A new analysis of the benchmarks that auditors use to identify financial statement fraud risk finds that the most commonly used benchmarks are less effective at identifying fraud than benchmarks that are less commonly used.
“We wanted to look not only at the benchmarks that standards say auditors can use, but the benchmarks that auditors are actually using in practice, to see which of these benchmarks is most effective,” said Joe Brazel, co-author of a paper on the work and professor at North Carolina State University’s Poole College of Management, in a statement.
“Our findings suggest that auditors may want to increase their use of a benchmark that compares a company’s revenue growth to the revenue growth of their industry sector,” Brazel said. “That benchmark is not one of the most commonly used, but we found that it is most indicative of fraud risk.”
The two most common benchmarks were both trend analyses that looked only at a company’s financial statements. For example, looking at a company’s revenue in the current year and seeing whether it departed significantly from its revenue the previous year. However, the survey found that auditors also used four other benchmarks to lesser degrees. Researchers found the two most commonly used benchmarks – which relied solely on a company’s financial statements – weren’t very useful.
By far the most useful benchmark involved evaluating the difference between a company’s revenue growth and the revenue growth of its industry. The study also identified a related trend that upends conventional wisdom about fraud.
“It’s long been thought that companies commit fraud in order to keep up with their competitors…Instead, we found that when revenues were down across an entire industry, some companies committed fraud in order to keep their reported revenues artificially high. In essence, their revenues declined along with everyone else’s, but they cooked their books to avoid admitting it,” he said in a statement.
The paper includes guidance “that is the sort of thing I would have wanted when I was a practicing auditor,” Brazel added.