Using Financial and Nonfinancial Measures to Improve Fraud Detection*

1. Using Financial and Nonfinancial Measures to Improve Fraud Detection* Joseph F. Brazel North Carolina State University The State and Future of Financial Fraud November 3, 2011 * This research was supported by a grant from the FINRA Investor Education Foundation. All results, interpretations and conclusions expressed are those of the authors alone, and do not necessarily represent the views of the FINRA Investor Education Foundation or any of its affiliated companies. No portion of this work may be reproduced, cited, or circulated without the express written permission of the authors.

2. Presentation Overview • Background on Nonfinancial Measures (NFMs) • Research findings • Website • Data from website and future research

3. Sponsors • Financial Industry Regulatory Authority (FINRA) Investor Education Foundation • Institute of Internal Auditors Research Foundation • The Institute for Fraud Prevention • Ernst & Young Summer Research Grant • Accounting Firms – for providing access to audit professionals • NCSU Poole COM – for research grants

4. Background • Financial Measures = Revenue, Earnings, Total Assets, etc. • What are “Nonfinancial Measures” (NFMs)? • Examples from Brazel, Jones, and Zimbelman (2009) • Number of: • Employees • Retail outlets • Patient visits • Production facilities • Patents • Distribution Centers • Square footage of production facilities

5. Background • NFMs are measures of business activity: • Often in 10-K (Part 1 and MD&A) – in the same 10-K filing as fraudulent financial statements • Produced internally and externally (e.g., customer satisfaction) • “Explains” financial results, current push for more disclosure • Correlated with financial statement data • Easy to verify / hard to conceal manipulation • Good benchmark for financial statements • “Fraud” = Fraudulent Financial Reporting, “cooking the books” • Enron, WorldCom, Xerox, The North Face, Rite Aid, Computer Associates

6. “Using Nonfinancial Measures to Assess Fraud Risk,” Joe Brazel, Keith Jones, and Mark Zimbelman. Journal of Accounting Research, December 2009, Volume 47, Issue 5, pp. 1135-1166. Research Question If NFMs serve as a good benchmark for the financial statements, do fraudulent firms exhibit NFM RED FLAGS?

7. Example: Fraudulent Electronic Component Manufacturer 1997 Income: Overstated $3.7 million. Revenue:25% from Prior Year. Employees:6%(440 to 412) Distribution Dealers: 38% (400 to 250) Non-fraud Electronic Component Manufacturer: Revenue: 27% Employees: 20% Distribution Dealers: 7%

8. Using Nonfinancial Measures to Assess Fraud Risk DIFF = Growth in Revenue – Average Growth in NFMs Variable   N Mean EMPLOYEE DIFF Fraud Firms 110 20% RED FLAG Competitors 110 4% CAPACITY DIFF Fraud Firms 50 30% RED FLAG Competitors 50 11%

9. “Improving Fraud Detection: Evaluating Auditors’ Reactions to Abnormal Inconsistencies between Financial and Nonfinancial Measures” • Joe Brazel, Keith Jones, and Doug Prawitt • Key findings: Initial experiment: • Virtually no reaction (5% detected) • Auditors need help detecting abnormal inconsistencies • Tool/prompt greatly improves this process • (but ignored under low and medium fraud risk)

10. Improving Fraud Detection: Evaluating Auditors’ Reactions to Abnormal Inconsistencies between Financial and Nonfinancial Measures FR Assessment + NFM Prompt Revenue Expectation Reliance on NFMs + -

11. Reports from the Field (n = 226 senior level auditors)

12. Reports from the Field What percent of the time do you use NFMs when performing A/Ps? Avg = 34% of the time. 13% say never. Things are getting better. To what extent would you test controls/verify data to make sure the nonfinancial measures were accurate? (1= None; 10 = Extensively) Avg = 7.14

13. Reports from the Field Constraints ? (n= 89 senior level auditors) (1) Lack of easy availability (58%) (2) Lack of understanding about how NFMs drive company performance (29%) (3) Prior year workpapers do not include analyses of NFMs (18%)

14. Reports from the Field Importance of Fraud Red Flags (n = 23 audit managers and partners) 12 common red flags investigated (1) MW over revenue recognition (2) NFM red flag (3) Significant EBC for Mgt (4) Difficult discussions with Mgt over audit adjustments (5) CFO resignation Important that staff bring NFM red flag to attention of engagement management, but may not always be the case.

15. “Do Nonprofessional Investors • React to Fraud Red Flags?” • Joe Brazel, Tina Carpenter, Keith Jones, and Jane Thayer. • Key findings: The average NP investor does not react to red flags (accrual and NFM RFs) in the current disclosure environment (not transparent). • Investors do not react to a single, transparent RF. Good(?) • Making multiple, intuitive red flags transparentleads to lower investment levels. Investor thoughts on NFM red flag drives this.

16. SO …… investors, regulators, auditors, BODs, etc. could use NFMs to better assess fraud risk / improve fraud detection.

17. Tenet Healthcare -- 2009 10-K (page 48)

18. Problems • F/S comparative, NFM disclosures for CY only • NFM data scattered in 50-100 page 10-K • What specific NFMs should I look for? What are the benchmarks for my investment/client and industry? • So, using NFMs is too hard and too time consuming (5-6 hours to hand collect per company) • Only limited evidence, in very specific industries (pharma), of PROFESSIONAL investors using NFMs. • FINRA grants → Create a tool to solve problems based on research

25. Low DIFF Example

26. High DIFF Example

27. Thank you!!!