17

FINANCIAL STATEMENT FRAUD:

MOTIVATION, METHODS, AND DETECTION
S. David Young

INTRODUCTION

This chapter reports on fraud in corporate financial statements, while

focusing on publicly traded firms. But before proceeding, clarifying how
financial statement fraud is related to other forms of unethical or criminal
behavior in companies is worthwhile. A recent annual report of the Associ-
ation of Certified Fraud Examiners (ACFE) notes that, “[a]mong the various
kinds of fraud that organizations might be faced with, occupational fraud is
likely the largest and most prevalent threat” (Association of Certified Fraud
Examiners 2018, p. 6). Occupational fraud is defined as “fraud committed
against the organization by its own officers, directors, or employees”
(Association of Certified Fraud Examiners 2018, p. 6). In effect, it is an attack
on the company from within by the very people entrusted to protect it.
Accounting fraud is a form of occupational fraud, but not all (or even most)
occupational fraud is accounting fraud. To understand why, consider that
occupational fraud falls into three broad categories: (1) corruption, (2) asset
misappropriation, and (3) financial statement fraud.

• Corruption includes conflicts of interest, invoice kickbacks, and bid

rigging. In a recent survey of the ACFE, this category accounts for nearly
half of all occupational fraud worldwide.

• Asset misappropriation includes the theft of cash, tampering with checks

and payments, expense reimbursement schemes, and hiring “ghost”
employees.

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322 S. David Young

• Financial statement fraud, which is the focus of this chapter, consists of the
deliberate (and sometimes criminal) misstatement of elements found on
corporate balance sheets, income statements, and statements of cash flow.

This chapter begins by putting the subject of fraud in the broader context
of accounting error and bias, after which it addresses the contentious ques-
tion of when accounting bias and manipulation become fraud. Although legal
and regulatory guidelines offer definitions of accounting fraud, the discussion
here reveals that the boundary separating bias from fraud is often blurred.
This chapter then discusses the motives that underlie accounting fraud. Some
of these motives are related to capital market behavior, whereas others
mainly reflect the contractual incentives typical of management compensation
programs. The subsequent section describes several tools and empirical
approaches that users of financial statements can use to detect accounting
fraud. This chapter finishes with some remarks on the role of auditors in
fraud detection as well as a summary and conclusions.

SOURCES OF ACCOUNTING ERROR

According to Young and Cohen (2013, p. 1), “[f]inancial statements exist to

provide useful information on businesses to people who have, or may have, an
economic stake in those businesses.” These statements should help investors to
make value-enhancing decisions on where to place their capital; bankers to
determine whether a company can service its debts; and suppliers to assess the
credit risk of a potential customer. Other key constituencies include tax
authorities, trade union representatives, competitors, courts of law, antitrust
regulators, customers, and prospective employees. Besides having a stake or
potential stake in the company, all of these groups share the status of being an
external constituency. Financial statements provide a means by which corpo-
rate insiders – officers and directors – can communicate to outsiders their
company’s financial strength, profitability, and capacity to generate cash flow.
To fulfill its economic and social function, financial accounting must
capture the underlying economic reality of the business – a goal that can be
expressed schematically as follows:

Financial accounting 5 Economic reality.

Financial Statement Fraud 323

For many reasons, however, the truth is much more complicated:

Financial accounting 5 Economic reality 6 Error.

Financial statements are error filled because producing them requires so

many estimates and so much judgment. The subject of this chapter – fraud –
is a form of error, but most mistakes are not fraudulent. Error in the
accounting process comes from three sources, of which only one has any-
thing to do with fraud: (1) limits of measurement technology, (2) random-
ness, and (3) management bias.

