Investor Perceptions About Financial Statement Fraud and Their Use of Red Flags

Abstract

We surveyed 194 experienced, nonprofessional investors to examine the relations between their perceptions of the frequency of financial statement fraud in the economy, their use of financial statement information, the importance they place on conducting their own fraud risk assessments, and their use of fraud red flags. We find that both investors’ perceptions of the frequency of fraud in the economy and their use of financial statement information positively influence the importance they place on conducting their own fraud risk assessments. In turn, investors who place importance on conducting fraud risk assessments make greater use of fraud red flags to avoid potentially fraudulent investments. In terms of red flags commonly relied upon, investors tend to focus on SEC investigations, pending litigation, violations of debt covenants, and high management turnover. In contrast, they rely less on company size and age, the need for external financing, and the use of a non-Big 4 auditor. We also find evidence of positive associations between the use of specific red flags and investors’ portfolio returns. In addition to their own assessment of fraud risk, investors in our sample report relying more on analysts, regulators, and external auditors to detect and report fraud, while relying less on low- and mid-level employees, upper management, the media, and short-sellers for fraud detection and reporting.