Master Thesis

International University of Applied Sciences Bad Honnef · Bonn

IUBH School of Business and Management
International Management

The Analysis and Detection of Financial Statement Fraud

Insa Tönnemann

Supervisor: Prof. Dr. Franz Isselstein

Date of Submission: 10.12.2017

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 ACKNOWLEDGEMENT

First of all, I would like to express my sincere gratitude and appreciation to my supervisor
Prof. Dr. Franz Isselstein for his advice and useful recommendations.

I would like to express my deepest gratitude to my parents for all their love, patience and
inspiration throughout my life.

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 ABSTRACT

„Financial statements tell a story and the story should make sense. If not, it’s possible
the story is a fake”.
W. Steve Albrecht.

The incentives of fraudsters and their patterns applied to mislead stakeholders were
analysed in this study. By examining SDAX and MDAX listed companies between 2010
and 2016, the risk of financial statement fraud in Germany was investigated. The results
of the study show, that the majority of German shares are disclosing a high quality of
financial information. This seems to be related to an effective audit approach of German
audit firms. Nevertheless, irregularities in financial data could be detected by the
application of two accounting-based models, namely Beneish M-Score and Dechow F-
Score. It is recommended to implement these two models into the audit field work.

Key words: Financial Statement Fraud, MDAX, SDAX, M-Score, F-Score

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 TABLE OF CONTENTS

1. INTRODUCTION............................................................................................. 11

1.1 Definition of financial statement fraud ...................................................... 11

1.2 Analytical Procedures ................................................................................ 13

1.2.1 Fraud Triangle ....................................................................................... 14

1.2.1.4 (Perceived) Pressure........................................................................ 15

1.2.1.4 (Perceived) Opportunity.................................................................. 15

1.2.1.4 (Rationalisation) .............................................................................. 16

1.2.2 Fraud Diamond ...................................................................................... 16

2. LITERATURE REVIEW.................................................................................. 17

2.1 Incentives ................................................................................................... 17

2.1.1 Debt Covenant Hypothesis and Borrowing Costs ................................. 17

2.1.2 Executive Incentives.............................................................................. 18

2.1.3 Meeting or beating analysts’ forecasts .................................................... 19

2.2 The line between legality and illegality ..................................................... 20

2.3 Fraud Patterns ............................................................................................ 21

2.3.1 Increase Income...................................................................................... 23

2.3.1.1 Fictitious and misdated transactions ............................................... 23

2.3.1.2 Premature Recognition .................................................................... 24

2.3.1.3 Misclassification ............................................................................. 25

2.3.1.4 Transactions without serving the actual business ............................. 26

2.3.2 Decrease Expenses ................................................................................ 26

2.3.2.1 Shifting or concealing expenses ...................................................... 27

2.3.2.2 Capitalising Expenses ..................................................................... 27

2.3.2.3 Use Provision Accounting .............................................................. 28

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 2.3.2.4 Lengthen Depreciation Lives .......................................................... 28

2.3.3 Misstatement of Asset Values ............................................................... 28

2.3.3.1. Misstating Fixed Assets ................................................................... 29

2.3.3.2 Misstating intangible assets .............................................................. 29

2.3.3.3 Misstatement of Inventory ................................................................ 29

2.3.3.4 Misstating Accounts receivable ........................................................ 31

2.3.3.5 Fictitious Bank Accounts .................................................................. 31

2.3.4 Misstatement of liabilities ....................................................................... 32

2.3.4.1 Accounts Payable.............................................................................. 32

2.3.4.2 Off balance sheet financing .............................................................. 32

2.3.4.3 Reclassifying Debt as Equity ............................................................ 33

2.3.5 Increasing operating cash flows .............................................................. 33

2.4 Costs of Financial Statement Fraud ........................................................... 34

2.4.1 Capital Market Reaction .......................................................................... 34

2.4.2 Lawsuits, delisting and bankruptcies....................................................... 36

2.4.3 Discipline of the labour market ............................................................... 36

2.4.4 Auditor-Client relationship...................................................................... 37

2.5 Auditor’s responsibility.................................................................................. 37

2.6 Auditors’ approach of fraud detection ........................................................... 39

2.6.1 Red Flags Checklists ............................................................................... 39

2.6.2 Fraud Interviews ...................................................................................... 41

2.6.2.1 Content of the interview ................................................................... 41

2.6.2.2 Interview Technique ......................................................................... 42

2.6.2.3 Questions to ask ................................................................................ 43

2.6.3 Analytical Review Procedures ................................................................ 44

2.6.3.1 Application ....................................................................................... 44

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 2.6.3.2 Types of analytical review procedures ............................................. 45

2.6.4 Digital Analysis ....................................................................................... 47

2.6.4.1 Benford’s Law .................................................................................. 47

2.6.4.2 Application in Auditing .................................................................... 49

2.6.4.3 First-Order-Tests............................................................................... 49

2.6.4.4 Number Duplication Tests ................................................................ 50

2.6.4.5 Tests for rounded numbers ............................................................... 51

2.6.4.6 Last-Two Digit Test .......................................................................... 51

2.6.5 Specific audit procedures ........................................................................ 52

3. Existing Research and Hypothesis Development ................................................ 53

3.1 Empirical findings and practitioner’s experience on Fraud Detection .......... 53

3.1.1 Red Flags Checklists ............................................................................... 53

3.1.2 Fraud Interviews ...................................................................................... 54

3.1.3 Analytical Review Procedures ................................................................ 55

3.1.4 Digital Analysis ....................................................................................... 57

3.2 Accounting research’s approach of fraud detection................................... 58

3.2.1 Beneish’s M-Score .................................................................................. 59

3.2.2 Dechow’s F-Score ................................................................................... 60

3.3 Hypotheses Development .......................................................................... 62

4. Methodology and Data ........................................................................................ 63

4.1 Research Approach and Research Design ................................................. 63

4.2 Data Collection .............................................................................................. 64

4.3 Quantitative Data ........................................................................................... 64

4.4 Sample Description ........................................................................................ 65

4.4.1 Sample of misstating firms ...................................................................... 65

4.4.2 Sample of German corporations .............................................................. 66

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 4.5 Model Description.......................................................................................... 67

4.5.1 M-Score ................................................................................................... 67

4.5.2 F-Score .................................................................................................... 70

5. Empirical Results ................................................................................................. 73