Limits of Measurement Technology

The first source refers to errors that reflect limitations of the world’s two
dominant financial reporting regimes: International Financial Reporting
Standards (IFRS) and US Generally Accepted Accounting Principles (GAAP).
Both regimes have experienced much progress in recent years, but the work of
improving accounting standards is far from complete. Consider, for instance,
that currently most corporate investments are made in “knowhow” and other
intangibles – in contrast to a not-too-distant past when most investments
were in physical assets. Accounting for the latter is not without controversy,
but issues regarding their proper treatment are far closer to being resolved
than are those for the accounting of intangibles. Such accounting is compli-
cated by the ephemeral nature of most intangibles. For example: Should the
investments made in employee knowhow be treated as assets when employees
can leave? Accounting regulators have yet to resolve this issue and others like
it. Of course, accounting standards on intangibles already exist, but the
resulting numbers do not necessarily capture economic reality.

Randomness

The second source of error comes from manager estimates. Suppose, for
example, that a company has planned a major restructuring. Both IFRS and
GAAP require an estimate of the loss on restructuring as soon as the decision
324 S. David Young

becomes irreversible. Yet is it even possible to know the cost of such events
before the fact? If a firm expects total costs of (say) $100 million, then the
only thing it can be sure of is that the actual cost will differ from that esti-
mate. Financial statements are full of such inadvertent errors. Because of
these errors and given the uncertainties that naturally arise when preparing
financial statements, two highly qualified practitioners can examine the same
data and arrive at different conclusions. In short, errors occur even when
management’s intent is entirely honest. Hence, presuming that a financial
statement is free of errors is never reasonable.

Management Bias

The third source of error – management bias – differs in kind from the
random, accidental errors alluded to previously. What separates such bias
from random error is that, in this case, the error is by design. In the preceding
restructuring example, management could decide to recognize $125 million
(instead of $100 million) in restructuring costs. The immediate effect would
be to reduce firm profits, or to increase firm losses, by $25 million. At the
same time, a restructuring provision (a liability account) is recognized,
creating what Europeans refer to as a “hidden reserve.” The term most
widely used in the United States is “cookie jar reserve,” coined years ago by
The Wall Street Journal. A firm can later reverse or recover these reserves to
artificially boost profits.
One motive for this practice is income smoothing, which reduces profits
in highly successful years while using the resulting profit reserves to raise
profits in mediocre years. The effect is to smooth the time series of earnings,
which can make the company appear to be less risky than it actually is.
Savvy investors are unlikely to be fooled by this “sleight of hand,” but it
does offer another potential advantage to the senior executive team. Sup-
pose, by way of illustration, that a company’s performance in the current
year leads to the chief financial officer’s bonus reaching the maximum
before the year’s end – as might occur if the CFO’s compensation plan
incorporated a limit on the amount of bonus that can be earned in a given
year. Reporting profits in excess of that bonus-maximizing amount does not
benefit the CFO because that portion of the profits is unrewarded. Hence, a
clear incentive exists to “overprovision” in a high-profit year with the aim
Financial Statement Fraud 325

of creating a reserve of accounting profit that can boost performance-related

bonuses in a future, or low-profit, year. Biasing financial statement numbers
upward or downward in this way does not in itself constitute fraud. Ethical
questions are raised, to be sure, but such practices almost never land
corporate executives in prison.
Much management bias arises because of “accounting choice,” or the
latitude given to managers in their selection of accounting policies and esti-
mates. Accounting choice is a powerful weapon in the hands of managers who
are disposed – for any of several motives – to mislead the capital markets or
other constituencies. Experience teaches that most efforts to manipulate
accounting numbers focus on the components of earnings: revenues, expenses,
gains, and losses. For this reason, the term “earnings management” is often
used interchangeably with “financial statement manipulation” and also with
more colloquial terms, such as “cooking the books” and “creative account-
ing.” Of course, the other financial statements are subject to manipulation too,
including balance sheets (often to understate debt) and statements of cash flow
(usually to overstate cash flow from operations).

Earnings Management and Fraud: What Is the Difference?

