Article: The Decline of Accounting and the Rise of Forensic Finance

The following entry appeared as part of Governance Metrics International’s GMI Blog. GMI is the leading independent provider of global corporate governance and ESG ratings and research. Corporate stakeholders – including leading investors, insurers, auditors, regulators and others – use GovernanceMetrics services to identify and monitor risks related to non-financial measures covering key environmental, social, governance and accounting risk factors. Full article is available at http://bit.ly/15bhkUJ

May 28, 2013 in Corporate Governance, Daily Viewpoint

By Lev Janashvili

At the GMI Ratings seminar on May 14, NYU finance professor Dr. Baruch Lev spoke memorably about the decline of traditional accounting and our collective hope for a superior model. The relevance of this topic for investors today continues to become clearer, as evidence accumulates about the incidence and systemic repercussions of corporate fraud and misleading disclosure practices.

The latest research (summarized below) strongly suggests that, under the current regulatory regime, many material risks remain mispriced and inadequately disclosed. Accounting practices that distort underlying economic realities remain widespread. Regulators remain resource-constrained, notwithstanding the report in the Wall Street Journal today that the SEC plans to continue to increase its focus on quantitative forensic fraud detection.

This confluence of trends creates ideal conditions for the rise of forensic finance, a more skeptical version of its traditional predecessor. Recently published research reveals a clear need for stronger forensic sensibilities throughout the ecosystem of capital markets. Academic research and global surveys point to detection-resistant systemic anomalies that distort and destroy value. Below is a summary of recent reports on the incidence and economic cost of undetected risks.

ACFE 2012 Global Fraud Study

According to a 2012 estimate by the Association of Certified Fraud Examiners (ACFE), organizations lose 5% of their total revenue to fraud, which translates into a global annual loss of $US3.5 trillion. ACFE’s latest global fraud survey also found that: [OUTLINE: Full article available at: http://bit.ly/15bhkUJ. ]

Concentrations of power exacerbate the impact of fraud.

Entrenchments of power exacerbate the impact of fraud.

Fraud is predictable

External audits provide inadequate protection against fraud.

Fraud Detection and Expected Returns

Misleading accounting conceals material risks.

Forensic analysis can improve fraud detection and portfolio performance.

How Pervasive is Corporate Fraud?

Ernst & Young Fraud Survey

Financial manipulation is widespread.

Financial manipulation is often an open secret.

Pressure to grow fuels fraud.

Survey of CFOs

Auditor Deficiencie

In Conclusion

The evidence clearly suggests that, because of shortfalls across the spectrum capital market participants, the value of mandated corporate disclosures continues to diminish. Institutional investors today have few better practical choices than to methodically cultivate greater skepticism, which serves as the organizing principle of forensic analysis.

The Board Director Training Institute (BDTI) is a "public interest" nonprofit in Japan dedicated to training about directorship, corporate governance, and related management techniques. It is certified by the Japanese government to conduct these activities as a regulated nonprofit. Read a summary about BDTI here, and see a menu of its services for both corporations and investors here.

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