Auditor Use of Benchmarks to Assess Fraud Risk: The Case for Industry Data

• In Event: Risk Assesssments and Auditor Judgment

Abstract

Fraud detection is among the highest priorities for the accounting profession, standard setters, regulators, and stakeholders in the financial reporting process. During planning, auditors are required to perform preliminary analytical procedures with the objective of identifying unusual or inconsistent relationships between expectations and recorded balances. Auditors use the results of preliminary analytical procedures when assessing the risk that financial statements are materially misstated due to fraud. Via a survey of practicing auditors, we find that auditors rely heavily on prior year balances and relations within the client’s financial data (e.g., comparing revenue growth to growth in accounts receivable) as benchmarks when developing expectations during planning. Auditing standards describe additional benchmarks that are less susceptible to management manipulation, but our survey results indicate that auditors are less apt to employ these benchmarks on their engagements. Our empirical analyses reveal that benchmarks derived from industry data, nonfinancial measures, and cash flows outperform both prior year balances and relations within the client’s financial data when assessing fraud risk. Of all the benchmarks suggested by auditing standards, we observe that the difference between a company’s revenue growth and the revenue growth of its industry has historically been the best indicator of fraud. When a firm reports revenue growth that substantially exceeds that of its industry, it may be too good to be true and auditors should consider increasing their fraud risk assessments and proceeding with skepticism.

Authors

• Joseph F Brazel, North Carolina State University

• Keith Jones, University of Kansas

• Qiyang Lian, University of Missouri-Kansas City