Corporate Governance

Alternative Methods for Detecting Corporate Fraud

By Tamar Weinrib

Countless times in the past few years the markets have been struck by the revelation of a pervasive fraud.  To say shareholders have suffered is an understatement.  As such, there is a constant effort by analysts, commentators and regulators to uncover more effective ways of detecting and preventing fraud.  Recently, certain studies have suggested that an analysis of non-financial factors may provide a better indication of whether a particular company is engaged in misconduct.  

One such study, titled Using Nonfinancial Measures to Assess Fraud Risk, appeared in the July 2009 Journal of Accounting Research and was authored by Joseph F. Brazel of North Carolina State University, Keith L. Jones of George Mason University, and Mark F. Zimbelman of Brigham Young University.  That study suggested that the use of non-financial measures may be valuable for auditors and others when performing analytical procedures and assessing fraud risk.   Specifically, it provides evidence showing that comparisons between financial measures, such as revenue growth, and non-financial measures, such as facilities growth, can be effectively used to assess fraud risk.  

As an example, the study cites to the trial of former HealthSouth CEO Richard Scrushy, where federal prosecutors argued that Scrushy must have known something was amiss with HealthSouth?s financial statements since there was a discrepancy between the company?s financial and non-financial performance. ?The prosecution noted that, twice during the seven-year fraud, revenues and assets increased even though the number of HealthSouth facilities decreased. ?And that?s not a red flag to you?? asked prosecutor Colleen Conry during the trial. Conry?s question implied that HealthSouth?s financial information was inconsistent with its nonfinancial information and thus, the risk of financial statement fraud [ ] at HealthSouth should have been a concern.?

Significantly, the study points out that the Public Company Accounting Oversight Board (?PCAOB?) is considering whether auditors should be required to use non-financial measures to help detect fraud.  It notes that the PCAOB believes that using only financial data to detect fraud is ineffective because corporate management can manipulate financial data to minimize the possibility that an auditor would uncover any issues.

In another recent study, titled Like Moths Attracted to Flames: Managerial Hubris and Financial Reporting Frauds, Michel Magnan of Concordia University in Montreal, Denis Cormier of UQAM and Pascale Lapointe-Antunes of Brock University suggest taking a look at the size of management?s ego as a possible indicator of fraud. Though the paper analyzes improprieties committed at Canadian publicly traded firms between 1995 and 2005, the same concepts could conceivably apply to U.S. corporations as well.  As reported by the D&O Diary, the authors suggest that egotistical managers, stoked by media attention and analyst praise, gain a "feeling of invincibility" that leads them to "take more risks in fraudulent activities," akin to the "moths attracted to the flames that ultimately kill them."  The study notes that the usual indicators of fraud, which include ?incentives, opportunity and rationalization,? are not exclusive to companies engaging in fraud and these "red flags morph into red herrings, that may lead to numerous and unfruitful wild investigation chases."  However, the study suggests that ?managerial hubris? ignites and accelerates the propensity of senior executives to commit or to be oblivious to fraud" and thus may just be the red flag that can effectively weed out the truly fraudulent operations from the non-fraudulent.  The authors opine that "inconsistencies between executives? statements and observable facts or realities, outlandish claims, and a lack of concern for operational detail can be signals that managerial hubris has set in."  Though it is wholly unclear how auditors or regulators would incorporate an analysis of something as subjective as corporate ego into their fraud detection procedures, the general concept of analyzing non-financial factors to more effectively detect fraud is gaining momentum.

Full post as published by PomTalk on August 31, 2009 (boomark / email).