Auditor Use of Benchmarks to Identify Fraud Risks: The Case for Industry Data

Which Benchmark is Best at Assessing Fraud Risk When Planning an Audit? The Case for Industry Data

Since analytical procedures using only financial data are likely to be ineffective for detecting fraud, the profession has re-evaluated its fraud assessment processes and has attempted to find new ways identifying fraud. The purpose of this study is to examine whether auditors can effectively use nonfinancial measures (NFMs) that are positively correlated with financial measures (e.g., revenue growth) to assess fraud, restatement and distress risk. Given that auditors can identify NFMs (e.g., employee growth) that are positively correlated with financial measures (e.g., revenue growth) and NFMs are less easily manipulated than financial statements, inconsistencies between NFMs and financial performance measures may be indicative of higher fraud ,restatement and distress risk. It is found that discrepancies between NFMs and financial measures are greater for fraud, restatement and distress firms than is the case for their competitors. It is also found that inconsistencies between NFMs and financial measures appear to be a red flag for fraud, restatement and distress when variables that have been previously linked to the likelihood of fraud, restatement and distress are included in the model. Overall, the results empirically show that NFMs can be effectively used to assess fraud, restatement and distress risk.

Auditors perform preliminary analytical procedures to identify unusual or inconsistent relationships between expectations and recorded balances. The results of preliminary analytical procedures help auditors assess the risk that financial statements are materially misstated due to fraud. Via a survey of practicing auditors, we find that auditors rely heavily on prior-year balances and relations within the client’s financial data as benchmarks when developing expectations. Even though auditing standards describe additional benchmarks, which are less susceptible to management manipulation (e.g., industry trends), our survey results indicate that auditors are less apt to employ these benchmarks. Meanwhile, our empirical analyses of revenue frauds reveal that benchmarks derived from industry data, nonfinancial measures, and cash flows outperform both prior-year balances and relations within the client’s financial data. Of the benchmarks we examine, the difference between a company’s revenue growth and the revenue growth of its industry has historically been the best fraud indicator. Data Availability: Data are available from the authors upon request. JEL Classifications: M40; M41; M42; M48.

Identifying and assessing audit risk is a key part of the audit process. Prior research documented that auditors primarily look at financial data, information, and measures when assessing the audit risk for an audit engagement. However, professional standard setters, regulators, and academic researchers have discussed the potential for non-financial data, information, and measures to provide a powerful and independent benchmark for evaluating the validity of the numbers of financial statements of an audit client. A field study was conducted in Egypt during the years 2013 and 2014 to explore how auditors perceive and assess audit risk for an audit engagement in the period following the Egyptian revolution of January 25, 2011. The results of the field study indicated that auditors appear not to give sufficient attention to non-financial data, information, and measures when assessing the audit risk during an audit engagement. Auditors seem to rely on financial data, information, and measures when assessing the audit risk of an audit engagement. Furthermore, auditors do not seem to consider the inconsistencies between financial and non-financial data, information, and measures of an audit client as an indicator of the existence of fraud or material misstatements in the financial statements of an audit client.

Previous research indicates a growing need to address the issue of fraudulent financial research. In addition to financial measures, non-financial measures are those that should be considered in the process of measuring the economic performance of the company. This research points to the importance of an integrated way of measuring the financial performance of a company in assessing the risk of fraud, which implies the application of non-financial performance measures together with financial ones. If there is a difference between non-financial measures and financial performance, this may be a warning sign that there may be a risk of fraud. Research on the application of non-financial measures in improving the risk assessment of fraud is scarce when looking at the Serbian context. Therefore, this research will add value to the existing literature on fraud risk management in financial statements.

