Electronic copy available at: http://ssrn.

com/abstract=1460820


Investor Perceptions about Financial Statement Fraud and Their Use of Red Flags


Joseph F. Brazel
Department of Accounting
College of Management
North Carolina State University
Campus Box 8113
Nelson Hall
Raleigh, NC 27695
919-513-1772
joe_brazel@ncsu.edu


Keith L. Jones*
Department of Accounting
George Mason University
Enterprise Hall, MSN 5F4
Fairfax, VA 22030-4444
703-993-4819
kjonesm@gmu.edu


Rick C. Warne
Department of Accounting
George Mason University
Enterprise Hall, MSN 5F4
Fairfax, VA 22030-4444
703-993-1763
rwarne@gmu.edu


September 2010






We are grateful for the helpful comments provided by Jagadison Aier, Tina Carpenter, Brooke
Elliott, Frank Hodge, Molly Mercer, Jason Smith, Steve Smith, and the Office of the Chief
Accountant of the Securities and Exchange Commission. This study was funded by a research
grant from the Financial Industry Regulatory Authority Investor Education Foundation.
* Corresponding Author
Electronic copy available at: http://ssrn.com/abstract=1460820
Investor Perceptions about Financial Statement Fraud and Their Use of Red Flags

ABSTRACT

We draw upon literature in psychology to develop a model that examines nonprofessional
investors use of financial statement information, their perception of the frequency of fraud
occurrence, the importance they place on fraud risk assessment, and ultimately, their use of fraud
red flags. To test our model, we administered a survey to 194 nonprofessional investors. Our
model predicts and we find that the positive relation between investor reliance on financial
statement information and the importance of fraud risk assessment becomes stronger as investor
perceptions of the rate of fraud increase (i.e., when investors are more likely to question the
validity of financial statement information). Investors who perceive fraud risk assessment as an
important activity appear to act on these perceptions. We find a positive association between the
importance of making fraud risk assessments and investors use of fraud red flags (e.g., analyses
of accruals, management turnover) when making investment decisions. With respect to the
importance of red flags documented in the literature, additional analysis reveals that investors
tend to focus on SEC investigations, pending litigation, violations of debt covenants, and high
management turnover. In contrast, investors rely less on company size, age of the company, the
need for external financing, and the use of a non-Big 4 auditor. We also illustrate that investors
rely more on analysts, regulators, external auditors, and audit committees to detect and report
fraud. Investors expect less from low/mid-level employees, upper management, the media, and
short-sellers. Finally, we provide initial empirical evidence that nonprofessional investors may
be achieving higher market returns by assessing fraud risk and using red flags when investing.

Keywords: fraud risk; fraud detection; investor; red flags
Data availability: Contact the authors









1

I. INTRODUCTION
Investors experience significant financial losses when fraud occurs at publicly-traded
companies such as Enron and WorldCom. Glass Lewis & Co. (2005) report that investors lost
nearly $900 billion in market capitalization from 1997 to 2004 due to high-profile frauds.
According to a 2006 report by the North American Securities Administrators Association,
investors lose $40 billion annually due to securities fraud (NASAA 2006). Some experts suggest
that the rate of fraudulent financial reporting (hereafter, fraud) will likely increase during the
current economic recession (Mintz 2009). Nonprofessional investors play an important role in
the capital markets, owning approximately 34% of all corporate equity (Bogle 2005). Despite
their potential exposure to fraud, little research to date has examined if and how nonprofessional
investors evaluate fraud risk before making investment decisions.
We conduct a comprehensive survey that asks nonprofessional investors to describe their
perceptions about financial statement fraud and how they protect themselves against fraud. Our
objective is to address and study the links between the following questions: To what extent do
nonprofessional investors rely on financial statement information? What are their perceptions
regarding how often financial statement fraud is perpetrated? How important is assessing the risk
of fraud prior to investing? Do nonprofessional investors analyze red flags (e.g., high
management turnover) to avoid fraudulent investments? Thus, the primary purpose of this study
is to gain an understanding of nonprofessional investor (hereafter, investors) perceptions and
actions with respect to fraud. Overall, our evidence provides a reference point for future
academic research and establishes a link between prior behavioral research related to investor
decision-making processes and archival research that has identified fraud red flags. We are not
2

aware of any prior research that investigates investors perceptions, judgments, and actions
related to financial statement fraud.
Prior research in psychology reveals that, as decision makers rely more heavily on an
information source, they become increasingly concerned about the credibility of that source
(Coleman and Irving 1997). With specific reference to accounting information and the potential
for fraud, prior accounting research indicates that the credibility of information provided by
management influences investors judgments (Jennings 1987; Mercer 2004). Thus, the more
investors rely on accounting information, the more likely they are to perform due diligence by
searching for evidence of fraud.
However, prior research also finds that individuals tend to underweight the probability of
a rare event when they derive through experience the probability that the event will occur. On the
other hand, if information regarding the rare event is received via description, individuals tend to
overweight the probability of the event (Hertwig et al. 2004). For example, a doctor will tend to
underweight the probability of a side-effect occurring from the use of a particular drug because
the doctor has likely experienced few, if any, instances of the side-effect. A patient with no
experience with the drug will likely overweight the probability of the side-effect if the patient
relies on news reports for descriptive data about the side-effect (Hertwig et al. 2004).
Since descriptive data on the probability of fraud is scarce, investors are likely to rely on
their own direct and indirect experiences with fraud. With respect to fraud experiences, investors
can be divided into two segments: (1) those that have experienced fraud in their investment
portfolio (or have experienced fraud through close contacts) and (2) those that have not
experienced fraud. Material financial statement fraud is a rare event.
1
Thus, a large portion of

1
While the actual rate of fraudulent financial reporting is unknown, research related to financial statement auditors
and fraud detection suggests that the rate is very low (e.g., Loebbecke et al. 1989; Nieschwietz et al. 2000).
3

investors have not directly or indirectly experienced financial statement fraud and are likely to
underweight the probability that fraud will occur. Consequently, regardless of the extent to
which they rely on financial statement information, these investors will not foresee a great need
to assess fraud risk when investing. However, for investors who perceive a high rate of fraud in
the market (likely caused by direct or indirect experiences with fraud), we do expect to observe a
positive relation between financial statement reliance and the importance placed on fraud risk
assessment.
Therefore, our theoretical model predicts that as investors rely more on financial
statements to make investment decisions, they perceive fraud risk assessment to be a more
important investment activity. However, this positive association is driven by investors who
perceive that a higher rate of fraud exists. We then examine if investors who perceive fraud risk
assessment as more important act on these perceptions by using red flags to avoid potentially
fraudulent investments.
To test our model, we administered a survey to 194 nonprofessional investors. We pre-
screened participants to ensure that they had purchased or sold individual company stocks within
the prior 12 months. Our sample consists of a geographically diverse group of active investors
from all 50 states and the District of Columbia. Similar to Elliott et al. (2008), we employ the
survey method because we examine independent variables that cannot be manipulated between
investors (e.g., investors perceptions related to the rate of financial statement fraud) and
dependent variables that are not publicly available (e.g., investors use of fraud red flags during
investment). The model we examine is most effectively addressed using the survey method.
We find that the positive relation between investors use of financial statement data and
the importance of making fraud risk assessments is positively moderated by investors
4

perceptions of the current rate of fraudulent financial reporting. For investors, we also observe a
positive relation between the importance placed on fraud risk assessment and the extent of red
flag usage. While extensive research describes the usefulness of red flags to identify if fraudulent
financial reporting exists (e.g., Beasley 1996; Lee et al. 1999, Brazel et al. 2009a), we are the
first study to provide detailed empirical evidence on investors use of these red flags.
In addition to the results related to our model, we report several key findings with respect
to investor perceptions about fraud and their use of red flags. First, investors rely more on
analysts, regulators, external auditors, and audit committees to detect and report fraud. In
contrast, investors rely less on low/mid-level employees, upper management, the media, and
short-sellers. We are not aware of any other study that compares the responsibility to detect fraud
(at least perceived by investors) across such a wide spectrum of capital market participants.
Second, investors tend to focus on the following red flags: SEC investigations, pending
litigation, violations of debt covenants, and high management turnover. In contrast, investors rely
less on company size, company age, the need for external financing, and the use of a non-Big 4
auditor.
Third, a considerable amount of archival research has been devoted to understanding the
negative relation between accruals and future market returns. Additional research has examined
whether this link is driven by nonprofessional or professional investors (e.g., Sloan 1996; Ali et
al. 2000). Our study offers a unique contribution to this research stream. We provide evidence
that investors who specifically evaluate the accrual component of earnings (a red flag if
abnormally large (Lee et al. 1999)) achieve higher market returns. We also illustrate that
nonprofessional investors may be attaining higher returns by assessing fraud risk and using the
most predictive red flags identified in prior research.
5

Despite numerous high-profile frauds in the past and the high cost of fraud to market
participants, investors a priori decision processes vis--vis fraud are largely unknown. Levitt
and Dubner (2005) posit that little is known about fraud-related issues because there is a paucity
of good data. We offer descriptive evidence of, and key insights into, investors fraud-related
perceptions, judgments, and actions. Our findings can guide and fuel future research into the
decision processes of nonprofessional investors in relation to fraud. Our model and descriptive
data can inform policymakers and help standard-setters implement financial reforms to better
protect individual investors (e.g., Zweig 2009). Furthermore, the empirical evidence derived
from our survey can help future researchers design appropriate experimental materials or collect
relevant archival data to better understand investor behavior.
The remainder of the paper is organized as follows. Section II describes the background
and develops our hypotheses. Sections III and IV provide the methods and results of the study,
respectively. Section V concludes the paper.

