Can Investors Detect Fraud Using Financial Statements: An Exploratory Study

This study explores the question of whether investors can successfully detect management fraud using a firm's financial statements. Using financial ratios obtained from fraudulent companies’ financial statements, we examine the effectiveness of both logit and discriminant analyses in predicting the likelihood of fraud. Sixty-eight fraudulent companies used in the study are identified from the SEC's Accounting and Auditing Enforcement Releases. Our research design has addressed certain weaknesses present in prior fraud-detection studies. The empirical results suggest that ratio analysis is grossly ineffective in detecting financial statement fraud. We also discuss the implications of our findings on future research.