5.1 Validity and Reliability .................................................................................. 73

5.2 Research findings ....................................................................................... 73

5.2.1 Hypothesis 1 ............................................................................................ 74

5.2.2 Hypothesis 2 ............................................................................................ 77

5.2.3 Hypothesis 3 ............................................................................................ 79

5.2.4 Hypothesis 4 ............................................................................................ 82

6. Concluding Remarks ........................................................................................... 85

Appendix……………………………………………………………………………. 86

References……………………………………………………………………………. 95

Declaration of Authenticity………………………………………………………… 115

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 LIST OF TABLES

Table 1: Fraud Patterns ............................................................................................ 22

Table 2: Red Flags ................................................................................................... 40
Table 3: Sample Questions for a Fraud Interview ................................................... 43
Table 4: Benford's Law: Expected digital frequencies ............................................ 48
Table 5: M-Score - Relative Costs of Type I and Type II Errors ............................ 60
Table 6: Interpreting F-Score................................................................................... 62
Table 7: Toshiba: M-Scores..................................................................................... 74
Table 8: Lime Energy: M-Scores ............................................................................ 74
Table 9: Marrone Bio Innovations: M-Scores ......................................................... 75
Table 10: Miller Energy M-Scores .......................................................................... 76
Table 11: Diamond Foods M-Scores ....................................................................... 76
Table 12: KTG Agrar M-Scores .............................................................................. 77
Table 13: Diamond Foods F-Scores ........................................................................ 78
Table 14: Lime Energy F-Scores ............................................................................. 79
Table 15: KTG Agrar F-Scores ............................................................................... 79

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 LIST OF FIGURES

Figure 1: Fraud Triangle .......................................................................................... 15

Figure 2: Operational Structure of Analytical Review Procedures ......................... 45
Figure 3: M-Scores of MDAX and SDAX .............................................................. 80
Figure 4: Capital Stage M-Score Variables ............................................................. 81
Figure 5: Zeal Network M-Score Variables ............................................................ 82
Figure 6: F-Scores of MDAX and SDAX ............................................................... 83
Figure 7: Bertrandt AG F-Score variables ............................................................... 84
Figure 8: Zooplus F-Score variables ........................................................................ 84

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 LIST OF ABBREVIATIONS

F……………………………..Framework International Financial Reporting Standards

GAAP……………………………………...Generally Accepted Acocunting Principles

IDW……………………………………………………....Institut der Wirtschaftsprüfer

IDW PS………………………………..Institut der Wirtschaftsprüfer Prüfungsstandard

IFRS………………………………………International Financial Reporting Principles

ISA……………………………………………..…,,International Standards on Auditing

SIC………………………………………..,,,,,,,,,,,,,,Standing Interpretations Committee

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 1. INTRODUCTION

The efficient functioning of capital markets is highly dependent on the quality of

financial information disclosed (Healy & Palepu, 2001). Financial statements are expected
to give a true and fair view of the assets, liabilities, financial position and profit or loss of
the company. One might say, financial disclosure is starting point for management to
communicate with stakeholders (Healy & Palepu, 2001). On the basis of financial
statements, investment decisions are made and the initiation or continuation of business
relationships is discussed. For this purpose, the accounting documents of certain types of
companies are subject to statutory auditing. By verifying their compliance with General
Accepted Accounting Principles (GAAP), existing information asymmetries are decreased
such that stakeholders can easily distinguish healthy companies from risky assets (Becker et
al., 1998, Healy & Wahlen, 1999).
But in reality, things have turned out differently. Major corporate scandals like
Enron, WorldCom or Parmalat revealed faults in the system as managers along with
accountants committed financial statement fraud deceiving stakeholders on a large scale. A
further issue was that auditors did not detect these massive misrepresentations. In case of
Enron, the assigned chartered accountant Arthur Andersen was even involved in the scandal.
Because of the serious financial damage caused by financial statement fraud, significant
interest exists in the early detection of fraudulent actions.

In this paper, I will analyse the motivation and incentives for managers to violate
GAAP and comprehensively explain commonly applied fraud patterns. In this context, it is
important to clearly define the term financial statement fraud and to conceptually distinguish
it from earnings management which not necessarily breaches legal accounting practices.
Subsequently, I would like to examine customary audit procedures adopted to detect
financial statement fraud. Furthermore, I will investigate the incidence of undetected
financial statement fraud in German issued corporations. I will analyse financial statement
data using two commonly known accounting-based models, namely Beneish’s M-Score and
Dechow’s F-Score.

1.1 Definition of financial statement fraud

The objective to fully understand and detect financial statement fraud requires a
proper definition of the term fraud, particularly with regards to its meaning in context with
financial statements. Black’s Law Dictionary (8th ed. 2004) defines fraud as “a knowing

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misrepresentation of the truth or concealment of a material fact to induce another to act to
his or her detriment”. According to Elliott and Willingham (1980) management fraud is
“deliberate fraud committed by management that injures investors and creditors through
misleading financial statements” (p.4). By simply modifying Healy and Wahlen’s definition
of earnings management (1999), Perols and Lougee (2011) define financial statement fraud
as follows: “Financial statement fraud occurs when managers use accounting practices that
do not conform to GAAP to alter financial reports to either mislead some stakeholders about
the underlying economic performance of the company or to influence contractual outcomes
that rely on reported accounting numbers” (p. 40). GAAP is “a common set of standards and
procedures for the preparation of general-purpose financial statements that have either been
established by an authoritative accounting rule-making body, (…), or over time have become
accepted practice because of their universal application” (Mulford & Comiskey, 2002, p.
52). The terms management fraud and financial statement fraud have been used
interchangeably over the years as management is responsible for financial reporting (Rezaee
& Riley, 2009). All these definitions have in common that financial statement fraud
constitutes an intentional manipulation of financial statements which aims at deceiving
external users.
In the Anglo-American sphere, financial statement users apply the presentation of
the Association of Certified Fraud Examiners (ACFE) to characterise fraud (Hofmann,
2008). ACFE defines financial statement fraud as “the deliberate misrepresentation of the
financial condition of an enterprise accomplished through the intentional misstatement or
omission of amounts or disclosures in the financial statements to deceive financial
statements users”. In this context, ACFE has developed the “Occupational Fraud and Abuse
Classification System” also known as “Fraud tree” which depicts different fraudulent actions
and categorises occupational fraud into corruption, asset misappropriation and financial
statement fraud. Each of these categories is broken down into several subcategories (ACFE,
2016.
Following international aspirations, Institut der Wirtschaftsprüfer (Institute of Public
Auditors in Germany) (IDW) promulgated generally accepted standards for the review of
financial statements in Germany. The auditing standard “IDW PS 210: Zur Aufdeckung von
Unregelmäßigkeiten im Rahmen der Abschlussprüfung” deals with the detection of
misstatements as part of the audit engagement. Its rules and regulations are in accordance
with the International Standard on Auditing (ISA) 240 and ISA 250 codified by the
International Auditing and Assurance Standards Board (IAASB). IDW PS 210 initially

