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Keywords Auditing, Financial reporting, Fraud
Abstract Fraudulent financial reporting is a matter of grave social and economic concern. The Treadway Commission recommended that the Auditing Standards Board require the use of analytical procedures to improve the detection of fraudulent financial reporting. This is an exploratory study to determine if financial ratios of fraudulent companies differ from those of nonfraudulent companies. Fraudulent firms were identified by examining the SEC's Accounting and Auditing Enforcement Releases issued between 1982 and 1999. The fraudulent firms (n=79) were then matched with nonfraudulent firms on the basis of firm size, time period, and industry. Using this matched-pairs design, ratio analysis for a seven-year period (i.e. the fraud year - /+ 3 years) was conducted on 21 ratios. Overall, 16 ratios were found to be significant. Of these, only three ratios were significant for three time periods. Of the 16 statistically significant ratios, only five were significant during the period prior to the fraud year. Using discriminant analysis, misdassifications for fraud firms ranged from 58 percent to 98 percent. These results provide empirical evidence of the limited ability of financial ratios to detect and/or predict fraudulent financial reporting.
Introduction
Fraudulent financial reporting is a matter of grave social and economic concern[1]. Recent news abounds with corporate fraud scandals (e.g. Enron, WorldCom, Qwest). Such fraudulent reporting is a critical problem for external auditors, both because of the potential legal liability for failure to detect false financial statements and because of the damage to professional reputation that results from public dissatisfaction about undetected fraud. This is most recently evidenced by the demise of Arthur Andersen.
Increasing pressure to reduce fraudulent financial reporting over the past 30 years has resulted in new laws, commission reports, and standards. Congressional inquiry into the savings and loan debacle led to the formation of the Treadway Commission, whose charge was to prescribe effective recommendations to guide the Auditing Standards Board's (ASB) development of standards to help prevent and detect fraud. The Commission defined fraudulent financial reporting as intentional or reckless conduct, either by act or omission, that results in materially misleading financial statements (NCFFR, 1987). "The Treadway Commission recommended that the ASB require the use of analytical procedures on all audits to improve the detection of fraudulent financial...