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An Evaluation of the Hennes Indicator: Does It Detect Fraud?

Fri, March 15, 3:30 to 5:00pm, Meeting Hotel, TBA

Abstract

This paper addresses the efficacy of the Hennes indicator in detecting fraud. The methodology applied is a robust approach based on support for two propositions. Results suggest that the Hennes indicator remains a valuable tool for researchers examining fraud. However, the researchers approach should not include the indicator as a variable in a logistic regression framework. Consistent with research suggesting firms would not voluntarily disclose fraud, the study finds only roughly 1 in 8 fraud firms disclose the fraud and in most instances internal investigations are associated with external (regulatory) investigations. Dependent on the fraud measure, the Hennes indicator misses approximately 30% of fraud observations. The frauds missed are from firms with higher growth. Results suggest the frauds missed (Type II errors) could be reduced by applying an accrual estimation model to observations where the fraud indicator suggests no fraud. Alternative approaches are also proposed. Type I errors are related to debt/assets and market capitalization. Evidence presented suggests that when researchers use class action lawsuits as evidence of fraud, they may be excluding smaller firms with less market capitalization and firms with less equity financing and should control for potential endogeneity issues.

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