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separates material misstatements in the financial statements from other violations of law, as
the latter are of no interest for the purposes of IDW. The misstatement of the financial
statements can result from either “fraud” or “error” (IDW PS 210). The latter are an
aftereffect of unintentional actions such as typing and calculation errors, unconscious
misapplication and accidental overlooking of accounting principles (IDW PS 210.7).
Furthermore, they can be caused by incorrect assumptions according transactions (IDW PS
210.7).
On the contrary, fraud always occurs as a consequence of intentional behaviour (IDW
PS 210.7). It includes fraudulent financial reporting and misstatements resulting from
misappropriation of assets. Fraudulent financial reporting is accomplished by the
manipulation, falsification or alteration of accounting records or supporting documentation
from which the financial statements are prepared (IDW PS 210.7, ISA 240.A3).
Furthermore, fraudsters misrepresent events, transactions or other significant information in
the financial statements and deliberately misapply accounting principles (IDW PS 210.7,
ISA 240.A3). Financial statement fraud can be committed by legal representatives,
supervisory bodies, employees and in some cases assisted by third parties (IDW PS 210.7).
It is often characterised by the management override of controls that otherwise may appear
to be operating effectively (IDW PS 210.7, ISA 240.A3). Misappropriation of assets includes
the unlawful appropriation or reduction of corporate assets as well as the increase of legal
obligations. This especially includes embezzlement and theft. It has to be stated that
misappropriations of assets only constitute a misstatement of financial statements in the
sense of IDW PS 210 provided that they reflect a misrepresentation in the financial
statements. In other respects, they have to be classified as other violations of the law.
Following IDW PS 210, this study concentrates on violations of law which result in
misstatements in the financial statements.

1.2 Analytical Procedures

In business administration and economics, researchers have developed several
geometric figures to vividly explain complex phenomena (Hofmann, 2008). In this context,
the “fraud triangle” and the “fraud diamond” were devised to constitute the circumstances
needed for white-collar criminals to commit fraud.

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 1.2.1 Fraud Triangle
The “Fraud Triangle” was once created by Donald R. Cressey (1953) who
investigated the origin of fraud within the scope of his dissertation. While interviewing
violators (among them were accountants, bankers, business executives and independent
businessmen), he identifies three common characteristics leading to criminal activities
(Cressey, 1953). Firstly, the perpetrators have the opportunity to commit fraud. Secondly,
they feel an individual perceived, non-shareable financial need (pressure). And thirdly, they
rationalise their behaviour, as “trust violators usually consider the conditions under which
they violated their own positions of trust as the only “justifiable” conditions” (Cressey, 1953,
pp. 140-141). In the following years, many researchers examined the relation between the
three factors of the fraud triangle. Romney, Albrecht and Cherrington (1980), express their
findings in an additive model:

Fraud = Pressure + Opportunity + Character

This model hypothesises that it does not depend on the single values of the three
variables to assume fraud (Romney et al., 1980). In fact, the total amount of the formula is
of importance, meaning that one variable has the power to substitute another (Romney et al.,
1980). Following this assumption, “a fraud could theoretically occur under any situation if a
person is motivated enough, even in the absence of outward opportunities or pressures”
(Romney et al., 1980, p. 64). From a logical point of view this cannot be true. If there is no
opportunity to break the rules, it will be impossible for the individual to implement its
preconceived plan of committing fraud (Terlinde, 2005).

Thereupon, Loebbecke et al. (1989) developed another model to assess the likelihood
of fraud, consisting of the three factors condition, motivation and attitude. According to their
interpretation there have to be appropriate conditions in the organisation such that a fraud
can be committed. Additionally, the potential perpetrators have to be motivated (Loebbecke
et al., 1989). The attitude or set of ethical values allowing themselves “to knowingly commit
a dishonest, criminal act” is an absolute precondition of committing fraud (Loebbecke et al.,
1989, p. 4). In contrast to Romney et al. (1980), Loebbecke et al. (1989) come to the
conclusion that the requirements of all single factors have to be fulfilled in order to assume
a high probability of fraud:

P (Material Irregularities) = f (Condition, Motivation, Attitude)

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favourable when the company has a weak board of directors, inadequate internal controls,
or complex, impermanent organisational structures (Albrecht et al., 2008, Hofmann, 2008).
Moreover, managers frequently take advantage of certain responsibilities to circumvent
controls (management override) (Behringer, 2014). Reversely, the likelihood of committing
fraud is low, when managers fear the detection of their unlawful behaviour (Albrecht et al.,
2008).
1.2.1.4 (Rationalisation)
Fraudsters use explanations to justify their behaviour as acceptable. In doing so, they
pretend that their actions pursue an overarching goal and they talk themselves into believing
the legitimacy of their criminal approach (Duffield & Grabosky, 2001). This behaviour
pattern is called neutralisation and includes different techniques (Duffield & Grabosky,
2001). Committing fraud in a large company is often excused on the spurious ground of not
causing damage, arguing “they can afford it” (Duffield & Grabosky, 2001). Furthermore,
fraudsters relativize their practices by pretending to pursue necessary business practices: “all
companies use aggressive accounting practices” (Duffield & Grabosky, 2001, Albrecht et
al., 2004, p. 118). Additionally, many perpetrators reassure themselves by asserting to
support the long-term success of the company, “we need to keep the stock price high” or
“the problem is temporary and will be offset by future positive results” (Albrecht et al., 2004,
p. 118).
1.2.2 Fraud Diamond
Wolfe and Hermanson (2004) supplement the three factors of the fraud triangle by a
fourth element, creating a four-sided fraud diamond.
The researchers argue, that the three factors pressure, opportunity and rationalisation
are not sufficient conditions to commit fraud, rather the individual’s capability would be
decisive (Wolfe & Hermanson, 2004). From their point of view, potential perpetrators must
have specific skills and traits to realise their preconceived plans (Wolfe & Hermanson,
2004). Capability assumes a certain hierarchy level and area of responsibility which allows
the individual to commit fraud (Wolfe & Hermanson, 2004). Moreover, the “capable” person
needs to be smart and confident to outwit the organisation’s control systems while not being
detected (Wolfe & Hermanson, 2004). Therefore, a successful white-collar criminal is
effective in consistent lying and has a high level of stress tolerance in order to deal with the
permanent risk of detection (Wolfe & Hermanson, 2004). Another significant competence
is the ability to coerce others to join or at least not report the activity (Wolfe & Hermanson,
2004).

