Please Read Question In Comment Section Below. We hear it in the news, we see it on 60 Minutes, 20/20 and we read  about it in the paper, but often many bu

We hear it in the news, we see it on 60 Minutes, 20/20 and we read  about it in the paper, but often many businesses think they’re  invulnerable to fraud. Owners and managers alike, believe that because  they have a set of internal controls that their businesses are  protected. This mindset of “if it’s not broken why fix it?”, begs the  question do they really know “it’s” not broken?

As we’ve seen in  the last two videos this complacent attitude has severe consequences,  not only financially but publicly as well.

The article “The Four Elements of Fraud”  focuses in on behavior – and offers insight to risk factors involved  with fraudulent behavior and those behaviors that companies should keep  an eye out for. While this is an older article, the fundamentals remain  today.

Before reading the article:
Pretend  you own your own business. You are a sole proprietor with three  employees. One employee is a sales person; one employee is a bookkeeper  and the other employee is in shipping. You have a product that is very  popular amongst college students and therefore sales are amazing – and  the company sustains itself very nicely. As the owner, you tend to  travel to develop personal relationships with College Presidents; and  Marketing VP’s.

After reading the article: Keeping the above scenario in mind (you’re the owner, etc.) respond to the prompt below in proper written format (please follow this Discussion Board Requirements & Rubric) and answer the following: 

Prompt:  As the owner of this company, what type of internal controls do you  have in place to ensure that while you’re away the mice won’t play  (ahem, engage in fraudulent behavior)? List at least four  internal controls; and what type of protection of fraudulent behavior  they control” or in other words will provide protection from. 

Need 300 Words or 1 Page 

Need References

and Plagiarism Report

Please read attached document for reference

M A N A G E M E N T

f r a u d

The Fraud Diamond: Considering
the Four Elements of Fraud

By David T. Wolfe and
Dana R. Hermanson

D
espite intense efforts to stamp out
L-orruption. misappropriation of
assets, and fraudulent financial

reporting, it appears that fraud in its vari-
ous foniis 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 account-
ing restatements and SEC enforcement
actions in recent years. (See 2003 Annual
Review of Financial Reporting Matters
by the Huron Consulting Group and the
SEC’s Report Pursuant to Section 704 of
the Sarbanes-Oxley Act of 2002.)

In response to the fraud problem.
Congress and regulatory authorities have
enacted tougher laws and increased
enforcement actions. Organizations are
implementing tighter controls and broader
oversight. The auditing profession has
adopted more rigorous auditing standards
and procedures, and softv -̂are developers
are adding continuous monitoring features
to back-office systems. It remains unclear
whether these efforts are sufficient to mit-
igate the fraud problem.

Many studies suggest fraud is more like-
ly to occur when someone has an incen-
tive (pressure) to commit fraud, weak con-
trols or oversight provide an opportunity
for the person to commit fraud, and the
person can rationalize the fraudulent
behavior (attitude). This three-pronged
framework, commonly known as the
“fraud triangle.” has long been a useful tool

for CPAs seeking to understand and man-
age fraud risks. The framework has been
fomially adopted by the auditing profes-
sion as part of SAS 99.

A Different Way to Think About Fraud Risks
The authors believe that the fraud trian-

gle could be enhanced to improve both
fraud prevention and detection by consid-
ering a fourth element. In addition to
addressing incentive, opportunity, and ratio-

nalization, 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 dtwrway to fraud, and incentive

EXHIBIT 1

THE FRAUD DIAMOND

Incentive Opportunity

Rationalization Capability

3 8 DECEMBER 2(M>4 / THE CPA JOURNAL

and rationalization can draw the person
loward 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
lime and time again. Accordingly, the crit-
ical question is. “Who could turn an oppor-
tunity for fraud into reality?”