II. BACKGROUND AND DEVELOPMENT OF HYPOTHESES

Standard setters have clearly indicated that nonprofessional investors should be a primary
consideration when assessing the utility of financial statement information. Statement of
Financial Accounting Concept No.1 asserts that financial reporting should provide information
that can be used by all nonprofessionals as well as professionals who are willing to learn how
to use it properly. Efforts may be needed to increase the understandability of financial
information (FASB 2008, p. 11). Indeed, Congress (Public Law [107-204] 2002) and the
Securities and Exchange Commission (Cox 2005) have explicitly stated their intent to protect
nonprofessional investors. The Financial Industry Regulatory Authority (FINRA) states that one
6

of its primary objectives is to help investors build their financial knowledge and provide them
with essential tools to better understand the markets and basic principles of saving and
investing.
2
In his State of the Union address, President Barack Obama noted, We need to make
sure consumers and middle-class families have the information they need to make financial
decisions (White House 2010). In short, the decision-making processes of nonprofessional
investors matter to standard setters, The White House, Congress, the SEC, and investor
protection groups. Given the red flags that accompanied high profile frauds at Enron and Bernard
L. Madoff Investment Securities LLC, policy-makers should be particularly interested in ways
investors can use red flags to protect themselves from fraud (Hubbard 2002; Markopolos 2010).
However, little is known about if and how nonprofessional investors consider the risk of fraud
or use red flags when making investment decisions.
This dearth of research is troubling because fraudulent financial reporting at publically-
traded companies has a significant impact on investors.
3
Enron investors lost a reported $60
billion (Vinod 2002), and trial testimony revealed that investors in WorldCom lost up to $200
billion (Rakoff 2003). The recent $50 billion fraud committed by Bernard Madoff indicates that
investors continue to suffer serious consequences from financial statement fraud (Feiden and
Zambito 2008). Without first understanding investors decision-making processes with respect to
fraud, it is difficult for future researchers, policy makers, and investor protection groups to
develop methods to protect investors. A baseline must be established to describe how investors

2
The FINRA is the largest independent regulator for all securities firms doing business in the United States. All
told, FINRA oversees nearly 4,800 brokerage firms, about 170,400 branch offices and approximately 643,000
registered securities representatives. Created in July 2007 through the consolidation of NASD and the member
regulation, enforcement and arbitration functions of the New York Stock Exchange, FINRA is dedicated to investor
protection and market integrity through effective and efficient regulation and complementary compliance and
technology-based services (see www.finra.org). The FINRA sponsored this research in an effort to improve investor
protection with respect to fraud.
3
We use the term fraud in the context of fraudulent financial reporting as described in Statement on Auditing
Standards No. 99 (AICPA 2002) as opposed to misappropriation of assets.
7

currently behave with respect to fraud. Then, future research can more effectively evaluate the
potential impact of new policies to protect investors.
4

Investor Perceptions about Financial Statement Fraud and their Use of Red Flags

Prior research has shown that accounting information, including its presentation format,
affects investors judgments and investment decisions (Maines and McDaniel 2000; Elliott 2006;
Warne 2010). Recent research has provided insights into investors judgment processes in
relation to accounting information sources (Elliott et al. 2008), comprehensive income (Maines
and McDaniel 2000), pro-forma earnings (Elliott 2006), fair-market valuations (Warne 2010),
and auditor opinions over internal controls (Smith 2010). This research stream provides
interesting insights into the relation between accounting information and the investment
decisions of nonprofessional investors. However, research has yet to examine how investors
address the possibility that the accounting information may intentionally contain material
misstatements (i.e., be fraudulent). Though investors may benefit from considering whether
fraud exists in a company before making an investment decision, research to date has not
examined if or how investors deliberately perform such fraud-related activities.
We draw upon psychology research and propose a model of investor decision processes
with respect to fraud. Figure 1 provides an illustration of our proposed model. We discuss the
relations in the model and develop hypotheses to test the model below.
[Insert Figure 1]
Investor Fraud Risk Assessments
Research in psychology suggests that, unless investors have been victims of fraud (or
have experienced fraud through a close contact); they are unlikely to perform fraud risk

4
In a complex world where people can be atypical in an infinite number of ways, Levitt and Dubner (2009, 14)
note the great value in discovering the baseline.
8

assessments. Individuals have difficulty assessing small-probability outcomes (i.e., rare events)
such as the occurrence of a major fraud. Prior research indicates that individuals either
underweight or overweight the probability of a rare event depending on how they learn about the
likelihood of the event (Hertwig et al. 2004; Erev and Haruvy 2010). Individuals learn about the
likelihood of rare events from description or from experience. For example, when individuals
have access to a weather forecast they assess the probability of a hurricane from description.
However, when individuals decide whether to back-up their hard drive, they assess the risk that
their hard drive will be lost from experience because it is unlikely that they possess descriptive
data about the probability of a lost hard drive. In the case of decision-making from description,
individuals tend to overweight the probability of a rare event, which is consistent with Prospect
Theory (Hertwig et al. 2004). In the case of decision-making from experience, individuals tend
to underweight the probability of a rare event due to the likelihood that they have not
experienced the rare event (Friedman and Massaro 1998; Hertwig et al. 2004; Erev and Haruvy
2010).
For example, underweighting the probability of a national collapse in the real estate
market would account for mortgage underwriters originating risky loans and banks investing so
heavily in mortgage-backed securities. Historical data about mortgage default rates was scarce
which led banks and underwriters to rely on experience (Tett 2009). Even when speculation of a
real estate bubble began to surface, banks still continued to invest heavily in mortgage-backed
securities (Tett 2009). Since there had not been a national collapse in the real estate market since
the 1930s, banks and others appeared to underweight the probability of this rare event.
5


5
It is important to note that historical data on mortgage defaults was available for certain regions of the country, and
certain regions had experienced drops in real estate values over extended periods of time. However, national data
was limited. In addition, banks incorrectly assumed that there was very little correlation between home prices across
the country. For example, it was assumed that real estate values in Las Vegas would have little, if any, correlation
9

Investors normally make decisions with respect to financial statement fraud by
experience since the true likelihood of fraud is generally unknown and descriptive data is
unavailable. Given that fraud is a rare event, it can be assumed that the majority of investors
have not experienced fraud either directly in their own portfolio or indirectly through a close
contact. If investors have not experienced investing in a fraudulent company, then they will
likely underweight the probability that an individual investment is fraudulent. In addition,
nonprofessional investors may simply rely on others who are more qualified (e.g. regulators,
auditor) to assess and detect fraud.
6
Therefore, it is possible that investors generally underweight
the risk of fraud and place little importance on assessing fraud risk themselves.
On the other hand, prior research in psychology also indicates that source credibility is an
important consideration for decision makers (Coleman and Irving 1997). Individuals examine the
source of information when determining whether to rely on that information. When information
comes from an outside source, decision makers search for knowledge and reporting biases (Eagly
et al. 1978). Specifically, in ambiguous situations when the decision is important, source
credibility significantly influences individuals judgments (Chaiken and Maheswaran 1994).
7
In
a capital market context, investment decisions involve uncertainty and financial statement
information from an outside party (the company and its management). Thus, these findings
suggest that source credibility and fraud risk assessment would be important to investors who
rely heavily on financial information. Consequently, despite investors underweighting the

with real estate values in Miami. Thus, banks felt they could diversify the risk of a drop in real estate values in one
region by investing in portfolios of mortgages from across the country. With limited data and no recent history of a
national collapse in real estate, banks apparently underweighted the possibility that the entire country could
experience a simultaneous decline in real estate values. See Tett (2009) for a more thorough description of these
events and how banks began to rely on experience, versus descriptive data, when making investments in mortgage-
backed securities.
6
We measure and control for investor perceptions that, regulators, auditors, etc. will detect fraud (see RELIANCE
ON OTHERS (item 15) in Table 2).
7
In an accounting context, research has shown that auditors attend to the reliability of a source when making
judgments (e.g., Hirst 1994).
10

probability of fraud, we posit that a positive association could exist between the extent to which
an investor relies on financial statement data and the importance of making fraud risk
assessments (see Figure 1).
However, as described above, we hypothesize that aforementioned relation between
financial statement reliance and fraud risk assessment is influenced by an investors perception
of the rate of fraudulent financial reporting. For investors who rely heavily on financial
statements, but through experiences perceive the rate of fraud to be low, it is unlikely that they
will perceive fraud risk assessment as an important activity. On the other hand, an investor in
Enron or whose acquaintances held WorldCom stock would not consider fraud to be a rare event.
Investors who through experience consider fraud to be a more common event will be (1) less
likely to underweight the probability of its occurrence and (2) more likely to protect themselves
by assessing the risk of fraud. We therefore predict that the positive relation between investor
reliance on financial statement data and the importance they place on making fraud risk
assessments will be positively moderated by investor perceptions of the rate of fraud. We
formally state Hypothesis One as follows:
H1: The positive relation between investor reliance on financial statement information
and the importance of fraud risk assessment becomes stronger as investor
perceptions of the rate of fraud increase.