In the growing debate about stakeholder values, there has been little discussion about information overload or whether the requested disclosures can be effectively used. Stakeholder advocates call for complicated and massive environmental and related social disclosures while not considering how information overload might affect the discourse about corporate performance. Stakeholders, including shareholders, plead for more transparency in financial statements, management discussion and analysis (MDA), and other corporate disclosures. As we know, shareholders and boards of directors are most concerned with the ‘Holy Trinity’ of earnings per share, dividends and market value changes. We believe that managers and stakeholders involved in performance evaluations have multiple interests that extend beyond traditional shareholder value measures. We note that the Balanced Scorecard (BSC) was developed as one tool to reflect and communicate these multiple measures. We test how managers use (or ignore) multiple performance measures and we posit that stakeholders will face many of the same constraints when using and processing multiple disclosures including Corporate Social Reports (CSR), environmental, or similar disclosures. While we do not directly test a wide variety of stakeholder disclosures, we examine eight (four for a single subject) shareholder values (financial measures) and four stakeholder values (nonfinancial measures). The eight measures included in our research instruments serve as proxies for the multiple concerns that might be of interest to many stakeholders. Note that stakeholders are likely to be extremely interested in nonfinancial performance measures, while many shareholders will likely concentrate on financial performance measures. Field research has reported managers tend to favor financial measures while discounting or ignoring nonfinancial measures when evaluating subordinates, making it difficult to align performance evaluations and incentives with corporate strategies (Ittner et al. Account Rev 78:725–758, 2003). In this study, we find the relative weights managers place on financial and nonfinancial performance measures are influenced by both (1) presentation order and (2) the relative importance of specific measures. When financial measures are presented first, the manager who performs better on financial measures is rated higher than the manager who performs better on nonfinancial measures. However, when nonfinancial measures are presented first, managers who excel on nonfinancial measures are rated higher. Reports that include financial measures that are relatively more (less) important also produce higher (lower) ratings for the manager who excels on financial measures. Thus, the relative weights that superiors place on financial and nonfinancial measures in evaluating corporate managers’ performance are substantially anchored both by the order in which measures are presented as well as by the importance of the specific performance measures employed. Other stakeholder disclosures are likely to be similarly anchored, perhaps biased, by primacy and a priori importance rankings.

Nonfinancial measures (NFMs), such as employee headcount and production space, are operational measures that are not included on the face of the financial statements but are often disclosed elsewhere in the annual report or 10-K (e.g., in Management's Discussion and Analysis). Professional standards, auditing texts, and prior research suggest that external auditors can use NFMs to verify their clients' reported financial information and, in turn, improve audit quality. In an initial experiment where auditors develop an expectation for a client's sales balance, they generally fail to identify a seeded inconsistency between the client's sales and related NFMs. In our second experiment, where we introduce an NFM prompt and manipulate fraud risk as high and low, auditors are more likely to react to the inconsistency (i.e., rely more on inconsistent NFMs/develop expectations that reflect the client's current year decline in NFMs) when they are specifically prompted to consider the implications of NFMs and fraud risk is high (versus low). Our results suggest the following: (1) a minority of auditors use NFMs as an information source for testing and do not increase their reliance on NFMs when the NFMs point to a fraud red flag; (2) the presence of high fraud risk alone is insufficient to increase auditor consideration of inconsistent NFMs; (3) auditors are able to react appropriately to an inconsistency if they are effectively prompted; and (4) the influence of a prompt on auditor reliance on NFMs and account balance expectations is stronger when fraud risk is assessed as high. Data Availability: Data are available upon request.

SUMMARY Nonfinancial measures (e.g., number of employees, square feet of operations, independent customer satisfaction, number of customer accounts) can be helpful in assessing the risk of revenue frauds. Companies committing such frauds may have a hard time falsifying nonfinancial measures, especially those produced independently (e.g., customer satisfaction). Auditors can benefit from examining relationships between nonfinancial measures and financial measures to validate financial statement data. A recent study, “Using Nonfinancial Measures to Assess Fraud Risk” (Brazel et al. 2009), provides empirical evidence concerning the relationship between various nonfinancial measures and revenue frauds. This article may be useful as a reference for auditors, or as a teaching tool in the classroom, as it reviews and summarizes Brazel et al.'s (2009) study and provides specific actual examples.

