Magazine article Strategic Finance

Detect Fraud before Catastrophe: Proactive Content Analysis Techniques Can Help Management Accountants Prevent Catastrophic Financial Fallout

Magazine article Strategic Finance

Detect Fraud before Catastrophe: Proactive Content Analysis Techniques Can Help Management Accountants Prevent Catastrophic Financial Fallout

Article excerpt

Reducing fraudulent activity is a crucial issue facing accountants today. Data from trusted sources, such as the Association of Certified Fraud Examiners (ACFE), concludes that fraud levels aren't receding. This is especially troubling given that we now have tougher laws, more aggressive enforcement, and steeper penalties with fines and settlements regularly topping $100 million when they were only several million dollars a few years ago.

Internal fraud is on the rise. On January 29, 2013, reported that 80% of financial loss suffered by companies through fraud was caused by internal personnel. "The number of these cases reaching court rose from 22 in 2011 to 35 in 2012, with the value of these frauds more than doubling from [pounds sterling]12 million to [pounds sterling]25.1 million." The authors of the website suggest a persistent need for prevention, detection, and responding with better fraud prevention modeling. We couldn't agree more.

The Sarbanes-Oxley Act of 2002 (SOX) was intended to aid in preventing fraud by making organizations more responsible for their financial statements--something they were already responsible for. Also, Congress created the Public Company Accounting Oversight Board (PCAOB) to oversee the audits of public companies in order to protect stockholders' and the public's interests. Nevertheless, fraud has continued to increase, and the damages from fraud have increased even more.

When external auditors use conventional audit procedures, their efforts often come too late to avoid catastrophic damage to the organization--think Enron and WorldCom. External auditors typically use financial ratio analysis (conventional models) after the audit year is over and the books have been closed. At this point, the damage has already been done, and it's too late to prevent fallout. Moreover, numbers are easy to manipulate, and auditors won't see a dramatic change in the financial ratios if fraud increases gradually.

There's a better option: Companies can use early fraud detection models at any time in a given year. These models often involve nonfinancial, language-based variables or contemporaneous risk factors that can be measured as leading indicators long before the financial results are known. For example, variables could include number of words, amount of specific punctuation used, or certain suggestive words, such as emotionally positive or negative words.

These content analysis techniques create increasingly better modeling. With this in mind, we explored the proposition of being able to detect fraud earlier without having to rely primarily on public accounting or external auditors. We believe that internal auditors can use early fraud detection models to detect fraud and reduce the damage it causes. This view is consistent with the role of management accounting professionals to provide risk assessment as well as design and implement internal controls to safeguard against fraud.

Theoretically sound, these early detection mechanisms provide a higher level of accuracy in fraud detection than the conventional models that many external auditors currently emphasize. Studies have shown that conventional financial models are 30% to 40% accurate in predicting fraud. But examining narrative disclosures with new language-based models is both timelier and closer to 70% accurate.

To successfully mitigate financial disaster, both accuracy and timeliness in fraud detection are important: Accuracy increases the reliability and probability of results, and greater timeliness increases the likelihood that a company will discover fraud before the effects become overwhelming. The earlier a company detects ongoing fraud, the less financial damage accrues. Accordingly, our project using the content analysis method seeks to place the emphasis where it belongs--on those accountants adding value to their organizations in a timely manner. In this regard, we believe this approach provides a significant contribution to rebalancing the profession. …

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