In Part 1 of this series, I provided an overview of the Fraud Triangle and how incorporating it into compliance risk assessments can improve a compliance program’s assessment and prioritization of compliance risks. Part 2 went into more detail concerning the “opportunity” factor of the Fraud Triangle. This article will focus on the “rationalization” factor of the Fraud Triangle and provide some practical ways to incorporate the assessment of this factor as part of larger compliance risk assessment.
To briefly recap from Part 1, in the context of the Fraud Triangle, “rationalization” relates to a person’s ability to internally justify their unethical, wrongful or criminal actions. This is often affected not only by a person’s individual moral compass, but also by the ethical tone within an organization and the person’s perception(s) about the fairness and equality of rewards and punishments for actions and behavior.
Among the chief elements of proving fraud is proving “knowledge” and “intent.” Corporate fraud is not a mistake. This also applies to ethical violations and, generally, though not necessarily, to many compliance deviations (it is possible for a person to violate a compliance policy without realizing that they have done so, particularly when the violation does not compromise ethical values and where no, little and/or poor training has occurred to make the person aware of the compliance policies of an organization).
When one commits fraud or acts unethically, he or she knows that they have done something wrong. With the exception of sociopaths, who generally lack a conscience, most people are “good” and the temptation to do something wrong is affected by the anxiety that wrong-doing creates inside of them.
Rationalization helps a person avoid or reduce that anxiety, enabling them to justify their wrongful actions. Within an organization, rationalization is affected by such factors as: ethical tone (“tone at the top”); fair and equal punishments for bad behavior or wrongful actions; decentralization; employee turnover; compensation; and career – promotional or award considerations.
An ethical tone that promotes high ethical values and standards, as well as good behavior and actions, can encourage good behavior and reduce an employee’s ability to rationalize actions inconsistent with that tone. If management condones or demonstrates a poor ethical tone, it increases the ability for employees to rationalize their own misconduct, perhaps even encourages them to do so. Conversely, if management, starting at the highest level(s), promotes and demonstrates a high ethical tone, it is like an anti-virus that spreads throughout an organization.
Accordingly, compliance officers may consider incorporating an ethical tone assessment as part of their compliance risk(s) assessment. Understanding the ethical tone, real and perceived, will help the compliance officer evaluate the associated risk for the “rationalization” factor of the Fraud Triangle, which directly relates to the compliance risk(s). One of the most effective tools I have found in assessing ethical tone is interviews (see “The Compliance Interview – Six Helpful Questions”).
Another aspect of “rationalization” relates to the perception regarding fair and equal punishments for bad behavior or wrongful actions. If executives and/or senior people within organizations are perceived to be treated more leniently for ethics or compliance violations, those at lower levels are more able to rationalize their own violations.
Organizations should strive to assure that their penalties for such violations are commensurate with the violation and that the penalties are applied equally to all within the organization, regardless of their position or role. It could also be argued that those at higher levels within organizations should be held to an even higher standard, given the impact upon the organization should they violate a compliance policy or act unethically. Such things as “golden parachutes” for executives who leave their position, even if they left under circumstances involving ethical or compliance violations, can significantly increase employees’ ability to rationalize their own misconduct.
Compensation, along with career advancement/promotional opportunities and award considerations also affect the “rationalization” factor of the Fraud Triangle. Such things should be, generally speaking, based on merit and within some boundaries of equality and fairness.
While executives often merit large bonuses and/or incentive based compensation, taking such actions without the general employee population understanding the basis for it having been earned, can engender an “us versus them” mentality within an organization that increases lower level persons’ ability to rationalize misconduct.
While compensation cannot satisfy everyone’s perception about their personal worth (most feel they are worth more than they are paid), a perception about compensation being fair helps mitigate the negative perceptions. In tough economic times, where many have not received raises, received minimal wages and/or not been paid bonuses, organization’s should consider the affect of rewarding only top-level persons on the organization’s broader employee base and how such actions impact the “rationalization” factor of the Fraud Triangle.
Similarly, when employees who have been in a position for some length of time are not promoted as others above them retire or are promoted themselves, can affect the “rationalization” factor. A classic and real-life example is the assistant controller who, after many years of faithful service, is not promoted to controller when that role is vacated. Instead, a person from the outside is brought in to fill that position, creating a feeling of “that person took my job” within the assistant controller, which better enables that person to rationalize committing a fraud or other misconduct.