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 However, it is questionable whether the term “capability” added by the fraud
diamond really constitutes a new research finding in order to explain the occurrence of fraud.
Critics argue that the requirements of capability are already included in the factors
motivation and opportunity of the fraud triangle (Nimwegen, 2009 in Boecker & Zwirner).
In the audit industry, it is a widespread opinion that the three factors presented by the fraud
triangle are adequate to outline the conducive circumstances of fraud (Behringer, 2014). The
IAASB applies the fraud triangle as reference model in IAS 240 regulating “The Auditor’s
Responsibilities relating to fraud in an audit of financial statements”. The same goes for the
American audit profession (Behringer, 2014).

2. LITERATURE REVIEW
2.1 Incentives
After determining the circumstances which in general cause fraudulent actions, one
has to consider employees’ motivations to specifically misstate financial statements.
Understanding the incentives of executives to commit financial statement fraud is “a
necessary precursor to effectively preventing future occurrences” (Erickson et al., 2006, p.
114).
Over the last decades, accounting research has extensively investigated perpetrator’s
motives to manage earnings. Kellog and Kellog (1991) find evidence that the primary
reasons for earnings management are the need to raise capital and the target to continuously
increase shareholder’s value (Dechow et al., 1996, p. 4). Although earnings management
and financial statement fraud are different in so far that the latter invariably violates GAAP,
both have the same objective (Perols & Lougee, 2011). Their shared aim is to “either mislead
some stakeholders about the underlying economic performance of the company or to
influence contractual outcomes that rely on reported accounting numbers” (Perols & Lougee,
2011, p. 40). Therefore, the findings concerning executives’ incentives to manage earnings
are as well applicable in order to explain the occurrence of financial statement fraud. In
accordance with the latest academic research, the most important incentives for earnings
management are the debt covenant hypothesis in connection with borrowing costs, the bonus
hypothesis and the meeting or beating of analysts’ forecasts.

2.1.1 Debt Covenant Hypothesis and Borrowing Costs

A large body of accounting research examines the influence of debt covenants and
borrowing costs on management’s strategy concerning accounting policy choices (Dichev
& Skinner, 2002). Debt covenants constitute contractual agreements between the lender and

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the borrower regulating the borrower’s compliance with certain key performance indicators.
The purpose of debt covenants is to restrain managers from courses of action which would
jeopardise the orderly repayment of the loans (DeFond & Jiambalvo, 1994). Managers have
to constantly monitor the financial development of their companies in order to meet the
specific accounting-based requirements (Mulford & Comiskey, 2002). In this context, the
question rises to what extent these conditions exert pressure on employees to exceed legal
limitations. Positive accounting theory hypothesises that debtors engage in earnings
management when facing the violation of contractually agreed financial measures (Debt
Covenant Hypothesis) (Watts & Zimmermann, 1986 in DeFond & Jiambalvo, 1994).
Companies will mislead about their financial performance and their financial position
because interventions by the creditors are feared (Watts & Zimmermann, 1986). This is
particularly the case, when the costs of non-compliance with debt covenants are significant
(Dichev & Skinner, 2002). Even if managers cannot avoid default, they still have the
intention of deceiving creditors in order to “improve their bargaining position in the event
of renegotiation” (DeFond & Jiambalvo, 1993). This behaviour is also applied long before
the first contractual negotiations (Mulford & Comiskey, 2002). By presenting high earnings
power and a strong balance sheet, debtors endeavour to convince creditors of a low default
risk hoping that they are charged less interest. Dechow et al. (1996) coincide with the debt
covenant hypothesis stating that managers employ legally questionable or even illegal
accounting choices in order to observe their contractually-fixed requirements. (Dechow et
al., 1996). However, some kind of short-sightedness is noted in this procedure. The
consequences of detecting earnings manipulation should not be underestimated, as “capital
market imposes substantial costs on firms revealed to be manipulators” (Dechow et al., 1996,
p. 3). Furthermore, the credibility of the fraudulent entity is seriously called into question.
Similar studies of DeFond and Jiambalvo (1994) and Franz et al. (2014) support the debt
covenant hypothesis.

2.1.2 Executive Incentives

In recent years, there have been discussions whether executive incentives in terms of
managerial ownership lead to earnings management. Actually, the idea of managerial
ownership is to align the incentives of managers with those of shareholders, such that the
former are motivated to maximise the shareholder’s value (Erickson et al., 2006). For this
purpose managers receive shares or the right to obtain shares provided that the company is
performing successful (Mulford & Comiskey, 2002). However, regulators and investors

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have raised concerns about the influence of share-based compensation plans. Critics fear an
opposite effect, as managers could be encouraged to personally enrich themselves and thus
disregard their fiduciary duties. (Cheng & Warfield, 2005, Erickson et al., 2006) Whereas
Dechow et al. (1996) do not find systematic evidence for this hypothesis, Beneish (1999)
ascertains insider trading. Beneish (1999) determines that managers illegally overstate
earnings in order to profit from inflated prices. Therefore, they would have a particular
interest “to sell their equity holdings and cash-in their equity contingent compensation prior
to the public discovery of the overstatement” (Beneish, 1999, p. 454). Fraudsters would
proceed in this way because they know that once earnings manipulation is detected share
prices will decrease resulting in significant shareholder’s losses (Beneish, 1999). Summers
and Sweeny (1998) come to the same conclusion. They uncovered that fraudsters “reduce
their holdings of company through high levels of selling activity as measured by either the
number of transactions, the number of shares sold, or the dollar amount of shares sold”
(Summers & Sweeny, 1998, p. 131). Interpreting these findings, executive incentives seem
to encourage fraudulent behaviour in two stages. Firstly, share-based payment envisages
managers to manipulate earnings (legally or illegally). And secondly, managers exploit the
previously created effect of inflated prices by selling their overvalued shares.

