The Use of Nonfinancial Measures to Assess the Likelihood of Fraud

Topics: Financial audit, Auditing, Audit Pages: 16 (4243 words) Published: March 8, 2011
For auditors, failing to detect fraud at their clients is usually accompanied by substantial monetary penalties and/or negative publicity. Thus, the profession has re-evaluated its fraud assessment processes and has attempted to find new ways in which material misstatements due to fraud can be identified. The purpose of this study is to determine whether auditors can effectively use nonfinancial measures (NFMs) in their analyses of fraud. Given that auditors can identify NFMs (e.g., facilities growth) that should coincide with financial measures (e.g., revenue growth), inconsistencies between these two variables may be indicative of higher fraud risk. The results show that all of the respondents believed that financial measures should be accounted for most in an auditing, but more than half disagreed that only the financial measures dictate the performance of the company. While majority of the respondents agreed that NFMs are effective indicators in assessing fraud risk, less than half opined that NFMs can be used effectively in conducting an audit. Auditors believed that the differences between NFMs and financial measures are very significant in assessing fraud risk. Majority agreed that NFMs are highly acceptable and highly recommended fraud risk indicators. It appears from the study that NFMs are merely supporting data for financial measures, which are still considered as primary tool in auditing. NFMs are useful indicators, but only with the presence of a primary financial data. .

For several decades, the audit profession has attempted to find efficient and effective methods of improving auditors’ fraud risk assessments so as to enhance audit quality, reduce auditor liability, and improve investor protection. This study examined whether auditors can effectively use nonfinancial measures (NFMs) 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. (Brazel, et al, August 2008). Fraud, according to Black’s Law Directory, consists of “all multifarious means which human ingenuity can devise, and which are resorted to by one individual to get an advantage over another by false suggestions or suppression of the truth. It includes all surprise, trick, cunning, or dissembling, and any unfair way which another is cheated.” In an occupational fraud setting, however, the ways organizations can be victimized from inside are limited to three principle methods: asset misappropriations, corruption, and fraudulent statements. While each of these methods takes various forms, the result is always the same: The numbers generated by fraud cannot hold up to the unfailing logic of the accounting equation. If executives add false sales and accounts receivable to increase the company’s revenue, profits and cash will be out of kilter. Should employees embezzle money, take bribes, or steal merchandise, the organization’s expenses will be higher than ordinary. As a result of these rather obvious accounting clues, one could wonder why auditors don’t detect more fraud.

There are several reasons, starting with the most difficult: Unlike other crimes, the clues to fraud are not unique. Lower profits or higher expenses could easily be the result of inefficiency, market downturns, higher costs of production---the list goes on. So even when accounting clues exist, the auditor doesn’t know if he has uncovered a red flag or a red herring.

Another reason auditors don’t detect more fraud is that they sometimes see clues which are explained away. As humans, we don’t want to think that the person looking us in the eye is lying....
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