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Geometry of Fraud and Improving Risk Management


This column discusses the evolution of fraud models that are designed to help CPAs understand the occurrence of fraud and offers strategies for improving fraud risk management.

Aug 20th 2021
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Financial and occupational fraud has become a serious problem in the United States, clarifying the need for enhanced fraud risk management.

Donald R. Cressey’s Other People’s Money: A Study in the Social Psychology of Embezzlement set the foundation for studying fraud. From his research, the fraud triangle was born. Each side represents one of three conditions generally present when fraud occurs: incentives (or pressures), opportunities, and attitudes (or rationalizations).

Statement on Auditing Standards No. 99 (SAS 99), Consideration of Fraud in a Financial Statement Audit (AU 316), describes each of these risk factors relating to misstatements arising from fraudulent financial reporting. For example, there can be an increased risk of fraud when financial stability or profitability is threatened and management faces pressure to meet the expectations of financial goals.

The COVID-19 pandemic has already resulted in increased frauds via Paycheck Protection Program loans, and undoubtedly other types of occupational fraud will follow. Additionally, the nature of an entity’s operations may provide opportunities to engage in fraudulent financial reporting by way of a complex or unstable structure or deficient internal controls.

Risk factors reflective of attitudes (or rationalizations) may express themselves in a disregard for the need of monitoring or reducing risks related to misappropriation of assets, a disregard or failing to correct internal controls, behavior indicating dissatisfaction with the company, or changes in behavior or lifestyle that may indicate assets have been misappropriated. Economic survival, too, is a strong rationalization and motivator to commit fraud.

The Fraud Diamond

In a December 2004 CPA Journal article, David T. Wolfe and Dana R. Hermanson introduced the fraud diamond as a way to further analyze the characteristics behind fraud.  While the authors believe that opportunity opens the doorway, and incentive and rationalization draw the person toward fraud, they also believe a person must have the capability to recognize the open doorway as an opportunity and walk through it, not just once, but time and time again.

Thus, they enhance the fraud triangle by adding the fourth dimension of capability. The authors further stress that the capabilities to commit fraud are explicitly and separately considered in the assessment of fraud.

The Fraud Pentagon

Crowe Horwath (now Crowe LLP) further extended the fraud triangle and fraud diamond in 2009 through the development of the fraud pentagon. In addition to pressure, opportunity, and rationalization, Crowe recognizes that fraudsters need competence and a certain level of arrogance to commit the act.

Competence, like capability, can be characterized as the ability to ignore internal controls, develop concealment strategies, and control social situations. Arrogance, on the other hand, is the characteristic of superiority regarding the rights that people have and the feeling that internal controls and company policies do not apply.

Additional Strategies

CPAs can play an important role by understanding and raising awareness of fraud schemes. One key to detection and prevention is to focus on situations offering incentives, opportunities, and rationalizations to commit fraud.

In addition, CPAs should assess the capabilities of those in positions of authority. Leaders with a dark triad of personality traits (i.e., narcissism, Machiavellianism, and psychopathy) can have harmful effects on organizations. Through these fraud models, CPAs can take steps toward becoming anti-fraud watchdogs by considering the dimensions that lead individuals to commit fraud.

The original aritcle appeared in the Pennsylvania CPA Journal, the official publication of the Pennsylvania Institute of CPAs.

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