Companies committing fraud can find innovative ways to fudge numbers, making it hard to detect wrongdoing. But researchers have unveiled a new warning system that sees through such sharp practices by evaluating things that are easily verifiable, namely the number of employees or the area that a company owns.
If a company says its profits are up, but these non-financial measures (NFMs) are down, that’s a sign something is probably wrong.
“Some companies commit financial statement fraud, and a good portion of those overstate their revenue,” says Joe Brazel, Assistant Professor of accounting at North Carolina State University (NCSU) and co-author of a new paper on the subject.
“They’re able to do that because they can manipulate the accounting. But there are NFMs that can’t be manipulated as easily,” he adds.
Brazel explains that companies may fraudulently claim inflated revenues in order to meet market expectations and maintain, or improve, their stock price - as well as protecting company management from criticism.
But, Brazel says, “when these firms commit fraud, we found a huge gap between their reported revenue growth and related NFMs - their revenue was up, but the NFMs were either flat or declining.”
“And when you looked at their competitors, you see revenue growth and NFMs closely correlated. So when you see that gap, it’s a red flag - you need to take a closer look.” Brazel added.
For example, Brazel says that researchers found a difference of approximately four percent between revenue growth and employee growth in companies that did not commit fraud, says an NCSU release.
In contrast, the difference between revenue growth and employee growth in fraudulent companies was 20 percent. “It’s pretty obvious, when you look at it,” Brazel added.
These findings are slated for publication in the Journal of Accounting Research.