Financial and occupational fraud is a serious problem in the United States, resulting in nearly $2 billion in losses every year.1 With the onset of COVID-19, this problem has only been exacerbated because it created additional opportunities for fraudsters. This has clarified the need for enhanced fraud risk management. This column discusses the evolution of fraud models that are designed to help CPAs understand the occurrence of fraud and offers strategies for improving fraud risk management.
The Fraud Triangle
Donald R. Cressey’s Other People’s Money: A Study in the Social Psychology of Embezzlement set the foundation for studying fraud. From his research, the fraud triangle was born. Each side represents one of three conditions generally present when fraud occurs: incentives (or pressures), opportunities, and attitudes (or rationalizations). Statement on Auditing Standards No. 99, Consideration of Fraud in a Financial Statement Audit (AU 316), describes each of these risk factors relating to misstatements arising from fraudulent financial reporting.2 For example, there can be an increased risk of fraud when financial stability or profitability is threatened and management faces pressure to meet the expectations of financial goals. The COVID-19 pandemic has already resulted in increased frauds via Paycheck Protection Program loans, and undoubtedly other types of occupational fraud will follow. Additionally, the nature of an entity’s operations may provide opportunities to engage in fraudulent financial reporting by way of a complex or unstable structure or deficient internal controls. Risk factors reflective of attitudes (or rationalizations) may express themselves in a disregard for the need of monitoring or reducing risks related to misappropriation of assets, a disregard or failing to correct internal controls, behavior indicating dissatisfaction with the company, or changes in behavior or lifestyle that may indicate assets have been misappropriated. Economic survival, too, is a strong rationalization and motivator to commit fraud.
The Fraud Diamond
In a December 2004 CPA Journal article, David T. Wolfe and Dana R. Hermanson introduced the fraud diamond as a way to further analyze the characteristics behind fraud.3 While the authors believe that opportunity opens the doorway, and incentive and rationalization draw the person toward fraud, they also believe a person must have the capability to recognize the open doorway as an opportunity and walk through it, not just once, but time and time again. Thus, they enhance the fraud triangle by adding the fourth dimension of capability. The authors further stress that the capabilities to commit fraud are explicitly and separately considered in the assessment of fraud.
The Fraud Pentagon
Crowe Horwath (now Crowe LLP) further extended the fraud triangle and fraud diamond in 2009 through the development of the fraud pentagon. In addition to pressure, opportunity, and rationalization, Crowe recognizes that fraudsters need competence and a certain level of arrogance to commit the act. Competence, like capability, can be characterized as the ability to ignore internal controls, develop concealment strategies, and control social situations. Arrogance, on the other hand, is the characteristic of superiority regarding the rights that people have and the feeling that internal controls and company policies do not apply.4
CPAs can play an important role by understanding and raising awareness of fraud schemes.5 A key to detection and prevention is to focus on situations offering incentives, opportunities, and rationalizations to commit fraud. In addition, CPAs should assess the capabilities of those in positions of authority. Leaders with a dark triad of personality traits (i.e., narcissism, Machiavellianism, and psychopathy) can have harmful effects on organizations.6 Through these fraud models, CPAs can take steps toward becoming anti-fraud watchdogs by considering the dimensions that lead individuals to commit fraud.
2 Consideration of Fraud in a Financial Statement Audit (AU 316), AICPA. https://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00316.pdf
3 David T. Wolfe and Dana R. Hermanson, “The Fraud Diamond: Considering the Four Elements of Fraud,” The CPA Journal (2004).
4 Noer Sasongko, Mahruf N. Hasyim, and Dahlia Fernandez, “Analysis of Behavioral Factors that Cause Student Academic Fraud,” The Journal of Social Sciences Research (2019) 5 (3): 830-837.
5 James A. Stavros, “Keep an Eye Open for Fraud After Disaster,” Pennsylvania CPA Journal (2018).
6 Joshua C. Palmer, R. Michael Holmes Jr., and Pamela L. Perrewe, “The Cascading Effects of CEO Dark Triad Personality on Subordinate Behavior and Firm Performance: A Multilevel Theoretical Model,” Group & Organization Management (2020) 45 (2): 143-180.
James W. Sunday, CMA, is a financial analyst at GWC Warranty in Wilkes-Barre and an accounting doctorate student at the University of Scranton in Scranton. He can be reached at firstname.lastname@example.org.