In this video, learn about the three components of the fraud triangle. This is important for understanding the control environment.
- One of our colleagues, Steve Albrecht, helped develop and explain the fraud triangle metaphor. - The fraud triangle is based on the fire triangle that many of us learned about as children. - In order for a fire to burn, three components are necessary. Heat, oxygen, and fuel. Remove any one of these three, and the fire will go out. - Rapid evaporation of water removes heat from the fire. So you put fires out by spraying water on them. - A blanket, or carbon dioxide from a fire extinguisher, keeps oxygen away and puts out the fire. - Removing fuel and potential fuel, as firefighters do in clearing away trees to create a fire break, also puts out a fire. - Remove any one of these three fire components, heat, oxygen, or fuel, and you put out the fire. - [Instructor] The fraud triangle is based on the fact that three conditions are necessary for a fraud to exist. Remove any one of the three conditions, and there's no fraud. - [Instructor] First, a person must feel financial pressure. This financial pressure can result from poor personal budgeting, unexpected family illness, divorce, gambling, job loss, and many more events. - The sobering thought is that you can't necessary tell who is under financial pressure just by looking at them. Almost all of us would go to great lengths to keep the knowledge of our personal financial pressure from being widely known. - So, to have a fraud, first there must be a person feeling financial pressure. - But that's not enough. All three conditions of the fraud triangle must exist for there to be a fraud. - [Instructor] Second, a person must be able to rationalize the fraud, and it turns out we humans can be quite creative in our rationalizations. - Here are some rationalizations given by people who have stolen money from their companies. - "Hey, they owe me! "I've been working for them for years, "and they've always underpaid me!" - Or, "This doesn't hurt anyone! "They're a big company, they can afford a small loss." - Or, "I'm only borrowing the money. "I'll pay it back next month." - Or, "I'm desperate. "This is to get my family out of financial catastrophe. "This is a good purpose." - [Instructor] The third condition is opportunity. Without a fraud opportunity, a person feeling such financial pressure that she or he can rationalize stealing money from the company still cannot steal the money because there just isn't any way to do it! - [Instructor] This is where internal control enters the picture. By removing the third condition in the fraud triangle, opportunity, internal control can reduce the incidence of fraud. - Now imagine a charitable organization that receives large amounts of cash donations. Those donations are counted, recorded, and deposited in the bank. - Because of unexpected family medical bills, one of the persons who counts these cash donations is currently feeling financial pressure. - But no fraud yet! But after some thinking, this person concludes that some cash can be taken now, temporarily, and then be repaid in a couple of weeks. The person has not rationalized the theft. - But no fraud yet! The person needs the opportunity. Let's say that the charitable organization has put in place an internal control procedure dictating that cash donations can only be handled, counted, and deposited with two people physically present at all times. - Even though the person is feeling financial pressure, and has been able to rationalize taking some cash as a short-term loan, the two-person rule has eliminated the opportunity to grab some cash now, with the hopes of repaying it in the future. - The insight of the fraud triangle is that a good system of internal control reduces the incidence of fraud in a company by removing the third leg of the fraud triangle, the fraud opportunity.
Note: This course does not satisfy compliance training requirements for SOX.
- Common problems in financial statements
- Segregating duties and physical controls
- Conducting independent checks
- Earnings management
- Sarbanes-Oxley requirements
- Internal vs. external auditing
- How the SEC regulates financial documentation