The fraud triangle and the Scandals in Accounting

Sep 6, 2021 - 16:08

The fraud triangle is a model for explaining the factors that cause someone to commit fraudulent behaviours in accounting.

It consists of three components, which together, lead to fraudulent behaviour,  Incentives/ Pressure, Management or other employees have incentives or pressures to commit fraud.

Opportunities: Circumstances provide opportunities for management or employees to commit fraud.

Attitudes/rationalization: An attitude, character, or set of ethical values exists that allows management or employees to commit a dishonest act, or they are in an environment that imposes sufficient pressure that causes them to rationalize committing a dishonest act.

Incentives/pressures: A common incentive for companies to manipulate financial statements is a decline in the company's financial prospects.

Companies may also manipulate earnings to meet analysts' forecasts or benchmarks such as prior-year earnings to meet debt covenant restrictions, achieve a bonus target based on earnings, or artificially inflate stock prices.

As for the misappropriation of assets, financial pressures are a common incentive for employees.

Employees with excessive financial obligations, or those with substance abuse or gambling problems may steal to meet their personal needs.

Opportunities: Although the financial statements of all companies are potentially subject to manipulation, the risk is greater for companies in industries where significant judgments and accounting estimates are involved.

Turnover in accounting personnel or other deficiencies in accounting and information processes can create an opportunity for misstatement. As for misappropriation of assets, opportunities are greater in companies with accessible cash or with inventory or other valuable assets, especially if the assets are small or easily removed.

A lack of controls over payments to vendors or payroll systems, can allow employees to create fictitious vendors or employees and bill the company for services or time.

Attitudes/rationalization: The attitude of top management toward financial reporting is a critical risk factor in assessing the likelihood of fraudulent financial statements. If the CEO or other top managers display a significant disregard for the financial reporting process, such as consistently issuing overly optimistic forecasts, or they are overly concerned about the meeting analysts' earnings forecast, fraudulent financial reporting is more likely.

Similarly, for misappropriation of assets, if management cheats customers through overcharging for goods or engaging in high-pressure sales tactics, employees may feel that it is acceptable for them to behave in the same fashion.

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