Exploring the Psychology behind Corporate Fraudsters
Alyssa Durant
Professor Beck
ACG4632-Honors
April 15, 2016
Survey participants in a survey conducted by the Association of Certified Fraud Examiners in 2014 estimated that “the typical organization loses 5% of revenues each year to fraud”. The median loss of frauds in the study was $145,000 and 22% of the cases had loss from fraud of over $1,000,000. (“Report to the Nations on Occupational Fraud and Abuse”) It is clear that corporate fraud causes significant financial damage yearly to companies. The unclear and unpredictable part of these types of frauds is the human behavior behind it. Professor Pamela Murphy of Queen’s University at Kingston School of Business has completed extensive research in the fields of fraud and rationalization, how otherwise honest, trusted individuals allow themselves to commit corporate fraud. As Murphy has shared with Smith Magazine, “rationalization…enables people to maintain their code of ethics and avoid guilt or self-condemnation.” (Morantz) It is my goal to explore the human behavior behind fraud and rationalization throughout this essay, specifically what is going on in a fraudster’s mind and how fraudsters rationalize their behaviors to maintain their personal code of ethics.
“Fraud involves intentional acts and is perpetrated by human beings using deception, trickery, and cunning that can be broadly classified as comprising two types of misrepresentation: suggestio falsi (suggestion of falsehood) or suppressio veri (suppression of truth).” (Ramamoorti 522) As Bill Barrett, CPA/ABV/CFF has shared with AccountingWEB, higher levels of management are usually responsible for financial statement fraud. These individuals are “well-educated, have a high social standing and are respected members of the community. They use their social and cultural background as well as their specialized knowledge and skills to their advantage”. (Barrett) A key component of fraud, compared to a misstatement or mistake, is that the individual knows they are acting fraudulent and intends to deceive.
Rationalization is one component of the Fraud Triangle, developed by Edwin Sutherland and Donald Cressey in 1978. (Albrecht) This relatively straightforward theory is featured in accounting and criminology textbooks across the globe. Pressure, opportunity and rationalization are the three essential risk factors that allow individuals to commit fraud. Pressure and opportunity can be explained quite simply. Pressures are the initial motivation for a fraudster. Pressures may include personal financial issues, addictions, or financial benchmarks a company must meet. Pressures are the starting point to a white collar fraud. Next is opportunity, the method a fraudster uses to steal. “The person must see some way he can use (abuse) his position of trust to solve his financial problem with a low perceived risk of getting caught. This is the one angle of the Fraud Triangle that employers can control”. (“Employers: Learn The “Fraud Triangle” To Prevent Fraud What Is the Fraud Triangle?”) Rationalization, the final risk factor in the Fraud Triangle, however, is more complex and unpredictable. “The scary part here is that rationalization takes place in the mind and cannot be seen” (“Rationalization- the Final Side of the Fraud Triangle”). As “FRAUD: The Human Factor”, an article from Financial Executive points out, “Personal incentives and perceived pressure drive human behavior, and the need to rationalize wrong doing as being somehow defensible is very much psychologically rooted.” (Ramamoorti & Olsen 54)
Pamela Murphy is a trailblazer in the research of rationalization. In 2010, she released “Psychological Pathways to Fraud: Understanding and Preventing Fraud in Organizations” to the Journal of Business Ethics sharing her revolutionary findings. Murphy introduces a fraud framework that “describes an individual’s decision-making process when faced with the opportunity and motivation to commit fraud” (Murphy 1) The three pathways explain how frauds are initially committed. Throughout the remainder of my rationalization analysis I will share Murphy’s conclusions regarding various components of rationalization.
