ChapterII LiteratureReview 2.1TheFraudDiamondModel 2.1.1OriginofFraudDiamondModel InitiallyDonaldCresseydevelopedtheFraudTriangleTheory,thetheorywas developedin1950toexplorethereasonswhypeoplecommitembezzlementandthe factorswecandiveintotofindthesepeoplewithinthecompany.Cresseydeveloped3 factorswhichmayabandonethicsandviolatethecompany’strust.Thosefactors beingpressureisnon-shareable,theopportunitytodoembezzlementand rationalizationitself.Withthatbeingsaid,employeeswhocommitfraudduetoa specificreason,havetheabilitytodosowithzerochanceofgettingcaughtaswellas thejustificationtodosowillmoreoftenthannotcommitthecrime.Despitethatthe theoryitselfwasnotperfectandcanbeexploredfurther. Cressey'stheoryinterestinglyexplainswhyseeminglyhonestindividualscommit embezzlementbuthasitslimitations,particularlywhenappliedbeyondtheoriginal study.Theanalytic-inductionmethodinwhichheemployedishighlybeneficialfor theexplanationregardingthedatabutlackspredictivecapability.Theabsenceof conventionalhypothesistestingmighthavecontributedtofindingswhicharebiased towardswhatCresseybelieved.Furthermore,Cresseydidnotinvestigatethepast historyperindividualaswellasafocusgroup.Instead,heusedtheindividual’s non-violatingactitself. ThefirstintroductionofthismodelwasdonebyDavidT.WolfandDanaR. Hermansonintheirpaper,alongsidethethefactorsfirstfoundbyCresseytheyadd capabilityassomethingtofactorintodetecttheactorswhichcommitembezzlement. Thisitselfisthesituationwhereapersonhasthequalities,abilities,andskills necessarytocommitdeception.Atthispoint,theconartistunderstoodtherewasa particularpossibilityforfraudandhadtheresourcestomakeithappen.Position, intelligence,ego,coercion,dishonesty,andstressaretheauxiliarycomponentsof capability(WolfeandHermanson,2004). Overtime,concealedfraudisexpectedtoincreaseitscostandvolume.Inorderto proactivelymitigatetheriskfactorsandpreventfraud,anti-graftauthoritiesrequirea thoroughunderstandingofthebasicfundamentalswhichleadstothefraudulent activity.Theunderlyingcausesoftrustviolationsareone'sappraisalofthedanger involvedandthedesiretoprofitfromthecircumstance(WolfandHermanson,2004). 2.1.2Theadditionalfactor Aspreviouslymentionedbeforethereisanadditionalfactorinthedevelopedtheory whichiscapability.Capabilityisanimportantfactorwhichweneedtoanalyzedeeper sinceitisinitiallythecrucialpartoftheactofcommittingfinancialfraud.Notevery personwiththedesire,chances,andjustificationcanenactfraudwithouttheproper skillset.Thisunderlinesthecrucialroleofindividualabilitiesinbothexecutingand hidingfraudulentacts,particularlyincomplexorextendedfraudscenarios(Albert ,WilliamandWernz,1995). TakenbytheunderstandingsofAbdullahiandMansorhe(2015),thefactorof capabilitycanbederivedinto3mainsubfactorswhicharefunction,Intelligenceand egoaswellascoercion,deceitandstress.Functionistheroleorpositionan individualholdsinanorganizationcansignificantlyimpacttheirabilitytocommit fraud.High-rankingpositionsoftenhavelessoversightandthereforeprovidemore opportunitiestoengageinfraudulentactivities,especiallyincompanieslacking sufficientchecksandbalances.Asignificantportionoffraudcasesinvolvetop executiveswhoexploittheirpositionstobreachorganizationaltrust. Mostfraudperpetratorsarecharacterizedbyintelligence,creativity,andanin-depth understandingofinternalcontrolsandvulnerabilities.Theseindividualsoftenhave significantegos,markedbynarcissismandoverconfidence,leadingthemtobelieve theywillnotbecaughtorcaneasilymanagethesituationifdiscovered.This overconfidencecandistorttheirriskassessment,causingthemtounderestimatethe risksinvolvedintheirfraudulentactions. Successfulpeoplewhodidfraudoftenusecoercivebehaviortocompelothersto participateinorignorefraudulentactivities.Theymaycreateanatmosphereoffear ratherthanrespect,bypassingtheusualchecksandbalances.Effectivelyingand deceitarecrucialformaintainingtheirschemeswithoutdetection.Additionally,the abilitytomanagestressisvital,asongoingfraudulentactivitiescanbehighly demandingandstressful. 