2.1.3 Meeting or beating analysts’ forecasts

Many investors rely on the professional judgment of financial analysts to value
shares. This can be explained by the need for immediate financial information, which is not
provided by the current financial reporting system (Cox & Weirich, 2002). As companies
are solely obliged to disclose quarterly and annual reports, analysts’ forecasts play a major
role in valuing shares (Cox & Weirich, 2002). One capital market expectation hypothesis
predicts that earnings management occurs for the purpose of meeting or beating analysts’
forecasts (Perols & Lougee, 2011, Burgstahler & Eames, 2006). The overall aim of this
approach is to boost share prices on a sustainable basis (Healy & Wahlen, Commentary,
1999). Evidence shows that companies which continuously report increasing earnings
power, achieve higher price-earnings ratios than average performers (Barth et al., 1999).
This can be explained by the fact that “patterns of increasing earnings are positively
correlated with proxies for growth and negatively correlated with proxies for risk” (Barth et
al., 1999, p. 410). Thus, growth shares conversely suffer large price decreases in case they
report a declining development (Skinner & Slown, 2002). As share prices will be
immediately revised downwards, managers are highly motivated to avoid the announcement

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of negative earnings surprises (Lakonishok et al., 1994). For this reason, executives regard
earnings management as an acceptable solution (Burgstahler & Dichev, 1996). Later
research of Burgstahler and Eames (2006) supports the previous findings. They confirm that
the high frequency of recognising “zero and small positive surprises” in contrast to the
infrequent reporting of losses results from accountants’ interventions (Burgstahler and
Eames, 1996, pp. 650-651). Arbabanell and Lehavy (2003) further investigate financial
analysts’ stock recommendations to predict the occurrence of earnings management.
Managers of shares receiving “buy” recommendations seem to be regularly involved in
earnings management to meet prospective analysts’ forecasts (Arbabanell & Lehavy, 2003).
On the contrary, companies which receive “sell” recommendations do not hesitate to show
negative unexpected accruals (Arbabanell & Lehavy, 2003). While researchers mostly
concentrate on the relation between analyst’s forecasts and legal earnings management,
Dechow et al. (2011), specifically observed managers’ motivation to commit financial
statement fraud. According to their findings, managers of fraudulent companies report
unusually strong earnings and share price performance over a longer period. Later on, this
puts pressure on managers “covering up a slowdown in financial performance in order to
maintain high stock market valuations” (Dechow et al., 2011, p. 77). Thus, managers are
highly incentivised to legally or even illegally manage earnings for the purpose of meeting
or beating analysts’ forecasts.

2.2 The line between legality and illegality

Accountants, responsible for the preparation of the monthly, quarterly and annual
statements, are in a position to mislead stakeholders about the underlying economic reality
of their company (Vladu et al., 2016). In order to influence the respective financial results,
various accounting practices can be adopted. According to GAAP, accountants are generally
allowed to choose between accounting policies and to decide upon the application of certain
principles. The purpose of this flexibility is “to keep path with business innovations” (Levitt,
1998 in Melumad & Nissim, p. 96). Therefore, not all practices “that may be described as
earnings management are illegal” (Sauer, 2002, p. 957). By benefiting from accounting
flexibility, it rather depends on the executives’ responsibility to respect the line between
legality and illegality (Healy & Wahlen, Commentary, 1999). According to Mulford and
Comiskey (1996), “earnings management is the active manipulation of accounting results
for the purpose of creating an altered impression of business performance” (Mulford &
Comiskey, 2002, p. 360). Evidence shows that the form of earnings management applied, is

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often closely related to the financial condition of the company (Schirmeister & Siebold,
2008). Although earnings management is mainly associated with earnings overstatement, it
also includes accounting choices which lead to understated earnings (Melumad & Nissim,
2009). During successful fiscal years in which a company generates high profits, earnings
are often adjusted conservatively in order to reduce tax payments and dividend distribution
(conservative accounting). On the contrary, management commonly strives a better
presentation of the real economic situation provided that financial performance is declining
(Schirmeister & Siebold, 2008). In this situation, accountants may aggressively apply
accounting principles, highly extending the scope of GAAP (Mulford & Comiskey, 2002).
The target of aggressive accounting is to mislead about the company’s success, by reporting
higher earnings and presenting a stronger balance sheet (Mulford & Comiskey, 2002).
Whereas some managers exploit legal opportunities, others violate GAAP to deceive
financial statement users. Identifying the line which separates aggressive accounting from
fraudulent financial reporting may be difficult, as it sometimes constitutes a fluent transition
(Mulford & Comiskey, 2002). Fraudulent financial reporting as a special case of earnings
management is under any circumstances outside of GAAP and thus invariably illegal
(Dechow & Skinner, 2000, Erickson et al., 2006). It includes “intentional misstatements or
omissions of amounts or disclosures in financial statements (…) that are determined to be
fraudulent by an administrative, civil, or criminal proceeding” (Mulford & Comiskey, 2002,
p. xx). Provided that fraudulent financial reporting causes a detriment effect on financial
statement users, it constitutes financial statement fraud (Mulford & Comiskey, 2002).

2.3 Fraud Patterns

Over the last decades certain fraud patterns have been repeatedly applied, affecting
the fair presentation of financial statements. Fraudsters materially misstate financial
accounts by exceeding legal framework of accounting flexibility or alternatively by
recognising fictitious transactions (Jones, 2011). Whereas the latter practice clearly
constitutes financial statement fraud, the unlawfulness of the former can depend on the
choice and application of the particular financial reporting principles.
Generally speaking, there are five different approaches to commit financial statement
fraud, depending on the individual motivation and incentive of the perpetrator (Jones, 2011).
The first two approaches imperil the integrity of the income statement (Jones, 2011). Against
the background of meeting analyst’s forecasts, managers might illegally polish up profits.

