(2008) Fraudulent Financial Reporting Detection. Key Ratios Plus Corporate Governance Factors - Grove & Basilico

Fraudulent Financial Reporting Detection: Key Ratios Plus Corporate Governance Factors
Author(s): Hugh Grove and Elisabetta Basilico

Source: International Studies of Management & Organization, Vol. 38, No. 3, Corporate
Governance Development Levels of Boards (Fall, 2008), pp. 10-42
Published by: Taylor & Francis, Ltd.
Stable URL: https://www.jstor.org/stable/40397733
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Int. Studies ofMgt. & Org., vol. 38, no. 3, Fall 2008, pp. 10-42.
© 2008 M.E. Sharpe, Inc. All rights reserved.
ISSN 0020-8825 / 2008 $9.50 + 0.00.
DOI 10.2753/IMO0020-8825380301
Hugh Grove and Elisabetta Basilico
Fraudulent Financial Reporting Detection

Key Ratios Plus Corporate Governance Factors
Abstract: Prior research studies have examined the detection of fraudulent fi-
nancial reporting using either financial ratios or nonfinancial factors relating to
corporate governance. Are both types of factors relevant for such fraud detection?
In this paper, we consider both types of factors, using experiences of fraudulent
financial reporting companies as a learning opportunity for management, govern-
ment regulators, investors, and auditors to develop early warning systems or red
flags for fraudulent financial reporting.
Concerning financial factors, a probit statistical model of five financial ratios

worked very well in detecting fraudulent financial reporting. For identifying both
fraud (earnings manipulator companies) and nonfraud (nonearnings manipulator
companies) one year before the frauds became public knowledge, this model had
overall 76 percent accuracy with 14 percent Type I errors and 10 percent Type
II errors. Three ratios in the model really drove these results: the gross margin
index, the sales growth index, and the accounts receivable index. These results are
consistent with the American Institute of CPAs' (2003) checklist of fraud detec-
tion, which recommends that these three indexes be computed for each company
being audited.
Concerning nonfinancial factors related to corporate governance issues, the fol-
lowing three corporate governance variables were significant for the mean difference
Hugh Grove is a professor and Elisabetta Basilico is a lecturer in the School of Accountancy
Daniels College of Business, University of Denver, 2101 South University Boulevard, Den-
ver, CO 80208 (tel.: 303-871-2026; fax: 303-871-2016; e-mail: hgrove@du.edu, ebasilic®
du.edu). The authors thank the participants at the European Institute for Advanced Studies
in Management's First Workshop on Corporate Governance, Brussels, November 4-5, 2004,
for their comments.
10
FRAUDULENT FINANCIAL REPORTING DETECTION 1 1
of the fraud versus nonfraud companies: percentage of board members' commo

stock holdings held by insiders, insiders having greater than 50 percent control
the board, and the chief executive officer (CEO) being the chairman of the boar
Also, the following factors were present in many fraud companies: (1) all-powerf
CEO, (2) weak system of management control, (3) senior management turnover,
insider stock trading, and (5) questionable business strategies with opaque (unclea
disclosures. All the qualitative red flags were matched with specific provisions
the Sarbanes-Oxley Act, which attempted to strengthen corporate governance f
boards of directors in the United States. This study shows that a combination o
quantitative financial ratio indexes and qualitative corporate governance facto
appears to work best for detecting fraudulent financial reporting. As one financ
analyst observed, financial analysis is necessary but not sufficient for investme
(and fraudulent financial reporting) analysis.
Prior research studies have examined the detection of fraudulent financial
reporting either using financial ratios or nonfinancial factors relating to corporate
governance. Are both types of factors relevant for such fraud detection? Very few
studies have considered both financial and nonfinancial factors. Do corporate
governance factors relating to a board of directors' ability to represent and protect
shareholders' interests play a role in fraudulent financial reporting? In this paper,
we consider how the experiences of fraudulent financial reporting companies in
five industries can be used as learning opportunities for management, government
regulators, investors, and auditors to develop early warning systems or red flags
for fraudulent financial reporting.
These five industries with high-profile fraud cases are energy with Enron and
Dynegy; telecommunications with WorldCom (now MCI), Global Crossing, and
Qwest; software with Microstrategy; food service with Parmalat, Cirio, and Dutch
Ahold; and computer equipment with Xerox. Our sample includes these fraud or
earnings-manipulator companies, which have been investigated for fraudulent fi-
nancial reporting by the U.S. Securities and Exchange Commission (SEC) through
its Accounting and Auditing Enforcement Releases (AAERs) or by European
investigators.
The purpose of our paper is to demonstrate the usefulness of both types of red
flags - quantitative fraud ratios and qualitative corporate governance factors - for
detecting fraudulent financial reporting. The qualitative corporate governance red
flags are just as, or even more, important than the quantitative ones for both detecting
and preventing fraudulent financial reporting, according to many fund managers,
short sellers, financial analysts, and financial press writers.
Literature review
Major work took place over 30 years ago regarding the use of financial ratios to
detect corporate financial difficulties (Beaver 1967; Deakin 1972). Although such
studies anticipated the potential prediction power of financial ratios, they were
12 HUGH GROVE (USA) AND ELISABETTA BASILICO (USA)
primarily univariate in nature, which limited their applicability. A logical extension