Using the four-element fraud diamond,
a fraudster’s thought process might pro-
ceed as follows {Exhibit I):
• 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: 1 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 over-
lap, the primary contribution of the fraud
diamond is that the capabilities to commit
fraud are explicitly and separately consid-
ered in the assessment of fraud risk. By
doing so. the fraud diamond moves beyond
viewing fraud opportunity largely in
terms of environmental or situational fac-
tors, as has been the praetiee under current
and previous auditing standards.

For example, consider a company
where the internal controls allow the pos-
sibility that revenues could be recorded
prematurely by altering sales contract
dates in the sales system. An opportuni-
ty 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 man-
ager 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 p o s s i b i l i t y would never
become reality, despite the presence of the
elements of the fraud triangle. Thus, the
CEO’s capabilities arc a major factor in
determining whether this control weak-
ness 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 com-
mitting 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 fumish the ability to
create or exploit an opportunity for fraud

not available to others. For example, a CEO
or divisional president has the positional
authority to influence when contracts or
deals take effect, thus affecting the timing
of revenue or e x p e n s e r e c o g n i t i o n .
Fraudulent Einancial Reporting:
1987-1997. An Analysis of U.S. Public
Companies {Beasley et al.. 1999) found that
corporate CEOs were implicated in over

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70% of public-company accounting frauds.
indicating that many organizations do not
implement suMlcient checks and balances
to mitigate the CEO’s capabilities to influ-
ence and perpetuate fraud. Additionally.
when people perform a certain function
repeatedly, such as bank reconciliations or
setting up new vendor accounts, their capa-
bility to commit fraud increases as iheir
knowledge of the function’s processes and
controls expands over time.

Second, the right person for a fraud is
smart enough to understand and exploit
internal control weaknesses and to use
position, function, or authorized access to
the greatest advantage. Many of today’s
largest frauds are committed by intelli-
gent, experienced, creative people, with
a solid grasp of company controls and vul-
nerabilities. This knowledge is used to
leverage the person’s responsibility over
or authorized access to systems or
assets. According lo the Association of
Certified Fraud Examiners. 5 1 % of the
perpetrators of occupational fraud had at
least a bachelor’s degree, and 49% of
the fraudsters were over 40 years old. In
a d d i t i o n , 4 6 % of the frauds the
Association recently studied were com-
mitted by managers or executives.

Third, the right person has a strong ego
and great confidence that he will not be
detected, or the person believes that he
could easily talk himself out of trouble if
caught. Such confidence or arrogance can
affect one’s cost-benefit analysis of engag-
ing in fraud: the more confldent the per-
son, the lower tbe estimated cost of fratid
will be. In “The Human Face of Fraud”
(C4 Magazine, May 2003), R. Allan notes
that one of the common personality types
among fraudsters is the “egotist”—some-
one who is “driven to succeed at all costs,
self-absorbed, self-confident and n;ircissis-
tic.” Similarly. DLifiield and Grabosky
(‘The Psychology of Fraud.” Trends &
issues in Crime and Criminal Justice.
March 2001) note that, in addition to finan-
cial strain. “Another aspect of motivation
that may apply to some or all types of fraud
is ego/power.” The authors go on to
quote Stotland (“White Collar Criminals.”
Journal of Social Issues. 1977) regarding
ego: “As [fraudsters] found thetnseives suc-
cessful at this crime, they began to gain
some secondary delight in the knowledge
that they are fooling the world, that they

are showing their superiority to others.”
Fourth, a sticcessful fratidster can coerce

others to commit or conceal fraud. A per-
son with a very persuasive personality may
be able to convince others to go along
with a fraud or to simply kwk the other way.
In addition. Allan notes that a common per-
.sonality type among fraudsters is the “bully,”
who “makes unusual and significant
demands of those who work for him or her,
cultivates fear rather than respect … and
consequently avoids being subject to the
same rales and procedures as others.” Many
financial reporting frauds are cotnmitted
by subordinates reacting to an edict from
above to “make your numbers at all costs,
or else.”

