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

Abstract

During planning, auditors are required to perform preliminary analytical procedures by looking for unusual or inconsistent relationships between expectations and recorded balances. Auditors use the results of preliminary analytical procedures to assess the risk that the 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 (e.g., comparing current year revenue growth to current year accounts receivable growth) as benchmarks when developing expectations during planning. Auditing standards describe additional benchmarks that are less susceptible to management manipulation, but our survey results indicate that auditors are less apt to employ these benchmarks on their engagements. Our empirical analyses reveal that benchmarks derived from industry data, non-financial measures, and cash flows outperform both prior year balances and relations within the client’s financial data when assessing fraud risk. In particular, we observe that the difference between a company’s revenue growth and the revenue growth of its industry is the best indicator of fraud. When a firm reports revenue growth that substantially exceeds that of its industry, it may be too good to be true and auditors should consider increasing their fraud risk assessments and proceeding with skepticism.