2.2TheFraudPentagonModel TheFraudPentagonModelisanextensionfromtheprevious2modelsthislatest modelexplainsfurtherpastboththeories.Thistheoryaddsanadditionalfactorinto theoriginalmodelbyDonaldCresseyaswellasWolfeandHermanson’sadditional factor.ThismodeldevelopedbyCrowein2011becauseheexaminedthatboth previousmodelswerelimited,hefoundthattheactorcommittingthesefraudsneeda certaintypeofarrogancewhichisneededtomakeonebelievethattherulesand regulationsinacompanydonotapplytoone’sself. TheFraudPentagonModelbuildsontheFraudTrianglebyaddingtothetraditional twocomponentsoffraud,whichare"capability"and"arrogance,"andincreasesthe elaborationoffrauddynamics.Thisoverallapproachassistsorganizationsin developingnuancedanti-fraudmeasuresthatarecustom-madetoindividualrisks (Crowe,2011). Inacorporateenvironment,thismodelcanbeappliedtobuildamoreresilient strategyforthesensitivenuancesoffraud,whichwouldassistincreatinganevenand morefortifieddefensemechanismagainstunethicalbehaviors(Wolfe&Hermanson, 2004). Anorganizationalclimatethatemphasizesethicswilllowerfraudulentproclivity. Therefore,notonlyindividualfactorsbutalsoorganizationalclimatefactorsareas necessaryasindividualfactorsforthepreventionoffraud(Ramos,2003). 2.3ComplexityofFraud 2.3.1Frameworks Thereareseveralframeworksofthedetectionoffraudsuchasthetriangle,diamond aswellaspentagontheory.Thesetheoriesdwellintotheunderstandingofthehuman psychologybehindfraudwithdetail.However,thereismoretofrauddetection besidesthepsychologyitself.TheGovernmentAccountabilityOfficehascomeup withaconceptualframeworkthatseekstofurtherhelpmanagersincurbingfraudas wellasfacilitatingintegritypreservationwithingovernmentprograms.Thisleadsto controllingactivitiesmorespecificallyrelatingtopreventionthatmayprevent,detect, orrespondtofraud. AccordingtoMcKinsey,goodfraudmanagementtypicallydependsoncapabilities suchasatestusinghistoricaldataonfraudulentbehaviorsandA/Btestingtocompare alternativefrauddetectionstrategieswithinrealtimecircumstances.Advanced analyticsinsuchcasestypicallydeployspecialtechnologiessoastoenablethe applicationoffraudcontrolsproactively. Therearemanyframeworkstochoosefrombutthebestandmosteffectiveoneis whenwecombineseveralapproaches.Inacompany,therightframeworktodetect fraudisquiteoftenacombinationofadvancedanalytics,machinelearning,together withasoundfraudriskmanagementapproach.It'sbasicallyahybridsystemthat includestraditionalrule-basedsystemsandmodernMLalgorithmstoidentify fraudulentactivitiesonareal-timebasis.Theotherimportantfeaturesofadaptability, scalability,andabilitytolearnnewtrends.Theremustbeguidanceintheformofa frameworkthatcouldbebasedonthepeculiarneedsofthecompany,data infrastructure,andthegeneralset-upintheindustry. 2.3.2Typesoffrauds Thereare5maintypesoffinancialfraudinacompany,thosebeingpayrollfraud, financialstatementsfraud,skimming,taxfraudaswellasinvoicefraud.Theseare thetypesoffraudsthattendtohappenastheycanalsobededucedtomorespecific frauds.Payrollfraudusuallyreferstothealterationofsomedetailswithinthepayroll byanemployeeinordertoreceiveunduecompensation.Financialstatementfraud referstothemisrepresentationofthefirm’sfinancialstateinordertoproduceabetter positiontotheupcominginvestmentsorloansacquisition.Taxfraudinvolves producingafalseclaimontheincomeortheexpensesinthetaxreturnwithapurpose ofunderpaying.Invoicefraudreferstotheoverinflationorfalseinvoicinginrelation towardsthenon-deliveryofgoodsandservicestocreatetheoccurrenceofpayments whicharenotauthorized.Thismakesthefirmliableandnottrustworthy,effective governanceandexternalauditorsarerequiredtopreventthesecasesandminimize opportunitiesforfinancialfraudtocometolight(Hoganetal,2008). 