The Evolution Theory of Fraud

Fraud Triangle Theory

Employees should be cognizant of pressures and how they relate to the school district’s and charter school’s overall fraud risk. Rationalizations can be reduced by promoting a strong sense of ethical behavior amongst employees and creating a positive work environment. By implementing strong internal controls, the district can remove much of the opportunity for fraud to occur and can increase the chances of detecting it.

Pressure

Pressure is what causes a person to commit fraud. Pressure can include almost anything including

medical bills, expensive tastes, addiction problems, etc. Most of the time, pressure comes from a

significant financial need/problem. Often this need/problem is non-sharable in the eyes of the fraudster. That is, the person believes, for whatever reason, that their problem must be solved in secret. However, some frauds are committed simply out of greed alone.

Opportunity

Opportunity is the ability to commit fraud. Because fraudsters don’t wish to be caught, they must also believe that their activities will not be detected. Opportunity is created by weak internal controls, poor management oversight, and/or through use of one’s position and authority. Failure to establish adequate procedures to detect fraudulent activity also increases the opportunities fraud for to occur. Of the three elements, opportunity is the leg that organizations have the most control over. It is essential that organizations build processes, procedures and controls that don’t needlessly put employees in a position to commit fraud and that effectively detect fraudulent activity if it occurs.

Rationalization

Rationalization is a crucial component in most frauds. Rationalization involves a person reconciling his/her behavior (stealing) with the commonly accepted notions of decency and trust. Some common rationalizations for committing fraud are:

 The person believes committing fraud is justified to save a family member or loved one;

 The person believes they will lose everything – family, home, car, etc. if they don’t take the

money;

 The person believes that no help is available from outside;

 The person labels the theft as “borrowing”, and fully intends to pay the stolen money back at

some point;

 The person, because of job dissatisfaction (salaries, job environment, treatment by managers,

etc.), believes that something is owed to him/her;

 The person is unable to understand or does not care about the consequence of their actions or of

accepted notions of decency and trust.

Fraud Diamond Theory

Thanasak Ruankaew, 2016. Beyond the Fraud Diamond. Colorado, United States

The FDT was first presented by Wolfe and Hermanson in the CPA Journal (December 2004). It is generally viewed as an expanded version of the FTT. Figure 2 presents the diagram for FDT. In this theory, an element termed capability has been added to the three initial fraud elements of the FTT. Wolfe and Hermanson (2004) argued that although perceived pressure or incentive might coexist with an opportunity to commit fraud and a rationalization for doing so, it is unlikely for fraud to take place unless the fourth element (i.e., capability) is also present. In other words, the potential perpetrator must have the skills and ability to commit fraud.

Incentive

Every perpetrator must face some type of pressure to commit fraud. Perceived pressure is defined as the motivation that leads the perpetrator to engage in unethical behaviors. It is important to point out that perceived pressures can occur with all employees at any level of the organization and can occur for various reasons. Such pressure does not have to be real, if the perpetrators believe they are being pressured, it can lead to fraudulent behavior (Albrecht, Hill, & Albrecht, 2006). Although an individual may demonstrate different motives, research has shown that fraud often occurs as a response to economic pressures, and most pressures involve a financial need such as greed, living beyond one’s means, large expenses or personal debt, poor credit, personal financial losses, and an inability to meet a financial forecast.

Opportunity

This is the second element necessary for fraud to occur. Opportunity that exists in organizations has a major impact on an individual’s decision to commit fraud. Rae and Subramaniam (2008) suggested that, if a susceptible individual perceives opportunities due to a lack of or inefficient internal controls and has the ability or power to exploit these opportunities, that individual may perpetrate a fraud. Perceived opportunity is similar to perceived pressure; the opportunity does not have to be real, the perpetrators simply have to believe or perceive that the opportunity exists in order to take fraudulent action (Albrecht, Hill, et al., 2006; Zikmund, 2008). Individual factors such as financial need and personal issues are variables that businesses cannot control; therefore, they can only decide how to react to these factors through the use of internal controls (McClurg & Butler, 2006).

Rationalization

An attitude or morally acceptable rationalization needs to occur before fraudulent behavior emerges. It is important to acknowledge that fraud perpetrators sometimes do not view their actions as unethical; they merely justify their actions as ethical before fraud takes place (Dorminey et al., 2010). In other words, rationalization allows the fraudster to view his or her illegal actions as acceptable. Jackson, Holland, Albrecht, and Woolstenhulme (2010) concluded that, if a person cannot justify unethical actions, it is unlikely he or she will engage in fraud. That person, however, may rationalize those actions in different ways using various justifications. These are some examples: “I am only borrowing,” “The organization can afford it,” “I deserve a bonus or a raise but did not get one,” “Everyone’s getting rich, so why shouldn’t I?” and “It is not really a serious matter” (Ramamoorti, 2008; Zikmund, 2008).

