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2016 CARE ConferencePerspectives on FraudAugust 5 -6, 2016Panel 3: Models for Predicting/Detecting Fraud
Patricia M. Dechow
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Financial Misstatement and Fraud
Kenneth Lay and Jeffrey Skilling 1B charge and Enron collapse
Joseph Nacchio and 3B Revenue fraud at Qw
Bernard Ebber and $11 billion Worldcom fraud
Martin Grass and Rite Aid and 2.3 billion fraud
Paul Allaire and Richard Thoman CEOs and 1.4B fraud at XeroxRamalinga Raju Chairman 1.04B fraud at Satyam
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Overview of academic perspective
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Distinguishing between fraud and earnings management
Dechow and Skinner (2000)
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Dechow and Skinner (2000)
Academic research focuses on Motivations, causes and consequences
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Regulator perspective
Aggressive Accounting
Violates GAAPObjective: Who has crossed the line?
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Manipulation years identified in AAERS
0
50
100
150
200
250
0.0%
0.2%
0.4%
0.6%
0.8%
1.0%
1.2%
1.4%
1.6%
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
% of Compustat
# of AAERs
About half a percent of firmcommit fraud each yearNote:
The percentage is calculated as follows: the number of firms that manipulated earnings in a particular year obtained from the AAER database (see CFRM: http://groups.haas.berkeley.edu/accounting/aaer_database/ ) divided by the number of firms in Compustat. The # of AAERs is the number of firms in the AAER database that manipulated earnings in a particular year.
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Percentage of Firms going BankruptPerformance- Related Delistings
Note:The percentage is calculated as follows: the number of firms with performance related delistings divided by number of firms in CRSP. Sample universe is NYSE, AMEX, and NASDAQ firms. We define firms with performance related delistings if they have delisting code that is equal to 400 or between 550 and 585.
About 3% of firms delist each year
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MODELS TO DETECT MANIPULATION
General overview
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Source: Ak, Dechow, Sun and Wang (2013)
F-score
M-score
Chief Financial Officers are pressured by CEO
CEO pay sensitivity not incrementally important
Fraud Models: Financial and Governance Variables
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Compares commercial measures to Academic measures
Unexplained audit fees are incremental to F-Score
Fraud Models: Financial and Governance Variables
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Classification Accuracy of Models
Source: Dechow, Ge, Larson, and Sloan (2011)
Models detect fraud firms, but a lot of firms classified as fraud firms do not end up in the SEC sample
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Classification Accuracy of Models
Source: Dechow, Ge, Larson, and Sloan (2011)
Correct classification; fraud and non-fraud firms correctly classified out of the total firms.
Perfect model: 100% accuracy
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Classification Accuracy of Models
Source: Dechow, Ge, Larson, and Sloan (2011)
Sensitivity tells us how good the model is given the cut-offHigher is better.
Sensitivity: % of fraud firms correctly identified
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Classification Accuracy of Models
Source: Dechow, Ge, Larson, and Sloan (2011)
A lot of firms classified as fraud firms do not end up in the SEC sample.- Costs- SEC investigation with no
outcome- Audit firm does not accept a client
Type I errors: % of non-fraud that are classified as fraud firms
“innocent man goes to jail”
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Classification Accuracy of Models
Source: Dechow, Ge, Larson, and Sloan (2011)
Cost of Type II errors- When fraud is revealed…- Audit firm get sued- Regulator is criticized- Investors lose money
- Lowering the cutoff will reduce Type II errors but increase Type I errors
Type II errors: % of fraud firms that are classified as non-fraud firms
“Thief that got away”
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Fraud Models Continued: Computer intensive approaches.Amiram, Bozanic and Rouen (2015)
Benfords Law: First digit of numbers in Financial StatementsMore 1’s than 9’s
Distribution of monthly returns from investing in Bernie Madoff’s fund
Much higher than expected
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Fraud Models: Benford’s Law..Amiram, Bozanic and Rouen (2015)
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Fraud Models: Machine Learning
• Identify 23 financial statement variables used in prior research
• Have the computer learn on early data
Cecchini, Aytug, Koehler, Pathak (2010)
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Fraud Models: Machine Learning
Cecchini et al 2010
Cecchini, Aytug, Koehler, Pathak (2010)
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Fraud Models: Machine LearningReplicating models using same dataset
F-Score
Machine-Learning
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Fraud Models: Nonfinancial MeasuresBrazel, Jones, and Zimmerman (2009)
NFM – students collected up to four measures for fraud firm and a matched firm.Examples, number of stores, square feet of floor space, energy producing capacity
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Fraud Models: Nonfinancial Measures
NFM – students collected up to four measures for fraud firm and a matched firm.Examples, number of stores, square feet of floor space, energy producing capacity
Brazel, Jones, and Zimmerman (2009)
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Fraud Models: Other sources of Information• “Deceptive words in conference calls”
(Larcker and Zakolyukina 2012)• Fraud Detection Using Vocal, Linguistic,
and Financial Cues” (Throckmorton, Mayew, Collins and Venkatachalam 2015)
• Executive off the job behavior - Luxury goods and prior legal infractions (Davidson, Dey, Smith 2012)
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Fraud Models: Managing Market Expectations..• Manipulating firms (AAER firms) are more likely to
consistently beat analyst expectations for up to 8 quarters than propensity matched firms (Chu, Dechow, Hui, Wang 2016)
• Firms that use non-GAAP earnings are more likely to restate. Audit Analytics – WSJ August 4,
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Does stock market anticipate manipulation?
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Stock returns and Misstatements
Source: Dechow, Ge, Larson, Sloan (2011), Figure 1.
Accounting misstatements firms do particularly poorly after manipulation stops
Strong stock price performance before the fraud occurs
Manipulation Years
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Accounting misstatements are a very negative signal to market
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Summary: Fraud Models• Detection: Financial ratios help – Accruals, receivables,
inventory, ROA,• Computer intensive functions also appear to help – Benfords
law, machine learning, text analysis, etc.,• Non-financial measures help – but not comprehensively
studied due to data collection issues.• Firms relation with stock market – prior returns, conference
calls, non-GAAP earnings, consistent beating of earnings expectations, raising financing
• Management characteristics – risk takers, ego, crime, founder, power
• Governance – board characteristics• Management Incentives
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Summary of Academic Models• Academics focus on understanding
incentives of managers, causes, and consequences.
• Many papers do not directly address whether the model improves fraud detection (correct classification, sensitivity, type I, type II errors)
• From a practical perspective (Regulators, Auditors, director insurance, etc.,) such tests would be helpful.
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THANK YOU!