While hiring and promotion decisions should be done in accordance with the best interests of the organization, consideration should be given to how such decisions affect the “rationalization” factor of the Fraud Triangle. An organization that routinely fills vacated positions from the outside rather than promoting from within may create an environment that better enables employees to rationalize misconduct. This particular area should also be considered in light of the “opportunity” factor of the Fraud Triangle. The more likely that those in positions that have greater opportunity for wrongdoing can rationalize such wrongdoing, the greater the risk that they might do so (two of the three factors of the Fraud Triangle exists).
Any situations that create a more individualistic environment, rather than a team or environment can increase the risk of rationalization within employees. Decentralization, which can distance employees from the organization, as well as high-employee turnover, are two such areas that organizations frequently face.
Another, which occurs frequently within organizations heavily involved in government contracting, is where employees are “inherited” from the previous government contractor, such that they may not appreciate or feel part of the organization that actually employs them. Compliance officers should consider such positions in light of the “rationalization” factor of the Fraud Triangle when conducting their compliance risk assessment(s).
Consideration and incorporation of the Fraud Triangle’s “rationalization” factor can help a compliance officer both identify and prioritize compliance risks. In some instances, actions can be taken at a policy or policy enforcement level to help mitigate such risks. Audits can also be accordingly planned to continuously monitor and report on such risks.
The next article in this series will address the “motivation” factor of the Fraud Triangle.
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John “The Fraud Guy” Hanson is the founder and executive director of Artifice Forensic Financial Services LLC. He has over 20 years of fraud investigations, forensic accounting, and corporate compliance/ethics and audit experience. John has applied his extensive experience in these areas across a wide array of areas and industries, frequently assisting counsel, government agencies and companies with internal corporate investigations and other sensitive matters arising from alleged fraud or misconduct. In addition to being an expert on fraud, John is a recognized thought leader and expert in the field of independent corporate monitoring, a relatively new and highly specialized practice area involving the imposition of an independent third-party by a government agency or department upon an organization to verify that organization’s compliance with the terms of a settlement agreement between the organization and the government. John has previously served in a leadership role in a federal monitorship and is currently involved in three significant federal monitorships, two as the named monitor. John’s practical experience as a corporate monitor and extensive knowledge in this area was recognized by the American Bar Association, which appointed him to the Criminal Justice Section’s Ad-Hoc Task Force on Corporate Monitors, responsible for creating “best practices” and formal standards for corporate monitors. John is the only nonlawyer member of the task force and a frequently sought speaker on the topic. He has provided practical advice, ideas and strategies to lawyers, government officials and corporate executives involved in such matters as well as newly appointed corporate monitors. John’s diverse corporate compliance & ethics, fraud investigations, audit, accounting, finance, legal, regulatory, business operations and management, internal controls, professional training, international, fraud risk & vulnerability, interviewing, and quality control experience combined with his actual experience as a corporate monitor and passionate commitment to best practices in monitorships uniquely qualifies him as a premier advisor and provider of monitorship services. Prior to Artifice, John spent nearly six years as a leader in the fraud investigations and forensic accounting practice of a large publicly traded international financial consulting firm, where he focused on helping organizations prevent, detect, respond to and resolve issues associated with fraud or questions of corporate integrity. John was also a special agent with the Federal Bureau of Investigation (FBI), where for nearly ten years he specialized in white collar crime and investigated a wide variety of complex fraud schemes and financial crimes. For his last two years as an FBI Agent, John served as an instructor in the Investigative Training Unit at the FBI Academy, where he developed and facilitated fraud and investigative training curriculum for new agent trainees and conducted advanced fraud related in-service trainings for experienced FBI agents. Prior to the FBI, John was the director of internal audit and quality control for a large privately held mortgage origination and servicing company, where he designed and implemented the internal audit program from the ground up. In the course of his internal audit work, his techniques and instinct for fraud identified numerous instances involving borrowers attempting or involved in fraud schemes, which he helped resolve, at times using creative techniques not customary in the early 1990s to do so. John is a licensed Certified Public Accountant (Louisiana), a Certified Fraud Examiner and a Certified Compliance & Ethics Professional. Keep up with John on the web:Inside the Mind of a Corporate Monitor, for CCI.