of such models combined several ratios into multivariate predictive models.
For financial-fraud-prediction purposes, both logit and probit models have
been used. Many of these studies used firms that have been cited by the SEC in its
AAERs. In an AAER, the SEC has taken an enforcement action against a firm or
individual it identified as having violated the financial-reporting requirements of
the Securities Exchange Act of 1934.
Concerning just financial factors, Beneish (1999) used a sample of 74 public
companies that had committed financial statement manipulations or distortions of
earnings, assets, and liabilities, as cited in AAERs from 1987 to 1993 and 2,332
public companies, matched by two-digit standard industry classification codes
(SIC) and not cited by the SEC. This study applied a weighted exogenous sample
maximum likelihood probit model and an unweighted one that included eight time
series ratios or indexes. Five indexes were statistically significant in predicting
earnings manipulation: days-sales in receivable index, gross margin index, asset
quality index, sales growth index, and total accruals to total assets.
Also concerning just financial factors, Cook and Grove (2004) used AAERs
from 1986 to 2001 in analyzing a sample of 120 manipulators and over 4,000
nonmanipulators listed in the Compustat database. Two probit models were used:
(1) statistically significant index variables from the literature and (2) variables,
not as indexes, but as two-year averages of the raw data making up the indexes.
They found that individual ratios, such as the sales growth index, long-term debt
to total capitalization, and gross margin index, were statistically significant and
could be used on a case-by-case basis to check for earnings manipulation and
financial fraud.
Only one study has investigated both financial and nonfinancial red flags.
Dechow, Sloan, and Sweeney (1996) examined a sample of 92 earnings manipulators
in AAERs from 1982 to 1992 and 92 nonmanipulators, matched by three-digit SIC
codes. Their correlation models tested 19 variables. The only financial ratios that
were significant were leverage and ex-ante finance (cash from operations-average
capital expenditures/current assets). They found that firms with weak governance
structure were more likely to manipulate earnings. Also, they discovered that ma-
nipulators experienced significant increases in their costs of capital after public
announcement of their malpractices.
Concerning just nonfinancial factors, Beasley, Carello, and Hermanson (1999)
analyzed a random sample of 200 manipulators in AAERs from 1987 to 1997.
They found that these companies were mainly small and not listed on major stock
exchanges. Concerning internal controls, they found that top senior executives
were usually involved in the fraud. Also, boards of directors were composed
mainly of insiders, and family relationships among directors and officers were
fairly common.
Also concerning just nonfinancial factors, Cullinan and Suttom (2002) used
the AAERs from 1987 to 1999 to identify 276 manipulators. They found that the
FRAUDULENT FINANCIAL REPORTING DETECTION 13
chief executive officer was involved in 70 percent of these frauds and anoth
percent involved senior managers. They concluded that external audit me
were not designed to detect fraudulent financial reporting by senior manag
because external auditors claimed that senior management effectively hid the
from them.
Again concerning mainly nonfinancial factors, Bell and Carello (2000) dev
a logit model that estimated the likelihood of fraudulent financial reporting
the presence of several fraud-risk factors. The significant risk factors were
internal control environment, rapid company growth, inconsistent or inad
profitability, undue management focus on meeting earnings projections, o
evasive or lying management, private ownership status, and an interactio
tor between weak controls and aggressive management attitude toward fin
accounting. In a study of just one no-financial fraud-risk factor, Beasley
found that no-fraud firms have boards with significantly higher percenta
outside members than fraud firms, based on a logit model analysis of 75 fra
75 matched no-fraud firms.
In summary, the literature primarily has used either financial or nonfin
factors for detecting financial statement fraud and earnings manipulation
and Wahlen 1999). However, in developing a framework for classifying acc
manipulation from an extensive literature review, Stolowy and Breton (2
found more academic empirical research is needed for both types of factor
help address this deficiency, our study empirically analyzed companies' fin
statements for both types of factors, starting with the year prior to the frau
nouncement, in five industries.
Analytical justification for fraud ratio indexes
Key fraud ratios (Beneish 1999; Cook and Grove 2004) were calculated fro
most recent financial statements of these fraud companies before their inv
tions became publicly known. From Beneish's 1999 study of companies cite
fraudulent financial reporting and earnings management in the AAERs fro
through 1996, Wells (2001) developed analytical explanations for why Ben
five fraud detection ratio indexes should work. First, a material increase in th
sales in receivables index (DSRI) could indicate that a company's receivable
phony, or alternatively, a legitimate explanation could be liberalized credit p
Second, concerning the gross margin index (GMI), if a company's gross ma
on sales shrink from one period to the next, the risk is higher that manag
will engage in fraud to offset declining operating performance. Third, an in
in the amount of intangible assets or asset quality index (AQI) may indicate
company is capitalizing costs into intangible assets to offset declining econ
performance. Fourth, an increase in the sales growth index (SGI) reflects an in
in sales, which may or may not be legitimate. Fifth, an increase in total ac
to total assets index (ACC) may indicate that larger accruals and, thus, le
(net income = operating cash flow + accruals) are associated with a higher risk of
earnings manipulation.
For each of these five ratio indexes, Beneish calculated benchmarks for the
nonmanipulators' mean index and the manipulators' mean index and developed a
statistical model for predicting fraudulent financial reporting, using empirical data
for these five ratio indexes:
Z = -4.840 + 0.920 DSRI + 0.528 GMI + 0.404 AQI + 0.892 SGI + 4.679 ACC
Beneish determined a cutoff score of -1.49 to be used as a classification tool for
fraud detection. A probit model can make two types of errors: Type I (classifying a
company as a "nonmanipulator" when in fact it manipulates) or Type II (classifying
a company as a "manipulator" when in fact it does not manipulate). The probability
cutoff scores that minimize the expected costs of misclassification depend on costs
associated with the relative cost of making an error of either type (Maddala 1983).
On the one hand, most likely investors have high Type I error costs because mis-
classifying a manipulator can cause a dramatic loss of value for its stock. On the
other hand, regulators are also concerned with Type II errors because they prefer
not to falsely accuse a company of fraudulent financial reporting.
In Beneish's study, the typical manipulator (and investors) lost approximately
30 percent of its market value on a risk-adjusted basis in the quarter containing the
discovery of the manipulation as compared with a 1 to 2 percent appreciation occur-
ring on a regular term. Based on this assumption, Beneish determined the probability
cutoffs that would minimize the expected costs of misclassification. However, the
stock drop for manipulators was much higher for more recent, spectacular frauds
(Grove and Cook 2004). Examples included WorldCom (with a 90 percent stock
price decrease and related market capitalization destruction of $180 billion), Enron
(100 percent and $67 billion), Global Crossing (100 percent and $54 billion), Qwest
(90 percent and $77 billion), and Parmalat (97 percent and $3 billion). Thus, instead
of using relative costs in the 20-30: 1 range, we chose higher relative costs in the
40:60: 1 range to acknowledge investors' higher losses and calculated a higher Z-
score cutoff of -1.99 for fraud predictive purposes in the probit model.
Quantitative analysis: financial ratio indexes
Our sample consisted of 42 companies from five industries: global energy, tele-
communication, food service, software, and computer equipment. These specific
industries were chosen because they were the industries with the most companies
under SEC or European investigations. The 19 fraud or manipulator companies
were Enron, Dynegy, Duke Energy, El Paso, and Reliant in the global energy in-
dustry; WorldCom, Global Crossing, and Qwest in the telecommunication industry;
Ahold, Parmalat, and Cirio in the food service industry; Microstrategy, Tenfold,
Unify, Indus International, and First Virtual in the software industry; and Centennial
Technologies, Xerox, and Cylink in the computer equipment industry.
Major competitors from these same industries were used as control grou
nonfraud or nonmanipulator companies, defined as companies not under
or European investigations. The 23 nonfraud companies were ENI Spa, Bri
Petroleum, Exxon, Entergy, and Xcel Energy in the global energy industry
South, SBC, Alltel, AT&T, Verizon, and Sprint in the telecommunication
try; Sara Lee, Conagra, Kraft Foods, and Unilever in the food service ind
Progress Software, Scientific Learning, Neomedia, Vital Works, and Nest
the software industry; and Eagle Point, Scansoft, and Netsmart in the com
equipment industry.
The financial statement manipulator companies had statistically signifi
smaller values for both sales and total assets, using a i-test at a 10 percen
nificance level. However, if the two very large companies, Indus Internatio
software company, and Xerox, an office equipment company, were elimina
outliers, then the /-test was significant at a 5 percent level. The probit mod
applied to financial statement data (income statement, balance, and stateme
cash flow) for the above companies starting from the year prior to the fraud
made public by SEC or European investigators (Year 1) and going back ano
year (Year 2). The Compustat database (2003) provided most of the data, a
financial statements of foreign companies provided the rest of the data.
The fraudulent financial reporting detection analysis is presented in Tab
through 6, using the five financial ratio indexes discussed above for the five i
tries analyzed. The probit model was used to analyze the combined effect of al
ratios in detecting fraudulent financial reporting. Also, Beneish's nonmanipu
and manipulators' mean index numbers for each of the five ratio indexes (
2001) were used to analyze each ratio separately.
Applied to the global energy industry (Table 1), the probit model corr
classified 80 percent (8/10) of the companies with one Type I error of 10 p
(1/10) and one Type II error of 10 percent (1/10). In the telecommunication in
(Table 2), the probit model correctly classified 78 percent (7/9) of the com
with two Type I errors of 22 percent (2/9) and no Type II errors. In the food
industry (Table 3), the probit model correctly classified 86 percent (6/7)
companies with one Type I error of 14 percent (1/7) and no Type II errors.
software industry (Table 4), the probit model correctly classified 60 percent
of the companies in Year 1 with one Type I error of 10 percent (1/10) and
Type II errors of 30 percent (3/10). In the computer equipment industry (T
the probit model correctly classified 83 percent (5/6) of the companies in
with one Type I error of 17 percent (1/6) and no Type II errors.
In Table 6, the results are summarized for each of the five industries an
for Type I and Type II errors in both Year 1 and Year 2. In Year 2, the accurac
reduced because the frauds had usually not grown large enough to be detec
the financial statements. The percentages of accuracy for identifying both ma
lator and nonmanipulator companies in all five industries were consistentl
high in Year 1 and still high in Year 2: global energy (80 percent and 56 pe
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telecommunication (78 percent and 67 percent); food service (86 percent a

