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Review of Accounting Studies

, Volume 20, Issue 4, pp 1373–1406 | Cite as

Understanding investor perceptions of financial statement fraud and their use of red flags: evidence from the field

  • Joseph F. Brazel
  • Keith L. Jones
  • Jane Thayer
  • Rick C. Warne
Article

Abstract

We surveyed 194 experienced, nonprofessional investors to examine the relations between their perceptions of the frequency of financial reporting fraud, their use of financial statement information, the importance they place on conducting their own fraud risk assessments, and their use of fraud red flags. We find that investors’ perceptions of the frequency of fraud and their use of financial statement information positively influence the importance they place on conducting their own fraud risk assessments. Investors who place importance on assessing fraud risk make greater use of fraud red flags to avoid fraudulent investments. Red flags commonly relied upon include SEC investigations, pending litigation, violations of debt covenants, and high management turnover. Investors rely less on company size and age, the need for external financing, and the use of a non-Big 4 auditor. We also find evidence of positive associations between the use of specific red flags and investors’ portfolio returns.

Keywords

Financial statements Fraud red flags Fraud risk Investors 

JEL Classifications

M40 M41 M48 

Notes

Acknowledgments

This study has benefited from comments provided by Chris Agoglia, Jagadison Aier, Ben Ayers, Linda Bamber, Michael Bamber, Mark Beasley, Paul Beswick, Frank Buckless, Tina Carpenter, Brian Croteau, Brooke Elliott, Blake Hetrick, Frank Hodge, Susan Krische, James Kroeker, Kathleen Linn, Molly Mercer, Jason Smith, Steve Smith, Hun-Tong Tan and input received from presentations to the Office of the Chief Accountant of the Securities and Exchange Commission, the Financial Industry Regulatory Authority (FINRA), the 2011 Conference of the Research Center on the Prevention of Financial Fraud, the 2012 Mid-Atlantic Region Conference for the Institute of Internal Auditors, and the 2012 Meeting of the Association of Certified Fraud Examiners—Central Carolina Chapter. This research was supported by a grant from the FINRA Investor Education Foundation. All results, interpretations, and conclusions expressed are those of the authors alone and do not necessarily represent the views of the FINRA Investor Education Foundation or any of its affiliated companies.

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Copyright information

© Springer Science+Business Media New York 2015

Authors and Affiliations

  • Joseph F. Brazel
    • 1
  • Keith L. Jones
    • 2
  • Jane Thayer
    • 3
  • Rick C. Warne
    • 4
  1. 1.North Carolina State UniversityRaleighUSA
  2. 2.George Mason UniversityFairfaxUSA
  3. 3.University of VirginiaCharlottesvilleUSA
  4. 4.University of CincinnatiCincinnatiUSA

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