2.4ImplementationofAIandmachinelearning Financialinstitutionsarestrugglingtodetectfinancialfraudwithhighaccuracythatis whytheyneedtoincorporateAIaswellasmachinelearningintheirwork.One reasontheyarestrugglingisbecauseinstitutionssuchasthistypicallyleanon statisticalmeasures,suchasmeanandstandarddeviation.However,thisapproach isn'texactlythemostefficientandeffective.Itdemandsalotofhumaneffortto pinpointthosesuspiciousactivities(KhacandM.T.Kechadi,2010).Someofthe implementationofAIandmachinelearningcanbeseenthroughvariousmethods suchasclustering,fuzzylogic,ensemble,logisticregression,randomforest,Naive Bayes,Geneticalgorithm,artificialneuralnetwork,neighbors,supportvector machineandothers.OutofthesemethodsafewthatareusedfrequentlyareNaive Bayes,artificialneuralnetworkaswellassupportvectormachine(Ali,A.,Abd Razak,S.,Othman,S.H.,etal,2022). Duetomoderntimesaneedforafasterandaccuratemethodtoperformaudit,we needamoreefficientwaytoassistwithauditing.TheabilitytouseAIaswellas machinelearningincreasesefficiencyofauditorstoperformrepetitivetasks,thiswill allowauditorstofocusontheinterpretationofdataitselfratherthantedioustasks (GabeDickey,DBA.,CPA.,etal,2019).Theintegrationofthismethodwillnotonly increaseefficiencybutaccuracy,scalabilityandprovidereal-timeinsights.Thereare severalcommonlyusedmethodswhichisusedtoassistauditcurrentlyareNaive Bayesmethod,NeuralNetworksandSupportVectorMachines(Tantuğ,A.C.,Eryiğit, G.2006) 2.4.1NaiveBayesMethod ThisStatisticalapproachisusedtoidentifyfinancialfraudbyidentifyingpatterns withinthefinancialdata.ThisisbasedontheBayes’Theoremwhereitcalculatesthe profitabilityofaneventoccurringbasedontheknowledgewehave.Thisishighly suitableforsituationswhereahighdimensionofinputsexists,thecoreprinciple itselfinauditingcanbeseenthroughitsabilitytoclassifyandflagtransactionsas normalorsuspiciousthroughthefeaturessetbytheauditor.Theauditorneedsto inputitemstodetectandanalyzeinorderforthistoworkproperly,thisissuitablefor identifyinganomaliesinamulticlassclassificationproblem. 2.4.2ArtificialNeuralNetworkMethod Thismethodrepresentsasophisticatedcomputationalapproachinspiredbythe structureandfunctionalityofbiologicalneuralnetworks.ThismethodusesAIto mimicthebiologicalneuralnetworkthroughidentifyingcomplexandnonlinear relationshipsinalargedataset.Thismethodiscomposedoflayersofinterconnected nodeswhereeachconnectionisabletotransmitsignalstothenext.Thereceiving signalthanpassesstotheother,inauditingthiscanbeusedtoassesspastfinancial dataandlearnthecreditrisk.Thisnetworkisabletoadjustitsinternalparameters basedontheinputdataitreceivesmakingithighlyeffectivetofindtrendsinfinancial datasets.Throughthiscorrelationsandtrendscanbeuncoveredandreviewedbythe auditorincharge. 2.4.3SupportVectorMachineMethod SupportVectorMachineisamachinelearningalgorithmmainlyusedfor classificationoftaskswhichincludesauditing.Inauditingthiscanhelpidentifycases offinancialfraudoranomaliesbydevelopingthedatapointsintocategories.Through findingtheoptimalhyperplanewhichmaximizesthemargin.SVMareutilizedto processaswellasanalyzetheselargedatasetstofindirregularitiesandpatternswhich canbeeasilyclassifiedbytheauditorinchargeasfinancialfraud. 2.5ErrorsinInternalAuditing 2.5.1CommissionErrors Insteadoferrorsoccurringwhenthereisafailuretoact,mistakesininternalauditing mightarisewhenactionsaretakenorjudgmentsaremade.wrongdataprocessing, wronginterpretationofapplicablestandards,andoversightissuesareallexamplesof thetypesoferrorsthatfallunderthiscategory.Thesekindsoferrorscanhavesevere repercussions,includingthepossibilityofputtingatriskthecorrectnessofaudit resultsaswellasthedependabilityoffinancialreportingandevaluationsofinternal controls. 2.5.2OmissionErrors Omissionerrorshappenwhencriticalinformationortransactionalactivitiesareleft outofthefinancialstatements.Unlikecommissionserrorswherethedataismistaken, thedatainomissionserrorsarenotimputedinthefinancialstatement.Thisleadstoan unintentionalmisrepresentation.Insomecasesmanagersusethismethodtoreduce theperceptionofthecompanybeinguntruthfulwiththeirstatementsunintentionally. 