percent); software and programming (60 percent and 70 percent); and com
and office equipment (83 percent and 67 percent). Also, the percentages o
correctly classifying a manipulator (Type I errors) were generally quite low
five industries for both years.
The overall accuracy of the probit model for all five industries was 76 pe
(32/42) in Year 1 with six Type I errors of 14 percent (6/42) and four Type II
of 10 percent (4/42). The overall accuracy slipped to 66 percent (27/41) in Y
with seven Type I errors of 17 percent (7/41) and seven Type II errors of 17 p
(7/41 ). Thus, the overall accuracy of the model was good from 76 percent i
1 and only slipped to 66 percent in Year 2, ahead of the frauds becoming p
knowledge. Also, our model misclassified 32 percent (6/19) of the manipu
and 17 percent (4/23) of the nonmanipulators.
In Tables 1 through 5, the five ratio indexes or variables of the probit m
were also analyzed individually. A "yes" response to the red flag question m
that the individual index was above the manipulators' mean index (MMI),
mined by Beneish in his prior research. Similarly, a "no" response was belo
nonmanipulators' mean index (NMI). A "possible" response was within the
of the NMI and the MMI. To determine the accuracy of these five individu
dexes, "yes" and "possible" responses were combined as red flags versus th
responses as not being red flags.
Concerning the manipulator or fraud companies, the gross margin index
indicated the most red flags- 72 percent (14/19) of the time. The GMI al
62 percent (26/42) accuracy in identifying both fraud and nonfraud com
Concerning the fraud companies, the next two best ratios were the sales g
index (SGI) and the days' sales in receivables index (DSRI), as both indicat
flags 42 percent (8/19) of the time. Overall accuracies were 67 percent (2
and 48 percent (20/42), respectively. The other two financial ratio indexes
indicate as many red flags as the first three ratio indexes. For identifying th
and the total companies, the liability accruals to total assets (ACC) result
32 percent (6/19) and 60 percent (25/42), respectively, and the asset quality
(AQI) results were 16 percent (3/19) and 52 percent (22/42), respectively.
Qualitative analysis: corporate governance factors
Various short sellers, fund managers, investors, and financial analysts hav
used corporate governance, relating to board of directors' responsibilities, and
qualitative red flags in making their investment decisions (Anders 2002; Bryan
and Opdyke 2002; Mulford and Comiskey 2002; Schilit 2002; Willis 2002).
corporate governance factors have been leading indicators of fraud prob
many of our 19 fraud companies, as these factors have occurred well befo
stock prices of these companies dropped down near zero. For example, m
Enron's qualitative factors (weak controls, senior management turnover, i
Table 7
Significant corporate governance variables
Manipulators Nonmanipulators
1 . Percent board holdings

