Failing The Sniff Test: Researchers Find New Way to Spot Fraud

Companies that commit fraud can find innovative ways to fudge the numbers, making it hard to tell something is wrong by just looking at their financial statements. But research from North Carolina State University unveils a new warning system that sees through accounting tricks by evaluating things that are easily verifiable, such as the number of employees or the square footage that a company owns. If a company says that its profits are up, but these nonfinancial measures (NFMs) are down, that’s a sign that something is probably wrong.

“Some companies commit financial statement fraud, and a good portion of those overstate their revenue,” says Dr. Joe Brazel, an assistant professor of accounting at NC State and co-author of the research. “They’re able to do that because they can manipulate the accounting. But there are NFMs that can’t be manipulated as easily.” These NFMs include the number of employees, as well as industry-specific measures, such as the square footage of facilities in the manufacturing sector, the number of retail outlets in the retail sector or the number of hospital visits in the hospital industry.

Brazel explains that companies may fraudulently claim inflated revenues in order to meet market expectations and maintain, or improve, their stock price – as well as protecting company management from criticism.

But, Brazel says, “when these firms commit fraud, we found a huge gap between their reported revenue growth and related NFMs – their revenue was up, but the NFMs were either flat or declining. And when you looked at their competitors, you see revenue growth and NFMs closely correlated. So when you see that gap, it’s a red flag – you need to take a closer look.”

For example, Brazel says that researchers found a difference of approximately 4 percent between revenue growth and employee growth in companies that did not commit fraud. The difference between revenue growth and employee growth in fraudulent companies was 20 percent. “It’s pretty obvious, when you look at it,” Brazel says.

Furthermore, the NFM data are easy to find. Brazel explains that each company’s NFMs and revenue numbers are disclosed in the same financial filings, which the company is required to submit each year to the U.S. Securities and Exchange Commission.

The researchers evaluated 220 companies when evaluating employee growth versus revenue growth  – 110 companies that were known to have committed fraud between 1994 and 2002, and 110 that had not. Similarly, they looked at 100 companies when evaluating other NFMs, 50 fraudulent and 50 that had not committed fraud.

The researchers are now in the process of developing an online tool that will perform the NFM analysis, as well as conducting experimental studies with auditors to help detect fraud and with investors to help make wise investment decisions.

The paper, “Using Nonfinancial Measures to Assess Fraud Risk,” was co-authored by Brazel, Dr. Keith Jones of George Mason University and Dr. Mark Zimbelman of Brigham Young University. The work was funded by the Institute of Internal Auditors Research Foundation and the Financial Industry Regulatory Authority Investor Education Foundation, and will be published in the Journal of Accounting Research later this year.

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Note to Editors: The research abstract follows.

“Using Nonfinancial Measures to Assess Fraud Risk”

Authors: Joseph F. Brazel, North Carolina State University; Keith L. Jones, George Mason University; Mark F. Zimbelman, Brigham Young University

Published: Winter 2009, Journal of Accounting Research

Abstract: This study examines whether auditors can effectively use nonfinancial measures (NFMs) to assess the reasonableness of financial performance and, thereby, help detect financial statement fraud (hereafter, fraud). If auditors or other interested parties (e.g., directors, lenders, investors, or regulators) can identify NFMs (e.g., facilities growth) that are correlated with financial measures (e.g., revenue growth), inconsistent patterns between the NFMs and financial measures can be used to detect firms with high fraud risk. We find that the difference between financial and nonfinancial performance is significantly greater for firms that committed fraud than for their nonfraud competitors. We also find that this difference is a significant fraud indicator when included in a model containing variables that have previously been linked to the likelihood of fraud. Overall, our results provide empirical evidence suggesting that NFMs can be effectively used to assess the likelihood of fraud.