Using Economic Links between Firms to Detect Accounting Fraud

Abstract

We explore whether accounting fraud can be detected using the information of firms economically linked to a focal firm. Specifically, we examine whether customer information disclosed by a supplier firm, combined with customers’ accounting information, helps to detect the supplier’s revenue fraud. We first confirm the economic link between the supplier and customers by showing a strong positive correlation between the supplier’s sales growth and the growth rate of total customer purchases. We then introduce two variables based on customer accounting information—the discrepancy between supplier sales growth and customer purchase growth and customer excess purchases—and show that they are predictive of supplier revenue fraud. We conduct a battery of cross-sectional tests to further examine the two fraud predictors and generally find results to vary cross-sectionally in a predictable way. Finally, the out-of-sample tests indicate adding the two variables to Dechow et al.’s (2011) model increases fraud prediction accuracy.

Keywords: Fraud, economic link, revenue, accounting information, customer

JEL Classification: G14, M40, M41, M42