renew financing that cannot be acquired by providing honest financial statements.

How to avoid it: Closely watch the financial statements for inaccurate and inconsistent information before they got published. Also, delegate the different accounting functions to the different employees over time.

Data, intellectual property, and identity theft

Securing the sensitive information of your company that can be personal data or intellectual property is a crucial matter for each organization because data theft can damage the businesses if trade secrets got leaked or patents shared with the competitors by an inside employee of the organization, they can hurt the reputation of the company by lowering customer trust.

How to avoid it: Tighten your security inside the organization and restrict access to high-level documents of the company. Formulate a security policy for the classification and handling of sensitive information.

Tax fraud

This type of fraud occurs when an individual or the business entity intentionally provides false information about the earnings and expenses of the company to Internal Revenue Service in order to limit the amount of tax liability. The company cheats on the reporting tax return to avoid paying the entire tax obligation.

Tax fraud includes claiming the false deduction, using a false Social Security number, claiming personal expenses as business expenses, and not reporting income. The government suffers millions of dollars’ loss each year as the result of tax fraud.

How to avoid it: Do not misreport the earning and expense information of your company in tax returns. Ensure filing your taxes completely and accurately on time.

Insurance and banking fraud

Insurance fraud is an illegal fraud that happens from both the buyer’s and seller’s sides. Insurance fraud from the seller’s side includes selling policies from companies that don’t exist, failing to submit premiums, or swapping policies to cost more commissions. Buyers fraud however by exaggerating claims, post-dated policies, providing falsified medical history, viatical fraud, faking death, disease, kidnapping, murder.

How to avoid it: Companies should be strict about the requirement of the filing of the information from the customers while filing insurance/workers’ compensation. Ensure that the documents provided at the hand of the customer are not fake and the information provided is accurate.

Money fraud

Money fraud occurs when the customers fake the bills to make real purchases. If you don’t check the bills on time you may make foul decisions and not even notice before it’s too late as they would pay counterfeit notes.

How to avoid it: Train your employees to check if the customer is paying counterfeit banknotes. You can invest in the counterfeit money detector if you handle large amounts of cash regularly.

Return fraud

Some retail businesses have the policy of return, refund, and exchange that allows the customers to return to items that have defects but some customers take advantage of this policy by lying about the purchases returning stolen items, using items before the return period is up to get the money back, stealing receipts, etc. the return industry loses $24 billion on annual basis in return fraud or policy abuse, accounting for 8% of returns.

How to avoid it: Make sure to receive receipts of returns and exchanges. If you have to refund the customers, give store credit instead of cash.

Bribery and corruption

If a company has a frequent practice of bribery and corruption, it can ruin the organization from its core. It encompasses a variety of practices such as skimming/getting kickbacks from projects, manipulating contracts to favor some over others, using money to influence major company decisions.

How to avoid it: Make policies and implement stricter measures and gifting guidelines so that the employees are rewarded for their responsible conduct at the organization. Conduct due diligence with the employees, management, and third-party vendors.

Other fraud risk protection measures

  • Make fraud reporting a welcoming culture in your organization where everyone gets easy channels to deliver if they see any red flags in the office. Make sure that the one reporting any mischief happening in the office gets highly rewarded.
  • Restrict and closely monitor access to sensitive information
  • Make surprise audits and inspections a norm of the organization, regular checkups can help you spot and identify fraudulent behavior and mitigate the damage immediately. These practices will also help you identify the weakness of the system that needs prompt action.
  • Compose comprehensive anti-fraud, anti-bribery, and anti-corruption policies and make sure they are implemented in their true spirit. And make sure the perpetrators meet the consequences if they commit any fraud.
  • Welcome whistleblowing environment

Reporting fraud and scams

If you have been scammed fraud by a criminal group or a business entity, you can claim fraud to your respective authorities by:

  • Report scam to your state consumer protection office
  • Reporting federal government via federal agency directory
  • Submitting a complaint online with the Federal Trade Commission. FTC is the most common agency that collects scam reports. The claim can be reported online or by phone at 1-877-382-4357
  • Contacting your local police or sheriff’s house
  • Reporting claim to your state attorney general

Conclusion

Where the employer’s team of an organization can make it a swift success story in the market, it can also wreak havoc if they are not managed in the proper way and if they indulge in fraudulent activities. Fraud culture can shake an organization to its core leaving it at a complete loss for the long run. Companies should hire and maintain a strict management team that watches out for every potential fraudulent activity whether it is done by an individual employee or a group of people from different departments of the organization.

Companies should formulate comprehensive anti-fraud policies that ensure smooth and honest conduct of business at the place and prevent criminal activities from becoming a norm of the organization. If any crime is conducted at the organization, the management team should make sure that it is reported to the relevant authorities on time and the perpetrator meets the strict consequences so that other people in the organization pay heed in the future. Also, companies should allow and facilitate a whistleblowing culture so that they are being reported before some serious damage occurs.

Tony Bennett

Tony Bennett

Tony Benett makes his living in the insurance industry by teaching and consulting. He is also recognized by the legal profession as an expert on insurance coverages. His insurance experience includes having worked at the company level, owned an independent general agency and having worked for an insurance association. He has received various certificates over the past few years and helps his clients and readers by giving them a realistic outlook on what they can expect to achieve within their set targets. At Insurance Noon, he is known for his in-depth analysis and attention to details with accuracy. He has been published as one of the most referred agents by his peers in the insurance community. Tony loves the outdoors and most sport events. His passion other than providing excellent advice is playing golf.