Investor Use of Red Flags
Prior accounting research has examined firms that engaged in financial statement fraud
and documented the characteristics of fraud firms. Hogan et al. (2008) and Dechow et al.
(2010) summarize the red flags that fraud firms typically exhibit. Notably absent from the
literature is any evidence regarding investors use of fraud red flags prior to making investment
11

decisions. In fact, whether investors actually use red flags, regardless of the importance investors
place on making fraud risk assessments, is an unanswered research question.
We expect that as investors perceive fraud risk assessment as a more important
investment activity, they should have greater motivation to engage in behaviors designed to
avoid investments in fraudulent companies and the losses that follow. A primary and logical way
to avoid fraudulent investments is to evaluate red flags previously shown to discriminate fraud
firms from non-fraud firms (e.g., boards of directors with high proportions of insiders (Beasley
1996)). Thus, when investors place more value on fraud risk assessment, they are more likely to
act on this perception by analyzing red flags prior to investment.
8
We formally state Hypothesis
Two as follows:
H2: The importance of fraud risk assessment is positively associated with investor use
of red flags.

While we expect the aforementioned positive relation, we acknowledge that variation in
the use of fraud red flags (i.e., investor action) may not occur. Just as a managers strategy does
not necessarily lead to actions or successful implementation (Auer and Reponen 1995),
investors opinions regarding fraud risk assessments may not lead to their use of fraud red flags
for a variety of reasons. First, an investor may not have the domain-specific knowledge to

8
The intuition behind our second hypothesis follows the Elaboration Likelihood Model (Petty and Cacioppo 1986).
This theory suggests that individuals who are highly motivated and have the ability to scrutinize issue-relevant
arguments follow the central route route of persuasion. Motivated individuals exhibit a willingness to expend
cognitive effort in evaluating the merits and attributes of a persuasive message. Motivation is directly correlated
with personal relevance. On the other hand, individuals follow the peripheral route when their motivation (and/or
ability) is relatively low. Under the peripheral route, attitudes and opinions are formed by simple positive and
negative cues due to an absence of significant cognitive effort. In the context of financial statement fraud, an
investor who believes fraud assessment is very important (due to prior experiences with fraud) will likely spend
significant cognitive effort collecting and evaluating a wide range of red flags. However, an investor who believes
fraud is extremely rare will likely underweight its likelihood and will expend little cognitive effort. Therefore,
his/her assessment of fraud will be based on peripheral cues. For example, if an investor with little motivation were
asked to assess fraud risk at Company X, the investor might think, the CEO seems like a very trust-worthy
individual and their products are very popular and innovative, thus it seems unlikely Company X is committing
fraud. While most investors might not admit to low cognitive effort with respect to fraud risk assessment, we do
expect that investors who place greater emphasis on assessing fraud risk (i.e., greater motivation) will also be more
likely to use red flags.
12

identify and interpret relevant red flags from information sources (cf. Anderson 1982). Second,
since decision makers often disregard information inconsistent with their prior expectations
(Fischer et al. 2008), some investors may attend to confirming/positive information rather than
utilizing red flags that may call into question the validity of financial statements. Third, because
investors have access to a large quantity of publicly-available information, such quantities may
exceed an investors processing abilities or overshadow red flag data (e.g., Kahneman 1973;
Hasher and Zacks 1979). Fourth, investors who perceive fraud risk assessment to be important
may not assess fraud risk via red flags, and instead choose to use some other form of information
to assess fraud risk. Finally, the possibility exists that investors utilize red flags equally
regardless of how important they perceive fraud risk assessment. Thus, whether investors who
perceive fraud risk assessment to be important actually act on this perception by using red flags
is an open empirical question.
9



III. METHOD

Sample
Similar to Elliott et al. (2008), we employ the survey method to test our hypotheses
because we examine independent variables that cannot be manipulated between investors (e.g.,
investors perceptions related to the rate of financial statement fraud) and dependent variables
that are not publicly available (e.g., investors use of fraud red flags during investment). Thus,

9
By way of comparison, auditors are required to assess fraud risk and act on their fraud risk assessments by altering
their audit testing, further analyzing red flags, etc. Unlike investors, auditors have a responsibility to detect material
fraud; they receive training and guidance related to fraud; and they are likely to have had more than one direct
experience related to fraud (AICPA 2002; Brazel et al. 2010). However, despite these advantages, prior research has
found that auditors have difficulty acting on their fraud risk assessments (e.g., Zimbelman 1997; Asare and Wright
2004). In sum, auditors, who are at an advantage with respect to fraud, have difficulty with fraud-related
analyses/testing. Therefore, nonprofessional investors, who are less knowledgeable than auditors, may perceive
fraud risk assessment as important, but fail to act on this perception by analyzing red flags.

13

the survey method is the most effective means of addressing our hypotheses. In addition, given
the paucity of research related to investors consideration of fraud, the survey method allows us
to examine multiple relations simultaneously (see Figure 1). Thus, we are able to shed light on
multiple forms of investor perceptions, judgments, and actions in a single study. The survey
method also allows for the collection and analysis of rich descriptive data that can serve as a
starting point for future empirical research in this important domain. Our survey results can help
future researchers design appropriate experimental materials or collect relevant archival data to
better understand investor behavior.
One hundred ninety-four nonprofessional investors completed an online survey for this
study. The survey was titled Survey on Investor Beliefs and we collected our fraud-related data
along with obtaining responses on a number of non-fraud-related topics. This variety in our
survey, which concealed the purpose of our study, is illustrated by the large number of non-
fraud-related control variables that we collected and discuss below. Greenfield Online
(http://www.greenfield-ciaosurveys.com) distributed the survey. For the purposes of our survey,
Greenfield screened their database for participants that actively traded individual shares of stock
(vs. simply investing in a mutual fund). We further screened participants by requiring that they
answer yes to the following statement in order to complete the survey: I have bought or sold
individual company stock in the last 12 months. Greenfield distributed the survey to 1,178
participants. Thus, our response rate is 16.5%, which is comparatively high given the response
rates of previous investor surveys (e.g., the response rate for Elliott et al. [2008] was
approximately 3%). Participants completed the survey from August 21 - 25 of 2008. Our data
collection occurred prior to the current economic recession.
10,11


10
Because not all individuals responded to our survey, we examined the potential for non-response bias. Oppenheim
(1992) recommends comparing data from late respondents to early respondents as a way of assessing this bias.
14

Participants were residents from all 50 states and Washington DC, approximately 50%
male, well educated (75% had a bachelors degree or higher), used a wide variety of investment
strategies, were, on average, between 40-49 years old, and had an average of 6-10 years of
investing experience. These demographic data, as well as other control variables, will be further
discussed in our review of descriptive statistics below. Given that researchers commonly use
MBA students to proxy for individual nonprofessional investors, we obtained a relatively diverse
and experienced sample of active investors.
Regression Models

In Hypothesis One we posit that the positive relation between investor reliance on
financial statement information and the importance of fraud risk assessment becomes stronger as
investor perceptions of the rate of fraud increase. To test Hypothesis One, we estimate the
following model via ordinal logistical regression:
FR =
0
+
1
RELIANCE ON FINANCIAL +
2
PERCEPTION OF FRAUD +
3
RELIANCE ON FINANCIAL X PERCEPTION OF FRAUD +
4-37
CONTROL
VARIABLES + (Model 1)

Our first hypothesis is supported if the interaction term RELIANCE ON FINANCIAL X
PERCEPTION OF FRAUD (
3
) is positive and significant. Hypothesis Two predicts that the

Accordingly, we compared the responses from the first quartile of respondents to those of the last quartile of
respondents. There were no statistically significant differences between early and late responses on any of our
hypothesized variables. In addition, we asked Greenfield to screen their database to ensure that all respondents were
nonprofessional investors. To determine if all respondents were indeed nonprofessional investors, we asked
respondents to supply their occupation. One respondent noted that they worked for a stock broker and potentially
could be a professional investor. On the other hand, the respondent could have worked in a nonprofessional investor
capacity for the broker (e.g., worked in the accounting or marketing departments). Our results are qualitatively the
same if we remove this participant from our analyses.
11
The CBOE Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed
by S&P 500 stock index option prices. Since its introduction in 1993, the VIX has been considered by many to be
the world's premier barometer of investor sentiment and market volatility (see
http://www.cboe.com/micro/vix/vixwhite.pdf). In short, higher indices are indicative of greater market fear. During
the period our data was collected the highest measure of the index was 21.22, whereas in mid-September 2008 the
index rose above 30 and did not fall below 30 until June 1, 2009 (see Lauricella 2009 and
http://www.cboe.com/micro/vix/historical.aspx). As of August 26, 2010, the VIX was 26.17 and the 52-week range
for the index was 15.23 - 48.20 (http://finance.yahoo.com/q/bc?s=%5EVIX&t=2y).
15

importance of the fraud risk assessment is positively associated with investor use of red flags. To
test Hypothesis Two, we estimate the following model via ordinary least squares regression:
USE OF RED FLAGS =
0
+
1
FR +
2-35
CONTROL VARIABLES

+ (Model 2)

Hypothesis Two is supported if the variable FR (
1
) is positive and significant. We define our
variables as follows:
FR = Importance of fraud risk assessment, relative to other
factors, when making buy/sell decisions for stock that you
currently hold, measured on a scale where 1 = not at all
important and 7 = extremely important.
RELIANCE ON FINANCIAL = Mean reliance on direct financial statement information /
Mean reliance on non-financial statement information
(further described below and in Table 1).
PERCEPTION OF FRAUD = In your opinion, how often do managers of publicly-
traded companies commit financial statement fraud,
measured on a scale where 1 = 0% of the time and 11 =
100% of the time.
USE OF RED FLAGS = Mean use of red flags (further described below and in
Table 1).

