Even fraud-savvy investors often look for the wrong red flags

Public Release: 29-Jun-2015
North Carolina State University

New research identifies the types of investors who are vigilant about corporate fraud, but finds that most of those investors are tracking the wrong red flags - meaning the warning signs they look for are clear only after it's too late to protect their investment. The work was performed by researchers at North Carolina State University, George Mason University, the University of Virginia and the University of Cincinnati.

"Individual investors get hurt if they own stock in fraudulent companies that cook the books, such as Enron," says Dr. Joe Brazel, a professor of accounting at NC State and lead author of a paper on the work. "But we wanted to know how investors think about fraud and whether they try to protect themselves."

The researchers surveyed 194 experienced, nonprofessional investors from 38 states about fraud and their investment activity. Among other things, the researchers asked investors if they looked for specific red flags that can be indicative of fraudulent activity, such as abnormally high revenue growth, a change in the company's auditor, or the launch of an investigation by the U.S. Securities and Exchange Commission (SEC).

The researchers found two factors that are common to investors who are concerned about fraud. First, if investors think corporate fraud is a common practice, they are more likely to place importance on assessing fraud risk when making investment decisions. Second, investors are more likely to assess fraud risk if they rely primarily on financial statements to make investment decisions, rather than other sources like news reports or advice from professionals.

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