held by insiders
Mean 0.722634 0.375459
Standard deviation 0.239602 0.319056
n 15 19
f 3.5
p-value (two-tailed) 0.0014

2. Insiders >50% control of board
Mean 0.73 0.26
n 15 19
t 2.99

3. CEO = Chairman of the board
Mean 0.67 0.37
n 15 19
t 1.75
trading) had surfaced by early September 2001 when Enron's sto

trading in the $30 to $35 range (off its all-time high of $90 in Su
qualitative red flags occurred well before November 30, 2001, wh
price dropped to near zero after its financial reporting fraud was
qualitative factors were also present when Parmalat's stock pric
September 3, 2003, before it dropped to €0.1 1 (US$0.09) on Dec
after its financial reporting fraud became public.
To assess nonfinancial factors for fraud detection, corporate go
ables were collected from proxy statements of U.S. companies in
compared for our fraud and nonfraud companies. Similar to the st
Sloan, and Sweeney (1996), the following corporate governance
collected: percentage of insiders (company managers) on the boa
percentage of board members' common stock holdings held by in
having greater than 50 percent control of the board, CEO also be
the board, CEO being the company founder, number of directors,
audit committee, and use of a Big Six auditor. The final sample c
the 19 fraud companies and 19 of the 23 nonfraud companies, as foreign fir

not have proxy statements. The following three corporate governance va
(see Table 7) were significant for the mean difference of the fraud versus non
companies: percentage of board members' common stock holdings held by
ers (99 percent significant), insiders having greater than 50 percent control
board (95 percent significant), and the CEO being the chairman of the boar
percent significant).
In studying these financial reporting frauds, we found the following c
mon corporate governance factors, expanded from studies by Dechow, Sl
and Sweeney (1996) and Cullinan and Sutton (2002): all-powerful CEO
system of management control, focus on short-term performance goals, C
uncomfortable with criticism, senior management turnover, insider stock
weak or nonexistent code of ethics, independence problems with the com
external auditors, independence problems with the company's investment ba
and questionable business strategies with opaque disclosures. These ten corp
governance-related factors represent common or repetitive qualitative red
that were leading indicators for many of our fraud companies. These ten f
(see Appendix 1) are elaborated with specific company examples in the foll
summary table.
Where applicable, these factors are also matched with regulations from th
Sarbanes-Oxley Act (SOX) passed in July 2002 by the U.S. Congress (see App
1). SOX posed remedies for the perceived ineffectiveness of corporate gover
and external audits. SOX is also applicable to the 300 European companies th
dual-listed on U.S. stock exchanges because they are being required to follo
by the SEC for their U.S. listings. Also, there are now 1 ,300 foreign firms reg
with the SEC versus only 500 firms in 1992. The SEC's resolve to enforce
with foreign firms has remained firm due to the recent European cases of frau
financial reporting (i.e., Parmalat, Cirio, Ahold, and Adecco).
Summary and conclusion
In this paper, the experiences of fraudulent financial reporting companies i