The control variables are defined in Appendix A.

Hypothesized Variables
Financial Statement Reliance
Descriptive statistics for our hypothesized variables are presented in Table 1. We present
mean responses and standard deviations for our measures of direct financial statement reliance
(items 1-6), and the same data for reliance on non-financial statement information (items 8-14).
All of these items were measured via a scale where 1 = very unimportant and 7 = very
important. While Hodge and Pronk (2006) and Elliott et al. (2008) provide evidence that
nonprofessional investors do indeed rely on financial and nonfinancial information when
investing, we contribute to this literature stream by providing detail with respects to the types of
financial and nonfinancial information these investors are likely and unlikely to use.
16

[Insert Table 1]
The means for reliance on financial statement information (item 7) and reliance on non-
financial statement information (item 15) were 5.13 and 4.69, respectively. Consistent with
Elliott at al. (2008), we calculate a relative measure of financial statement reliance (item 16) for
each participant by dividing item 7 by item 15. This measurement is termed RELIANCE ON
FINANCIAL and is an independent variable in Model 1 above. With respect to the importance of
financial statement information, investors appear to rely more on balance sheet data (see
statistical test in footnote b, Table 1) and rely less on the footnotes to the financial statements
(footnote d, Table 1). In relation to non-financial statement information, investors seem to rely
more on stock price information and advice from professionals (footnote f, Table 1) and rely less
on non-financial information related to operations, advice from the media, and advice from
nonprofessionals (footnote h, Table 1).
12
Finally, from non-tabulated analyses of frequency
distributions, the majority of investors deem the following information sources important (i.e.,
rated the information source as 5, 6, or 7 on our scale): stock price information (77.4%), the
balance sheet (73.8% of respondents), cash flow statement (73.3%), income statement (72.4%),
and advice from professionals (69.5%)
Perception of the Rate of Fraud and the Importance of Fraud Risk Assessment
Table 1 also provides descriptive statistics for our variables PERCEPTION OF FRAUD
(item 17) and FR (item 18). We asked participants, In your opinion, how often do managers of
publicly-traded companies commit financial statement fraud? Participants responded on a scale,
1 = 0% of the time and 11 = 100% of the time. The mean response was 5.06, indicating that
investors perceive fraudulent financial reporting as an issue (approximately a 40% rate). This

12
Our results are qualitatively the same if we employ item 7 from Table 1 (mean reliance on financial statement
information) in our analyses instead of RELIANCE ON FINANCIAL (item 16 from Table 1).
17

rather high rate may result from the fact that approximately 25% of our sample reported owning
shares of a company when it was found to have committed financial statement fraud (see item 2
in Table 2).
13
Thus, relating to our theory presented in Section II, a quarter of our sample has
directly experienced fraud and are unlikely to underweight its likelihood.
While fraud is the most extreme form of earnings management, this high perception of
fraud also appears consistent with research by Graham et al. (2006) who find, in a survey of 401
senior financial executives, that the presence of earnings management is pervasive. One CFO in
the study stated, You have to start with the premise that every company manages earnings
(Graham et al. 2006, p. 30). Thus, investors may perceive earnings management activities by
management to be fraudulent, yet understand/accept that such activities are commonplace in
the market and not substantial enough to warrant considerable attention. Likewise, what
constitutes a material fraud is likely lower for investors than those involved in the financial
reporting process (Jennings et al. 1987), which would explain participants high perceptions of
fraud in our study. Last, in an experimental study of nonprofessional investors, Brazel et al.
(2009b) report that investors perceive the rate of fraudulent financial reporting to be a relatively
high 35%.
Given this perception of the rate of fraud, one would expect that fraud risk assessment,
relative to other activities, would be fairly important to investors when making buy/sell
investment decisions. Participants provided data on the importance of fraud risk assessment (FR)
on a scale where 1 = not at all important and 7 = very important. The mean response was

13
Interestingly, in a non-tabulated analysis, we find PERCEPTION OF FRAUD to be positively, but not
significantly, correlated with OWNED THE STOCK OF A FRAUD COMPANY (p = 0.11). Thus, as described in
Section II, investors perceptions of the rate of fraud are likely affected by both their own direct experiences with
losses due to fraud as well as indirect experiences with losses incurred by others around them. OWNED THE
STOCK OF A FRAUD COMPANY is clearly a measure of investors own direct experiences with fraud. When we
replace PERCEPTION OF FRAUD with OWNED THE STOCK OF A FRAUD COMPANY in our analysis, we do
not observe support for Hypothesis One. Thus, it is important to consider both direct and indirect investor fraud
experiences when predicting investor behavior with respect to fraud.
18

5.24. This mean response indicates that, despite fraud being a rare event, investors perceive fraud
risk assessment to be a relatively important investment activity. As stated previously, our study is
the first academic study to examine such investor perceptions related to fraud and to determine if
they are associated with investor behavior (e.g., use of red flags).
Use of Red Flags
Prior research in the areas of fraud, restatements, and earnings management has created
an extensive list of red flags that correlate with financial statement quality. For example, Dechow
et al. (1996) find that companies in need of external financing may have incentives to manipulate
revenues in anticipation of accessing the capital markets. Also, companies have incentives to
manage earnings prior to an acquisition or merger in order to raise their stock price (Erickson
and Wang 1999; Louis 2004). Beasley (1996) concludes that fraud firms tend to have a higher
proportion of insiders (i.e., employees) on their boards of directors, and Efendi et al. (2007) find
a link between equity-based compensation and fraudulent financial reporting. In short, there are a
large number of potential red flags that prior empirical research has validated and investors
might use to assess fraud risk and avoid investing in fraudulent companies. In Table 1, we
provide data on the use of 21 red flags (items 19 39). For the use of each red flag, participants
responded to a scale where 1 = never and 7 = often. For each participant, we calculate their
mean use of red flags. We label this variable USE OF RED FLAGS, which becomes the
dependent variable in Model 2 above.
14
The mean use of red flags for our sample is 4.91 (item 40
in Table 1). With respect to the importance of red flags, we find that investors tend to focus on
SEC investigations, pending litigation, violation of debt covenant, and high management

14
In all instances where we use the mean of multiple variables to create one variable (e.g., USE OF RED FLAGS),
factor analyses were performed. Without exception, all factor analyses indicated that the items satisfactorily loaded
in excess of .50 on one factor (Nunnally 1978). Also, all tests of measurement reliability provided Cronbachs alpha
levels exceeding the generally accepted threshold of .70 (Nunnally 1978).
19

turnover (see statistical test in footnote l, Table 1). Investors rely less on the following red flags:
age of the company, need for external financing, company size, and use of a non-Big 4 auditor
(footnote n, Table 1). While extensive research has examined the usefulness of red flags to
identify fraudulent financial reporting, we are the first to provide empirical evidence on investor
use of these red flags.
Control Variables
As previously stated, during the course of their investment activities, investors are likely
influenced by a host of factors/information that are (and are not) fraud-related (e.g., reliance on
others to detect and report fraud, trading strategy). To ensure the reliability of our results, we
control for numerous variables that could potentially affect investor perceptions related to fraud,
their use of red flags, and their overall investment activities. We present descriptive statistics for
these control variables in Table 2. These data also highlight the diversity and appropriateness of
our sample. First, we document that 100% of our participants reported buying or selling
individual company stock in the 12 months prior to our survey (item 1). Intuitively, one would
expect that prior fraud experiences (item 2), the perception that losses due to fraud can be
recovered (item 3), and reliance on other parties to detect and report fraud (items 4 - 14) could
impact our hypothesized variables. As noted previously, 25% of our sample reported that they
held shares of a company that committed financial statement fraud (item 2). While we use the
mean RELIANCE ON OTHERS to detect and report fraud (item 15) as a control variable in our
analyses, Table 2 illustrates that investors see various capital market participants as more and
less responsible in this area. For each party, reliance was measured on a scale ranging from 1 =
not at all to 7 = completely. We are aware of no other study that compares the responsibility
to detect fraud (at least perceived by investors) across such a wide spectrum of capital market
20

players. Investors appear to rely more on regulators, external auditors, analysts, and audit
committees to detect and report fraud (see statistical test in footnote d, Table 2).
15
Investors
expect less from upper management, low/mid-level employees, the media, and short-sellers
(footnote f, Table 2). Overall, mean RELIANCE ON OTHERS to detect and report fraud was
moderate (mean = 4.56, item 15).
[Insert Table 2]
Consistent with Elliott et al. (2008) and Barber and Odean (2001), we control for a
number of variables related to participants investing experiences, activities, and returns (items
16 21). These data suggest that our sample consists of a diverse and experienced set of active
investors. For example, we measured investing experience (item 16) by asking, How many
years have you been actively buying/selling the stocks of individual companies (as opposed to
mutual funds, etc.)? Participants responded on a scale where 1 = less than one year and 6 =
more than 20 years. The mean response for our sample was 3.34 (i.e., between 6 10 years).
Although not tabulated, 32 of our participants (16% of our sample) have actively invested for
over 20 years.
As suggested by prior research (e.g., Markowitz 1952; Elliott et al. 2008), we control for
participant trading strategies/risk preferences (items 22 30) and, given that fraud may be more
prevalent in certain industries (e.g., Dechow et al. 2010), we control for the industries in which
participants invested most heavily (items 31 38). The results indicate that our sample of
investors employed a diverse set of investment strategies and invested heavily in a wide array of
industries. Finally, consistent with Bertaut (1998), Masters (1989), Barber and Odean (2001),
and Elliott et al. (2008), we control for a host of demographic data (items 39 46). Our sample

