Compensation Structure Can Increase Fraud Risk

A recent study in The Journal of Financial Economics suggests that a compensation structure that relies on financial performance measures can be tied to incidences of fraud.  Generally, the study concludes that individuals are more likely to engage in financial misstatements when the there is little downside and high upside.  The implication is that this relationship can have predictive value and alert compliance officers and other interested parties to situations where vigilance should be heightened due to the increased likelihood that fraud may exist. The idea that there is more incentive for an executive to participate in financial misstatement when it seems achievable without detection and directly affects their pay (or continued employment) is reasonably intuitive.

Understanding the circumstances which set the stage for potential fraud is an important component in its prevention and detection.  While the study described above is not necessarily ground breaking, it is a good reminder that evaluating the motivations and opportunities for fraud are key steps in assessing the risk of fraud.  The risks of fraud are often discussed in the context of the fraud triangle, as more fully described here.

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