The first path that Murphy outlines is lack of awareness. This would be “overpowering situations or contexts in which the individual makes a decision”. (Murphy 2) Abnormal behavior generated by overwhelming situation is an example of this. A West Virginia fraudster interviewed by Murphy shared that “fraud can hit you in the head like a feather”. This man had worked at an organization that stressed efficiency, and once he saw his coworkers take shortcuts, he did too without realizing he was committing fraud. According to Murphy, “At times, it’s difficult to distinguish between fraudulent and non-fraudulent activity”. (Morantz) “…It leads directly to fraudulent behavior with no reasoning, no negative affect and no attempts to reduce negative affect. These situations lead individuals to continuously commit fraud with their moral values intact” (Murphy 6).
Certain situational factors can cause fraud by “lack of awareness”. Obedience to authority can lead to this pathway to fraud. For example, “Several former CFOs at HealthSouth testified that Richard Scrushy… ‘managed greatly by fear and intimidation’ and would not accept financial statements unless they met forecasts”. (Murphy 7) In these cases, the individual is simply following instruction and committing the fraud without realizing . Organizational climate may also cause fraud by “lack of awareness”. The example mentioned previously about the West Virginia man convicted of fraud is a great example. A company made up of employees consistently taking shortcuts or subtly manipulating numbers to meet their personal goals, or a company that solely rewards those who “furthers the organizational interests” is in danger of fraud. Finally, executives who obsess over forecasts instead of the procedures the company is taking may be committing fraud by “(evaluating) accounting information in an unconsciously biased manner in order to meet that goal”. (Murphy 10-11) Over time, the actions by employees become the norm, and new employees to the company simply follow the actions that have been set in place.
The second path is “intuition coupled with rationalization”. This is when the individual knows what they are doing is wrong. “The individual goes through an affect-driven intuition process that results in a gut level, immediate decision”. (Murphy XXX) If that individual is able to think of a split-second rationalization to decrease their negative affect (gut feeling), they will likely decide to commit the fraudulent act. They will not feel guilt afterwards because they previously rationalized their action as being congruent with their moral standards. If the individual cannot think of a rationalization for their negative gut feeling, they are likely not going to proceed in committing the fraud. “Everyone else does it” and “no one gets hurt” are popular rationalizations. (Morantz)
The situational factors that lead to fraud by “lack of awareness” can also cause this path to fraud by intention. For example, an individual may be aware that the course of action an authority figure is demanding of them is fraudulent, but rationalize that they must commit the fraud to keep their job. These individuals “believed the more important ‘right’ thing was to be loyal to their boss”. (amaze essay) This individual can easily “(shift) blame to the authority figure” (amaze essay) to clear their own conscience.
The third path is when the individual knows that the action is wrong but the “intuition is conflicting or unclear”. It is then likely that the individual will compare costs and benefits of the situation, and act based on the result of this analysis. The rationalization they provide themselves is not created split-second, as in the second path. If the fraud is committed, the individual will then be motivated to reduce the resulting negative affect. “These negative feelings are either psychological discomfort or guilt.” (amaze essay)
Fraudsters can use one of many approaches to reduce their negative feelings of discomfort or guilt. First, they can simply “tolerate” the guilt. (amaze esssay) These individuals are stuck with the guilt from that point forward but are able to live with it. The individual may try to avoid the guilt. After the fact, “individuals (such as these) simply stated that they hadn’t thought about it”. (amaze essay) This approach allows the perpetrator to feel less guilty about the fraud by simply ignoring it. Alternatively, the individual might confess to their crime or try to repair the damage they had done. If the individual had stolen money, they may try to pay the money back before it is noticed. The next approach a fraudster could use is self-affirmation. “If an individual commits fraud, s/he is motivated to improve self-image in some other way”. (amaze essay) For a charitable person, this might mean donating money to charity.
Throughout the various pathways to fraud and actions an individual takes after committing a fraud, rationalization is a key component. Rationalization is what allows an individual to justify to themselves their action, while still maintaining their own personal code of ethics. Murphy describes rationalization as “…a mechanism that allows individuals to justify an inconsistent (‘bad’) behavior in order to reduce or avoid the negative affect that would normally accompany it.” (amaze essay) She goes on to say that “individuals who rationalize fraudulent behavior are able to sleep at night, believing they are honest and ethical.” (amaze esssay) An article featuring Pamela Murphy in Smith Magazine outlines six Degrees of Rationalization that allow an individual to neutralize negative feelings regarding their crime.
