Despite intense efforts to stamp out corruption, misappropriation of assets, and fraudulent financial reporting, it appears that fraud in its various forms is a problem that is increasing in frequency and severity. KPMG’s Fraud Survey 2003 documented a marked increase in overall fraud levels since its 1998 survey, with employee fraud by far the most common type of fraud. The 2003 survey also noted that fraudulent financial reporting had more than doubled from 1998. This trend is consistent with the unprecedented recent spate of large accounting frauds (Enron, WorldCom), as well as the increased number of accounting restatements and SEC enforcement actions in recent years. (See 2003 Annual ...view middle of the document...
In addition to addressing incentive, opportunity, and rationalization, the authors’ four-sided “fraud diamond” also considers an individual’s capability: personal traits and abilities that play a major role in whether fraud may actually occur even with the presence of the other three elements.
Many frauds, especially some of the multibillion-dollar ones, would not have occurred without the right person with the right capabilities in place. Opportunity opens the doorway to fraud, and incentive and rationalization can draw the person toward it. But the person must have the capability to recognize the open doorway as an opportunity and to take advantage of it by walking through, not just once, but time and time again. Accordingly, the critical question is, “Who could turn an opportunity for fraud into reality?”
Using the four-element fraud diamond, a fraudster’s thought process might proceed as follows (Exhibit 1):
Incentive: I want to, or have a need to, commit fraud.
Opportunity: There is a weakness in the system that the right person could exploit. Fraud is possible.
Rationalization: I have convinced myself that this fraudulent behavior is worth the risks.
Capability: I have the necessary traits and abilities to be the right person to pull it off. I have recognized this particular fraud opportunity and can turn it into reality.
While these four elements certainly overlap, the primary contribution of the fraud diamond is that the capabilities to commit fraud are explicitly and separately considered in the assessment of fraud risk. By doing so, the fraud diamond moves beyond viewing fraud opportunity largely in terms of environmental or situational factors, as has been the practice under current and previous auditing standards.
For example, consider a company where the internal controls allow the possibility that revenues could be recorded prematurely by altering sales contract dates in the sales system. An opportunity for fraud exists, if the right person is in place to understand and exploit it. This opportunity for fraud becomes a much more serious problem if the company’s CEO, who is under intense pressure to increase sales, has the technical skills to understand that the control weakness exists, can coerce the CFO and sales manager to manipulate the sales contract dates, and can consistently lie to analysts and board members about the company’s growth. In the absence of such a CEO, the fraud possibility would never become reality, despite the presence of the elements of the fraud triangle. Thus, the CEO’s capabilities are a major factor in determining whether this control weakness will ultimately lead to fraud.
The Person with Capability
Based on one author’s experiences in investigating frauds for the past 15 years, there are several essential traits for committing fraud, especially for large sums or for a long period of time (Exhibit 2). First, the person’s position or function within the organization may...