15
Since our results suggest that investors rely heavily on auditors to detect fraud, we confirm the relevancy of
research that investigates jurors verdicts when auditors fail to detect financial statement fraud (e.g., Lowe and
Reckers 1994; Kadous 2001; Cornell et al. 2009).
21

appears to be well educated (items 39 42), approximately half male/female (item 44) and, on
average, between 40 49 years old (item 45).
Correlation Matrix
A correlation matrix is presented in Table 3. To present a parsimonious correlation
matrix, control variables were excluded from presentation in Table 3 if they were not
significantly correlated (p < 0.05) with at least two of the four hypothesized variables (e.g.,
reliance on financial statement information, importance of fraud risk assessment). Reducing this
constraint from two to one led to a substantially larger correlation matrix. Of particular note is
that neither reliance on financial statement information (Reliance) nor the investors perception
of the rate of fraudulent financial reporting (Rate) is significantly correlated with the importance
of fraud risk assessment (FR). However, as Hypothesis One posits, these two variables may
positively interact to affect FR.
[Insert Table 3]
Consistent with Hypothesis Two, FR is significantly, positively correlated with the use of
red flags (Flags). We will test Hypotheses One and Two in multivariate settings in the next
section. It is also interesting to note that reliance on financial statement information (Reliance) is
not significantly correlated with the use of red flags (Flags). While one might expect a straight-
forward, positive relation between the two variables, it appears that this relation is more complex
and may involve moderating and mediating variables as described by our model (see Figure 1).
In the next section we analyze the moderating and mediating links depicted by our model. With
respect to multicollinearity, all reported regression analyses of our models provide variance
inflation factors for all of our variables that are less than 3.00 and substantially below the
standard threshold of 10 (e.g., Neter et al. 1996; Kennedy 1998).

22

IV. RESULTS
Hypothesis One Testing
Table 4 provides the results of Hypothesis One testing. Hypothesis One predicts that the
positive relation between investor reliance on financial statement information and the importance
of fraud risk assessment becomes stronger as investor perceptions of the rate of fraud increase.
Thus, Hypothesis One would be supported by regression results that provide a positive and
significant interaction between RELIANCE ON FINANCIAL and the PERCPETION OF
FRAUD on FR. For presentation purposes, only effects related to our control variables with p-
values < 0.10 are presented in our tables related to hypotheses testing. As predicted by
Hypothesis One, we find a significant and positive interaction between RELIANCE ON
FINANCIAL and PERCEPTION OF FRAUD (A X B in Table 4) on FR (p < 0.05). Thus, our
results provide support for Hypothesis One.
[Insert Table 4]
To illustrate the form of this interactive effect, we partition the sample into two groups:
high and low PERCEPTION OF FRAUD. We partition the sample at the median PERCEPTION
OF FRAUD (5.00) and delete observations at the median. We then re-perform the regression
analysis described above for each of the two groups (removing the interaction term). For the high
PERCEPTION OF FRAUD group, the relation between RELIANCE ON FINANCIAL and FR
is significant and positive (p = 0.06). For the low PERCEPTION OF FRAUD group, the relation
between RELIANCE ON FINANCIAL and FR is not significant (p = 0.18). Thus, the form of
the interaction presented in Table 4 is consistent with the form of the interaction posited by
Hypothesis One.
23

Consistent with our theory of investors typically underweighting the likelihood of fraud,
we observe a positive but not significant (p = .66) association between RELIANCE ON
FINANCIAL and FR. Because many investors likely underweight the probability of fraud, as
investors rely more heavily on financial statement data, they do not simply perceive fraud risk
assessment to be more important. It is when they rely on financial statements and perceive fraud
to be a more likely event (i.e., PERCEPTION OF FRAUD is higher) that we observe the positive
relation between RELIANCE ON FINANCIAL and FR.
Hypothesis Two Testing
Hypothesis Two predicts a positive relation between the importance of fraud risk
assessment and investor use of red flags. Table 5 presents the results of our Hypothesis Two
testing. We find support for Hypothesis Two as the relation between FR and USE OF RED
FLAGS is positive and significant (p < 0.01).
[Insert Table 5]
Discussion of Control Variables
With respect to the direct effects of control variables in Tables 4 and 5, several observed
relations contribute to our understanding of fraud-related investor judgments and decisions and
should spur future research. First, we note that investors who most often invest in the financial
services and manufacturing/energy industries are most likely to consider fraud risk assessment
important and use red flags, respectively. Given the recent crisis in the financial services market,
investors in this industry are likely even more concerned with fraud risks today. Whether red
flags are more transparent/easier to analyze in the manufacturing and energy industries, and
potentially less so in other industries, is a fruitful area of research.
16
Second, it is interesting to

16
For example, Enrons financial statements from 1995 include multiple red flags related to the accuracy of its
statements (Hubbard 2002).
24

note the positive relation between investor returns and fraud risk assessment. In analyses that
follow, we provide evidence of links between investor returns and the use of specific red flags
(e.g., accrual levels). Third, we observe a counter-intuitive negative relation between the value of
the investors portfolio and the use of red flags. Why investors, with potentially more to lose due
to fraud, are less likely to analyze fraud red flags is an interesting question for future research.
Fourth, we observe that investors with higher levels of education are more likely to use
red flags. Perhaps the training received or the complex analytical skills required at higher levels
of education are necessary to collect and analyze red flags. How investors can use both their
general and domain-specific knowledgebases to effectively use fraud red flags could be
addressed by future research. Last, the significant relation between gender and fraud risk
assessment suggests that male investors perceive fraud risk assessment to be a more important
activity than female investors. Future research can shed light on why this relation exists (e.g.,
male investors are currently more risk adverse vis--vis fraud than female investors, recent
publicized frauds have been largely perpetrated by men and male investors may be more
sensitive to fraud incentives faced by managers).
Mediation Analysis of the Overall Model
As Figure 1 illustrates, the importance of fraud risk assessment (FR) should mediate the
interactive effect of RELIANCE ON FINANCIAL X PERCEPTION OF FRAUD on the USE
OF RED FLAGS. Following Baron and Kenney (1986), we conduct a mediation analysis to
determine the validity of the model presented in Figure 1.
Statistical evidence of FR mediating the relation between RELIANCE ON FINANCIAL
X PERCEPTION OF FRAUD on the USE OF RED FLAGS first requires that the interaction
significantly affect the USE OF RED FLAGS. In non-tabulated regression analysis, controlling
25

for all variables described above with the exception of FR, we find the interaction positive and
statistically significant (p = 0.03). Second, the interaction must affect FR. Our test of Hypothesis
One finds this relation to be positive and significant. Third, FR must also be significantly
correlated with the USE OF RED FLAGS. Our test of Hypothesis Two finds this relation to be
positive and significant. Lastly, when both FR and the interaction are included in Model 2: (1)
FR must be significant; and (2) the interaction term must either be insignificant (full mediation)
or its significance must decline (partial mediation). Non-tabulated regression results find (1) FR
is positive and significant (p < 0.01); and (2) the significance level for the interaction has
dropped from the previously described level (p = 0.03) to a lower level of significance (p =
0.08).
These results point to FR partially mediating the interactive effect of RELIANCE ON
FINANCIAL X PERCEPTION OF FRAUD on the USE OF RED FLAGS. Specifically,
investors that rely more on financial statements perceive that fraud risk assessment is a more
important investing activity. However, this relation is driven by the rate at which investors
believe that fraud occurs in the capital markets. In turn, investors who perceive fraud risk
assessment to be an important part of investing appear to act on these perceptions. They are more
likely to use red flags to avoid investing in companies that might be committing financial
statement fraud.
Use of Accruals and Investor Portfolio Returns
Sloan (1996) finds investors fixate on earnings and have difficulty distinguishing
between earnings derived from cash flows and earnings derived from accruals. Consequently,
Sloan finds a negative association between accruals and future abnormal stock returns. Ali et al.
(2000) posit that the negative association between accruals and future abnormal returns is due to
26

earnings fixation by nave or nonprofessional investors. Contrary to their expectation, Ali et al.
(2000) find that the negative association between accruals and stock returns is stronger for larger
firms which are more likely to be followed by analysts and held by institutions, and weaker for
smaller firms which are less likely to be of interest to these sophisticated market participants.
This counter-intuitive result suggests that any failure to appreciate the valuation implications of
accruals is more pronounced for sophisticated investors than for nonprofessional investors.
Given our dataset related to nonprofessional investors, we are in a unique position to add
to this research stream. Specifically, we have a measure of investor usage of accrual data (item
36, Table 1) and their twelve month return on their personal investment portfolios (item 21,
Table 2). Similarly, Elliott et al. (2008) use survey data to study variables associated with
investor returns (e.g., types of information used, experience levels). In a non-tabulated regression
controlling for the variables used in Elliott et al. (2008), we find the relation between the
consideration of accruals by nonprofessional investors and their market returns to be positive and
significant (p = 0.02).
17
As illustrated in Table 4, we also observe a positive and significant
association between FR and investor returns. Thus, we are able to provide initial empirical
evidence that nonprofessional investors may be benefitting from using accrual data and assessing
fraud risk when investing.
Use of Ex-Ante Red Flags and Investor Portfolio Returns
Table 1 illustrates that the red flags investors report using most often are usually manifest
later in the fraud discovery process and are usually revealed to investors ex-post (i.e., after the