Capacity

A person’s position or function within a company may give him or her the ability to create or exploit an opportunity for fraud not available to others. According to Wolfe and Hermanson (2004), the fraudster also has the necessary traits and abilities to be the right person to pull it off, and that this person has recognized this particular fraud opportunity and can turn it into reality. Wolfe and Hermanson identified important observable traits related to individuals’ capacity to commit fraud.

Those threats include:

(a) authoritative position or function within the organization; for example, a CEO might have the ability to influence and perpetuate frauds due to his or her position within the organization

(b) intelligence to exploit the accounting and internal control systems’ weaknesses to the greatest advantage and have the ability to understand how the system works

(c) ego and confidence that fraudulent behaviors will not be detected, which will have an impact on their decision-making process; thus, the more confident they are, the greater chance that they will commit fraud

(d) capability toeffectively deal with stress due to the risk of getting caught and manage the fraud over a long period of time. That person also must effectively and consistently lie to avoid detection and may even have to persuade others to believe that fraud does not take place.

MICE Fraud

Several models and extended theories of fraud attempt to explain why individuals commit fraud and financial crimes beyond the rationale afforded by the Fraud Triangle. These additional models seek to identify supplementary psychological or sociological antecedents (personality and behavioral characteristics) to describe those tending toward fraud.

At this initial step we relate the Fraud Triangle to the Triangle of Fraud Action and identify an area around the Fraud Triangle where other theories and models are informative. The area around the Fraud Triangle, Individual Characteristics—Measures, Constructs, and Combinations of Hazard, is where we introduce additional behavior and decision models that affect rationalization, perceived opportunity, and financial pressure. One of the models in this area is M.I.CE

Recent discussions have suggested that the motivations of fraud perpetrators may be more appropriately expanded and identified with the acronym M.I.C.E. (Kranacher et al. 2011):

M : money

I : ideology

C : coercion

E : ego (entitlement)

M-I-C-E modifies the pressure side of the Fraud Triangle, as it provides an expanded set of motivations beyond a non-shareable financial pressure. Money and ego appear to be common motivations for fraud. Case histories of Madoff, Stanford, Enron, WorldCom, Adelphia, Phar-Mor, and ZZZZ Best provide examples where the convicted perpetrator appears to be motivated by ego or entitlement, as well as money.

Ideology is probably a less-frequent motivation for white-collar crime, yet examples come to mind. First, tax evasion, where the perpetrator cites that ‘‘taxes are unconstitutional’’ or ‘‘I pay enough taxes,’’ might be examples.

Coercion describes the condition where an individual is unwilling, but nonetheless pressured into participating in a fraud scheme. As an example, referring again to the Walmart–Coughlin case, Patsy Stephens sued Thomas Coughlin claiming that she was coerced into submitting vouchers and laundering the money through her own bank account.

Scale Fraud

The fraud scale was developed through an analysis of 212 frauds in the early 1980s (Albrecht

et al. 1984). The study was based on data obtained from internal auditors of companies that were victims of fraud. Operationalizing the fraud scale, the degree of fraud risk is determined by jointly considering three criteria—pressure, opportunity, and integrity.

The benefit of examining integrity is that an individual’s integrity can be inferred from past behavior. For example, a person’s integrity is reflected in his decisions as well as in his decision making processes. More importantly, personal integrity affects the probability that an individual may rationalize inappropriate behavior. For example, persons with greater integrity would be less likely to form rationalizations for justifying inappropriate behavior. From that perspective, integrity is a refinement of the rationalization construct.

Fraud Pentagon Theory

Renewable theories that explore more deeply on the trigger factors of fraud is

pentagon fraud theory (Crowe's fraud pentagon theory). This theory was put forward by Crowe Howarth in 2011. The theory of fraud pentagon is an extension of the previous theory of fraud triangle stated by Cressey, in theory adds two more fraud elements are competence and arrogance.

Additional component on Fraud Pentagon which didn’t exist on Fraud Triangle:

•  Competence (competence) which is described in the theory of fraud pentagon has similar meaning to the capability / ability previously described in the fraud diamond theory by Wolfe and Hermanson in 2014.  Competency / capability is the ability employees to ignore internal controls, develop a strategy of concealment, and control the social situation for personal gain (Crowe, 2011).
• Arrogance, according to Crowe, is attitude of superiority over the rights owned and feel that the company's internal controls or policies does not apply to him.

