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Can financial ratios detect fraudulent financial reporting?

Kathleen A. Kaminski (Georgia College and State University, School of Business, Milledgeville, Georgia, USA)
T. Sterling Wetzel (Oklahoma State University, School of Accounting, Oklahoma, USA)
Liming Guan (University of Hawaii at Manoa, School of Accountancy, Honolulu, Hawaii, USA)

Managerial Auditing Journal

ISSN: 0268-6902

Article publication date: 1 January 2004

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, 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.

Keywords

Citation

Kaminski, K.A., Sterling Wetzel, T. and Guan, L. (2004), "Can financial ratios detect fraudulent financial reporting?", Managerial Auditing Journal, Vol. 19 No. 1, pp. 15-28. https://doi.org/10.1108/02686900410509802

Publisher

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Emerald Group Publishing Limited

Copyright © 2004, Emerald Group Publishing Limited