Ratio Analysis – Predictor of Fraud?

ABSTRACT: Fraud in business is a matter of grave social and economic concern. The Treadway Commission recommended that the Auditing Standards Board require the use of analytical review procedures to improve the detection of fraudulent financial reporting. This research is an exploratory study to determine if the financial statements of fraudulent companies differ from those of non-fraudulent companies. Fraudulent firms were identified by examining the SEC’s Accounting and Auditing Enforcement Releases issued between 1982 and 1995. The fraudulent firms (n = 79) were then matched with non-fraudulent firms on the basis of firm size 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 variables. 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 41 % to 76%. These results provide empirical evidence that financial ratios are not an effective means to detect the occurrence of fraud