The Triangle of Fraud Risk

A 2014 Global Fraud Study conducted by the Association of Certified Fraud Examiners (ACFE) estimates that the average business loses five percent of their revenues to fraud. The global total of fraud losses is $3.7 trillion. The median fraud case goes 18 months before detection and results in a $145,000 loss. How can you avoid being a fraud victim? The Fraud Triangle

The first step is to become more aware of the conditions that make fraud possible. The fraud triangle is a model that describes three components that need to be present in order for fraud to occur.

Motivation (or Need)
Rationalization
Opportunity

When fewer than three legs of the triangle are present, we can deter fraud. When all three are present, fraud could occur. Motivation Financial pressure at home is an example of motivation to commit fraud. The fraud perpetrator finds him or herself in need of significant cash due to any number of reasons: poor investments, gambling, an extravagant lifestyle, health care costs, family requirements or social pressure. In short, the person needs money, and fast. Rationalization Those who commit fraud may rationalize the act in their mind:

I’m too smart to get caught.
I’ll put it back when my luck changes.
The big company won’t miss it.
I don’t like the person I’m stealing from.
I’m entitled to the money.

At some point in the process, the person who commits fraud may lose their sense of right and wrong or their fear of consequences. In many cases, they may intend to replace the money but never have the funds available to do so. Opportunity Here’s where you as a business owner have to be aware of your company’s operations. If there’s a leak in your control processes, then you have created an opportunity for fraud to occur. People who handle cash, have signing authority on a bank account, or maintain financial records with poor oversight could notice that there is an opportunity for fraud to occur with the ability to cover up the act for some time. Seventy-seven percent of all frauds occur in one of these departments: accounting, operations, sales, executive/upper management, customer service, purchasing and finance. The banking and financial services, government and public administration, and manufacturing industries are at the highest risk for fraud cases. (Source: ACFE) Prevention

Once you understand about fraud, prevention is the next step. To some degree, all three points on the triangle can be controlled; however, fraud prevention programs typically focus on the third area: Opportunity. Internal control measures such as the following can be put in place to minimize fraud risk:

Segregation of duties – by splitting the functions of, for example, receiving cash receipts, preparing bank deposits and posting customer payments, a single staff member would have less opportunity to misappropriate funds.
Owner/officer review of the bank statement – this simple control gives, at the very least, the illusion that someone is reviewing the cancelled checks for proper authorization and signature.
Written policies and procedures - these should document how job functions are to be carried out, leaving little room for deviation. Following up and monitoring these procedures is a necessary part of maintaining control over each function.
Budgeting and regular financial reporting – are you, as a business owner/officer, involved with all aspects of the business? While you may trust your individual unit managers explicitly, they need to know that their actions are being watched, making it difficult for misappropriation to occur. Budgeting and regular financial reporting provide business owners/officers comparative financial data they can use to help identify trends and deviations and highlight possible areas of misappropriation.

While small businesses may not have the personnel or wherewithal to document and enforce strict internal control measures, it makes good sense to develop some level of control, and institute preventative steps, where possible, to avoid fraud. When you minimize the opportunity for fraud, you’ve gone a long way to prevent it. Feel free to contact ECS to help review your systems, suggest areas to improve your internal control and minimize fraud risk.

About the Author - Mitchell M. Cohen is a Certified Public Accountant (CPA), a Certified Fraud Examiner (CFE) a Forensic Certified Public Accountant (FCPA) and a Certified Forensic Litigation Consultant (CFLC) with over 26 years of accounting and tax experience. Mr. Cohen is a Shareholder with ECS and has been with the firm since 2003. Mr. Cohen’s expertise includes expert guidance in many areas such as strategic business planning, financial negotiation, accounting system design, personal and corporate tax planning, IRS audits, financial statement compilations, reviews and audits in the areas of for profit, governmental and not-for-profit entities, manufacturing, distribution, interior design, catering companies and restaurants among many types of closely held businesses. Mr. Cohen has also conducted numerous forensic investigations in the areas of divorce, loss of income calculations, piercing the corporate veil, and conversion. Mr. Cohen is also a testifying expert witness.