industries have been used to analyze financial and nonfinancial factors for
tection of fraudulent financial reporting. Key fraud detection ratios worke
using the financial reports of these companies in the year before their fin
reporting problems surfaced.
In particular, the gross margin index (72 percent accuracy), the sales growth
(42 percent accuracy), and the accounts receivable index (42 percent accuracy) w
well in detecting fraudulent financial reporting. These results are consistent w
American Institute of CPAs' (2003) checklist of fraud detection, which recomm
that these three indexes be computed for each company being audited.
Combining all five ratio indexes into a probit model worked very well in det
fraudulent financial reporting. For identifying both fraud and nonfraud comp
one year before the frauds became public knowledge, this model had overall 76
percent accuracy with 14 percent Type I errors and 10 percent Type II errors. The
overall accuracy slipped to 66 percent two years ahead of the frauds with 17 percent
Type I errors and 17 percent Type II errors. For both fraud and nonfraud companies
in specific industries, this model had accuracies of 80 percent, 78 percent, 86 percent,
60 percent, and 83 percent for the global energy, telecommunication, food service,
software, and computer equipment industries, respectively, in the year prior to the
frauds being publicly announced.
Qualitative red flags included corporate governance factors and worked well
for the fraudulent companies, particularly the following: all-powerful CEO, weak
system of management control, senior management turnover, insider stock trading,
and questionable business strategies with opaque disclosures.
For future research, the ten corporate governance factors might be measured or
operationalized with dummy variables ("on" if the factor exists or "off" if it does
not exist) as follows:
1 . All-powerful CEO: determine if the CEO is also the chairman of the

board of directors.
2. Weak system of management control: determine if insiders (company

managers) have a majority control of the board of directors.
3. Focus on short-term performance goals: review company press releases

for focus on meeting quarterly performance goals.
4. CEO is uncomfortable with criticism: review conference calls with

financial analysts.
5. Senior management turnover: review company press releases, especially

for CEO and chief financial officer (CFO) turnover.
6. Insider stock sales: review insider stock sales reported to the SEC.
7. Weak or nonexistent code of ethics: review any corresponding SOX

violations reported to the SEC.
8. Independence problems with the company's external auditors: review any

corresponding SOX violations reported to the SEC.
9. Independence problems with the company's investment bankers: review

any corresponding SOX violations reported to the SEC.
10. Questionable business strategies with opaque disclosures: review financial

press articles on these topics.
In this paper, it was shown that a combination of quantitative financial ratio

indexes and qualitative corporate governance factors appears to work best in detect-
ing and preventing fraudulent financial reporting. Corporate managers, government
regulators, auditors, investors, financial analysts, and other financial statement

should use both types of factors in their work. As one financial analyst obs
financial analysis is necessary but not sufficient for investment (and frau
financial reporting) analysis.
Major changes in U.S. regulations appear to have good potential for stren
ening corporate governance factors to help prevent fraudulent financial rep
These new regulations should continue to facilitate strong corporate gover
and control systems.
However, at least one regulation has been ignored. The HealthSouth
signed the required Sarbanes-Oxley report, attesting to the fairness of the fin
statements, although these statements had been manipulated each year sin
company went public ten years ago. He was then acquitted of any crimes in
trial in his hometown. Such abuses reinforce the importance of combining
detection approaches with corporate governance prevention approaches to r
fraudulent financial reporting.
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(April): 126-128.
Appendix 1. Ten Typical Fraudulent Financial Reporting Factors for

Corporate Governance with Related Sarbanes-Oxley Act (SOX) Sections
1. All-powerful CEO
The CEO is also the chairperson of the board of directors. Insiders (senior company
managers) on the board have majority control, and there is a failure of corporate
governance by the board to protect shareholders.
Corporate examples
The original CEO, usually the company founder, was also the chairman of the
board at Enron, WorldCom, and Global Crossing. The Qwest Chairman of the
Board who was the largest single shareholder, hand-picked the CEO. In Europe,
Parmalat began as a family-owned meat company that grew into a global food gi-
ant. The CEO, who was the company founder, the CFO, and the company lawyer
continued to run the corporation together. Thus, insiders controlled the board of
directors even after it went public and rapidly expanded.
SOX section 402
Corporate loans to company officers and directors are now prohibited.
SOX section 1105
The SEC can ban, temporarily or permanently, individuals from serving as of-
ficers or directors of public companies if the individuals have committed securi-
ties fraud.
2. Weak system of management control
The system of internal control (checks and balances, separation of duties, e

so weak that senior management can override it anytime it wants. There is a f
of corporate governance to prevent fraud by one person.
Corporate examples
Parmalat's CEO has admitted shifting over €500 million ($400 million) cash
the company to other businesses. However, a recent Parmalat report prepared
independent auditor for prosecutors in Milan put that number closer to €1
($800 million) cash. Although Parmalat had reported profits each year, this
said that Parmalat had only one profitable year between 1990 and 2002. An
example is the Swiss company Adecco, the world's largest temporary emp
agency. It had a board of directors and three-person audit committee, comp
only Europeans. Meanwhile, 20% of total revenues were in the United States
the fraud occurred from overstated revenues, billing errors, lack of internal co
and poor information technology security.
SOX section 404
The CEO and the CFO are required to discuss their firm's internal controls and proce-
dures in place to prevent fraud. CEOs and CFOs are required to state that establishing
and maintaining the internal control structure is their responsibility and to provide an
annual assessment of the effectiveness of those procedures in annual reports.
SOX section 407
Audit committee members must be independent and are prohibited from receiving
compensation from the firm, except for board service. In addition, audit committees
must have at least one member who is a financial expert.
Auditing standard no. 2
The Public Companies Accounting Oversight Board (PCAOB), created by SOX,