One of the most complicated issues to untangle in financial statement

manipulation is where earnings management and other forms of accounting
manipulation end and fraud begins. Perhaps the most critical aspect of this
question is whether or not the misrepresentation was committed on purpose.
In other words, no such thing as an “accidental fraud” exists. Also, the
deception must be material (i.e., significant) and the act must have caused
another party to suffer a loss. The Public Company Accounting Oversight
Board (PCAOB), which is the organization tasked with overseeing the audits
of publicly traded companies that report under GAAP guidelines, puts the
matter this way: The primary factor that distinguishes fraud from error is
whether the underlying action that results in the misstatement of the financial
statements is intentional or unintentional (PCAOB, 2019). One problem with
this definition is that it does not clearly distinguish fraud from other forms of
financial misconduct. For example, routine types of earnings management,
such as overprovisioning, are undertaken deliberately but are rarely
326 S. David Young

considered to be fraudulent. Hence, the PCAOB’s definition is of little prac-

tical use to investigators or other interested parties.
Earnings management is rarely fraudulent – at least not in the legal sense.
For example, revenue is especially susceptible to manipulation yet is seldom
viewed as fraud. In a scheme known as “channel stuffing,” a company inflates
its revenues by shipping, near the end of an accounting period, more product
than its customers want. Often a customer will be enticed by such incentives
as discounted prices and/or extended payment terms. Regular use of such
tactics is almost certainly value destroying for the seller; the reason is that
customers will then be inclined to delay placing orders because they expect
more favorable terms are likely to become available near the end of the
supplier’s accounting period. But does the seller’s manipulation of revenue in
this way amount to fraud? Probably not.
To understand why, visualize accounting manipulation as a spectrum
with totally clean and honest accounting at one end and blatant fraud at the
other end. By moving along the spectrum from the former to the latter,
accounting policies become increasingly dishonest. All forms of false
accounting may be viewed as fraudulent, at least in a moral sense; yet from a
practical (or legal) perspective, a line exists that must be crossed. Whether
this has occurred depends on the magnitude of a misstatement, the extent to
which other parties (e.g., investors and bankers) suffer injury, the laws that
prevail in a given jurisdiction, and the resources available to government
investigators and prosecutors. One example of when the line may be crossed
is when a firm produces false documentation to support recognizing bogus
revenue. Most instances of accounting manipulation are more subtle,
of course, and so are less likely to be judged as fraudulent by government
officials.
Now consider the example of an apparel manufacturer that uses a
common practice known as “bill-and-hold.” This practice is further along
the fraud spectrum than channel stuffing, but is it bad enough to constitute
fraud from a legal perspective? Before answering, that question requires
understanding how bill-and-hold works. The company receives a legitimate
sales order, which is processed and readied for shipment, but the customer is
not yet willing or able to accept delivery. The seller then either holds the
goods or ships them to a different location – perhaps to a third-party
warehouse – until the customer is ready to take delivery. However, the
seller recognizes revenue immediately upon shipment to the interim
Financial Statement Fraud 327

location. Under current accounting standards, revenue should not be

recognized until title of the goods has changed hands from seller to buyer.
Yet, using a third party may allow the seller to claim that the products have
been transferred and hence that the revenue can be recognized. Is this action
fraud? Although bill-and-hold seems more ethically questionable even than
channel stuffing, the likelihood of prosecution is again quite slim. Man-
agement must know that the revenue is being recognized too quickly, for
otherwise there would be no point in shipping to a third-party warehouse.
Such behavior raises troubling questions about management’s intent, but
prosecutors have to pick their battles. They tend to pursue more egregious
cases of unscrupulous accounting at the expense of prosecuting less clear-cut
instances.

WHY DO MANAGERS COMMIT ACCOUNTING FRAUD?

