Fraud Triangle and Fraud Diamond Theory
Understanding the factors that contribute to fraudulent behaviour within organizations enables the implementation of preventive measures and controls to mitigate the risk of fraud. The Fraud Triangle and Fraud Diamond are both models used in forensic accounting and fraud examination that provide a structured framework to understand the dynamics of fraud.
FRAUD TRIANGLE THEORY
The Fraud Triangle theory, introduced by criminologist Dr. Donald Cressey in 1950, is a conceptual framework used to explain the psychological and situational factors that drive individuals to commit fraudulent acts. This model involves three key components: opportunity, incentive, and rationalization.
Figure: Fraud Triangle Theory
a) Opportunity
Opportunity refers to conditions or situations within an organization that make it possible for an individual to commit fraud. It involves having the chance to carry out fraudulent actions without facing immediate consequences or getting caught. Within the fraud triangle, it is the sole aspect that can be controlled by the company. Situations that provide opportunities for committing fraud include:
Weak internal controls: Weak internal controls such as poor separation of duties, lack of supervision, and poor documentation of processes create opportunities for fraud by exploiting loopholes and bypassing checks.
Poor tone at the top: Poor tone at the top refers to a situation within an organization where higher authorities or leaders fail to set a strong ethical culture or demonstrate a commitment to integrity and compliance with laws and regulations. Poor tone at the top can increase the risk of fraudulent behaviour.
Inadequate accounting policies: Accounting policies refer to how items on the financial statements are recorded. Inadequate accounting policies may provide an opportunity for employees to misconduct, manipulate confidential data, increase financial pressure, and compromise the ethical standards within the organization.
b) Incentive
Incentive, also called pressure, refers to the underlying motivations that push individuals towards committing fraud. Situations that provide incentives for committing fraud include:
Financial pressure: Financial pressure or financial burden refers to the stress, strain, or difficulty individuals experience due to their financial obligations or constraints. It includes various factors such as debt repayment, high expenses relative to income, insufficient savings, unexpected financial emergencies, mismanagement of personal finances, compulsive behaviours such as gambling addiction, and other financial challenges. When individuals face significant financial pressures, they may feel compelled to resort to fraudulent behavior as a means to fulfill their financial needs.
Work pressure: Work pressures can often push employees to consider fraudulent actions to address dissatisfaction with their pay or perceived lack of recognition. When employees feel undervalued or overlooked for promotions or performance-based rewards, they may engage in fraudulent activities in hopes of gaining attention from management or senior authorities. This can include manipulating records or engaging in deceitful behaviours to showcase their contributions and skills for acknowledgment.
c) Rationalization
Rationalization is the cognitive process through which an individual justifies or excuse their fraudulent behaviour to themselves. Rationalization plays a crucial role in enabling fraud because it allows people to overcome their moral objections, reduce the feeling of guilt, and convince themselves that what they are doing is not wrong. Examples of common rationalizations that fraud committers use include:
“They treated me wrong”: Individuals may be revengeful towards their manager or employer and believe that committing fraud is a way of getting payback.
“Everyone else is doing it”: Individuals may convince themselves that their fraudulent behavior is common or accepted within the organization.
“There is no other solution”: Individuals may believe that they might lose everything (for example, losing a job) unless they commit fraud.
“I deserve it”: Individuals may convince themselves that they are entitled to the gains.
“No one will get hurt”: Individuals may believe that their actions will not have significant negative consequences on others.
FRAUD DIAMOND THEORY
The Fraud Diamond theory, given by David T. Wolfe and Dana R. Hermanson in 2004 is an extension of the fraud triangle theory. While the Fraud Triangle consists of three elements- opportunity, pressure, and rationalization, the Fraud Diamond theory adds a fourth element: capability.
Figure: Fraud Diamond Theory
According to this theory, even if a fraudster has a strong motive (pressure), opportunity, and justification (rationalization) there will be chances that they might not commit fraud if there is no ‘capability’. Capability refers to the technical skills, knowledge, position, and resources that enable an individual to carry out fraudulent activities within an organization.
Wolfe and Hermanson list six factors that constitute capability:
Position within the Organization: The position and authority of an individual within the company heavily influence their capability to engage in fraudulent activities. Those in high-ranking roles or with access to sensitive information may find it easier to exploit their position for fraudulent gains.
Intellectual Capacity and Knowledge: The intellectual understanding of financial systems, processing loopholes, and controlling weaknesses are important in executing fraudulent schemes. Proficiency in these areas can facilitate fraud without drawing attention.
Technical Proficiency: Depending on the nature of the fraud, technical skills such as programming, data manipulation, or forgery may be essential. Individuals proficient in these technical aspects can exploit system vulnerabilities or fabricate fraudulent documents more effectively.
Ego: Committing fraud requires a strong ego and robust self-confidence. Fraudsters tell themselves that they won’t be caught or if they are, they can lie convincingly.
Coercion Skills: The ability to coerce or influence others into participating in fraudulent activities through intimidation, persuasion, or leveraging personal connections plays a significant role in executing complex fraud schemes.
Access to Resources: Accessibility to resources like funds, assets, or confidential information increases the capability to plan and conceal fraudulent activities. Having such resources enables individuals to carry out schemes more efficiently and avoid detection.