Fraud is a broad concept with two basic types seen in practice. The first is the misappropriation of assets and the second is fraudulent financial reporting. Fraudulent financial reporting usually occurs in the form of falsification of financial statements in order to obtain some forms of benefit. The current research compares the financial ratios between fraudulent and non-fraudulent firms for the companies listed on Tehran Stock Exchange. The sample consists of 134 companies from 2009-2014 and for testing the hypothesis Independent sample t-test was exerted. The results show that there is a significant difference between the means of Current Assets to Total Assets, Inventory to Total Assets and Revenue to Total Assets ratios. This means that management of fraud firms may be less competitive than management of non-fraud firms in using assets to generate revenue. Management may manipulate inventories. The company may not match sales with corresponding cost of goods sold, thus increasing gross margin, net income and strengthening the balance sheet. In addition, manipulation of inventory is in form of reporting inventory lower than cost or market value, and companies choosing not to record the obsolete inventory. Higher or lower margins are related to the issuing of fraudulent financial reporting. In addition, the results show that there is not a significant difference between the means of Total Debt to Total Equity, Total Debt to Total Asset, Net Profit to Revenue, Receivables to Revenue and Working Capital to Total Assets ratios.
Financial fraud is a broad legal concept, however, covering a wide range of activities. The American Institute of Certified Public Accountantsi (Statement on Auditing Standardsii No. 82) and the USA Government Accountability Office have defined two types of financial misstatement. The first, known as management fraud, arises from intentional misstatements or omissions of amounts and disclosures in financial statements. These are perpetrated by management with the intent to deceive. The second arises from the misappropriation of assets, and is known as employee fraud or defalcation. The majority of research on fraudulent financial reporting models focuses on the first type of fraud (Persons, 1995). Fraudulent financial reporting is one type of fraud with substantial negative impacts, loss of investor confidence, reputational damage, potential fines and criminal actions (Ernst and Young, 2009). Fraudulent financial reporting may result from an attempt to hide other acts of corporate fraud or be perpetrated to improve the company’s financial appearance (Hasnan et al., 2013). Fraudulent financial reporting is more likely to occur in companies experiencing financial difficulties than in normal companies (Beasley et al., 1999; Kinney and McDaniel, 1989; Mishra and Drtina, 2004).
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 (Kaminski et al). SAS No. 53 was designed to narrow the gap between clients’ expectations regarding the auditor’s responsibility to detect fraud during an audit and what that responsibility actually is (Levy, 1989: 52). SAS No. 82, Consideration of Fraud in a Financial Statement Audit, provides guidance on the auditor’s responsibility to “plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud” (Bell and Carcello, 2000).
Howe (1999) suggested that firms turn to fraudulent financial reporting when they have already taken advantage of the most aggressive Generally Accepted Accounting Principlesiii .
“Analysis of ratios of account balances is a widely applied attention-direction procedure, yet little is known of the ability of ratio analysis to identify material monetary error in actual accounting data” (Kinney, 1987: 60). Such financial analysis is frequently posited to be a useful tool for identifying irregularities and/or fraud (Thornhill, 1995). For example financial leverage, capital turnover, asset composition and firm size are associated with fraudulent financial reporting (Persons, 1995).
Fraud detection is one of the specific tasks assigned to auditors as stated in International Standards on Auditingiv 240. Auditors commonly use tools known as analytical procedures to assist them in detecting fraud (Thornhill, 1995; Albrecht et al., 2009). “The Treadway Commission recommended that the ASB Security requires the use of analytical procedures on all audits to improve the detection of fraudulent financial reporting” (Wheeler and Pany, 1996: 558). Analytical procedure is the name used for a variety of techniques the auditor can use to assess the risk of material misstatements in financial records. These procedures involve the analysis of trends, ratios, and reasonableness tests derived from an entity’s financial and operating data. SAS No. 56 requires that Analytical procedures be performed in planning the audit with an objective of identifying the existence of unusual events, amounts, ratios and trends that might indicate matters that have financial statement and audit planning implications (AICPA, 1988). According to SAS No. 99, the current fraud standard, the auditor should consider the results of Analytical procedures in identifying the risks of material misstatement due to fraud (AICPA, 2002). While the procedures are well known and widely used, there is a general lack of understanding of how they are properly applied, and how much reliance should be placed on them. So, companies, auditors, and regulators have increased their focus on understanding fraudulent reporting and how to mitigate its occurrence (Liu et al., 2014).
Due to the importance of fraudulent financial reporting issue the objective of this paper is to investigate the significant differences between the mean of financial ratios of fraud and non- fraud companies.
The remainder of the paper is organized as follows: Section 2 discusses the fraudulent financial reporting and highlights the prior research, Section 3 develops eight hypotheses, and Section 4 describes the research design and methodology. Section 5 describes the results of research and finally, Section 6 provides conclusions.
The increased focus on internal controls by organizations as a mechanism to prevent unethical behavior is consistent with the Fraud Triangle, a widely recognized framework used to understand factors that are predictive of fraudulent reporting and thereby as a means to identify ways to mitigate fraud (AICPA, 2002; The Committee of Sponsoring Organizationsv , 1999). The framework of Fraud Triangle identifies three broad factors that increase the likelihood for fraud: incentives, opportunities, and rationalization. The impact of fraudulent financial reporting often goes far beyond losses for investors and selected classes of creditors. An adequate economic and ethical analysis requires consideration of the outcomes of unethical behavior on multiple stakeholders, and even the ripple effect on the economy and society as a whole (Kalbers, 2009).