The first Degree of Rationalization is moral justification. The individual would justify to themselves, “I’m protecting the company…the employees…my family.” This individual thus decides that their loyalty to their company, employees, family, etc. is more valuable than their loyalty to the victim of the fraud. (Morantz) An employee could rationalize that stealing money for a sick relative is acceptable in this way. “An individual argues s/he had no choice but to engage in a criminal act.” (amaze essay)
The next Degree of Rationalization is advantageous comparison. This type of rationalization includes the employee convincing themselves that the object they stole is insignificant compared to a more valuable object they could have stolen. In this situation, they are justifying that since their crime was not as bad as it “could have been”, they do not have to feel guilty. “This is nothing compared to…” An example is using a large fraud scandal as a comparative measure over whether they were committing fraud or not. A harmful situation is one “in which individuals perpetrate a financial statement fraud while arguing it is not nearly as bad as Enron”, Murphy has quoted in her research.
The next Degree of Rationalization is euphemistic labeling. In this case, an individual would justify to themselves they they are “trying to level the playing field”. (Morantz) For example, the individual could justify that since the GAAP rules they are following are confusing and complex, they can make “aggressive interpretations” (amaze essay) Another example is
Next is a mechanism known as “minimize, ignore, or misconstrue consequences of the act”. (amaze essay) In other words, the fraudster is pleading ignorance. In this instance, the individual disregards the harm that they caused as if it were insignificant or did not exist.
The next Degree of Rationalization is shifting blame. In this case, the fraudster justifies that since they are not the only person committing a particular fraud, or since a superior instructed them to commit the fraud, they are not responsible. In a way, they are removing themselves from the fraud and any damage it caused. An example of this type of rationalization is speeding on a highway. One may think, “I am not the only person speeding”, and justify their unlawful behavior in this way.
The next Degree of Rationalization is denying or blaming the victim. An example of this would be claiming that the victim “had it coming” or deserved the harm it incurred. This type of rationalization could be used if an employee was passed over for a promotion or has some type of motive to retaliate against the company.
The six Degrees of Rationalization show some insight into a fraudster’s motives. Once rationalization, along with incentive and opportunity, is considered, the individual then chooses whether to act on the fraud. Murphy’s research highlights several different approaches an individual can take. In the most ideal outcome, “some people will automatically avoid fraud when they are aware of it and their intuition tells them to. The negative affect are great enough that the individual does not consider committing fraud”. (amaze essay) Obviously, this type of individual represents the best-case scenario. The next type of individual will avoid the fraud, but not until after reasoning. This individual will weigh the costs and benefits but decide to not commit the fraud in the end. The next type of individual decides to commit a fraud but does not commit a fraud again. This type of individual is unable to handle the negative affect that accompanies their crime and either confesses or tries to fix their crime. Although this type of individual is not ideal for a company, it is unlikely that this type of individual will place themselves in a similar position again (amaze essay). The worst type of individual for a company is one who commits a crime, is aware that it is bad, rationalizes it and decides that they will commit a similar crime again.
Since one in three organizations fall victim to fraud (Morantz), it is important for companies to understand these motivations
There are “red flags” companies may be able to detect, whether it be a change in employee behavior or an internal control weakness. For example, internal control weakness may include a lack of segregation of duties, physical safeguards, independent checks, or authorization procedures or an inadequate accounting system. (Pwpt online) Other indicators may include employee complaints, accusations, changes in an employee’s lifestyle, or abrupt changes in an employee’s behavior.
In addition to The Journal of Accountancy’s has released a list of warning signs of cash misappropriation, presented verbatim in a table below. (Wells)