يهدف البحث إلى دراسة واختبار مدى تأثير بيئة البيانات الضخمة على اعتماد مراقبي الحسابات في مصر على الإجراءات التحليلية في اكتشاف الغش في القوائم المالية. وكذلك تحديد مدى تأثير كل من الخبرة والقيد لدى الهيئة العامة للرقابة المالية على مقدرة مراقبي الحسابات على استخدام الإجراءات التحليلية في اكتشاف الغش في القوائم المالية.ومن خلال تقديم حالتين تجريبيتين لمراقبي الحسابات بمكاتب المراجعة الخاصة، ولدى الجهاز المركزي للمحاسبات. فقد قدم الباحث في الحالة الأولى، الإجراءات التحليلية في صورة نسب مالية فقط تشتمل على وجود تلاعب في الإيرادات والمخزون لشركة افتراضية، وطلب من المشاركين تحديد احتمال وجود غش في القوائم المالية. ثم قدم إليهم فيما بعد، بيانات تعكس بيئة البيانات الضخمة عبر وسائل التوصل الاجتماعي وطلب منهم تحديد احتمال وجود غش في القوائم المالية. وقد بلغ عدد المشاركين في هذه الحالة التجريبية الأولى 47 مراقب حسابات. وفي الحالة التجريبية الثانية قدم الباحث نفس البيانات الحالة الافتراضية السابقة، بالإضافة إلى تقديم بيانات نصية (غير المالية) لتقرير مجلس الإدارة مع البيانات المالية (النسب المالية)، بحيث تشتمل الإجراءات التحليلية على كل من البيانات المالية وغير المالية، وطلب من المشاركين الإجابة على نفس الاسئلة في الحالة الأول سواء في توافر بيئة البيانات الضخمة أو عدم توافرها. وقد بلغ عدد المشاركين في هذه الحالة التجريبية الثانية 43 مراقب حسابات. كما طلب من المشاركين الإفصاح عن سنوات الخبرة في مراجعة القوائم المالية للشركات المساهمة، وما إذا كانوا مقيدين أو غير مقيدين لدى الهيئة العامة للرقابة المالية.وقد اشارت نتائج البحث إلى أن احتمال اكتشاف مراقبي الحسابات للغش كان أكبر في حالة استخدام البيانات المالية وغير المالية معاً مقارنة بحالة استخدام البيانات المالية فقط. وكذلك احتمال اكتشاف مراقبي الحسابات للغش كان أكبر في حالة توافر بيئة البيانات الضخمة مقارنة بعدم توافر البيانات الضخمة. كما اوضحت النتائج لم يكن هناك اختلاف معنوي في احتمال اكتشاف الغش بواسطة مراقبي الحسابات ذوي الخبرة أو المقيدين لدى الهيئة العامة للرقابة المالية مقارنة بمراقبي الحسابات الأقل خبرة أو غير المقيدين. ولكن عند اختبار التأثير المشترك للخبرة والقيد لدى الهيئة العامة للرقابة المالية، وجد أن مراقبي الحسابات ذوي الخبرة والمقيدين لدى الهيئة العامة للرقابة المالية لديهم مقدرة أكبر على اكتشاف الغش في القوائم المالية مقارنة بمراقبي الحسابات غير المقيدين وذوي الخبرة الاقل.

We examine whether increased transparency in the comparison of financial measures and nonfinancial measures (NFMs) influences nonprofessional investors' reactions to the risk of fraudulent financial reporting. We consider a comparison of key financial measures and NFMs to be transparent when the relevant information is presented in close proximity and formatted to provide an easy comparison of the individual measures. We manipulate the presence of an NFM red flag and the transparency of the comparison of financial measures and NFMs. We find that when the NFM red flag is present (i.e., higher fraud risk) and transparent, investors choose lower investment levels. However, without increased transparency, as is typical in the current reporting environment, we observe that investors are more likely to increase their investment levels in firms with elevated fraud risk. Additionally, we observe that the effect of transparency on investment levels is driven by investors with greater investing experience. Data Availability: Contact the authors. JEL Classifications: M40; M41; M48.

Improving Fraud Detection: Evaluating Auditors' Reactions to Abnormal Inconsistencies between Financial and Non-Financial Measures?

