Using Economic Links between Firms to Detect Accounting Fraud

This paper explores whether accounting fraud can be detected using the information of firms that are economically linked to a focal firm. Specifically, we examine whether customer information disclosed by a supplier firm, combined with customers’ accounting information, helps to detect the supplier’s revenue fraud. We first confirm the economic link between the supplier and its customers by showing a strong positive correlation between the supplier’s sales growth and the growth rate of total customer purchases. We then introduce two variables based on customer accounting information — (1) the discrepancy between supplier sales growth and customer purchase growth and (2) customer excess purchases — and show that they are predictive of supplier revenue fraud. We conduct a battery of cross-sectional tests to further examine the two fraud predictors and generally find empirical results to vary cross-sectionally in a predictable way. Finally, the out-of-sample tests indicate that adding the two variables to the Dechow et al. (2011) model increases fraud prediction accuracy