Fraud GONE Theory

GONE theory put forward by a thinker named Jack Bologne where there are four reasons of fraud. "GONE" which stands for the first letter of each factor put forward, namely Greed, Opportunity, Need, and Exposure.

a.     Greed (avarice / greed) is the desire to always get the most. Greed is associated with an individual moral.

b.       Opportunity (opportunity / opportunities) is a situation that could come at any time. In addition, the chance is very dependent on a position of a person. The higher one's position, the greater the chances of fraud.

c.       Need (requirement) may be a contributing factor fraudulent activity when a person needs (it can be said) is very urgent. Demands for fulfillment is what then makes a person to take a shortcut to act fraudulently.

d.       Exposure (disclosure) in relation to penalties fraud perpetrators. With the unfolding of a fraud in the company did not rule out recurrence of the same thing if given a sentence or a witness who is weak and does not pose a deterrent properties.

Greed and Need is often referred to as the individual factors, while the opportunity and exposure is referred to as a generic or common factor.

Created by:

·         Lalita Nadya A                 (C1L014014)      This is me.

·         Junika Pentarosa            (C1L014025)

·         Lintang Maharani          (C1L014028)

International Accounting

Jenderal Soedirman University

Analytical Procedures? Why Common-Size Financial Statement?

Analytical procedures are an important part of the audit process and  it’s consist of evaluations of financial information made by auditor and a study of plausible relationships among both financial and nonfinancial data. Analytical procedures range from simple comparisons to the use of complex models involving many relationships and elements of data. For auditor when planning and evaluating the analytical procedure, they should understand financial relationships through the company’s client and generally requires knowledge of the client and the industry/industries in which the client operates.

Analytical procedures purposes, there are:

·        Comparable of financial information within the prior periods to know whether it’s improved or not.

·        Anticipated results like for example, budgets, or forecasts including extrapolations from interim or annual data

·        Relationships among elements of financial information within the period

·        Information regarding the industry in which the client operates, like or example, gross margin information

·        Relationships of financial information with relevant nonfinancial information

In order to meet the purpose of analytical procedures, it’s necessary for the auditor to make calculations and identify comparison of the financial information within the client’s company that being audited. And the comparison itself can be made by these five ways:

•         Absolute Data Comparisons

•         Common-size Financial Statements

•         Ratio Analysis

•         Trend Analysis

•         Compare Financial Information with Nonfinancial Information

Now, I’m going to just focus on the 2^nd point whicih is the common-size financial statements.

Common-size financial statement is a  financial statement which is displayed the all items as a form of percentages or a common base figure. This financial statement allows the auditor to make a comparable between companies or between time periods of a company. The values on the common size statement are expressed as percentages of a statement component, such as revenue.

This is the example of Common-size Financial Statement

References:

-         https://www.stock-analysis-on.net/NYSE/Company/Nike-Inc

-         http://www.investopedia.com/terms/c/commonsizefinancialstatement.asp

-         http://www.netmba.com/finance/statements/common-size/

Created by:

Lalita Nadya Amalia

C1L014O14

International Accounting

Jenderal Soedirman University

Internal Control on Zara Resources Inc

Zara Resources Inc is a mineral’s company focusing its main effort on its forge lack gold project in Ontario, Canada.

Based on our group discussion, we think that Zara Resources Inc is quite good in implementing the internal control, it’s proved by the financial report which has no fraud detection and misstatement. Moreover,  the other evidence is this company use the accounting policy which is IFRS in making the estimation and assumption on reported their amounts of assets, liabilities, revenue, and expenses for the period. This company is established in 2012, and this audit report is produced in 2014, so it means that the company is basically good since its established.

This is group assignment, and my group consist of:

·         Lalita Nadya  A.            C1L014014 (this is me)

·         Junika Pentarosa         C1L014025

·         Lintang Maharani        C1L014028

International Accounting

Jenderal Soedirman University

COSO Internal Control-Integrated Framework

COSO Cube Integrated Framework (Updated)

What is COSO?

COSO, the Committee of Sponsoring Organizations of the Treadway Commission, is a private sector initiative established in 1985 by five financial professional associations. COSO’s goal is to improve the quality of financial reporting  through a focus on corporate governance,  ethical practices, and internal control. COSO’s Internal Control—Integrated Framework (Framework) enables organizations to effectively and efficiently develop systems of internal control that adapt to changing business and operating environments, mitigate risks to acceptable levels, and support sound decision making and governance of the organization.