Motivations for accounting fraud are many; yet most of them, at least
among publicly traded companies, fall into one of two categories. The first
category consists primarily of contracting incentives – especially bonus
programs linked to such accounting outcomes as earnings per share (EPS),
earnings before interest and taxes (EBIT), and sales growth – and avoiding
the violation of accounting-based debt covenants. The second, capital
market incentives, includes obtaining new corporate financing on more
favorable terms, boosting the value of equity-based compensation to
increase the value of options and restricted stock, and gains from insider
trading.

Contracting Incentives

The notion that executive equity incentives are explicitly linked to fraud
seems obvious, but empirical research on the matter is not entirely one-
sided. Some studies find a strong association, but other research finds little
or none. Efendi, Srivastava, and Swanson (2007) is an example of the
former; these authors document that the likelihood of a “restatement”
mandated by the US Securities and Exchange Commission (SEC) increases
328 S. David Young

substantially when the CEO has sizable holdings of in-the-money stock

options. The implication is that holdings tied directly to stock price increase
the incentives of senior executives to “game” their financials for the purpose
of boosting or at least sustaining the firm’s stock price. Peng and Röell
(2008) support the contention that equity incentives tend to encourage
unscrupulous accounting practices. They find, in particular, that the exis-
tence of employee stock options increases the likelihood of securities-related
class-action litigation.
In other words, the presence of stock-based compensation is more likely to
lead to suspect accounting practices than is the absence of such compensa-
tion. Call, Kedia, and Rajgopal (2016) report a similar finding. In contrast,
Armstrong, Guay, and Weber (2010) find no evidence of a positive associa-
tion between CEO equity incentives and accounting irregularities. So even
though stock-based compensation is frequently cited as a motivation for
accounting misconduct, including fraud, the academic evidence is decidedly
mixed.

Capital Market Incentives

A second capital market–based incentive is to acquire equity or debt financing

on more favorable terms. For example, a company might overstate its earn-
ings so as to obtain a higher price for a new equity issue or a lower interest
rate on new debt. In extreme cases, a firm might even use accounting games to
conceal financial distress (Dechow, Sloan, and Sweeney 1996). Is this fraud?
The errors are certainly biased, the amounts are often material, and investors
can be hurt by overpaying for new equity issues or by making loans at
artificially low interest rates. Nonetheless, corporate managers are rarely
subjected to criminal proceedings for such conduct.
Bias can be seen also when managers understate earnings, in a manage-
ment buyout scenario, because they hope to acquire the company (or a
division) at a lower price. Perry and Williams (1994) offer evidence on this
point. They find that firms taken private by managers usually adopt more
conservative accounting policies (i.e., policies that understate earnings) in the
months leading up to the buyout than do firms that do not undergo a
management buyout.
Financial Statement Fraud 329

Another incentive is to generate profits from insider trading by trying to

boost the company’s share price in the short term. Beneish (1999), for
example, finds that net insider selling (i.e., selling net of buying) is higher in
periods of earnings overstatement. This result implies that managers are
willing to overstate company performance anticipating later sales of shares.
Peng and Röell (2008) provide similar evidence of increased insider selling at
firms that are subject to securities class-action lawsuits. Because insiders
realize that accusations of financial reporting misconduct drive these lawsuits,
they exercise more options and sell more shares during class-action periods.
Compensation contracts make up a distinct category of motivations,
among which the most important may be the accounting-based bonus plan.
Bonuses tied directly to accounting numbers such as EPS, EBIT, and sales
growth provide all the incentive managers need to game the numbers. The
anecdotal evidence on this point is overwhelming, but academic research
findings are inconclusive. Healy (1985) shows that the direction of bias in
accounting choice (i.e., deliberately understating or overstating earnings) is
driven by whichever direction of the bias is in the best interest of manage-
ment. For example, if performance in a given period is weak so that managers
might fall short of the minimum performance levels required for a bonus, they
tend to adopt accounting policies that artificially boost the relevant
accounting measure. Conversely, if management expects an accounting
measure to exceed the level that maximizes the year’s bonus, then they are
likely to understate profits, since a portion of their reported performance will
otherwise be unrewarded. Also, the understatement creates a form of hidden
reserves that the managers can draw on in future periods if performance
declines. However, subsequent studies find little support for Healy’s
contention that bonus plans are a significant determinant of earnings
manipulation (Dechow et al. 1996; Beneish 1999).
Another contracting motivation is to avoid the violation of debt cove-
nants linked to accounting numbers. Here, too, the academic evidence is
mixed, although the anecdotal evidence is again overwhelmingly supportive.
Burns and Kedia (2006) address the issue in a somewhat roundabout
fashion – namely, using financial leverage as a proxy for covenants. Thus,
the authors assume that firms with high leverage tend to have more debt
covenants than do firms with low debt. They find that firms forced to
undergo an SEC-mandated restatement of their financials have greater
financial leverage than they do in nonrestatement years, which identifies a
330 S. David Young