This research experimentally examines the favorable/unfavorable outcomes of a firm's financial and nonfinancial performance measures on financial analysts' recommendation to divest or invest in a firm. The participants were financial analysts who made recommendations ranging from “definitely sell” to “hold” to “definitely buy.” The results show that financial and nonfinancial performance measures and their favorableness have an interactive impact on analysts' recommendations. To be precise, the recommendations were very close to the “definitely sell” anchor when the performance was unfavorable, irrespective of whether the measures presented were financial or nonfinancial. Further, favorableness of performance on nonfinancial measures appears to be irrelevant when performance on financial measures is unfavorable. However, when performance on financial measures is favorable, the effect of nonfinancial performance had a differential effect on analysts' recommendations depending on whether these measures indicated favorable or unfavorable performance. Specifically, when nonfinancial performance was unfavorable, the recommendations were closer to “hold” on average, but the recommendations were closer to “definitely buy” on average when nonfinancial performance was favorable. These results are consistent with our expectations. Overall, given that more and more firms are disclosing nonfinancial measures along with the traditional financial measures, and with an increasing number of firms reporting unfavorable financial performance, the results of this research underline the importance of considering both financial and nonfinancial measures and their outcomes—favorable and unfavorable—on analysts' recommendations. Data Availability: Please contact the authors.

When evaluating a prospective customer, the commercial banker's main task is to judge the prospect's ability to pay the obligation as stated in the loan agreement.' Judging ability to pay or risk requires the loan officer to estimate the probability distribution of the customer's future cash flows available to service the debt. Cash flows from operations and collateral provide the sources of repayment. Financial statement information plays a major role in the credit evaluation phase of the commercial loan decision. Cohen, Gilmore, and Singer [1966] present a descriptive model of this decision component. The generality of the basic elements of this model is supported by its concurrence with descriptions of the credit analysis process presented in many articles written by banking practitioners and academics (e.g., Jilk [1972], Smith [1974], Houget [1975], Reed et al. [1976]) and with my discussions with bankers. Three major sources of information relating to credit worthiness are specified in the model: financial statement data, management evaluation, and outside credit ratings. The first two sources are of primary importance for most new customers. In general, the financial statements indicate the nature of assets available to serve as collateral and the sources and amounts of prior years' cash flows from operations.

An audit is a regular and systematic process to collect and impartially evaluate evidence of management claims in relation to economic activities and events to determine the extent to which these claims comply with predetermined criteria and to report results to stakeholders. The study aims to know the strategic role of internal audit in detecting the risks of financial fraud, in addition to identifying the basic concepts of internal auditing and the types of fraud risks in the financial statements, and clarifying the role of the internal auditor in detecting the risks of financial fraud, by knowing the impact of the planning process and professional skepticism and understanding The work environment and its contribution to support the internal auditor in detecting fraud risks in the financial statements, and the study concluded that the internal auditor when developing an audit plan, must develop an integrated vision of the effectiveness of governance and risk management, which contributes to reducing the risks of fraud in financial information. In addition, he should consider the institution's evaluation of fraud risks and may evaluate the company's fraud detection abilities on a regular basis. The ability of the internal auditor to continuously assess the potential risks resulting from the work environment helps in discovering the risks of fraud in financial information, in addition to the internal auditor's knowledge of the nature of the work environment in which he works helps to know the risks and detect financial fraud. The internal auditor should identify the potential effects of fraud and discuss the matter with the appropriate level of management, whom management decides to initiate a full investigation and this is achieved through the professional skepticism of the auditor.

In this study, we examine two questions: (1) whether financial statement aggressiveness related to tax accounts is associated with the likelihood of having tax-related misstatements in the financial statements, and (2) whether the disclosure of the need to restate prior years' financial statements for a tax-related reason influences tax-related financial statement aggressiveness related to tax accounts in the fiscal year of announcement. Recent evidence of an increase in the rate of tax-related accounting restatements motivates these questions. In this study, we find empirical evidence suggesting that tax-related financial statement aggressiveness is positively associated with the likelihood of having tax-related misstatements in the financial statements. We also find that in the year in which the need to restate prior years' financial statements is announced, companies with tax-related misstatements in their financial statements appear to be less tax-related financial statement aggressive compared to the control group.