Pay attention to nonfinancial measures when performing audits

When ferreting out fraud, auditors want to use every tool at their disposal. Auditors who only examine financial data may be missing some important clues. Nonfinancial data can be just as important as dollars and cents when detecting fraud, yet it’s something many CPAs overlook.

Nonfinancial information, says Douglas Prawitt, CPA, Ph.D., an accounting professor at Brigham Young University, “is just about anything that does not have a dollar sign in front of it.” It can include a business’s square footage, amount of inventory, industry data, number of patents, products, employees, or customer accounts, or other types of information.

“Auditors have access to a lot of nonfinancial information but they don’t always focus on it,” Prawitt says.  He has researched the topic of auditors’ use of nonfinancial information with fellow academics, including Joseph Brazel, CPA, Ph.D., an accounting professor at North Carolina State University in Raleigh, and says it’s one area where CPAs could definitely improve.

Prawitt believes it’s important for auditors to pay attention to nonfinancial measures and determine if there are any glaring inconsistencies between them and companies’ financial measures. If they rent too little warehouse space for the amount of inventory they claim to have, for instance, it could be a red flag that something is amiss. Companies have been known to create fictitious inventories or overstate revenues by maneuvering their financial numbers to satisfy shareholders and make their performance look better than it really is, among other reasons.

Nonfinancial measures are encouraged by accounting standards and many auditors today do use them as part of their analytical procedures. Though nonfinancial measures were not typically used by auditors 20 years ago, Brazel says, about 50% of all auditors use them in some capacity today.

But still, that leaves about half of auditors who do not use these measures and who may be missing inconsistencies or failing to detect fraud at public companies. 

Ahava Goldman, senior technical manager—Audit & Attest Standards at the AICPA, says examining nonfinancial measures is not a new concept or idea, but that auditors have recently become more aware of the importance of comparing nonfinancial data to financial data to possibly detect fraud.

“Nonfinancial information is necessary to understanding business, and understanding an entity and how it operates,” she says.

Auditors tend to shy away from looking at nonfinancial information because of time constraints and other job pressures, or because their focus is elsewhere. But Brazel and others say fraud is easier to detect with nonfinancial measures because this data is disclosed in a public company’s annual filings with the SEC, and companies that commit fraud often fail to hide the nonfinancial evidence of their wrongdoing. In other words, the nonfinancial information is easier to obtain and more difficult for fraudsters to hide or falsify.

“If you are laying off employees and revenue is going up, that’s possible, but the question is, ‘How are you are doing it?’” Brazel says. “Our research shows that when people cook the books and manipulate revenues upward or expenses downward to boost their net income, they don’t cover their tracks with the nonfinancial measures.”

Experts offer the following tips to for using nonfinancial measures in an audit:

Ask for all relevant information. Obtain the records you need to gather all the information that could impact your audit. “As I walk through a manufacturing facility, I may not be paying a whole lot of attention to how many machines are operating, and how many are gathering dust,” Prawitt says. “But this information is available. I can look at the client’s records. They will have an asset and depreciation schedule.”

Determine the riskiest areas in the client’s business. For example, the area of greatest risk could be inventory, or revenue, or receivables. Once you determine what that area is, figure out the key nonfinancial pieces related to it, and pay them special attention.

Incorporate nonfinancial measures into the planning and analytical steps of an audit. While it’s a given that nonfinancial measures should be used, sources say CPAs should make it a point to include them in the planning and analytical procedures stages of an audit.

Go a step further than the obvious. If you know a company produces 200,000 widgets a year, find out how they produce that number of widgets and on how many machines. “Nonfinancial information can help auditors understand the client, the business, the industry that business operates in, and the economic environment,” Prawitt says.

Finally, look for glaring inconsistencies. If financial data and nonfinancial measures are off by about 10%, no big deal. “But if revenue growth is exceeding the growth in the operational data by 20% or more,” Brazel says, “our research says that while it may not be fraud, it is something to look into.”

Cheryl Meyer is a California-based freelance writer.