2.5.3PrincipleErrors Principleerrorsarethemisapplicationofaccountingprinciplestocreateinaccurate financialreporting.Accountingalwaysrequiresadebitandacredittoeveryaccount however,occasionallytheaccountsaresometimesmisplaced.Thiswillallowassets tobewrittenasexpensesandcreateahugeerrorwhichcanbeacrucialerrorinthe financialstatementsitselfsinceitviolatespoliciesandregulations. 2.5.4DuplicationErrors Duplicationerrorsoccurwhenthesametransactionappearsmorethanoncewhich leadstoamisrepresentationofthecompany’sfinancialhealth.Thiscanbea humanglitchorpoorinternalcontrolerrorseventhoughitseemssmallandnot important.Ifthiskeepsonhappeningthelosseswilladdupandcauseproblemsand untruthfulfinancialstatements.Sucherrorsdonotonlydistortthestatementsbut complicatethereconciliationprocessaswell.Thisishardertodetectandcantake significanttimetocorrect. 2.5.5CompensationErrors Compensationerrorsareincorrectattemptstobalanceouterrorsinsidethestatements given.Soaninitialerrorintheaccountswouldfirstneedtohappenbeforea compensationerroroccurs.Thiserroroftenhappenswhentheinternalauditorfound outthatthebalancesheetisnotbalancedandtheywouldtrytobalanceitoutby inputtingarandomaccountontheothersideofthebalancesheet.Thismisguided approachwillonlyincreasethedetectingandrevisionprocessoftheaccounthence increasingtheworkforauditors.Thiswillalsoleadtoapoorreflectionofthe company’saccountingprocessandintegrityaswellaslossofstakeholderconfidence. 2.6Regulatoryissues 2.6.1InternationalAuditingregulations TheInternationalAuditingandAssuranceStandardsBoard(IAASB)setscrucial standardsforauditing,assurance,andrelatedservicesglobally.Thisisahighly importantcomponentforauditingregulationssinceitisthepillarforethical requirements.Auditorsareobligatedtoadheretoprinciplesofintegrity,objectivity, andprofessionalskepticism.Theserulesincludetheethicalprinciplessetoutbythe InternationalEthicsStandardsBoardforAccountants(IESBA),whichguarantee auditorsupholdhighstandardsofprofessionalconduct. Moreover,therulesemphasizetheneedofauditexpertiseandquality.Theyoutline theneedofauditorscarryingouttheirdutiesinaccordancewithcompetence. Credibilityoftheauditingprocessdependsonthoroughguidancefororganizing, carryingout,andmanagingauditengagements,whichisprovidedinthispart. Importanttopicsaddressedbytheserulesincludealsoriskassessmentand management.Theygiveauditorsprocedurestofindandfixpossiblemajorerrorsor fraudinfinancialstatements.Thisapproachfocusedonriskimprovestheefficiency oftheauditprocedure. Furthermorerequiredbytheregulationsarestringentreportinganddocumentation requirements.Auditorshavetomaintaindetaileddocumentsthatsupporttheir conclusionsanddemonstratefollowingtheprescribedprocedures.Thisimproves responsibilityandopennessinfinancialreportinginadditiontosimplifyingauditing processes. Theglobalauditingprocessesaregreatlyimpactedbythesestandards,whichalso enhanceopenness,strengthenthereliabilityoffinancialreports,andinspire confidenceinfinancialreportingsystems.Still,theirrealinfluencemostlydependson enforcementandhowwidelyothernationsembraceandusethem. 2.6.2NationalAuditingStandards BothlocalrequiredrequirementsandinternationalstandardshaveshapedIndonesia's strongauditingregulatorystructure.TheIndonesianInstituteofCertifiedPublic Accountants(IAPI)collaborateswiththeFinancialServicesAuthority(OtoritasJasa Keuangan,OJK),themainregulatoryagencyinchargeofauditproceduresin Indonesia.ImportantFeaturesoftheAuditingLawsinIndonesia OJKRegulatorySupervisionOneimportanttaskoftheOJKistooverseeauditing proceduresinfinancialorganizations.Itensuresthatauditsfollowtherequirements