The opportunity for fraud exists in all types of businesses, and arguably more likely in nonprofits according to the 2013 Marquette International Ltd. Report on Embezzlement. The study found that nearly 12% of all fraud cases occurred in nonprofits while that sector accounted for only 5.5% of US GDP. To prevent it, nonprofit managers must understand the underlying causes of fraud, which are both psychological and operational. The Fraud Triangle is a widely accepted theory that explains how and why fraud is committed within an organization. It is comprised of three elements: Pressure, Rationalization and Opportunity. This article breaks down the Fraud Triangle and outlines an internal control system that minimizes the risk of fraud.
Understanding the Fraud Triangle:
Pressure – The employee’s motivation to commit fraud. Pressure can stem things like an individual’s personal financial struggles, a concern for presenting strong financial information to key players (existing or prospective donors, the board of directors, etc.), or if their compensation is directly or indirectly tied to the nonprofit’s financial performance. Depending on the type of pressure felt by the employee, a nonprofit could be at risk of misappropriation of assets (theft) or fraudulent reporting.
Rationalization – The employee’s internal justification for committing the fraud (a matter of morality). An employee could justify the fraud by convincing themselves that their family’s well-being depends on it, or that it wouldn’t be harmful to the organization (“they can afford it!”).
Opportunity – This is simply the means by which the employee commits the fraud (by exploiting a hole in the organization’s internal control system).
Key Takeaway: Pressure and Rationalization are psychological drivers, making them difficult to identify; it is often impractical for an employer to mitigate these risks. Instead, focus on limiting the opportunity to commit fraud via internal controls.
Implementing an Effective Internal Control System
The integrity of an internal control is determined by how well it segregates duties among individuals with accounting and financial responsibilities. A tightly designed control system requires collusion among multiple individuals for a breach to occur. This presents two challenges to typical nonprofits. Nonprofits often operate with minimal staffs, making it difficult to create the necessary overlap for a strong control system to operate. Additionally, managers might lack the expertise needed to rectify weaknesses in the control system. Therefore, creating cost effective internal control systems will be unique to every nonprofit based on its size and specific risks.
Additionally, our Nonprofit team would be happy to discuss the current structure of your internal controls system with you, and assist with identifying vulnerabilities in your current system and establishing more effective controls.
Contact Robert F. Hart, Jr., CPA, MST if you’d like an outline of a control system, or to schedule some time to talk!
Written By John Ead