17
We do not include the variable training from Elliott et al. (2008) for two reasons. First, it was specific to
trainings provided by the investment club from which their sample was derived. Second, it was not statistically
significant in their analysis.
27

fraud has been detected and reported publicly).
18
Consequently, it is questionable as to whether
investors attention and reaction to such ex-post red flags would (a) reduce the likelihood that
they experience losses due to fraud, and (b) increase their portfolio returns. Table 1 also
documents that, in practice, there are several red flags that investors are less likely to use (e.g.,
need for external financing, use of a non-Big 4 auditor, see footnote n). Given this
understanding, we explore whether ex-ante fraud indicators (e.g., large difference between
revenue growth and non-financial measure growth; auditor change), that investors report to
typically use, can help investors more effectively screen investments, avoid financial losses
related to fraud, and achieve higher portfolio returns. We develop a measure of the use of ex-ante
red flags for each participant (averaging their responses to items 22 35 from Table 1). Similar
to above, we include this measure in the model used by Elliott et al. (2008). In non-tabulated
analyses, we find the relation between the use of ex-ante red flags by nonprofessional investors
and their portfolio returns to be positive and significant (p < 0.01). As such, we provide evidence
of an association between the use of ex-ante red flags and the achievement of higher investment
returns.
V. CONCLUSION
This paper models nonprofessional investors use of financial statement information,
their perception of the frequency of fraud, the importance of assessing fraud risk, and their use of
fraud red flags. Investors are often victims of fraudulent financial reporting; however, very little
prior research investigates investors perception of fraud and how investors protect themselves
from fraudulent financial reporting. To shed light on these issues, we administered a survey to

18
In Table 1, investors report to use four fraud red flags relatively more often than other red flags: SEC
investigations, pending litigation, violations of debt covenants, and high management turnover (see footnote l).
Though high management turnover may occur before or after the market discovers the fraud, the other three red
flags can be considered ex-post fraud indicators.
28

194 nonprofessional investors. We find that the positive relation between investor reliance on
financial statement information and the importance of fraud risk assessment becomes stronger as
investor perceptions of the rate of fraud increase. We also consider whether investors act on their
fraud risk assessments by utilizing various fraud red flags in an effort to avoid potentially
fraudulent investments. We find a positive association between the importance of making fraud
risk assessments and investors use of fraud red flags when making investment decisions.
With respect to the importance of red flags, our additional analysis reveals that investors
tend to focus on SEC investigations, pending litigation, violations of debt covenants, and high
management turnover. In contrast, investors seem to rely less on company size, age of the
company, the need for external financing, and the use of a non-Big 4 auditor. Additionally, we
illustrate that investors appear to rely more on analysts, regulators, external auditors, and audit
committees to detect and report fraud. Investors rely less on low/mid-level employees, upper
management, the media, and short-sellers. Finally, we provide initial empirical evidence that
nonprofessional investors who are more apt to consider reed flags (accruals in particular; and ex-
ante red flags in general) achieve higher market returns.
Our model and our comprehensive set of control variables provide much detail into the
factors that investors consider important when making investment decisions vis--vis fraud. As
current policymakers have become increasingly concerned with the behavioral aspects of the
market (e.g., Zweig 2009), our descriptive results and model should inform future policies aimed
to protect investors from fraud. Our results also provide an important first step in examining how
investors both fall prey to, and avoid investments in, fraud firms. The results may help
policymakers as they determine what types of company information (i.e., red flag-related data)
should be made readily available or transparent to investors.
29

Future research can use our descriptive results to develop more refined models related to
the sources of information that investors utilize when making decisions. Because fraud risk
assessments and red flag usage appear to be concerns for some investors, experimentally
manipulating fraud red flags in investment settings and measuring investor reactions (e.g.,
investment decisions) would be a fruitful area of research. Future research may also investigate
which investor characteristics lead to more appropriate fraud risk assessments. Continuation of
such research will help standard setters make informed public-policy decisions designed to
protect individual investors from financial statement fraud.

30

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36

FIGURE 1

Investor Perceptions about Financial Statement Fraud and their Use of Red Flags








+



+ +









Reliance on
Financial Statement
Information








Importance of Fraud
Risk Assessment when
Investing



Use of Red Flags
Perception of the Rate of
Financial Statement Fraud



This figure provides a model of investor perceptions about financial statement fraud and their use
of red flags.







37

TABLE 1
Descriptive Statistics Hypothesized Variables

Response
[n = 194]
Mean (Std. Dev.) Variables

Reliance on Financial Statement and Non-Financial Statement Information When Investing
a

1. Balance sheet
b
5.32 (1.64)
2. Cash flow statement
c
5.30 (1.57)
3. Income statement
c
5.23 (1.72)
4. Internal control effectiveness
c
5.01 (1.66)
5. Statement of owners equity
c
4.98 (1.59)
6. Notes to financial statements
d
4.91 (1.59)
7. Mean reliance on financial statement information
e
5.13 (1.47)
8. Stock price
f
5.46 (1.75)
9. Advice from professionals
f
5.06 (1.74)
10. Company risk
f
4.98 (1.66)
11. Macroeconomic factors
g
4.75 (1.60)
12. Non-financial information related to operations
h
4.17 (1.77)
13. Advice from the media
h
4.09 (1.77)
14. Advice from nonprofessionals
h
4.03 (1.80)
15. Mean reliance on non-financial statement information
i
4.69 (1.31)
16. RELIANCE ON FINANCIAL
j
1.12 (.28)

Perception of Rate of Fraudulent Financial Reporting
17. PERCEPTION OF FRAUD
j
5.06 (2.38)

Importance of Fraud Risk Assessment When Investing
18. FR
j
5.24 (1.57)


38

Use of Red Flags
k


19. SEC investigation
l
5.28 (1.46)

20. Pending litigation
l
5.21 (1.53)

21. Violation of debt covenant
l
5.14 (1.57)

22. High management turnover
l
5.14 (1.52)

23. Insider trades
m
5.13 (1.59)

24. Abnormally high valuation ratios
m
5.08 (1.53)

25. Large difference between cash flow from operations and net
income
m
5.01 (1.54)

26. Anticipated merger or acquisition
m
5.01 (1.49)

27. Abnormally high revenue growth
m
5.00 (1.50)

28. Large change in a reserve account
m
4.98 (1.51)

29. Material weakness in internal control
m
4.93 (1.59)

30. Equity-based compensation
m
4.89 (1.48)

31. Recent stock or debt issuance
m
4.83 (1.44)

32. Large difference between revenue growth and non-financial
measure growth
m
4.82 (1.56)

33. Abnormal decline in non-financial measures
m
4.79 (1.47)

34. Auditor change
m
4.74 (1.60)

35. Number of insiders on board of directors
m
4.71 (1.64)

36. Age
n
4.65 (1.62)

37. Need for external financing
n
4.64 (1.46)

38. Size
n
4.59 (1.47)
39


39. Use of non-Big 4 auditor
n
4.42 (1.63)

40. USE OF RED FLAGS
j
4.91 (1.23)

a
Importance of financial statement information and non-financial statement information when
deciding to buy or sell a companys stock, measured on a scale where 1 = very unimportant
and 7 = very important.
b
In non-tabulated t-tests, mean response for financial statement item was significantly greater
than (p-value < .05) the mean reliance on financial statement information (item 7).
c
In non-tabulated t-tests, mean response for financial statement item was not significantly
different than (p-value > .05) the mean reliance on financial statement information (item 7).
d
In non-tabulated t-tests, mean response for financial statement item was significantly less than
(p-value < .05) the mean reliance on financial statement information (item 7).
e
Calculated as the mean response to items 1-6.
f
In non-tabulated t-tests, mean response for non-financial statement item was significantly
greater than (p-value < .05) the mean reliance on non-financial statement information (item 15).
g
In non-tabulated t-tests, mean response for non-financial statement item was not significantly
different than (p-value > .05) the mean reliance on non-financial statement information (item
15).
h
In non-tabulated t-tests, mean response for non-financial statement item was significantly less
than (p-value < .05) the mean reliance on non-financial statement information (item 15).
i
Calculated as the mean response to items 8-14.
j
RELIANCE ON FINANCIAL = Mean reliance on financial statement information / Mean
reliance on non-financial statement information (item 7 / 15).
PERCEPTION OF FRAUD = In your opinion, how often do managers of publicly-traded
companies commit financial statement fraud, measured on a scale where 1 = 0% of the time
and 11 = 100% of the time.
FR = Importance of fraud risk assessment, relative to other factors, when making buy/sell
decisions for stock that you currently hold, measured on a scale where 1 = not at all important
and 7 = extremely important.
USE OF RED FLAGS = Mean use of red flags (mean of items 19 - 39).
k
How often do you consider the following factors in assessing the risk of financial statement
fraud in companies that you are screening for investment or in firms that you currently hold in
your personal investment portfolio, measured on a scale where 1 = never and 7 = often.
l
In non-tabulated t-tests, mean response for red flag was significantly greater than (p-value <
.05) the mean for use of red flags (item 40).
m
In non-tabulated t-tests, mean response for red flag was not significantly different than (p-value
> .05) the mean for use of red flags (item 40).
n
In non-tabulated t-tests, mean response for red flag was significantly less than (p-value < .05)
the mean for use of red flags (item 40).





