Understanding Investor Perceptions of Financial Statement Fraud and Their Use of Red Flags: Evidence from the Field

Abstract:     
We propose a model of investor perceptions related to financial statement fraud and their use of fraud red flags (e.g., analyses of accruals, management turnover). We expect that investors who rely on financial statement information are more likely to place importance on conducting fraud risk assessments when they perceive a higher (vs. lower) rate of fraudulent reporting to exist across publicly-traded companies. In turn, we determine if investors who place more importance on fraud risk assessment make greater use of red flags when investing. To test our model, we administered a survey to a representative sample of 194 experienced, nonprofessional investors. We find that the relation between investor reliance on financial statement information and the importance of fraud risk assessment becomes stronger as investor perceptions of the rate of fraud increase. We also find a positive association between the importance investors place on making fraud risk assessments and their use of red flags when making investment decisions. In terms of red flags commonly relied upon, investors tend to focus on SEC investigations, pending litigation, violations of debt covenants, and high management turnover. In contrast, investors rely less on company size, age of the company, the need for external financing, and the use of a non-Big 4 auditor. Finally, investors who are more likely to assess fraud risk and use fraud red flags report earning higher market returns.

Number of Pages in PDF File: 56

Keywords: fraud, fraud detection, investor, red flags

JEL Classification: M40

working papers series