required that the external auditor give two opinions on a firm's internal controls: one
on management's assessment of internal controls and one on the actual effective-
ness of the internal controls. U.S. external auditors are now required to give three
opinions: two on internal controls and one on the financial statements.
3. Focus on short-term performance goals
The overriding performance goal is to "make the numbers" for each quarter and
each year. More performance emphasis is given to revenue, or "top-line" growth,
than earnings, or "bottom-line" growth.
Corporate examples
Qwest's CEO was criticized by his own board for having a short-term focus on
making the numbers, particularly double-digit revenue growth. For example, to
help make its revenue goals in one year, Qwest recorded 13 months of advertising
revenues from its telephone directories, instead of the normal 12 months. Qwest
also did quarter and year-end swaps of its fiber optic networks with other compa-
nies, such as Global Crossing and Enron, to make its double-digit revenue targets.
To make its revenue goals, the Dutch company Ahold recorded supplier rebates as
revenues. A German firm rejected a proposed merger with Enron, citing Enron's
huge off-balance-sheet debt and other aggressive accounting practices. Another
German firm rejected a proposed merger with Qwest, citing its huge on-balance
sheet debt and aggressive accounting practices.
SOX section 302
CEOs and CFOs are required to certify that they have reviewed all quarterly and
annual reports filed with the SEC. Also, in a written report, they must state that, to
the best of their knowledge, the reports present fairly the financial condition and
operations of the firm and do not omit material information. Individuals can be
fined up to $5 million and be sentenced to up to 20 years in prison for violating
this requirement.
SOX section 401 (b)
This enabled the SEC to adopt Regulation G governing the use of non-Generally
Accepted Accounting Principles (GAAP) financial measures, including disclosure
and reconciliation requirements. Thus, many U.S. technology companies that used
pro-forma (non-GAAP) accounting to make revenue and earnings targets in their
press releases have to reconcile such numbers to GAAP financial statement numbers
in an 8-K report to the SEC.
4. CEO is uncomfortable with criticism
When questioned by outsiders, like financial analysts during conference calls, the
CEO is defensive and abusive to these outsiders. The CEO and senior managers,
like the CFO, may wind up lying to outsiders.
Corporate examples
Enron's CEO was uncomfortable with criticism. In a conference call with financial
analysts, he called one financial analyst an "asshole" when questioned about En-
ron's performance. Jim Chanos, who was the first hedge fund manager to question
Enron's performance, called Enron's CEO's conference call a disaster and t

piece of the puzzle.
He began to short Enron's stock shortly thereafter while it was still trading
$70 per share. Also, Enron's CEO and CFO both repeatedly told financial analy
Enron would never be liable for bank loans with its special purpose entitie
However, there were credit triggers in the bank loan covenants that did mak
liable for such loans. The two major credit triggers were Enron's common stoc
falling below a certain level and Enron's credit rating falling to junk bond stat
Qwest's CEO criticized the Morgan Stanley financial analysts who question
company's performance and who downgraded Qwest's stock from a buy t
tral status. He said that they were "not the sharpest knives in the drawer" an
their report "hogwash." He pledged never to talk to them again and terminat
future investment banking business with Morgan Stanley. Also, Parmalat's CE
uncomfortable with criticism from his Italian bankers and new auditors. Italia
requires audit firms to be rotated every five years. To mitigate this law, he m
percent of Parmalat's operations and its questionable business practices to t
man Islands where the former lead audit firm had been rotated. Also, he beg
more American bankers and fabricated €4 billion ($3.2 billion) that were s
to be in a Bank of America account in the Cayman Islands.
5. Senior management turnover
The CEO and other senior managers, especially the CFO, quit their "drea
and many say they are doing so "to spend more time with their families."
Corporate examples
Enron's CEO, Jeffrey Skilling, resigned only six months after being prom
his "dream job," and called it a "purely personal" decision, elaborating t
wanted to devote more time to his family. One investment-fund manage
Hammerschmidt, said, "That was the worst excuse I've ever heard. As so
heard that, I dumped my shares" (Bryan-Low and Opdyke 2002). Others,
ing Sherron Watkins, the Enron whistleblower, have speculated that Skilli
that Enron's falling stock price would cause Enron's loan guarantees of
partnerships to be exposed and then lead to Enron's bankruptcy. Similarly
CFO resigned over one year in advance of its accounting problems surfac
Parmalat's CFO quit nine months before it went into bankruptcy after a bo
was surprisingly pulled out.
6. Insider stock sales
Senior managers, especially the CEO and the CFO, are selling their own company's
common stock at current prices, rather than holding these shares for the long term.
At the same time, they are misleading investors by saying that the company's stock
is undervalued and has a great future.
Corporate examples
Significant insider trading occurred at Enron in the second half of 2000 and the
first half of 2001 before its stock crashed in the last half of 2001. Top managers
voted with their feet. The former CEO (Kenneth Lay), and the current CEO (Jef-
frey Skilling), the general council, the CFO, and other chief executives all sold
large blocks of stock. In 2000, Lay made $66.3 million and Skilling made $60.7
million from exercising stock options and selling the shares, roughly double the
amounts the year before. A shareholder lawsuit has alleged that 29 Enron execu-
tives made $1.1 billion in profits on insider sales. Since the selling at Enron was
prolific and it persisted even as the stock fell throughout 2001 , one financial analyst
at Thomson Financial, Paul Elliot, called such insider sales a "screaming red flag,"
and questioned: "if Lay and Skilling believed that the stock was undervalued and
headed for $120, as they repeatedly told investors, then why were they cashing in
so heavily?" (McLean 2001, 124). Lay and Skilling have since been indicted by
the U.S. Department of Justice on numerous counts of conspiracy and securities
fraud. Similar insider trading occurred at Qwest where eight Qwest senior execu-
tives made $2.2 billion in profits while still "touting" the stock price prospects
at Qwest. Qwest's CEO has also been indicted on numerous counts of securities
fraud. Similarly, WorldCom's CEO and CFO have been convicted of securities
fraud for insider trading.
SOX section 403
This mandated that the SEC address executive trades of company stock. The SEC has
now required that such trades be reported electronically to it within two days as well
as being posted on the company's Web site. The old requirement was 45 days.
SOX section 304
This required forfeiture of bonuses and profits from equity sales by CEOs and CFOs
when firms restate financial statements for material noncompliance with financial
reporting requirements as a result of misconduct.
SOX section 306
Officers and directors are prohibited from purchasing or selling company stock
during blackout periods when employees are prohibited from selling their
company stock in 401(k) retirement plans while plan administrators are being
changed.
7. Weak or nonexistent code of ethics
Company employees are encouraged to push their behavior and financial r