andimprovethegeneralstabilityandopennessofthefinancialindustry. TheIAPIservesasbothaninternationalbenchmarkfortrainingandcertificationof auditorsinIndonesia.Auditorprofessionalismismaintainedinpartbythistechnique. OperatingLegallyinIndonesia:AuditfirmsmustregisterwiththeOJKandthe MinistryofFinanceinordertodobusiness.Auditfirmsarethereforeguaranteedthat, bycompletingthisregistrationprocedure,theywillpossesstheneededcredentialsand followthemoralandprofessionalnormsmandatedbyIndonesianlaw.Professionalism OngoingprofessionaldevelopmentismandatedbyIndonesianlawforauditorstobe uptodateonthenewestauditingtechniquesandregulatorychanges.Respectingthis requirementstrictlyisnecessarytomaintainthequalityandrelevanceofaudit proceduresinadynamicallychangingeconomy. Thepublictrustinfinancialstatementsistobeincreasedandtheintegrityoffinancial reportingistobeprotectedbytheIndonesianauditinglaws.Risksrelatedtofinancial misreportingandfraudarelessenedinpartbytheextensiveregulatorysystem.Like everyregulatorysystem,nevertheless,thesuccessofIndonesianauditingrulesmostly dependsontheirimplementationandtheregularstandardupdatetoaccountfor changingfinancialrealitiesanddifficulties.Allthingsconsidered,Indonesianauditing standardsofferastrongframeworkthatconformstoglobalstandardsandguarantees financialreportingqualityandcompliance. 2.6.3IndonesianAccountingStandards KnownbymanyastheIndonesianFinancialAccountingStandards(IFAS),Standar AkuntansiKeuangan(SAK)istheprimaryframeworkandstandardgoverning accountinglegislationinIndonesia.IssuerofthesestandardsistheIndonesian FinancialAccountingStandardsBoard(DSAKIAI),adivisionoftheIndonesian InstituteofAccountants(IAI). ThefollowingaresomesignificantfacetsofIndonesianaccountinglaws: 1.SecurityAccountingGuidelines(SAK):Thiscomprisesmultipleiterations customizedfordistinctcategoriesofentities,examplesaresuch: -SAK,whichisgenerallyinlinewithpublicinterestentities'International FinancialReportingStandards(IFRS). -SAKETAP(EntitasTanpaAkuntabilitasPublik),astreamlinedstandard designedfororganizationsthatarenotaccountabletothepublic. -AprogramcalledSAKEMKM(EntitasMikroKecildanMenengah)is intendedforsmallandmedium-sizedbusinesses. 2.ComplianceandEnforcement:TheDirectorateGeneralofTaxesutilizes thesestandardsfortaxreporting,whiletheFinancialServicesAuthorityof Indonesia(OJK)supervisesadherencetoaccountingstandardsforfinancial firms. 3.AuditRequirements:Anindependentauditorisrequiredtoauditthe financialstatementsofpubliclytradedfirmsandotherentitiesthatsatisfy specificrequirements. 4.TaxCompliance:FinancialaccountingdatacreatedinaccordancewithSAK servesasthefoundationfortaxcomputations,eventhoughtaxreportingin IndonesiaisgovernedbyIndonesiantaxlaw. 5.UpdatesandRevisions:Theguidelinesarerevisedonaregularbasisto reflectchangesinIndonesia'seconomyandtobringthemintolinewith internationalstandards. BusinessesoperatinginIndonesiamustcomprehendandabidebythesestandardsin ordertomaintaincomplianceandmakefinancialreportingandanalysiseasier. 2.7InternalControlsandRiskManagement 2.7.1RolesofInternalControl Throughouttheauditingprocess,internalcontrolsystemsarecrucialsincethey provideaframeworkthatensurescorrectness,effectiveness,andadherencetorelevant laws.Byproactiveriskmonitoringandmanagementwithinthecompany,these technologiescanimprovetheassuranceoffinancialreportingreliability. Mainfunctionsofinternalcontrolinauditing Internalcontrolsmakeiteasierforauditorstoidentifyandassessrisksthatcouldhave animpactonthefinancialstatements.Theauditplanisbuiltontheevaluationsinceit helpsdeterminetheexactfeatures,length,andscopeofauditingprocessesrequiredto effectivelymanageallfinancialrisks. PreventingErrorsandFraud:Byusingchecksandbalances,internalcontrolsput inplaceinsideacompanyserveasadefenseagainstfraudandmistakes.Auditor scopeislimitedbytheserestrictions,whichconcentrateonareaswithweakcontrols andahigherriskofmistakes.