Auditor Use of Benchmarks to Assess Fraud Risk: The Case for Industry Data

Abstract

Financial statement auditors, regulators, and researchers are constantly searching for
ways to improve the detection of financial statement fraud. Auditors are required to perform
preliminary analytical procedures with the objective of identifying unusual or inconsistent
relationships between expectations and recorded balances. Auditors use the results of preliminary
analytical procedures when assessing the risk that financial statements are materially misstated
due to fraud. Via a survey of practicing auditors, we find that auditors rely heavily on prior year
balances and relations within the client’s financial data as benchmarks when developing
expectations during planning. Auditing standards describe additional benchmarks, like industry
trends, which are less susceptible to management manipulation. However, our survey results
indicate that auditors are less apt to employ these benchmarks on their engagements. Our
empirical analyses reveal that benchmarks derived from industry data, nonfinancial measures,
and cash flows outperform both prior year balances and relations within the client’s financial
data when assessing fraud risk. Of all the benchmarks suggested by auditing standards, we
observe that the difference between a company’s revenue growth and the revenue growth of its
industry has historically been the best indicator of fraud. When a company reports revenue
growth that substantially exceeds that of its industry, it may be too good to be true, and auditors
should consider increasing their fraud risk assessment and proceeding with skepticism.

Keywords: Analytical Procedures, Audit, Benchmark, Data Analytics, Fraud Risk, Industry

JEL Classification: M40, M41, M42