to ethical and professional limits. The company's code of ethics (if one ex
not taken seriously.
Corporate examples
Parmalat unraveled quickly after it had trouble making a routine bond

payment, prompting tougher scrutiny of its books by Italian regulators
own auditors. A follow-up audit found that Parmalat's €4 billion ($3.2 b
cash in a Bank of America account did not exist. The auditors had sent the con-
firmation request to the bank through Parmalat's internal mail system where it
was intercepted. Then, the written confirmation from the bank back to Parmalat's
auditors was forged as were other supporting documents. The €4 billion ($3.2
billion) cash had just been fabricated to help cover up the CEO looting his com-
pany. A Fortune financial magazine reporter, Bethany McLean (2001), was the
first to question Enron's value in the financial press. She noted that the use of
the mark-to-market accounting method for pricing Enron's securities in illiquid
markets with no fair value benchmarks was a red flag for fraudulent financial
reporting. She said, "Enron often relied upon internal models which created
serious potential for abuse" (McLean 2001, 125). According to former Enron
managers, salespeople used wildly optimistic assumptions about the forward
price of commodities and other factors to value their contracts so profits would
be inflated and their bonuses would be bigger. One power-industry consultant
said, "That's valuation by rumor. There's no way for those results to be taken
seriously" (Willis 2002, 82). In a home video at a retirement party for an Enron
manager, Enron's CEO, Skilling, boasted that he could "add a kazillion dollars to
the bottom line anytime" (Anders 2002, 2) by using this mark-to-market method.
In another example, Tyco's CFO forgot to include $12 million of loans forgiven
by Tyco as income in his personal income tax return.
SOX section 406
Firms are required to disclose whether they have adopted a code of ethics for their
CEO, CFO, and senior accounting personnel. Also, they have to file a report (8-K)
with the SEC whenever there is a change or waiver in the code.
SOX section 407
Firms' audit committees are required to establish procedures, like whistleblower

hotlines, to receive and act on anonymous complaints concerning accounting, in-
40 HUGH GROVE (USA) AND EL1SABETTA BASILICO (USA)
ternal controls, and auditing. This section made retaliation against whistleblowers
a criminal act.
8. Independence problems with the company's external auditors
The company often pays the audit firm additional consulting fees that may exceed
the audit fees. Using the same audit partner as the chief engagement partner is often
a condition for retaining the audit firm.
Corporate examples
Italian securities laws require that a company change its external auditors every five
years. Parmalat got around that requirement in two ways: (1) it initially had its lead
audit partner change auditing firms, and (2) it subsequently switched 51 percent of
its business to the Cayman Islands where the former lead audit firm had been rotated.
Thus, the same audit partner had signed various parts of Parmalat's audits for 20 years.
There were also independence problems with Enron's auditor, Arthur Andersen (AA).
AAs consulting fees with Enron were $27 million, larger than its audit fees of $25
million. Many former AA auditors worked for Enron, and Enron outsourced its entire
internal auditing work to AA. AA was also the auditor of Qwest, Global Crossing,
and WorldCom and earned large consulting fees from those firms. The HealthSouth
auditors charged about $1 million annually for audit fees while earning slightly less
from performing janitorial inspections of HealthSouth's 1,800 health-care facilities.
SOX section 508
Lead audit partners, but not firms, must rotate off an audit engagement every five
years. Also, a company is prohibited from hiring anyone who has worked for its
audit firm during the one-year period preceding an audit. The prohibited jobs are
CEO, CFO, controller, chief accounting officer, and equivalent positions. Sec-
tion 508 also prohibited audit firms from designing and implementing financial
information systems, providing internal audit services, and offering valuation and
appraisal services to audit clients. Basically, only the major services of audit and
income-tax preparation may be performed by a firm's auditors.
SOX section 802
Public accounting firms now have to retain documents prepared to support their
audit reports for at least seven years.
9. Independence problems with the company's investment bankers
Favorable "buy" recommendations from an investment banker's financial analysts

may be a requirement for a company to do any new business with an investment
banking firm. Investment bankers' research may not represent an independe

