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 (n¼79)
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 2 /+ 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,
misclassifications 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
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 (n¼79)
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 2 /+ 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,
misclassifications 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
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