40

TABLE 2
Descriptive Statistics Control Variables

Response
[n = 194]
Mean (Std. Dev.) Variables

Screening Question
1. % bought or sold individual company stock in the last
the last twelve months
a
100.00

Fraud-related Measures
2. % that OWNED THE STOCK OF A FRAUD COMPANY
b
24.74

3. LOSS RECOVERY
b
3.37 (1.78)
4. Rely on regulators to detect and report fraud
c, d
5.02 (1.46)
5. Rely on external auditors to detect and report fraud
c, d
4.86 (1.45)
6. Rely on analysts to detect and report fraud
c, d
4.79 (1.31)
7. Rely on audit committees to detect and report fraud
c, d
4.56 (1.48)
8. Rely on other investors to detect and report fraud
c, e
4.54 (1.34)
9. Rely on internal auditors to detect and report fraud
c, e
4.52 (1.50)
10. Rely on internal controls to detect and report fraud
c, e
4.52 (1.39)
11. Rely on upper management to detect and report fraud
c, f
4.34 (1.48)
12. Rely on low/mid-level employee to detect and report fraud
c, f
4.32 (1.54)
13. Rely on media to detect and report fraud
c, f
4.31 (1.50)
14. Rely on short sellers to detect and report fraud
c, f
4.29 (1.59)
15. RELIANCE ON OTHERS
b
4.56 (1.06)

Investing Experience, Activity, and Return
b

16. INVESTING EXPERIENCE 3.34 (1.53)

17. TIME ALLOCATED 2.64 (1.63)

18. TRADING ACTIVITY

2.10 (1.33)
41


19. DIVERSIFICATION OF INVESTMENTS 1.82 (1.06)

20. VALUE OF PORTFOLIO 4.25 (1.99)

21. RETURN ON INVESTMENTS 6.12 (2.64)

Investment Strategies and Industries
b

22. RELY ON OTHERS VS. OWN ANALYSIS 4.04 (1.49)


23. GROWTH STOCK STRATEGY 4.75 (1.41)

24. A STRATEGY BASED ON YOUR FAMILIARITY WITH THE
COMPANY 4.70 (1.67)

25. HIGH YIELD STOCK STRATEGY 4.52 (1.47)

26. A STRATEGY BASED ON TECHNICAL ANALYSIS 4.44 (1.58)

27. LOW-RISK STOCK STRATEGY 4.41 (1.63)

28. VALUE STOCK STRATEGY 4.38 (1.43)

29. MOMENTUM STRATEGY 3.90 (1.58)

30. LAST YEARS WINNER STRATEGY

3.69 (1.64)

31. % invested heavily in ENERGY 41.23

32. % invested heavily in HIGH TECH/COMMUNICATIONS

40.72

33. % invested heavily in MANUFACTURING 32.98

34. % invested heavily in HEALTHCARE/PHARMACEUTICALS 29.38

35. % investing heavily in FINANCIAL SERVICES 25.77

36. % invested heavily in RETAIL 22.16

37. % investing heavily in MISCELLANEOUS INDUSTRIES 6.70

38. % invested heavily in GOVERNMENT/NOT-FOR-PROFIT 5.15

42

Demographic Data
b

39. EDUCATION 3.22 (1.14)

40. % with at least an UNDERGRADUATE DEGREE 74.22

41. % with UNDERGRADUATE BUSINESS-RELATED DEGREE 15.97

42. % with GRADUATE BUSINESS-RELATED DEGREE 9.79

43. % CERTIFIED 17.01

44. GENDER 51.51

45. AGE 4.31 (1.41)

46. HOUSEHOLD INCOME 3.18 (1.32)

a
Participants were asked to respond to the following statement (screening question): I have
bought or sold individual company stock in the last twelve month. Participants could respond
yes or no.
b
OWNED THE STOCK OF A FRAUD COMPANY = Have you ever owned the stock of an
individual company when it was found to have been committing financial statement fraud,
measured 1 = yes and 0 = no.
LOSS RECOVERY = If you held the stock of a firm that committed financial statement fraud,
how likely do you believe it is that you would recover your losses through shareholder lawsuits,
measured on a scale where 1 = extremely unlikely and 7 = extremely likely.
RELIANCE ON OTHERS = Mean reliance on others to detect and report fraud (mean of items 4
- 14).
INVESTING EXPERIENCE = How many years have you been actively buying/selling the
stocks of individual companies (as opposed to mutual funds, etc.), measured on a scale where 1 =
less than one year and 6 = more than 20 years.
TIME ALLOCATED = In an average week, how much time do you spend thinking about and
evaluating stocks that you are screening for possible investment or that you currently hold in
your personal investment portfolio, measured on a scale where 1 = less than one hour and 7 =
more than 10 hours.
TRADING ACTIVITY = Approximately, how many times, on average, do you buy or sell
stocks of individual companies in a one-year period, measured on a scale where 1 = 1-5 times
and 5 = more than 20 times.
DIVERSIFICATION OF INVESTMENTS = In how many individual companies do you own
stock (i.e., directly owning shares, not via a mutual fund, or pension), measured on a scale where
1 = 1-5 companies and 5 = more than 20 companies.
VALUE OF PORTFOLIO = What is the approximate value of your personal investment
portfolio, measured on a scale where 1 = less than $10,000 and 8 = more than $1,000,000.
43

RETURN ON INVESTMENTS = Over the last twelve months, what was the approximate return
on your personal investment portfolio, measured on a scale where 1 = less than -20% and 11 =
more than 20%.
RELY ON OTHERS VS. OWN ANALYSIS = To what extent are your decisions to buy or sell
stocks based on your own analysis relative to the advice of others, measured on a scale where 1 =
based completely on my own analysis and 7 = based completely on the advice of others.
GROWTH STOCK STRATEGY, A STRATEGY BASED ON FAMILIARITY WITH THE
COMPANY, HIGH YIELD STOCK STRATEGY, A STRATEGY BASED ON TECHNICAL
ANALYSIS, LOW-RISK STOCK STRATEGY, VALUE STOCK STRATEGY, MOMENTUM
STRATEGY, LAST YEARS WINNER STRATEGY = Each strategy measured with the
following question and scale: How often do you use the following investment strategies in your
decisions to buy or sell stocks, where 1 = never and 7 = often.
ENERGY, HIGH TECH/COMMUNICATIONS, MANUFACTURING,
HEALTHCARE/PHARMACEUTICALS, FINANCIAL SERVICES, RETAIL,
MISCELLANEOUS INDUSTRIES, GOVERNMENT/NOT-FOR-PROFIT = Measured with
one question: In what industries do you most often buy and sell stocks of individual companies,
response coded 1 if participant selected the industry, 0 otherwise. Participants could select more
than one industry.
EDUCATION = Please indicate the highest level of education you have completed, measured on
a scale where 1 = high school and 5 = post-graduate degree
UNDERGRADUATE DEGREE = coded 1 if participant obtained an undergraduate degree or
higher, 0 otherwise.
UNDERGRADUATE BUSINESS-RELATED DEGREE = coded 1 if participant obtained an
undergraduate business-related degree, 0 otherwise.
GRADUATE BUSINESS-RELATED DEGREE = coded 1 if participant obtained an graduate
business-related degree, 0 otherwise.
CERTIFIED = coded 1 if person obtained CPA, CFA, or CFP, 0 otherwise.
GENDER = Coded 1 if male, 0 otherwise.
AGE = Measured on a scale where 1 = under 20 and 8 = 80 or above.
HOUSEHOLD INCOME = What is your total annual household income, measured on a scale
where 1 = $0 - $30,000 and 6 = more than $150,000.
c
To what extent do you rely on the following parties to detect and report financial statement
fraud in companies that you are screening for investment or in firms that you currently hold in
your personal investment portfolio, measured on a scale where 1 = not at all and 7 =
completely.
d
In non-tabulated t-tests, mean response for reliance was significantly greater than (p-value <
.05) the mean for others to detect and report fraud (item 15).
e
In non-tabulated t-tests, mean response for reliance was not significantly different than (p-value
> .05) the mean for others to detect and report fraud (item 15).
f
In non-tabulated t-tests, mean response for reliance was significantly less than (p-value < .05)
the mean for others to detect and report fraud (item 15).

44

Table 3
Correlation Matrix

Variables
a
Reliance Rate FR Flags Recovery Others Time Return Momentum Growth Low Last Value High Technical Familiarity Misc
Rate -0.09
FR -0.01 0.08
Flags -0.08 0.12 0.51
Recovery -0.21 0.15 0.05 0.12
Others -0.24 -0.02 0.33 0.53 0.38
Time 0.04 0.06 0.23 0.32 0.18 0.21
Return -0.06 0.05 0.26 0.24 0.04 0.19 0.15
Momentum -0.17 0.09 0.22 0.30 0.41 0.43 0.28 0.12
Growth -0.01 -0.04 0.29 0.45 0.19 0.44 0.22 0.11 0.60
Low -0.12 0.02 0.30 0.42 0.28 0.37 0.12 0.13 0.42 0.50
Last -0.25 0.10 0.27 0.40 0.48 0.47 0.24 0.13 0.61 0.45 0.51
Value -0.15 0.12 0.30 0.52 0.15 0.43 0.40 0.15 0.34 0.42 0.36 0.44
High -0.16 0.13 0.41 0.49 0.20 0.49 0.33 0.27 0.40 0.45 0.46 0.47 0.55
Technical -0.21 0.15 0.29 0.42 0.42 0.49 0.29 0.16 0.59 0.43 0.39 0.56 0.51 0.62
Familiarity -0.18 -0.01 0.22 0.40 0.40 0.30 0.25 0.14 0.22 0.23 0.27 0.29 0.43 0.43 0.47
Misc 0.01 -0.15 -0.21 -0.20 -0.20 -0.15 -0.08 0.11 -0.07 -0.11 -0.13 -0.18 -0.08 -0.16 -0.19 -0.15
Gender -0.04 0.15 0.19 0.09 0.09 0.12 -0.02 0.14 0.10 0.01 0.06 0.11 -0.01 0.10 0.03 0.14 -0.13


