The Decline of Accounting and the Rise of Forensic Finance

By Lev Janashvili,  The

At the GMI Ratings seminar on May 14, NYU finance professor Dr. Baruch Lev spoke memorably about the decline of traditional accounting and our collective hope for a superior model. The relevance of this topic for investors today continues to become clearer, as evidence accumulates about the incidence and systemic repercussions of corporate fraud and misleading disclosure practices.

The latest research (summarized below) strongly suggests that, under the current regulatory regime, many material risks remain mispriced and inadequately disclosed. Accounting practices that distort underlying economic realities remain widespread. Regulators remain resource-constrained, notwithstanding the report in the Wall Street Journal today that the SEC plans to continue to increase its focus on quantitative forensic fraud detection.

This confluence of trends creates ideal conditions for the rise of forensic finance, a more skeptical version of its traditional predecessor. Recently published research reveals a clear need for stronger forensic sensibilities throughout the ecosystem of capital markets. Academic research and global surveys point to detection-resistant systemic anomalies that distort and destroy value. Below is a summary of recent reports on the incidence and economic cost of undetected risks.

ACFE 2012 Global Fraud Study

According to a 2012 estimate by the Association of Certified Fraud Examiners (ACFE), organizations lose 5% of their total revenue to fraud, which translates into a global annual loss of $US3.5 trillion. ACFE’s latest global fraud survey also found that:

  • Concentrations of power exacerbate the impact of fraud. Perpetrators with higher levels of authority tend to cause much larger losses. Median losses resulting from fraud perpetrated by owners and executives was more than three times higher than the losses resulting from fraud committed by managers and nearly ten times higher than the median economic impact of fraudulent conduct by employees.
  • Entrenchments of power exacerbate the impact of fraud. Perpetrators with longer tenures cause greater fraud-related losses. Fraud by perpetrators with more than ten years of experience with the firm cost shareholders ten times more than fraud committed in the first year of employment.
  • Fraud is predictable. In 81% of cases, the fraudster displayed one or more behavioral red flags that statistically associated with fraudulent conduct.
  • External audits provide inadequate protection against fraud. External audits were the most commonly implemented control at the companies in this study. However, these audits detected only 3% of the reported frauds. External audits also rank poorly in limiting fraud losses.

Fraud Detection and Expected Returns

A team of researchers from Indiana University, Stanford University and Syracuse University, recently reported out-of-sample results of an accounting-based model in predicting both fraud and equity returns.