motivation for firms to adopt aggressive accounting practices (i.e., overstate

profits) and thus reduce the costs of financial distress.

DETECTING FRAUD

Ironically, the target of accounting fraud accusations also provides much of

the data for detecting such fraud. This section discusses several approaches
and perspectives that users of financial statements can adopt to detect false
accounting.

Company Characteristics

The first tool for detecting fraud is based on a firm’s characteristics – its size,
rate of growth, and industry – given that some characteristics are more
conducive to fraud than others. For example, imagine a company with annual
growth of 15% or more for several years but then starts to experience slower
growth or worse, no growth. This fate awaits all companies, of course, but
the transition can be painful and even traumatic. The entire corporate culture
is organized around high growth, especially regarding the evaluation of
divisional performance and the compensation programs for senior managers.
When growth stalls, management may be tempted to sustain at least the
appearance of high growth by other means, such as aggressive revenue
recognition. Senior executives often view such behavior as temporary; they
convince themselves that the firm is merely borrowing from the future and
will pay back the loan (in the form of overstated revenues) when sales growth
recovers to its “normal” levels. However, a problem arises if the growth fails
to return. In that case, managers dig themselves into such a deep hole that
aggressive accounting ultimately becomes fraudulent accounting.

Abnormal Changes in Receivables

Increases in any component of working capital – receivables, inventories, or

accounts payable – should move roughly in line with changes in sales.
Financial Statement Fraud 331

This relation does not always hold, however. For example, a firm might
loosen or tighten credit policies. Loosening credit is a straightforward way to
increase sales; in that scenario, the percentage of changes in receivables can
deviate markedly from the percentage change in sales. Yet, in most years
comparable percentage changes should occur in receivables and sales. When
the relation fails to hold, questions might be raised about the integrity of the
firm’s accounting.
One way to test for this possibility is via the ratio.
%Change in receivables / %Change in sales
where “Change” is the difference between the value for the most recent
year and the previous year. Questions emerge whenever this change ratio
exceeds 1, and especially if it is increasing over time. For example, if the ratio
is greater than 1 but was not in the previous year, then this could indicate any
of several problems – of which some, including difficulty in collecting
receivables and aggressive revenue recognition (including channel stuffing or
fictitious revenue), might be related to accounting misconduct. A higher ratio
suggests also that the firm has started extending credit to riskier customers,
which increases the likelihood of nonpayment. This practice might seem
harmless enough, but revenue should not be recognized unless it is “realiz-
able,” which is the term accountants use for “collectible.” If collectability is
impaired, in which case the change ratio is likely to increase, then revenue is
overstated. Aggressive revenue recognition also causes the ratio to increase
because, when revenue is recognized too quickly or should not be recognized
at all (because it is not genuine), an increase in receivables is recognized at the
same time as the revenue itself. Given that receivables are nearly always
smaller than revenues, a comparable increase in both numbers will also
increase the ratio.

