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Study: Fraud-Savvy Investors Often Track the Wrong Red Flags

Jul 7th 2015
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Investors might be better able to protect themselves from fraud if they follow the proper red flags earlier. In fact, investors who use early red flags earn higher market returns for their portfolios.

Those are two key findings of a study, “Understanding Investor Perceptions of Financial Statement Fraud and Their Use of Red Flags: Evidence from the Field,” published late last month in Review of Accounting Studies.

“Individual investors get hurt if they own stock in fraudulent companies that cook the books, such as Enron,” Joe Brazel, PhD, an accounting professor at North Carolina State University and lead author of the paper, said in a prepared statement. “But we wanted to know how investors think about fraud and whether they try to protect themselves.”

Brazel and fellow researchers Keith Jones of George Mason University, Jane Thayer of the University of Virginia, and Rick Warne of the University of Cincinnati surveyed 194 experienced, nonprofessional investors in 38 states and the District of Columbia.

Investors were prescreened to ensure they had traded individual company stocks within the prior 12 months. They also provided researchers with their portfolio returns for the year preceding the survey. About half were men, most had at least a bachelor's degree, and they were on average 40 to 49 years old with a household income of $60,000 to $90,000. They also had been investing for an average of six to 10 years.

The research was funded by a grant from the Financial Industry Regulatory Authority (FINRA) Investor Education Foundation.

The study was based on the desire of elected officials and regulators to protect nonprofessional investors from fraud, and how those investors can use red flags to protect themselves.

Here's a snapshot of the findings.

  • Investors focus more on red flags such as US Securities and Exchange Commission (SEC) investigations, litigation, debt covenant violations, and high manager turnover. They also rely on analysts, regulators, and external auditors to detect fraud.
  • They rely less on a company's size and age, the need for external financing, the use of a non-Big Four auditor, low- to mid-level employees, upper management, the media, and short-sellers in assessing or reporting fraud. “Interestingly, these [two] perceptions run counter to recent evidence suggesting that the media, employees, analysts, and short-sellers are all more likely than auditors and the SEC to detect fraud,” the paper states.
  • Investors are more likely to use obvious late-stage red flags, such as an SEC investigation, than more helpful early-stage warning signs, such as unusually high revenue growth.
  • Investors perceive fraud to occur about half of the time for publicly traded companies. That may be partly because about a quarter of the respondents owned shares in a company when it was found to have committed fraud. That high perception also may be fueled by media coverage of how frequent financial statements are intentionally manipulated.
  • Investors who believe fraud is more prevalent or who rely more on financial statements compared to other information put more emphasis on their own fraud risk assessments.

But the study also indicates that using red flags may not be easy. And in the early stages of fraud, investors may not be sure exactly what suggests fraud.

For example, high revenue growth may not seem abnormal unless it's considered with other nonfinancial changes that don't indicate growth, such as a cutback in employees. But such changes aren't reported on the company's income statement with revenue, according to the study.

Investors may rely more on late-stage red flags, such as an SEC investigation, because it's tougher to get early-stage red flags, the study reports. And late-stage red flags more often get media attention and are easier to obtain for analysis.

Red flags also can be in reports – an auditor change cited in an 8-K, for example – that investors don't read.

And investors may simply not recognize indicators of fraud. For example, the study cites large accruals as a fraud red flag, but analysts and investors focus on earnings and find it tough to separate cash flows from accruals in financial statements.

The upshot? Researchers believe their findings indicate that regulator and investor websites could disclose red flag data to help investors in identifying companies that show early-stage red flags.

“Our findings raise a new question,” Brazel said. “If we care about the individual investor, then what can we do to get investors to pay attention to early red flags? One option is to make these red flags more transparent.”

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By peonysox
Jul 8th 2015 21:14

Great article.

Please visit a good SOX and internal controls website, which provides an overview of the SOX Act and compliance, as well as examples of financial controls:

www.soxlawcontrols.com

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