The Fraud Triangle: Assessing Fraud Risk

Introduction

Why does a company commit financial statement fraud? Could it have been detected before the stock plummeted and lost thousands of investors' money? These are some questions that investors, auditors, financial analysts and regulators wonder about every time a financial scandal is made public.

Academics have done a great deal of research on this topic, aiming to identify what causes managers to commit fraud, the most common ways to do so and what circumstances increase the likelihood of committing fraud. (See Hogan et al., 2008; Trompeter et al., 2012 for literature reviews on this topic).

One of the most used models used to analyse, explain and detect fraud is the Fraud Triangle, first developed by Donald Cressey in 1950. This model states that embezzlement has three elements in common: a perceived pressure or incentive, a perceived opportunity and the subsequent rationalisation of the fraudster behaviour. Other authors have reshaped the geometric figure with the capability and creating The Fraud Diamond (Wolfe & Hermanson, 2004) or with competence and arrogance creating the Crowe's fraud pentagon (developed by Crowe Horwath in 2010).

However, none of these extended geometric models has had the same impact as the original. The most relevant accounting regulators have taken the fraud triangle as the model for establishing fraud audit guidelines. For example, the International Standards on Auditing 240 (The auditor's responsibility to consider fraud in an Audit of Financial Statements and its equivalent SAS No 99 in the US states something very similar) states explicitly that the auditor should analyze the risk of fraud as follows: “Fraud, whether it consists of fraudulent financial information or misappropriation of assets entails the existence of an incentive or an element of pressure to commit fraud, as well as the perception of an opportunity to carry it out and some rationalization of the act.”

The first study case is Enron. At the beginning of the 21st century, some famous accounting scandals, and Enron at the top cause that the Sarbanes-Oxley Act in the US was put into place, setting new standards for auditing firms, corporate management and board of directors. Ten years later, in Europe, another scandal was made public. Although both cases happened in different countries and industries, they had some things in common; they overstated revenues and understated debt through companies outside the consolidation perimeter.

Background

In December of 1950, Donald Cressey published “The Criminal Violation of Financial Trust” in the American Sociological Review. The paper was the product of his research searching for generalisations in the criminology field, which was not very common. He thought that a better understanding of why managers commit fraud would reduce its incidence in the same way that research into the causes of some diseases had reduced its mortality rate. Some research has ignored this first approach of Cressey to the three elements of the later called fraud triangle as the publication of his book Other people's money in 1953 and re-edited in 1971 has usually been considered the starting point of this theory.

Cressey's primary concern was explaining embezzlement by defining a sequence of events always present in any case of trust violation. He interviewed around 130 inmates convicted for white-collar crime in three different prisons in the US. After redesigning his research questions and hypotheses several times, he came up with three characteristics: (i) the existence of a financial problem that is non-shareable (Incentive), (ii) the knowledge that they can secretly resolve this problem through trust violation (Opportunity) and (iii) the application to their conduct verbalisations which enable them to adjust their conceptions of themselves as trusted persons (Rationalisation).

These three elements were later called The Fraud Triangle (See Figure 1). This framework has been widely used to study any occupational and corporate fraud, and audit standard setters have also used it to set a basis for analyzing the likelihood of fraud in a financial statement audit.