analysis of the company's investment potential.
Corporate examples
The sell-side financial analysts who worked for the investment bank firms tha
earned significant fees from Enron and Parmalat had the same independence
problems as the auditors. Typically, investment fees are much higher than equi
research fees. As one example of independence problems, 17 of the 18 sell-sid
analysts following Enron still had buy recommendations the day after the C
Jeffrey Skilling resigned, ignoring that red flag. One investment bank fired
financial analyst for changing his investment rating to a "sell" recommenda-
tion on Enron at $38 per share. Another big firm told its financial analysts t
maintain a "buy" recommendation for Enron no matter what. One of Parmalat
investment bankers upgraded its investment recommendation from hold to buy
November 2003, saying the current price of €2.20 ($1.76) was a bargain becau
Parmalat's restructuring was attractive for its stock price. That bank has bee
sued in two lawsuits.
SOX section 501
This enabled the SEC to create rules governing research analysts' conflicts of inter-
est, but the SEC has not yet acted on this section.
New York Attorney General
In December 2002, the twelve largest U.S. investment banking firms agreed to pay
$1 billion in fines to end SEC and other investigations into whether they issued
misleading stock recommendations and handed out hot new shares to obtain favor
with corporate clients. These firms also have to pay an additional $500 million
over five years to buy stock research from independent analysts and distribute it
to investors. New York Attorney General Eliot Spitzer, the lead negotiator of the
settlement, said, "Hopefully, these rules will restore investor confidence by restor-
ing integrity to the marketplace" (Grove and Cook 2004, 140).
10. Questionable business strategies with opaque disclosures
An opaque (unclear) disclosure strategy may exist for the company's business
model and related financial reporting. The well-known investors, Warren Buffett
and Peter Lynch, have both given the following advice: "If you don't understand
what a company does, don't invest in it. If management refuses to fill in holes
and keeps investors in the dark, run!" (Buffett, Berkshire Hathaway annual report
2003, 18).
42 HUGH GROVE (USA) AND ELISABEJTA BASILICO (USA)
Corporate examples
Questionable business strategies existed along with opaque (unclear) disclosure

strategies at Enron. The Fortune reporter McLean said: "How exactly does Enron
make its money? Details are hard to come by because Enron keeps many of the
specifics confidential for what it terms competitive reasons. The numbers that
Enron does present are often extremely complicated. Seemingly basic questions,
like the effects of lower natural gas prices and less volatility in energy markets on
Enron's profits, are still unanswered" (McLean 2001, 124). Another example of
intentionally opaque, complex financial reporting and disclosure came from Enron's
related party transactions with special purpose entities (SPEs). As the short seller
Jim Chanos said, "We read the disclosure over and over and over again and we just
didn't understand it - and we read footnotes for a living" (Anders 2002, 3). Warren
Buffett made a similar comment in his 2003 CEO letter to shareholders. An A.G.
Edwards energy analyst, Michael Heim, said, "I've never seen such complicated
disclosures. It was hard to follow the movement of money" (Willis 2002, 127).
When pushed to reveal more, Enron management was uncooperative and pleaded
confidentiality concerns. Also, Qwest did not disclose that its revenue from fiber
optic swaps and equipment sales were nonrecurring.
Parmalat used a similar SPE strategy to earn its nickname as "Europe's Enron." It
created an elaborate network of related party transactions, using opaque disclosures
of its subsidiaries in tax havens such as the Cayman Islands and Luxembourg to
hide the declining state of its finances. One subsidiary was called Buconero, which
means "black hole" in Italian.
Section 401 (a)
This enabled the SEC to adopt rules requiring disclosure of all material off-balance
sheet transactions and debt.
Section 409
Firms have to report material changes in their financial condition on a "rapid and
current basis." This section encouraged real time reporting, as opposed to the
current 35-day and 90-day delays in quarterly and annual reporting to the SEC.
It also encouraged continuous assurance and auditing which is already enabled
by enterprise reporting systems (ERPs), provided by software vendors like SAP,
Baan, and Oracle.
To order reprints, call 1-800-352-2210; outside the United States, call 717-632-3535.

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(2008) Fraudulent Financial Reporting Detection. Key Ratios Plus Corporate Governance Factors - Grove & Basilico

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Fraudulent Financial Reporting Detection: Key Ratios Plus Corporate Governance Factors

Author(s): Hugh Grove and Elisabetta Basilico

Hugh Grove and Elisabetta Basilico

Fraudulent Financial Reporting Detection

Concerning financial factors, a probit statistical model of five financial ratios

of the fraud versus nonfraud companies: percentage of board members' commo

primarily univariate in nature, which limited their applicability. A logical extension

Analytical justification for fraud ratio indexes

Quantitative analysis: financial ratio indexes

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telecommunication (78 percent and 67 percent); food service (86 percent a

Qualitative analysis: corporate governance factors

1 . Percent board holdings

p-value (two-tailed) 0.0014

p-value (two-tailed) 0.0053

p-value (two-tailed) 0.089

trading) had surfaced by early September 2001 when Enron's sto

the 19 fraud companies and 19 of the 23 nonfraud companies, as foreign fir

Summary and conclusion

In this paper, the experiences of fraudulent financial reporting companies i

1 . All-powerful CEO: determine if the CEO is also the chairman of the

2. Weak system of management control: determine if insiders (company

3. Focus on short-term performance goals: review company press releases

4. CEO is uncomfortable with criticism: review conference calls with

5. Senior management turnover: review company press releases, especially

7. Weak or nonexistent code of ethics: review any corresponding SOX

8. Independence problems with the company's external auditors: review any

9. Independence problems with the company's investment bankers: review

10. Questionable business strategies with opaque disclosures: review financial

In this paper, it was shown that a combination of quantitative financial ratio

regulators, auditors, investors, financial analysts, and other financial statement

Appendix 1. Ten Typical Fraudulent Financial Reporting Factors for

SOX section 402

Corporate loans to company officers and directors are now prohibited.

SOX section 1105

2. Weak system of management control

The system of internal control (checks and balances, separation of duties, e

SOX section 404

SOX section 407

Auditing standard no. 2

The Public Companies Accounting Oversight Board (PCAOB), created by SOX,

3. Focus on short-term performance goals

SOX section 302

SOX section 401 (b)

4. CEO is uncomfortable with criticism

Enron's performance, called Enron's CEO's conference call a disaster and t

5. Senior management turnover

6. Insider stock sales

SOX section 403

SOX section 304

SOX section 306

7. Weak or nonexistent code of ethics

Company employees are encouraged to push their behavior and financial r

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