Detecting Financial Fraud
Posted: March 29, 2013 at 5:01 am, Last Updated: April 2, 2013 at 7:25 am
Does a struggling economy make people and companies more likely to commit financial fraud? Mason fraud expert Keith Jones says not necessarily. According to Jones, fraud is more common during the booms and the “bubbles.” It is when the economy takes a downward turn that these fraudulent activities and creative accounting practices are finally exposed.
“People have a tendency to overvalue what is new. They are always looking for the next big thing,” says Jones, who is director of the Investor Protection and Corporate Fraud Research Center at Mason. “When the economy turns, everyone starts looking more closely at the financial statements.”
In this case, he is speaking about the dot-com bubble in the late 1990s, companies such as Enron, and the real estate bubble that burst in 2008. He says similar events took place in the 1920s before the stock market crash.
Jones and his colleague, Joseph F. Brazel of North Carolina State University, have spent several years conducting research on what it is exactly that throws up a red flag for investors and auditors when it comes to rooting out financial fraud. Some of their research has been supported by the Financial Industry Regulatory Authority (FINRA) Investor Education Foundation.
Jones and Brazel set up two separate experiments working with auditors and nonprofessional investors to see what information would trigger a red flag in their analysis and make them suspicious of the financial information they were reviewing.
In one study, they surveyed 194 experienced nonprofessional investors who were actively trading individual shares of stock. “We gave them a case and asked, Would you invest in this company?” says Jones. “We manipulated how consistent the nonfinancial information was with the financial statement and the transparency of the nonfinancial information. For example, we manipulated whether the company hired or laid off employees and whether they sold more or less products than the prior year even though the company brought in more revenue in all cases.”
Nonfinancial information, such as employee headcount and amount of production space, are operational measures that are not included in financial statements but are often disclosed elsewhere in a company’s annual report.
Jones and Brazel found that if the nonfinancial information was just given to the investors in paragraph form, they actually thought that the stock was a good buy even when the nonfinancial information was not consistent with the financial information.
“They actually paid more for the stock when the nonfinancial information showed the company was in decline,” says Jones of the investors, “and we were totally puzzled by that.” After talking to investors, the researchers concluded that many investors simply thought the company was doing more with less (i.e., greater profits with fewer employees).
If they presented the inconsistent information in a table or a chart, Jones and Brazel found the investors didn’t buy as much. Instead, they became suspicious.
“So apparently format matters,” says Jones, who teaches classes on fraud and deterrence in Mason’s School of Management. “It isn’t enough to just give them the information. It needs to be in a format that enables them to digest the information.”
In an experiment with auditors, Jones and colleagues were looking at the auditors’ ability to detect inconsistencies between financial and nonfinancial measures. Jones says professional standards and auditing texts suggest that external auditors can use this information to verify their clients’ reported financial information and, in turn, improve audit quality.
In the experiment, 89 auditors were asked to develop an expectation for a client’s sales balance based on the financial and nonfinancial information provided. Jones and colleagues found that these auditors generally failed to identify the inconsistencies between the client’s sales reports and related nonfinancial information that the researchers planted in the reports. They found that the auditors, most of whom had three to five years of experience, only factored in the inconsistencies when they were told fraud risk at the company was already determined to be high.
According to Jones, the proof of financial fraud often shows up in the nonfinancial data. For example, if a company is reporting a wildly successful quarter, but the nonfinancial information is showing that they’ve cut their workforce and number of stores, then an external stakeholder might be suspicious of the financial statements.
“In our research, we’ve found that companies that are committing fraud report an average growth rate in their revenue that is 20 to 30 percent higher than the growth in nonfinancial information,” Jones says.
As a result of their research, Jones and Brazel have developed a website for FINRA that pulls in the nonfinancial data for companies and enables the user to compare years of data in a tabulated format—all in an effort to find financial fraud. These data could be used by not only shareholders and potential investors, but also by auditors and regulators.
Now that the website has been turned over to FINRA, Jones and Brazel continue to make enhancements to the system and hope to market it for commercial use. Jones says that he has several more research avenues to explore with respect to fraud detection. He expects much more research in this area once the website provides nonfinancial information for use on a wide-scale basis.
When fraudsters become aware that investors and auditors are using nonfinancial information to detect financial statement fraud, they will likely manipulate the nonfinancial information as well. Jones says it will be important in the future to consider how companies might start manipulating nonfinancial information, as well as financial information.
This article originally appeared in Mason Research 2013.
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