Pearson correlation statistic. Correlations with two-tailed p-values < .05 are italicized and in boldface type.
a
RELIANCE ON FINANCIAL (Reliance), PERCEPTION OF FRAUD (Rate), FR, and USE OF RED FLAGS (Flags) are defined in Table 1. LOSS RECOVERY (Recovery), RELIANCE ON
OTHERS (Others), TIME ALLOCATED (Time), RETURN ON INVESTMENTS (Return), MOMENTUM STRATEGY (Momentum), GROWTH STOCK STRATEGY (Growth), LOW-RISK
STOCK STRATEGY (Low), LAST YEARS WINNER STRATEGY (Last), VALUE STOCK STRATEGY (Value), HIGH YIELD STOCK STRATEGY (High), A STRATEGY BASED ON
TECHNICAL ANALYSIS (Technical), A STRATEGY BASED ON FAMILIARITY WITH THE COMPANY (Familiarity), MISCELLANEOUS INDUSTRIES (Misc), and GENDER (Gender) are
defined in Table 2.


45


TABLE 4
Hypothesis One Testing: Ordinal Logistic Regression Results for FR
a


Independent Variables
a

Estimated
Coefficient
Wald-
statistic p-value
RELIANCE ON FINANCIAL (A) 0.282 0.20 0.657
PERCEPTION OF FRAUD (B) -0.061 0.48 0.486
A X B 0.139 2.88 0.045
LOSS RECOVERY -0.248 5.72 0.017
RETURN ON INVESTMENTS 0.122 4.28 0.038
LAST YEARS WINNER 0.238 3.03 0.082
HIGH YIELD 0.245 2.73 0.099
GENDER 0.671 4.71 0.030
FINANCIAL SERVICES 0.795 4.46 0.035
HOUSEHOLD INCOME -0.266 3.84 0.050
Model Chi-Square statistic = 83.11 (p-value < .001)
R
2
= .348

a
FR = Importance of fraud risk assessment, relative to other factors, when making buy/sell
decisions for stock that you currently hold, measured on a scale where 1 = not at all important
and 7 = extremely important.
RELIANCE ON FINANCIAL (A) = Mean reliance on financial statement information / Mean
reliance on non-financial statement information (items 7 / 14 in Table 1).
PERCEPTION OF FRAUD (B) = In your opinion, how often do managers of publicly-traded
companies commit financial statement fraud, measured on a scale where 1 = 0% of the time
and 11 = 100% of the time.
A X B = Interaction term: RELIANCE ON FINANCIAL X PERCEPTION OF FRAUD
LOSS RECOVERY = If you held the stock of a firm that committed financial statement fraud,
how likely do you believe it is that you would recover your losses through shareholder lawsuits,
measured on a scale where 1 = extremely unlikely and 7 = extremely likely.
RETURN ON INVESTMENTS = Over the last twelve months, what was the approximate return
on your personal investment portfolio, measured on a scale where 1 = less than -20% and 11 =
more than 20%.
LAST YEARS WINNER, HIGH YIELD = Each strategy measured with the following question
and scale: How often do you use the following investment strategies in your decisions to buy or
sell stocks, where 1 = never and 7 = often.
FINANCIAL SERVICES = Measured with one question: In what industries do you most often
buy and sell stocks of individual companies, response coded 1 if participant selected the industry,
0 otherwise. Participants could select more than one industry.
GENDER = Coded 1 if male, 0 otherwise.
HOUSEHOLD INCOME = What is your total annual household income, measured on a scale
where 1 = $0 - $30,000 and 6 = more than $150,000.



46

TABLE 5
Hypothesis Two Testing: Linear Regression Results for USE OF RED FLAGS
a


Independent Variables
a

Estimated
Coefficient t-statistic p-value
FR 0.199 4.31 <.001
RELIANCE ON OTHERS 0.312 4.01 <.001
VALUE OF PORTFOLIO -0.089 2.01 .056
MANUFACTURING 0.295 2.03 .044
ENERGY 0.427 2.88 .005
VALUE STOCK STRATEGY 0.147 2.30 .023
EDUCATION 0.154 2.52 .013
Model F-statistic = 7.15 (p-value < .001)
R
2
= .613

a
USE OF RED FLAGS = Mean use of red flags (mean of items 19 39 in Table 1).
FR = Importance of fraud risk assessment, relative to other factors, when making buy/sell
decisions for stock that you currently hold, measured on a scale where 1 = not at all important
and 7 = extremely important.
RELIANCE ON OTHERS = Mean reliance on others to detect and report fraud (mean of items 4
14 in Table 2).
VALUE OF PORTFOLIO = What is the approximate value of your personal investment
portfolio, measured on a scale where 1 = less than $10,000 and 8 = more than $1,000,000.
MANUFACTURING and ENERGY = Measured with one question: In what industries do you
most often buy and sell stocks of individual companies, response coded 1 if participant selected
the industry, 0 otherwise. Participants could select more than one industry.
VALUE STOCK STRATEGY = Each strategy measured with the following question and scale:
How often do you use the following investment strategies in your decisions to buy or sell stocks,
where 1 = never and 7 = often.
EDUCATION = Please indicate the highest level of education you have completed, measured on
a scale where 1 = high school and 5 = post-graduate degree.
47

APPENDIX A

CONTROL VARIABLE DEFINITIONS:
OWNED THE STOCK OF A FRAUD COMPANY = Have you ever owned the stock of an
individual company when it was found to have been
committing financial statement fraud, measured 1 = yes
and 0 = no.
LOSS RECOVERY = If you held the stock of a firm that committed financial
statement fraud, how likely do you believe it is that you
would recover your losses through shareholder lawsuits,
measured on a scale where 1 = extremely unlikely and 7
= extremely likely.
RELIANCE ON OTHERS = Mean reliance on others to detect and report fraud
(further described below and in Table 2).
INVESTING EXPERIENCE = How many years have you been actively buying/selling
the stocks of individual companies (as opposed to mutual
funds, etc.), measured on a scale where 1 = less than one
year and 6 = more than 20 years.
TIME ALLOCATED = In an average week, how much time do you spend
thinking about and evaluating stocks that you are screening
for possible investment or that you currently hold in your
personal investment portfolio, measured on a scale where 1
= less than one hour and 7 = more than 10 hours.
TRADING ACTIVITY = Approximately, how many times, on average, do you buy
or sell stocks of individual companies in a one-year period,
measured on a scale where 1 = 1-5 times and 5 = more
than 20 times.
DIVERSIFICATION OF INVESTMENTS = In how many individual companies do you own
stock (i.e., directly owning shares, not via a mutual fund, or
pension), measured on a scale where 1 = 1-5 companies
and 5 = more than 20 companies.
VALUE OF PORTFOLIO = What is the approximate value of your personal
investment portfolio, measured on a scale where 1 = less
than $10,000 and 8 = more than $1,000,000.
RETURN ON INVESTMENTS = Over the last twelve months, what was the approximate
return on your personal investment portfolio, measured on
a scale where 1 = less than -20% and 11 = more than
20%.
RELY ON OTHERS VS. OWN ANALYSIS = To what extent are your decisions to buy or sell
stocks based on your own analysis relative to the advice of
others, measured on a scale where 1 = based completely
on my own analysis and 7 = based completely on the
advice of others.
TRADING STRATEGY = MOMENTUM, GROWTH, LOW-RISK, LAST
YEARS WINNER, VALUE, HIGH YIELD,
TECHNICAL ANALYSIS, FAMILIARITY WITH THE
48

COMPANY = Each strategy measured with the following
question and scale: How often do you use the following
investment strategies in your decisions to buy or sell stocks,
where 1 = never and 7 = often.
INDUSTRY = MANUFACTURING, RETAIL, GOVERNMENT/NOT-
FOR-PROFIT, ENERGY, HIGH
TECH/COMMUNICATIONS,
HEALTHCARE/PHARMACEUTICALS, FINANCIAL
SERVICES, MISCELLANEOUS INDUSTRIES =
Measured with one question: In what industries do you
most often buy and sell stocks of individual companies,
response coded 1 if participant selected the industry, 0
otherwise. Participants could select more than one industry.
EDUCATION = Please indicate the highest level of education you have
completed, measured on a scale where 1 = high school
and 5 = post-graduate degree.
UNDERGRADUATE DEGREE = Coded 1 if participant obtained an undergraduate degree
or higher, 0 otherwise.
UNDERGRADUATE BUSINESS-RELATED DEGREE = Coded 1 if participant obtained an
undergraduate business-related degree, 0 otherwise.
GRADUATE BUSINESS-RELATED DEGREE = Coded 1 if participant obtained a graduate
business-related degree, 0 otherwise.
CERTIFIED = Coded 1 if person obtained CPA, CFA, or CFP, 0
otherwise.
GENDER = Coded 1 if male, 0 otherwise.
AGE = Measured on a scale where 1 = under 20 and 8 = 80 or
above.
HOUSEHOLD INCOME = What is your total annual household income, measured
on a scale where 1 = $0 - $30,000 and 6 = more than
$150,000.