Three Leading Reasons why Corporate Fraud Slips Through the Net

Corporations are formed to create value for shareholders. They do this by carrying out business activities that take inputs (such as labour, materials and innovation) and create high-value outputs that generate a profit. Administrative functions such as finance, serve the primary business by accurately recording and reporting the results of the business. Using this timely information, managers can make investment decisions and change strategies to optimise business operations.

However, the finance function isn’t infallible and despite being staffed by qualified individuals, corporate fraud can occasionally occur.

Corporate fraud can cover a range of misdeeds including misstating the financial health of the business (either by hiding liabilities or overstating sales or assets), and theft of assets, known formally as misappropriation or embezzlement.

The fraud triangle is the theory that states three conditions must be in place for a fraud to occur. In this article, we’ll examine the fraud triangle to understand why corporate fraud can slip through the net.

An introduction to the fraud triangle

The fraud triangle is visualised as a triangle with three points, representing the following factors:

Incentive
Opportunity
Rationalisation

Incentive refers to the pressure that an employee is exerted under that ultimately drives them to step over the line and commit fraud. This pressure could come from within an organisation (via a line manager or CEO), or from outside factors such as needing cash to pay an aggressive creditor.

People don’t commit a crime and take such risks with their liberty when left to their own devices. Usually, there is an extraneous source of pressure that makes the risk logical or worthwhile.

Opportunity refers to the means through which an employee could possibly commit fraud. A shop floor cleaner is unlikely to perpetuate corporate fraud because they have no means to do so. In contrast, a senior accountant exercises much control over accounting entries that are posted into the accounting system, and this represents one opportunity to act unethically to gain some form of advantage.

Rationalisation addresses the human element of committing fraud; namely, why did the individual feel justified in betraying their employer or the company shareholders? Interviews with convicted corporate fraud felons have usually revealed how the fraudster rationalised what they were doing as the ‘right thing’.

Perhaps they had become indoctrinated by the company\’s purpose and therefore understand that any steps, no matter how illegal, were for the greater good if they enabled the company to continue its mission. Or the rationalisation could be more malicious; i.e. the employee felt they were owed something by the company. Perhaps they felt entitled to plunder cash from the firm after years of being denied pay rises and being passed over for promotion.

Now you have understood the fraud triangle, you will have insights into the different necessary failings of a company that must occur to let a corporate fraud slip through the net. If a company can reduce the pressure placed on employees to meet financial targets, remove or limit the opportunity for employees to commit fraud (by segregating duties, for example, which removes the power from a single individual to undermine the system), and give employees no reason to feel such ill-will towards the firm that they may rationalise stealing from them, then they will reduce the likelihood of corporate fraud.

Posted by Wealth & Finance International