Magnifying glass over financial statements highlighting fraud inconsistencies

Are Your Auditors Missing Red Flags? How to Spot Financial Fraud Early

Samir D’Costa in Business & Economy June 2025 • 4 min read.

"Uncover the Secrets Auditors Use to Constrain Inconsistencies Between Financial and Nonfinancial Measures"

In today's complex financial landscape, fraud poses a significant threat to businesses of all sizes. The consequences of financial fraud can be devastating, leading to substantial financial losses, reputational damage, and even legal repercussions. That’s why understanding how to detect and prevent fraudulent activities is more critical than ever.

One of the key areas of focus in fraud prevention is the role of auditors and audit committees. Traditionally, auditors are expected to provide reasonable assurance that financial statements are free from material misstatements, whether due to error or fraud. However, recent research indicates that auditors are not always adept at identifying fraudulent activities, leading to an ‘expectations gap’ between what auditors can provide and what financial statement users expect.

Recent studies highlight the importance of identifying inconsistencies between financial and nonfinancial measures to detect potential fraud. Nonfinancial measures, such as the number of retail stores, patents, or employee headcount, offer a powerful and independent benchmark for evaluating the validity of financial statement numbers. When these measures don't align with the reported financial performance, it can be a significant red flag.

How Auditors and Audit Committees Lower Fraud Risk

Magnifying glass over financial statements highlighting fraud inconsistencies

A recent study by Brazel and Schmidt (2018) sheds light on how auditors and audit committees can play a crucial role in lowering fraud risk. The study examines whether specific auditor attributes and audit committee compositions can effectively constrain inconsistencies between financial and related nonfinancial measures (NFMs).

The research indicates that companies committing fraud often exhibit large inconsistencies between reported revenue growth and growth in revenue-related nonfinancial measures. For example, if a company reports significant revenue growth but the number of stores or employees remains stagnant, it could signal potential fraud.

Auditor Tenure and Expertise: Auditors with greater industry expertise and longer tenure are more likely to identify and constrain inconsistencies, reducing the risk of fraud.
Audit Committee Chair Tenure: Audit committees chaired by individuals with longer tenure are also more effective at detecting inconsistencies.
Industry Expert Chairs: Surprisingly, audit committees with industry expert chairs can be more likely to overlook inconsistencies compared to those without industry expert chairs, suggesting potential over-reliance on management or conflicts of interest.

To assess these relationships, Brazel and Schmidt analyzed quantitative, revenue-related NFMs from 691 companies' 10-K filings between 2007 and 2009. They collected data on over 4,138 NFMs, categorized as 'Employees,' 'Facilities,' and 'Products & Inventory.' By comparing changes in NFMs with reported revenue changes, they identified companies exhibiting significant discrepancies, which they defined as a 'large DIFF' indicating higher fraud risk.

Key Implications for Businesses

The findings underscore the importance of having experienced and knowledgeable auditors and audit committee members. Longer tenure and industry expertise enable auditors to better identify and address potential fraud risks. However, the study also cautions against relying solely on industry expertise within audit committees, as it can sometimes lead to overlooking critical inconsistencies. Businesses should prioritize a balanced approach, combining expertise with independent oversight to effectively constrain fraud risk and protect their financial integrity.

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Everything You Need To Know

What is the primary role of auditors in the context of fraud prevention?

Auditors are primarily responsible for providing reasonable assurance that financial statements are free from material misstatements, whether due to error or fraud. However, research indicates an 'expectations gap' exists, meaning auditors may not always be adept at identifying fraudulent activities. Their role extends to helping detect and prevent fraudulent activities, which is crucial in today's complex financial landscape.

How can inconsistencies between financial and nonfinancial measures be used to detect fraud?

Inconsistencies between financial and nonfinancial measures can be a significant red flag for potential fraud. For example, if a company reports significant revenue growth but the number of retail stores or employee headcount remains stagnant, it could signal potential fraud. Nonfinancial measures such as the number of retail stores, patents, or employee headcount provide an independent benchmark for evaluating the validity of financial statement numbers. When these measures don't align with the reported financial performance, it warrants further investigation.

What impact does auditor tenure and expertise have on fraud detection?

Auditors with greater industry expertise and longer tenure are more likely to identify and constrain inconsistencies, reducing the risk of fraud. Their experience allows them to better understand industry-specific risks and trends, making them more adept at spotting discrepancies between financial and nonfinancial measures. Longer tenure also provides a deeper understanding of the company's operations and financial reporting practices.

How does the audit committee's composition, specifically the chair's tenure and expertise, influence fraud risk?

Audit committees chaired by individuals with longer tenure are more effective at detecting inconsistencies and reducing fraud risk. The longer tenure provides them with a more comprehensive understanding of the company and its financial reporting practices. However, the study suggests that audit committees with industry expert chairs can be more likely to overlook inconsistencies compared to those without industry expert chairs. This indicates potential over-reliance on management or conflicts of interest.

What practical steps can businesses take to reduce fraud risk based on the findings?

Businesses should prioritize having experienced and knowledgeable auditors and audit committee members. This includes selecting auditors with industry expertise and ensuring audit committee members, particularly the chair, have sufficient tenure. Businesses should avoid solely relying on industry experts on the audit committee, and instead, they should aim for a balanced approach combining expertise with independent oversight to effectively constrain fraud risk and protect their financial integrity. They can also monitor changes in revenue-related nonfinancial measures ('Employees,' 'Facilities,' and 'Products & Inventory') in conjunction with reported revenue changes to identify significant discrepancies, which may indicate higher fraud risk.