Fifth, a successful fraudster lies effec-
tively and consistently. To avoid detection.
she must look auditors., investors, and
others right in the eye and lie convincing-
ly. She also possesses the skill lo keep track
of the lies, so that the overall story remains
consistent. In the Phai-Mor fratid. the audi-
tors claimed that Phar-Mor had formed a
“fraud team” of executives and former
auditors who “continually worked to hide
evidence” abtiut the fraud from them. TTie
auditors claimed that the fraud team “lied.
forged dtKuments and ‘scrubbed’ every-
thing the auditors saw to hide any indica-
tions of malfeasance.” (See “Finding
Auditors Liable for Fraud: What the Jury
Heard in the Phar Mor Case.” Cottrell
and Glover, The CPA JournaL July 1997.)

Finally, a successful fraudster deals very
well with stress. Committing a fraud and
managing the fraud over a long period of
time can be extremely stressful. Ttiere is
the risk of detection, with its personal ram-
ifications, as well as the constant need to
conceal the fraud on a daily basis. Former
HealthSouth CEO Richiird Scrushy now
faces numerous criminal charges for
allegedly masterminding a long-running
scheme to inflate the company’s ejimings
during the terms of several different CFOs.
Despite the enormous pressure on him.
Scmshy has remained resolute dunng the
course of the investigation, even appearing
on 60 Minnies to proclaim his inmxrence.
In contrast, during his sentencing, former
HealthSouth Assistant Controller Emery
Harris, who allegedly was coerced to par-
ticipate in the fraud, told the Judge how
relieved he was after the company was
raided by federal agents, thinking it pro-

vided him the opportunity to finally “get
out of this mess.”

Dealing with Capability
Appreciating the importance of capa-

bility as a fourth element of fraud is only
p;ui of the challenge. The next task is to
address capability when assessing fraud
risk, and lo use knowledge about fraud
capability to prevent or detect fraud.
Beyond considering incentive, opportuni-
ty, and rationalization, the following steps
could shed light on capability.

Explicitly assess the capabilities of top
executives and key personnel. Focusing
on capability requires organizations and
their auditors to better understand employ-
ees’ individual traits and abilities. The audit
committee member, corporate accountant.
or auditor should focus on the personality
traits and skills of top executives and oth-
ers responsible for high-risk areas when
assessing fraud risk or seeking to prevent
or detect fraud. Routine background checks
on new employees can identify past crim-
inal convictions.

In assessing individuals’ traits and
abilities, several methods of gathering
information may be helpful. First, there
is no substitute for spending time with a
person. Frequent interaction under a vari-
ety of circumstances, both business and
social, can provide a meaningful picture

EXHIBIT 2
THE COMPONENTS OF CAPABILITY

Position/function

Brains

Confidence/ego

Coercion skills

Effective Lying

Immunity to stress

4 0 DECEMBER 2004 / THE CPA JOLiRNAL

of the person’s capabilities. Second, look
for signals in the “little things.” If the
person cuts comers on small issues or con-
sistently displays an absolute refusal to
lose or fail, no matter what the issue or
the cost, this may suggest similar behav-
ior on larger issues. For example, many
have said that an executive who cheats in
golf will cheat in business. Finally, pay
attention to what others say about a per-
son. If there are consistent statements
about certain traits or tendencies, this infor-
mation can supplement more direct obser-
vations. For example, if people in the orga-
nization are consistently in awe of some-
one’s technical or creative ability, this pro-
vides additional insight into the person’s
capabilities.

A key to mitigating fraud

is to focus particular attention

on situations offering, in addition

to incentive and rationayzation.

the combination of opportunity

and capability.

If there are concerns about capabili-
ty, respond accordingly. If someone’s
capabilities present a significant risk fac-
tor, respond with stronger controls or
enhanced audit testing. For example, if the
sales vice president is overly aggressive,
competitive, and obsessed with hitting
monthly sales quotas, there may be a need
for extra-tight controls over revenue recog-
nition or expanded testing of sales during
the annual audit. In addition, implement-
ing a periodic rotation of routine, but
key, ftinctions among staff can minimize

the opportunities for fraud gained from
long-term knowledge of the function and
its controls.

