Fraud triangle definition
/What is the Fraud Triangle?
The fraud triangle is a model showing the conditions that increase the likelihood of fraud being committed. Fraud is any intentional deception engaged in for personal gain. The three components of the fraud triangle are perceived pressure, opportunity, and rationalization. This model is commonly used to explain the conditions under which fraud is most likely to occur. They are explained further below.
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Perceived Pressure
A person may be liable for significant liabilities, such as the cost of supporting sick relatives, college loans, car loans, and so forth. Or, they may have an expensive habit that requires ongoing funding. When the individual sees no way out of the situation, they may resort to fraud. However, there may only be a perceived level of pressure, such as earning comparatively less than one’s friends. This latter situation can trigger expectations for a better lifestyle, perhaps involving a sports car, foreign travel, or a larger house. When a person does not see a clear path to meeting these expectations by honest means, he or she may resort to dishonest alternatives.
Opportunity
When the preceding pressures are present, a person must also see an opportunity to commit fraud. For example, a maintenance worker may realize that there are no controls over checking out and returning tools; this is an opportunity for theft. Generally, the opportunity for fraud increases when a business has poor internal controls.
Rationalization
An additional issue that is needed for fraud to continue over a period of time is the ability of the perpetrator to rationalize the situation as being acceptable. For example, a person stealing from a company’s petty cash box might rationalize it as merely borrowing, with the intent of paying back the funds at a later date. As another example, a management team adjusts reported earnings for a few months during mid-year, in the expectation that sales will rise towards the end of the year, allowing them to eliminate the adjustments by year-end.
The likelihood of fraud being committed increases when more of these conditions are present.
Example of the Fraud Triangle
A good example of the fraud triangle is the Enron scandal. Enron Corporation, once a major U.S. energy company, collapsed due to one of the largest accounting frauds in history. The fraud triangle can be clearly seen in this case:
Perceived pressure. Enron executives faced immense pressure to meet Wall Street’s high expectations for revenue and profit growth. The company’s aggressive growth targets and a culture that rewarded high stock prices created significant pressure to show continuous financial success.
Opportunity. Enron’s complex business model and a lack of effective internal controls provided opportunities for fraud. Executives exploited gaps in accounting regulations, using special purpose entities (SPEs) to hide debt and inflate profits without proper oversight or transparency. Arthur Andersen, Enron’s auditor, failed to detect or report the financial manipulations, further enabling the opportunity for fraud.
Rationalization. Executives at Enron, including CEO Jeffrey Skilling and CFO Andrew Fastow, rationalized their actions by believing that temporary financial manipulation would help the company overcome short-term challenges. They convinced themselves that maintaining high stock prices justified their deceptive accounting practices.
This example illustrates how perceived pressure, opportunity, and rationalization came together to enable one of the most infamous corporate frauds in history.