Speech Patterns of Senior Executives

One stream of research focuses on how financial reporting misconduct is

related to the personal traits of executives – for instance, their speech pat-
terns, marital status, testosterone levels, and length of tenure as CEO.
An example can be seen in the work of Larcker and Zakolyukina (2012),
who analyze the transcripts of nearly 30,000 conference calls by American
332 S. David Young

CEOs and CFOs between 2003 and 2007. These authors note each person’s
choice of words and how they were delivered, and they draw on psycho-
logical studies that show how people speak differently when they lie. Their
research addresses the following question: Were these “tells” (a term often
used by poker players) more common during calls to discuss profits that
were later “materially restated?” Larcker and Zakolyukina discovered that
deceptive managers

• refer less to shareholder value, perhaps to minimize the risk of a lawsuit;

• use more extremely positive words (e.g., instead of describing something

as “good,” they call it “great” or “fantastic”);

• avoid the word “I,” preferring to use the third person;

• use fewer hesitation words (e.g., “um,” “er”), perhaps because they were
coached in their deception; and

• more frequently use obscenities and other “swear” words.

In a similar vein, Hobson, Mayhew, and Venkatachalam (2012) use

specially designed software to extract vocal dissonance markers from
speech samples of CEOs during conference calls. The authors find that these
markers correlate with the likelihood of having to restate financial
accounts.
Hilary, Huang, and Xu (2017) document that married (male) CEOs are
much less likely to manipulate financial statements than are single CEOs. The
reasons for this finding are somewhat speculative, but plausible explanations
include the following:

• Married men have lower testosterone levels (on average) than do single
men, a fact well documented in the physiology literature. A vital attribute
of testosterone levels is that they are positively correlated with risk-taking
behavior, of which manipulative accounting practices and financial fraud
are certainly examples.

• Married CEOs may focus more than do single CEOs on job security and
stability to provide for their families. The desire for security increases risk
aversion, which makes them less likely to engage in risky behavior such as
accounting fraud.
Financial Statement Fraud 333

Another strand of research seeks to understand why certain managerial

traits are more likely to result in financial misconduct. One noteworthy
example is the work of Schrand and Zechman (2012), who maintain that
most accounting misstatements begin with an optimistic bias that is not
fraudulent. However, senior managers may feel compelled to make increas-
ingly optimistic statements to cover the initial bias. In this way, the bias
initiates a “slippery slope” that may ultimately lead to fraud. The same
tendency appears in the earlier discussion on the danger of high-growth firms
transitioning into lower rates of growth.

Benford’s Law

Benford’s law is an observation about the frequency distribution of leading

digits in many real-life sets of numerical data. The law states that, in many
naturally occurring collections of numbers, the leading digit is more likely to be
small than high. For example, in data sets that conform with the law, the
number 1 appears as the leading digit about 30% of the time, whereas 9
appears in that position less than 5% of the time. If the digits were distributed
uniformly, then each would each occur about 11.1% of the time. Benford’s law
also makes predictions about the distribution of second digits, third digits, digit
combinations, and so forth. Named after Frank Benford, an American physi-
cist who described it in a 1938 paper entitled “The Law of Anomalous
Numbers,” the law was largely forgotten until the late 1970s. However, by the
1990s it had become an essential weapon in the fight against fraud.
According to Nigrini (2012), examples of data sets that conform with
Benford’s law include

• the population of cities and towns in the United States (when any recent
census data are used),

• the length of the world’s rivers (in both feet and meters),

• the flow rates of rivers,

• revenues of companies listed on the New York Stock Exchange,

• trading volume on the London Stock Exchange, and

• the perimeters of the world’s lakes.