21
 It can be stated that most of the world’s capital markets adopt IFRS, which is
promulgated by the IASB (PwC – IFRS Adoption by country). At EU level, IFRS comes
into effect within the scope of a specific endorsement procedure. In contrast, companies with
headquarters in the US apply US GAAP which is published by FASB. Although both
standards contain the same or at least similar basic principles and conceptual frameworks,
leading to comparable accounting results, there are differences as well (US GAAP vs. IFRS
Dec 2011, EY). Against the background that German preparers of financial statements adopt
IFRS, the fraudulent financial reporting methods presented in the following are analysed
according to IFRS. Special fraud schemes, common in the US, are explained by US-GAAP.

2.3.1 Increase Income

According to the IASB Framework, income mainly consists of revenue generated “in
the course of the ordinary activities of an enterprise” (F.74). As such it constitutes “increases
in economic benefits during the accounting period” resulting from “the sale of goods, the
rendering of services and the use by others of entity assets yielding interest, royalties and
dividends” (IAS 18, 18.1).
Since management’s performance is closely related to its ability of generating
continuous revenue growth, revenue is particularly affected by manipulation.
Over the last decades “the proper recognition of revenue has caused considerable difficulty,
disagreement and controversy in the accounting profession” (Hurtt, 2000, p. 51). The legal
treatment of revenues is regulated by IAS 18, Revenue.

2.3.1.4 Fictitious and misdated transactions

Fictitious transactions represent the most common form of revenue fraud schemes,
requiring high criminal energy of the perpetrators. These frauds involve fake customers and
complicity or at least ignorance of business partners in order to report revenues without any
future economic benefit (Sauer, 2002). Well aware of the fact that auditors consider revenue
with professional scepticism, perpetrators perform several acts of deception. Documents
such as invoices and delivery notes are forged and staff is instructed to transport goods
between company’s warehouses to deceive about the products sold (Sauer, 2002, Hofmann,
2008). Some entities even contain manipulations in collaboration with third parties or related
parties (Hofmann, 2008). In case of the latter, sham transactions are carried out with
affiliated companies not in scope of the audit.
The objective of misdating transactions is to report revenues which are actually “borrowed
from future periods” (Sauer, 2002, p. 972). At the end of posting period, accountants adjust

23
their computer clocks for the purpose of backdating invoices, packing lists and shipping
records (Sauer, 2002). While content and scope of the ordering processes are displayed
correctly, the time of physical delivery is presented in a manner that is false (Hofmann,
2008). This means, accountants are capable of recognising revenue on product sales, which
actually will be ordered and delivered in the subsequent accounting period (Hofmann, 2008).
However, it has to be stated that most booking software and internal control systems will not
enable such a manipulation.

2.3.1.4 Premature Recognition

Likewise the before mentioned schemes, companies recognise revenue prematurely
to improve entity’s performance in the current period. This means an entity has already
reported revenue, even though the transfer of risk and rewards has not yet taken place or the
increase in economic benefits is uncertain.
Arthur Levitt, chairman of the Securities and Exchange Commission, explained the
curiosity of these procedures in his speech, “The Numbers Game,” presented September 28,
1998 at New York University, by the following statement:
“Think about a bottle of fine wine. You wouldn’t pop the cork on that bottle until it
was ready. But some companies are doing this with their revenue – recognising it before a
sale is complete, before the product is delivered to a customer, or at a time when the customer
still has options to terminate, void or delay the sale” (Hurtt et al., 2000, p. 53).
A classic case of premature revenue recognition is the deception about side letters
regulating that contractual performance predicates on certain conditions. Accountants record
sales although the receipt of payments depends on the occurrence of a future event beyond
the supplier’s control (Sauer, 2002). For example, suppliers may agree to defer cash
collection until customers obtain a grant from a third party or retailers successfully resell the
product (Sauer, 2002).
Similarly, sales with right of return are recognised by accountants although the
transactions have only “little underlying substance” or can be “easily dismissed as simply
illusory” (Sauer, 2002, p. 970). This includes for example the sale of dysfunctional products
needing further development or repair work to function smoothly (Sauer, 2002). In these
cases, the supplier takes into account that the customer is inhibited to make direct use of the
purchased goods and will later reverse the sale (Sauer, 2002).
The practice of channel stuffing, also known as trade loading, is as well
controversially discussed in accounting profession. The idea behind channel stuffing is the

24
encouragement of retailers to buy products in advance of their actual needs by promising
huge discounts, extended payment terms and favourable financing options (Sauer, 2002).
Channel stuffing constitutes fraud once the collectability of accounts receivable is highly
questionable (Wells, 2011). Therefore, side letters containing rights of return to unburden
retailers from unsaleable products are impermissible (Sauer, 2002). A risk transfer is rejected
in case suppliers offer an unlimited take-back of products with short expected shelf life
(Wells, 2011). The same applies to agreements allowing retailers to delay sales until products
are resold to end customers (Principles of Fraud Examination, Anti-Fraud-Management).
Furthermore, fraudsters preferably abuse exception rules created by the legislator in
order to respond efficiently to an economic approach. IASB specifically regulates the
accounting treatment of revenue and costs from long-term contracts. According to the
percentage-of-completion method, contract revenue and contract costs are allocated to the
respective accounting periods in which construction work is performed (IAS 11). This
approach is justified with the nature of the activity undertaken in construction contracts (IAS
11). Because the construction of an asset or a combination of assets usually extends over a
longer time, beginning and completion fall into different accounting periods (IAS 11). By
gradually recognising revenue, the company’s accomplishments are accurately represented
(Hurtt, 2000). However, the disadvantage of this method is its susceptibility to manipulation
(Wells, 2011). Typically, fraudulent companies deliberately overestimate the respective
project status in order to allocate more revenue to earlier accounting periods (Hurtt, 2000).

2.3.1.4 Misclassification
Against the background that loans and sales are both booked as credits in the
accounts, perpetrators exploit this systematic by classifying loans as income (Jones, 2011).
Moreover, fraudsters attempt to misallocate revenue, by misleading about what has been
sold (Sauer, 2002). Revenue from the rendering of services is illegally declared as revenue
from product sales in order to avoid a stage-of-completion accounting (IAS 18.20, IAS
18.21).
A preferred fraud scheme in the US is the misreporting of hybrid transactions,
consisting of a combination of sale of goods, provision of consulting and development
services (Sauer, 2002). Under US-GAAP, suppliers are not allowed to recognise revenue
from the product sale, for example the sale of a licence or software, unless it can be
interpreted as an independent contract (Sauer, 2002). Otherwise the revenue has to be
recognised over time along with the revenue of the rendering of the services (Sauer, 2002).