In this response phase, a key to miti-
gating fraud is to focus particular atten-
tion on situations offering, in addition to
incentive and rationalization, the combi-
nation of opportunity and capability. In
other words. “Do we have any dtxirways
to fraud that can be opened by people with
the right set of keys?” If so, these areas are
especially high risk, because all the ele-
ments are in place for a fraud opportunity
10 become reality.

For example, when designing detec-
tion systems, it is important to consider
who within the organization has the
capability to quash a red flag, or to cause
a potential inquiry by internal auditors to
be redirected. Cynthia Cooper, the inter-
nal auditor at WorldCom credited with dis-
covering the massive fraud, has described
in Time magazine how CFO Scott Sullivan
had exercised his position and seniority
to dissuade her team from looking into cer-
tain areas that later proved to have been
infested with massive fraud. But believing
they were on to something, her teams
worked behind Sullivan’s back, on many
occasions at night or from home, to
avoid detection and retribution. Although
it appears he tried, according to Cooper,
in this instance Sullivan was not capable
of completely thwarting the persistent
efforts of the auditors to uncover the
apparent fraud.

Reassess the capabilities of top execu-
tives and key personnel. Assessing capa-
bility and responding to concerns should
not be viewed as one-time exercises.
Continuous updating of the capability
assessment and response is warranted for
two reasons. First, people can develop new
capabilities over time, especially if they are
climbing the corporate ladder and growing
professionally. Just because someone did
not have enough power or knowledge of
an area to commit fraud in the past, there
is no guarantee that the person will not
develop such power or knowledge in the
future. Their capability to commit fraud
may increase, and additional controls or
scrutiny may be warranted.

Second, organizational processes, con-
trols, and circumstances change over
time. As a result, some people may be bet-
ter suited to commit fraud in the new envi-

ronment, even though they were not
capable under previous conditions. For
example, consider a company that has
recently implemented a complex new IT
system. The new system may render
those less digitally sophisticated employ-
ees incapable of exploiting its controls. On
the other hand, for those with strong IT
skills, the change might increase their capa-
bility of committing fraud. This new capa-
bility should be considered, and appropri-
ate responses implemented.

Beyond Standards
In the final analysis, recent legisla-

tion, increased enforcement, regulatory
oversight, broader controls, improved
auditing standards, and sophisticated
monitoring technology are all steps in the
right direction and will contribute to
preventing and detecting fraud. Limiting
this effort to current standards and prac-
tices may not be enough, however,
especially for auditors. Consistent with
this view, the 2(X)4 Miller GAAS Guide
describes the fraud triangle elements pre-
sented in SAS 99 and notes that “it is
obvious that the Auditing Standards
Board is struggling with the broad topic
of how to detect fraud … auditors should
be careful about following relevant pro-
fessional standards and then having a
sense of security about the likelihood that
fraud does not exist in a particular
engagement.”

Accordingly, if capability could play a
role in influencing or magnifying the other
fraud elements, other checks and balances
or detection systems should be imple-
mented, or an auditor should expand
audit scope, procedures, and testing for
potential fraud. Q

David T. Wolfe, CPA, is the founder of
Glasgow Forensic Group, a forensic
accounting ftmi in Allanla. Ga., and has
sen’ed a variety of clients, including top-
tier taw firms, govemmenl agencies, pri-
vately held small to mid-sized businesses,
and Fortune 500 companies. Dana R.
Hermanson, PhD, is a professor of
accounting in the Coles College of
Business at Kennesaw State University and
currently serves as a research fellow of the
Corporate Governance Center at the
University of Tennessee.

4 2 DECEMBER 2 0 0 4 / THE CPA JOURNAL

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