334 S. David Young

Durtschi, Hillison, and Pacini (2004) suggest other examples especially

applicable to financial statements that can be expected to apply and
not apply to Benford’s law. For example, transaction-level data (e.g.,
disbursement and sales) should be distributed in ways that conform to
Benford’s law. One can, therefore, infer that deviations represent a delib-
erate attempt to game the numbers. However, the same cannot be said for
all accounting-related distributions. Examples include cases in which
numbers are assigned sequentially (e.g., bank checks and invoices) or are
influenced by human thought, such as the prices that reflect psychological
thresholds (e.g., $9.99).
Using the example of revenue, Amiram, Bozanic, and Rouen (2015)
provide a helpful explanation for why Benford’s law works. For the first
digit of revenue to grow from 1 to 2 (whether in thousands, millions, or
billions of dollars), sales need to increase by 100%; in contrast, growth
from 2 to 3 requires only a 50% increase, growth from 3 to 4 requires 33%,
and so on. Hence, financial statement numbers are more likely to start with
the digit 1 than 2, with 2 than 3, and so forth. Benford’s law reflects this
decreasing likelihood. Amiram et al. hypothesize that if accounting numbers
are generated from many transactions in a given period and also over
multiple periods, the first digits of those numbers should appear to be
randomly generated. Therefore, financial statements not doctored by man-
agement should generally follow Benford’s law. Indeed, the Amiram et al.
sample of financial statement variables of US-based companies between
2001 and 2011 follows Benford’s law. This relation also holds for each
sample year and in each industry. In total, about 85% of firm years conform
to the law. Even so, is deviation from Benford’s law a reliable indicator of
accounting misconduct?
Amiram et al. (2015) use a simulation to demonstrate that, when man-
agement manipulates accounting numbers, one likely result is an increase in
the divergence from Benford’s law. They also show that, after a firm is forced
to restate accounting numbers, the restated numbers are much closer to
Benford’s law than the previous ones. Based on these results, the authors
assert that the statistic used to judge these deviations – what they call “10-K
Mean Absolute Deviation,” or 10-K MAD – is a useful tool for detecting
financial statement irregularities. Here “10-K” refers to the annual report
required by the SEC for all companies that are traded publicly in the United
States.
Financial Statement Fraud 335

Additionally, Amiram et al. (2015) apply Benford’s law to the financial

statements of a sample of publicly traded companies and show that deviations
from Benford’s law correlate with proxies for earnings management. More-
over, these authors document that firms with barely positive earnings deviate
from the law to a greater extent than do firms that just miss, a finding
emblematic of the phenomenon known as small-loss avoidance. The dynamic
at play here is that firms “dress up” earnings so that they do not have to
report a loss, even a small one. Instead, they manipulate the accounting
numbers just enough to report a positive profit number. Amiram et al. also
find that divergence from Benford’s law is negatively associated with earnings
persistence. In other words, when accounting numbers diverge from the
Benford law distribution, earnings become less sustainable. Many forensic
investigators, including the Internal Revenue Service and auditors from the
Big 4 accounting firms, now use statistical programs derived from Benford’s
law to detect irregularities in financial statements.

Whistle-blowing and External Tip-offs.

Despite all of the quantitative, analytical, and statistical tools available for
detecting accounting fraud, the most common sources of detection are
internal whistle-blowing and external tip-offs. To encourage such tips,
many firms now have hotlines on which employees and outsiders can report
suspicious activity. An important virtue of this approach, and one that
doubtlessly contributes to its effectiveness as a fraud-finding tool, is that it
offers the tipster anonymity and thereby overcomes fears of reprisal or of
the consequences from turning in a fellow employee. According to Maeda
(2010), studies of hotline use have shown that anonymity, although not
always important to tipsters, should always be made available. The fore-
most challenge in making such programs work is being able to investigate
the tips properly. Maeda points out that, for every legitimate tip, firms
receive dozens of complaints from disgruntled employees or third parties
who have their own motives for using the hotline. Tips need to be screened,
and a clear procedure must be in place to ensure that all legitimate tips are
pursued.
336 S. David Young

WATCHDOGS OR BLOODHOUNDS: WHERE ARE

THE AUDITORS?