25
In order to prevent the misstatement of revenues arising from multiple-element
arrangements, IASB has issued detailed legal regulations in IFRS 15.

2.3.1.4 Transactions without serving the actual business

Evidence shows the ingenuity of certain industries creating transactions with the sole
aim of artificially boosting revenue. The best known are contract designs such as barter
transactions and round trip trading.
A barter transaction constitutes a business practice concluded with the aim of
profiting from spare capacity (Melumad & Nissim, 2009). It contains provision and
obtainment of advertising services but does not necessarily require the exchange of money
(SIC-31). Barter transactions do regularly not affect the reported net profit, as both revenue
and expenses are recognised, but mislead investors about the level of sales revenue
(Melumad & Nissim, 2009). The difficulty of properly reporting revenue from barter
transactions is to find the fair value of the underlying transaction. According to SIC 31.5,
“the seller has to compare it with a frequently occurring non-barter transaction involving
similar advertising”. Accountants take advantage of this scope for assessment by overstating
their provision of services (Sauer, 2002). Moreover, accountants commit fraud, when
pretending to acquire fictitious services (Sauer, 2002). Other companies violate GAAP by
capitalising expenses of the transactions as CAPEX in order to overstate net profit (Melumad
& Nissim, 2009, p. 119).
Round trip trading is a market-manipulation practice which is popular in energy and
telecommunications industry comprising the trading with unused capacities (Hofmann,
2008). The term round trip trading can be explained by the fact that these transactions are
operated through circles of companies which are all owned by one main actor (Melumad &
Nissim, 2009). The objective of these artificial trades is to fraudulently recognise additional
revenue (Melumad & Nissim, 2009). Even though, expenses are increased by this procedure
and all things considered no value is added, a higher demand can be suggested (Hofmann,
2008). Furthermore, the involved companies are capable of boosting the balance sheet total
(Melumad & Nissim, 2009).

2.3.2 Decrease Expenses

Profit can be boosted in two ways, either by increasing revenue or by decreasing
expenses. However, evidence shows understatement of expenses is less common than
overstatement of revenue (Sauer, 2002). This can be explained by the fact that design
possibilities of the latter are restricted by their nature (Sauer, 2002). “The understatement of

26
expenses is limited to their actual amount” in contrast to the enormous potential of creating
fictitious revenue (Sauer, 2002, p. 975). According to Callen et al. (2008), especially for loss
firms expenses are not particularly important because company’s market value is more likely
related to the ability of generating higher revenues. Nevertheless, accountants apply various
strategies to mislead about the actual amount of expenses.
Expenses by definition encompass losses as well as those expenses that arise in the
course of ordinary activities, including, for example, cost of sales, wages and depreciation
(F78). The reporting of expenses underlies the application of the matching principle, which
is “arguably the most important theoretical underpinning for the traditional income statement
approach to financial reporting” (Jin et al., 2014). Under this basis, expenses are recognised
when they occur and reported in the financial statements of the periods to which they relate
(F22). Consequently, expenses have to be reported in the same period as revenue because
these would not have been occurred without the former (Mulford & Comiskey, 2002).

2.3.2.4 Shifting or concealing expenses

While fraudsters attempt to recognise revenue at earlier accounting periods, they
reversely aim at shifting expenses to later accounting periods. However, the most efficient
method to improve results is probably the concealment of expenses (Wells, 2011). This
needs less effort than falsifying journal entries and is considered relatively reliable as
auditors experience difficulties detecting missing transactions (Wells, 2011). Perpetrators
simply destroy supplier invoices, throw them away or hide them in boxes or cabinets (Wells,
2011). Pretending that expenses do not exist, they are not recorded in the income statement.

2.3.2.4 Capitalising Expenses

The improper capitalisation of expenses is a typical strategy to increase profit in the
current posting period (Jones, 2011, Mulford & Comiskey, 2002). Certainly, the legislator
has recognised that the strict application of the matching principle might be inappropriate
with regard to certain types of assets. Assets which are acquired in order to serve production
and business operations generate economic benefits over several accounting periods (F. 96).
Their underlying expenses should not be directly recognised but rather allocated in the
income statement on the basis of systematic and rational allocation procedures (F.96). This
accounting treatment is reasonable for expenses which are associated for example with the
using up of property, plant and equipment. Ignoring these requirements, fraudsters as well
capitalise other expenses such as costs of goods sold or R&D costs. The accountants simply
exploit the basic nature of accounting (expenses and assets are both entered on the debit side

27
of the respective accounts) and cover up the origin of the recorded expenses (Jones, 2011).
Through capitalising expenses, total assets are increased in the amount of the expense and
costs are spread over the following posting periods.

2.3.2.4 Use Provision Accounting

A company which plans to increase profits, may think about minimising the expenses
recorded as provisions (Jones, 2011). According to IAS 37.14, a provision shall be
recognised as liability when an entity has a present obligation and this obligation can be
reliably estimated. As the amount recognised as a provision shall be the best estimate with
regards to the present obligation its measurement has to be reviewed and adjusted at the end
of the reporting period (IAS 37.59). Thus, the valuation of provisions is particularly
vulnerable to misjudgement and manipulation. Accountants commit financial statement
fraud by deliberately understating the amount an entity would rationally pay to settle the
obligation (IAS 37.37). Furthermore, it is illegal to arbitrarily reverse provisions ignoring
the requirements of a reliable review (Hofmann, 2008).

2.3.2.4 Lengthen Depreciation Lives

As mentioned in chapter 2.3.2.2, it needs a systematic allocation procedure to
reasonably record expenses associated to items providing economic benefits over several
accounting periods. This accounting treatment is called depreciation. It is significant to
realise that depreciation is not a valuation process meaning that the items are measured at
cost and not according to market or fair value (Melumad & Nissim, 2009).
In order to decrease the annual depreciation expense, a straight-forward fraud pattern
is to misstate the depreciation period of the underlying asset (Jones, 2011, Mulford &
Comiskey, 2002). By extending the useful life or available use, the costs of the item are
allocated to a longer period (Jones, 2011). Consequently, the periodic depreciation charge is
lower, which increases operating profit.

2.3.3 Misstatement of Asset Values

A clear separation between “income statement fraud” and “balance sheet fraud” is
impossible. The reporting of earnings, especially the attempt to decrease expenses by
capitalising them as assets, has direct influence on the balance sheet total. However, certain
fraud schemes solely intend the misstatement of asset values, incidentally having an effect
on company’s earnings (Sauer, 2002).