Definition of Internal Control According to COSO

A process, effected by an entity's  board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives. The categories of internal control, there are:

•           Effectiveness and efficiency of operations
•           Reliability of financial reporting
•           Compliance with applicable laws and regulations

Components of Internal Control

Internal control consist of eight integrated components according to the updated COSO:

1.     Internal Environment

      It’s made the guidelines for how risk is viewed and addressed by     people on an entity, including risk philosophy and risk appetite,       their ethical values, and the environment in which they do the        work activities.

2.     Objective – Setting

It must exist before management can identify the potential events affecting their good results, so that entity must ensure that management has in place a process to set objectives and that the chosen objectives support and align with the mission of the entity itself or not and are consistent with its risk appetite.

3.     Event Identification

The internal control should identify the internal and external events which is affecting the good result of an entity’s objectives and also distinguish between risks and opportunities.

4.     Risk Assesment

It involves a dynamic and iterative process for identifying and assessing risks to the achievement of objectives. Risks to the achievement of these objectives from across the entity are considered relative to established risk tolerances. Thus, risk assessment forms the basis for determining how risks will be managed.

5.     Risk Response

Management of the entity should selects risk responses in order to avoiding, accepting, reducing or sharing risk which aligned with the entity’s risk tolerance and risk apetite.

6.     Control Activities

Is the actions established through policies and procedures that help ensure that management’s directives to mitigate risks to the achievement of objectives are carried out.

7.     Information and Communication

     Information is necessary for the entity to carry out internal control responsibilities to support the achievement of its objectives. Communication is the continual, iterative process of providing, sharing, and obtaining necessary information.

8.   Monitoring

    Ongoing evaluations, separate evaluations, or some combination of the two are used to ascertain whether each of the eight components of internal control, including controls to effect the principles within each component, is present and functioning.

References:

-          http://info.knowledgeleader.com/bid/163293/what-is-the-coso-enterprise-risk-management-framework

-          https://www.protiviti.com/sites/default/files/united_states/insights/updated-coso-internal-control-framework-faqs-third-edition-protiviti.pdf

-          https://www.coso.org/Documents/COSO-FAQs-May-2013-branded.pdf

Created by:

Lalita Nadya Amalia

C1L014014

International Accounting

Jenderal Soedirman University

Internal Control on Audit Process

• Definition of Internal Control

In the Accounting Theory, internal control can be defined as a process, which is influenced by human resources and information technology systems, which are designed to assist organizations in achieving a particular goal or objective.

In short, the definition of internal control is the way of human resources who helped by information technology to make sure that the organization or entity is running based on the goal that will be achieved by the organization itself and also to detect the fraud that might happen so that they can minimize it.

• The Purpose of Internal Control

To ensure the management of organization or entity to ensure that:

1. The goals set will be achieved.

2. The financial statements produced by the organization can be trusted

3. The oganization activities is running in accordance with the applicable laws and regulations.

4.  Prevent loss or waste processing resources by the organization.

5. Provide information on how to assess the performance of the company and the management company as well as provide information that will be used as a guide in planning.

• Why Internal Control is Important in Auditing Process?

In my opinion, internal control is important in the auditing process because to audit an entity, at first the auditor must know  the internal conditions itself in that entity, whether the management control is  good, monitoring among the members of is running well, whether the company has been carrying out its activities in accordance of laws and regulation which is existing or not, or the financial statements that produced absolutely true which is no miss calculation or fraud, and etc. To know the information of intern conditions of the entity that being audited, the auditor may know it by internal control of the entity itself. If the entity's internal control is good, then the work result and its financial statements can be justified. However, if the internal control of the entity is not good, then the auditor must do the extra work to find for evidence, in case of that entity have been operated out of the control, laws, and regulations. Internal control itself can help the auditor to obtain information that will be used as a planning guide in the assessment that will be given to shareholders. In addition, it is impractical for the auditor to perform auditing in whole or in detail for almost all of thr entity’s transactions in a limited time and cost.

• How to Test the Internal Control of an Entity?

To test whether the internal control in an entity is  running well or not, the entity should make a restrictions for the size of what things  will be controlled or in other words, entity must have an SOP (standard operating procedures) in carrying out their work activities. For example, if the entity want to control the management members in their attendance, the entity must prepare the tools absence and make a limit of how many times that  members can do absence within a year. Another example, in making a product, an entity must have a limit to how much resources will be used in making the product itself so that it can be clearly measured and minimize loss of resoures.

References:
- https://pcaobus.org/Standards/Auditing/pages/auditing_standard_5.aspx
- https://uiowa.edu/audit/what-are-internal-controls

Created by:
Lalita Nadya Amalia
C1L014014
International Accounting
Jenderal Soedirman University