Financial fraud protection now as simple as 1, 2, 3

Published: 2014-05-23

In an era of financial scandal headlines, has a reliable, cost-effective way to identify financial reporting fraud, as seen by the likes of Enron and WorldCom, been discovered? Researchers at Columbia Business School and Fisher College of Business believe so and have created a new way for financial regulators and investors to “red flag” irregularities in financial statements faster and more efficiently than ever before.

"In the last decade the SEC has dramatically reduced its already sparse resources for detecting accounting fraud," said Dan Amiram, an assistant professor of accounting from Columbia Business School. "Accounting fraud is a threat to businesses and investors across the globe that, as some studies have suggested, costs investors billions of dollars annually. Our approach is easy to implement, effective, and much needed given the current rise in the volume and amount of electronically-filed corporate disclosure."

Created by Professor Amiram, Ph.D. student Ethan Rouen, from Columbia Business School, and Zahn Bozanic, assistant professor of accounting and MIS at Fisher, the groundbreaking approach provides a novel way to identify irregularities in financial statements by examining how the numbers in these statements relate to naturally occurring statistical properties. Unlike existing strategies to detect fraud that can be gamed by determined managers, this new approach has no specific relationship to a company’s business model, making it more difficult to fool and potentially leading to the unearthing of numerous undetected frauds in the U.S.

"Our approach complements the SEC’s Accounting Quality Model, better known by its street name of 'Robocop'," Bozanic said. "It allows the SEC to quickly flag financial reports for review as soon as they are filed on Edgar."

The researchers identified three steps that significantly improved fraud detection. These included:

  1. Applying a Well Known Tool for a New Purpose
    For many years, forensic accountants looking for potential financial fraud in a company’s internal books have relied on Benford’s Law. The law looks for recurrent numerical patterns to detect fraud. For example, if the dollar amounts in a company’s financial statements contain as many numbers beginning with five as they do beginning with three, it’s a red flag for auditors to further investigate the numbers, which may have been invented. The new approach is the first of its kind to apply Benford’s Law to annual financial statements.
  2. Spotting Irregularities with a Special Score
    The new approach can also help the SEC, auditors, and investors generate a Financial Statement Divergence (FSD) score. A higher FSD score indicates a greater likelihood of financial irregularities. Investors, auditors, and regulators would be able to use the FSD Score to quickly and efficiently spot irregularities in financial reporting in a cost-effective manner. The FSD score has numerous advantages over existing measures as it does not require forward looking information and is available to virtually every firm with accounting information.
  3. Saving Time and Improving Quality of Misstatements Discovery
    There is a significant time lag between the occurrence of fraudulent financial reporting and SEC enforcement actions. As the FSD score is predictive of SEC Accounting and Auditing Enforcement Releases (AAERs), it can help to close this gap while accelerating and improving the quality of the auditing process itself.

The research paper is titled, "Financial Statement Irregularities: Evidence from the Distributional Properties of Financial Statement Numbers," and can be found on the Social Science Research Network. Amongst other results, the authors show that once misstatement firms have issued corrected financial statements, the restated financial statements have significantly lower divergence from Benford’s Law, as exhibited by lower FSD Scores. Importantly, the authors find that FSD scores successfully predict which firms materially misstate their financial statements.