The Perfect Recipe for Fraud

Fraud is most likely to occur in one of these departments: Accounting, Customer Service, Executive/Upper management, Operations, Sales or Purchasing — according to the Association of Certified Fraud Examiners (AFCE). In fact, in the ACFE’s most recent Report to the Nations on Occupational Fraud and Abuse, some 77% of frauds are committed in at least one of these departments. While most employees won’t even consider fraudulent behavior, others may look at fraud as a great way to get ahead. So, what should you know about conditions that make fraud likely to happen?

Just as fire requires fuel, oxygen, and heat, occupational fraud requires motive, opportunity and rationalization. These are what forensic accountants call the “fraud triangle.” And economic downturns, such as the ones we have experienced in the past, can ignite fraud by fueling all three factors.

As described by J.K Loebbecke, M.M. Eining, and J.J. Willingham, Jr., “Auditors’ experience with material irregularities: Frequency, nature, and Detectability” (Auditing: A Journal of Practice & Theory, Fall 1989), the fraud recipe contains three ingredients: Incentive, Opportunity, and Attitude/Rationalization.

The first ingredient, Incentive, addresses whether executives have a reason to commit accounting fraud. Common reasons include compensation factors (stock options, bonus targets), strong pressure to perform, and expectations analysts place on the company. Putting pressure on executives certainly is a good motivator, but it is important to recognize when the pressure becomes so intense that people resort to fraud to make the numbers.

The second ingredient is the Opportunity to commit accounting fraud. The main deterrent to opportunity is strong internal controls, the focus of section 404 of the Sarbanes-Oxley Act. Controls should address routine transaction processing and asset safeguarding, as well as estimates and assumptions used in preparing the financial statements. If section 404 work improves internal controls, the side benefit should be a reduced risk of accounting fraud.

The third ingredient in the fraud recipe is Attitude/Rationalization. In other words, can someone with a reason to commit fraud and the opportunity to do so explain away such behavior? Is the fraud okay because it saved jobs? Is it okay because it happened only once and will be corrected in the future? Is it okay because the CEO said “make the numbers or else”?

For this discussion, please address the following:

1. What four elements make for the perfect recipe for fraud?

2. How do they apply to every day business?

3. What conditions make fraud more likely to happen? Any thoughts or suggestions on how to prevent fraud from happening? For full credit on this assignment, please respond to at least one of your classmates’ responses to this 3rd question only.