A recent Financial Times (2019) editorial relates the story of a senior

accountant’s testimony before a committee of the UK Parliament. The chief
executive of Grant Thornton, the world’s fifth-largest accounting firm, came in
for a grilling when he told the committee that it is not the job of auditors to
look for fraud. One angry Member of Parliament responded by asking if the
auditor is not picking up on fraudulent behavior, then “what is the point of
audit in the first place?” Not all senior accountants agree with the Grant
Thornton chief, but a disconnect appears to exist between the general public’s
view of the auditing role and the way that auditors view it. Auditors have
traditionally maintained that their role is to determine whether company
financial statements are prepared in accordance with GAAP or IFRS. “We are
not FBI agents” is commonly heard; forensic accounting is the responsibility of
others. Yet, the large international accounting firms have increasingly come to
acknowledge that, as the Financial Times editorial puts it: “If auditors pick up
a scent of something wrong, they need to follow the bloody trail.” In short, an
audit firm should be a bloodhound, and not just a watchdog.
Auditors’ claim that their responsibilities stop at determining whether the
accounts offer a “true and fair” view (to borrow the British expression) of the
business is disingenuous. In the 1930s, an American company successfully
perpetrated a major fraud by faking the presence of inventories. Until then, US
auditors often did not check for the physical presence of certain assets, which
is why the company escaped detection for so long. Since then, however,
auditing principles have required that auditors confirm the existence of assets
– especially inventories as well as property, plant, and equipment. This
requirement offers assurance that an audit should prevent companies from
reporting nonexistent assets. Having auditors, who are fully aware of such a
rule, claiming that they are watchdogs only seems odd. Since the Enron
scandal in 2002, auditors in many countries have been required to obtain a
statement (signed by top management) attesting to the strength of a company’s
internal control system. An avowed purpose of such systems is to ensure the
integrity of the numbers that emerge from the company’s accounting
processes.
Financial regulators usually do not impose penalties on auditing firms
for audits that fail to detect accounting fraud, although penalties may be
Financial Statement Fraud 337

assessed for the most important cases. But in some countries, most notably
the United States, private litigation is the primary enforcement mechanism.
Also worth noting, as Kedia, Khan, and Rajgopal (2018) have shown, the
SEC’s enforcement actions against auditors tend to be fairly mild – espe-
cially regarding the Big 4 accounting firms.

SUMMARY AND CONCLUSIONS

Accounting manipulation and fraud are rife, but only a small share of the
perpetrators are detected and punished. Two main reasons explain this state
of affairs. First, the sheer volume of unscrupulous accounting overwhelms
regulators, prosecutors, auditors, and others responsible for enforcing the
integrity of financial statements. Second, distinguishing between criminal and
noncriminal behavior is difficult. By its nature, earnings management is a
deliberate act undertaken to bias financial statement numbers in a way that
benefits the firm or its senior managers at the expense of investors, bankers,
and other economic stakeholders. Some of these activities are blatantly
criminal and are often regarded as such by the authorities. But many others,
including most instances of accounting manipulation, occupy a large gray
area in which the behavior is ethically questionable but seldom viewed as
meriting even derisory punishment. These circumstances generate skepticism
among the general public about the trustworthiness of corporate accounting
and the auditing function.

DISCUSSION QUESTIONS

1. Identify the factors that separate earnings management and other forms of
accounting manipulation from financial statement fraud and indicate
where the line separating the two should be drawn.

2. Discuss the responsibilities that auditors have in detecting and reporting

fraud and whether auditors are “watchdogs” or “bloodhounds.”

3. Discuss whether gender is a useful discriminator in the detection of

fraud.
338 S. David Young

4. Are there instances in which deliberate bias in accounting numbers can be

justified from an ethical perspective and explain what makes them different
from other examples of management bias.

5. Explain why whistle-blowing is still the most common way that accounting
fraud is discovered despite the many tools available to detect accounting
fraud.

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