You are on page 1of 6

1

DETECTING FALSIFIED FINANCIAL STATEMENTS AND THEIR
IMPACT ON COMPANY’S PERFORMANCE (PAKISTAN)

Introduction
Financial statements are mandatory to be accurate because creditors and investors use financial
statements as base to make their investment decisions. Financial statements of companies are
considered very important for all stakeholders. Financial statements are useful to evaluate past
and future performance of company. Financial statements are also useful to access the
company’s liquidity, solvency and financial flexibility.
Falsified financial statements have become increasingly frequent over the last few years.
Falsified financial statements consists of manipulating elements by overstating assets, sales and
profits or understating the liabilities, expenses or losses. When financial statements contain
falsification then its elements no longer represent the true picture of the financial position of the
company. Falsified financial statements arise from either fraud or error but fraud and error have
different characteristics. Fraud arises through intentional activities and error arises through unintentional activities. According to International Federation of Accountants (IFAC) fraud is
defined as “Intentional act by one or more individuals among management, those charged within
governance, employees, third parties, involving the use of deception to obtain and unjust and
illegal advantage.
Fraud can be of two types. One is management fraud and other is employee fraud. Management
fraud can be defined as “deliberate fraud committed by management that injures investors
through misleading financial statements. Management fraud is often called fraudulent financial
reporting and is the intentional misstatement or omission of amounts or disclosures by the
management with the intent to deceive users.
Employee fraud can be defined as “theft and appropriation of cash stocks or securities. This
group of illegal acts may involve several people in or outside the enterprise. These actions are
intended to erase the traces of the unlawful appropriation of property thereby misleading users of
financial reports. Increasing trend of falsified financial statements in the world not only

FMAS

Corporate Finance

labor FMAS Corporate Finance . total debt to total assets. Weygandt and Warfield (2007) asserted that financial statements are useful for the assessment of a company’s liquidity. solvency and financial flexibility. According to Gibson (2009). Reeve and Warren (2008) defined financial statements as financial reports that summarize the affects of events on a business. Spathis (2002) detected financial statements by using published data.2 intimidates investors and adversely affect their investment decisions but also damages the credibility of capital markets around the world. For this purpose. net profit to sales. Due to high cost arising from financial statements fraud various countries establish regulations in order to combat fraud. inventory to sales. users of financial statements (such as company’s managers. employees. Literature review Previously many researches had been conducted related to our research topic that are as follows: Charalambos T. working capital to total assets. Auditor’s opinion can be used to classify the companies as fraudulent or non fraudulent. A total of ten variables are found to be possible indicators of FFS. Many firms go bankrupt each year due to the false financial statements. security analysts. False financial statements can be identified on the basis of the quantity and content of the qualifications filed by the auditors on the accounts. and financial distress (Z-score). accounts receivable to sales. suppliers. stockholders. They further stated that Financial Statements also helps in evaluating the past and future performances of the company. sales to total assets. gross profit to total assets. Fraudulent financial statements incur huge cost for companies. These include the ratios: debt to equity. Kieso. net profit to total assets. statistical tools are employed to investigate the usefulness of publicly available variables for detecting FFS. bondholders. This paper examines the published data to develop a model for detecting factors associated with false financial statements. Falsified financial statements can be detected through investigation of financial information. lending institutions.

Naser and Pendlesbury (1992). In this study. there were 41 FFSs and 123 non-FFSs identified. In addition. they claimed that certain financial ratios were important variables for detecting fraud. classified the fraudulent financial statements with 90% accuracy. Kotsiantis et al. and Okoye. For this purpose the Kolmogorov Smirnov and Shapiro Wilks test (because there are few samples for FFS) was performed. using data mining. Ilker Kiymetli SEN and Serkan Terzi (2012) conducted the research on detecting the falsified financial statements using data mining. According to auditors’ views. Spathis. Zopounidis conducted the study on detecting falsified financial statements. empirical research on finance sector in Turkey. (2007) used Athens Stock Exchange registered financial statements of 164 companies in Greece. Government and the general public) uses it to make valued decisions according to their areas of interest. As a result of their research. Spathis et al. Beasley. regulatory authorities. Pietesz (2007). The methodology is based on the concepts of multi criteria decision aid (MCDA) and the application of the UTADIS classification method (Utility’s Additives Discriminates). Ukenna and Ugwanyi (2009) studied the reasons and motives behind fraudulent preparation of financial statements. Financial ratios were FMAS Corporate Finance . M. Carcello and Hermanson (1999). Ch. The researchers used a method of data mining and selected financial ratios for fraud risk factors in financial statements. They conducted the comparative study using multi criteria analysis and multivariate statistical techniques. (2002) examined the effectiveness of an innovative classification methodology in order to detect companies’ FFSs and the identification of the factors associated to FFSs. Doumpos and C. the financial statements were classified as fraudulent and non-fraudulent. The researchers accessed financial data of 100 listed companies on ISE. the researchers detected that some financial ratios are important in detecting the FFSs. As a result. In order to determine the statistical test for variables the normality test is applied. the researchers.3 unions. Mulford and Comisky (2002). Ata and Seyrek (2009) used ANN and DT methods in order to determine FFSs.

We will detect fraudulent financial statements and see their impact on company performance. We will select both fraudulent financial statements companies and non fraudulent financial statement companies. Variables Independent variable Fraudulent financial statement is independent variable because it is cause for making change in company’s performance. The researchers found that the proposed MCDA methodology outperforms traditional statistical techniques which are widely used for FFSs detection purposes. Dependent variable Financial ratios or company performance is independent variable because it is affected by fraudulent financial statements. In addition. Sample We will collect data from 100 listed companies in Karachi Stock Exchange.4 determined as the fraud risk factors. We will select companies that are listed on Karachi Stock Exchange (KSE) in Pakistan. 50 fraudulent financial statements companies and 50 non fraudulent financial statements companies. the researcher detected that some financial ratios hold potential risk of FFSs. FMAS Corporate Finance . Objectives  Identification of fraudulent or falsified financial statement companies  To examine the impact of fraudulent or falsified financial statements on companies financial performance Methodology Data The purpose of this research paper is to identify the falsified financial statements and their impact on company’s financial performance and investor’s decision making.

We will identify the falsified financial statements and their impact on company’s financial performance through calculating financial ratios of companies. Hypothesis H0: (Null hypothesis) Financial ratios are not significantly effective on indentifying falsified financial statements and to determine their impact on company’s financial performance. We calculates the financial ratios of both fraudulent and not fraudulent companies and compare the results of both type of companies. H1 : Financial ratios are significantly effective on indentifying falsified financial statements and to determine their impact on company’s financial performance. Firstly we will identify the falsified financial statements by using the auditor’s opinion in the published data. We will collect data from the financial reports of the company/published data. FMAS Corporate Finance .5 Method We will use secondary data for our research. After that we will use the financial ratios to see the impact of the falsified financial statements on company’s performance.

6 FMAS Corporate Finance .