Brazel et al. [SSRN] post: Using Nonfinancial Measures to Assess Fraud Risk

Accounting fraud has, regrettably, dominated the news lately. From the recent conviction and sentencing of the Ponzi scheme architect extraordinaire, Bernie Madoff (see UPDATE 2-Massachusetts regulator finds new Madoff victims-Reuters) to GE  agreeing to pay $50 Miillion to settle US SEC accounting fraud charges (see BRIEF-GE pays $50 million to settle accounting fraud charges with SEC-Reuters). 
In the wake of such personal and financial devastation, the public rightly asks how these massive frauds were allowed to flourish undetected for so long? and why no one—securities regulators, accountants or lawyers—found out about the frauds sooner? Along comes an insightful article by Joseph F. Brazel (North Carolina State University – Department of Accounting), Keith L. Jones (George Mason University), Mark F. Zimbelman (Brigham Young University)  entitled “Using Nonfinancial Measures to Assess Fraud Risk”  which offers new analytical methodologies for forensic accounting fraud analysis. 
Here is the abstract:
This study examines whether auditors can effectively use nonfinancial measures 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 nonfinancial measures (e.g., facilities growth) that are correlated with financial measures (e.g., revenue growth), inconsistent patterns between the nonfinancial 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 non-fraud 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 nonfinancial measures can be effectively used to assess the likelihood of fraud.

HT: Professor Wayne Marr, Professor of Business Administration, U of Alaska Fairbanks; Founder of SSRN with Michael Jensen, Harvard U & Eugene Fama, U of Chicago (Twitter page: @waynemarr)

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