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 2.3.3.1. Misstating Fixed Assets
A typical fraud scheme for the purpose of inflating balance sheets includes the
recognition of fictitious assets (Wells, 2011). Considering balance sheet equilibrium,
perpetrators simultaneously adapt the liabilities side by the same amount. In most cases, the
corresponding account misused for this purpose is the owner’s equity account (Wells, 2011).

Another frequently applied strategy is the overstatement of fixed assets by

manipulating the initial measurement of the asset. Accountants, for example, misstate the
original purchase price or add costs which are not directly attributable costs. The legitimacy
of subsequent measurement depends on the company’s accounting standard adopted.
Regardless of value appreciations, the US-GAAP standard setter prohibits the revaluation of
assets. Therefore, many fraud schemes in the United States contain the inflation of assets by
reporting at market values, or recognising even higher values without having a sufficient
valuation basis (Wells, 2011). By contrast, IFRS permits revaluation provided that it can be
measured reliably (IAS 16.31). Accountants commit fraud by subjectively manipulating the
revaluation of assets. Another fraudulent behaviour violating both US-GAAP and IFRS is
the deliberate failure to record depreciation (Wells, 2011).

2.3.3.2 Misstating intangible assets

Intangible assets are commonly misstated during mergers and acquisitions. Ignoring
the actual acquisition price, managers overstate the amount to be capitalised by increasing
allocation to goodwill or other intangibles (Mulford & Comiskey, 2002). Similar to the
fraudulent procedures concerning fixed assets, accountants illegally extend the amortisation
periods for intangibles.

2.3.3.3 Misstatement of Inventory

Inventory is the raw materials, work-in-progress and finished goods held by a
commercial or industrial enterprise to be sold (Byington & Christensen, 2003). A correct
measurement of inventory is essential because when inventories are sold, the carrying
amount of those inventories shall be recognised as an expense. (IAS 2.34). Therefore, a
misstatement in the inventory account has a direct effect on company’s net income (Mulford
& Comiskey, 2002). Evidence shows that inventory is one of the most manipulated balance
sheet items and can be misstated in many ways.
A popular method to commit inventory fraud is to overstate the total quantity of items
recognised as inventory (Mulford & Comiskey, 2002). This can be either done by creating

29
fictitious inventory or by falsifying physical inventory amounts (Mulford & Comiskey,
2002). In order to disguise the non-existence of faked goods, employees store boxes without
any content or other material worthless for the company’s purposes in the warehouse.
Avoiding the detection in case of inventory observations, inventory is moved from location
to location to mislead the auditor (Byington & Christensen, 2003). Furthermore, accountants
report goods which have defects and are unusable for further processing and sale (Mulford
& Comiskey, 2002). Additionally, warehouse staff forges the count sheets by simply
entering additional non-existing quantities or modifying the number of the real count
(Byington & Christensen, 2003).
Additionally, accountants manipulate the valuation of the company’s inventory by
increasing unsold goods and simultaneously decreasing cost of goods sold (Byington &
Christensen, 2003). Besides the inflation of current assets in the balance sheet, the
company’s gross profit margin is boosted as cost of goods sold are understated (Mulford &
Comiskey, 2002). The fraudster can for example overstate inventory by recognising it at
current supplier costs, regularly exceeding historical costs (Byington & Comiskey, 2002).
Knowing that auditors become suspicious discovering measurement differences,
accountants periodically transfer a portion of inventory to property, plant and equipment
(Mulford & Comiskey, 2002). In the fraudster’s opinion this would be a good solution
believing that the falsely recorded amounts are harder to detect in the property, plant and
equipment account (Mulford & Comiskey, 2002).
Furthermore, perpetrators overstate the number of products manufactured which
results in reduction of unit production costs and an increase in profit margin (Mulford &
Comiskey, 2002). However, the downside of this method is, that more of the production
costs are left in the ending inventory when products are sold which can be easily detected by
a correct inventory count (Mulford & Comiskey, 2002).
Moreover, costing methods are disregarded. According to IFRS, the cost of inventory
shall generally be assigned by using the first-in, first-out (FIFO) or weighted average cost
formula (IAS 2.25). On the contrary, US-GAAP also provides accountants the application
of the last-in, last-out (LIFO) cost formula. According to this formula, the latest items
purchased during the period are recognised in the cost of goods sold account. This means
the amount of cost of goods sold is highly dependent on the volatility of prices on the
procurement markets. When inventory costs are rising, cost of goods sold increase by the
same amount, entailing lower gross margins. A typical fraud pattern which exploits these
fluctuating prices is called LIFO liquidation. In case of rising inventory prices, a company

30
reduces the purchase of inventory needed (Mulford & Comiskey, 2002). The objective is to
limit the cost of goods sold as older inventory is derecognised (Mulford & Comiskey, 2002).
Conversely, when a company aims at a lower income, a higher amount of inventory which
is not in line with demand, is purchased at high prices (Mulford & Comiskey, 2002).
Furthermore, accountants violate GAAP by avoiding to write off over-aged and
damaged inventory or write down slow-moving inventory (Byington & Christensen, 2003).

2.3.3.4 Misstating Accounts receivable

Accounts receivable are regularly manipulated in connection with the recognition of
premature or fictitious revenue (Mulford & Comiskey, 2002).
In order to conceal the non-existence of revenue and the missing receipt of payment,
fraudsters overstate accounts receivable (Mulford & Comiskey, 2002). It has to be
considered that this procedure has a huge impact on several key performance indicators.
Firstly, it distorts the accounts receivable turnover ratio as receivables disproportionately
increase compared to revenue growth (Mulford & Comiskey, 2002). Secondly, the days’
sales outstanding (DSO) ratio deteriorates as it takes longer or rather is impossible to collect
the outstanding accounts (Mulford & Comiskey, 2002). Therefore, these kind of fraud
schemes are typically committed at the end of the accounting period (Wells, 2011). To cover
up the scam, falsified confirmations of balances are provided to auditors by establishing
letter-box companies under the control of the fraudulent entity (Wells, 2011).
Furthermore, accountants commit fraud by deliberately ignoring facts which indicate
a payment default of their debtors (Mulford & Comiskey, 2002). For the purpose of
concealing “bad debt”, perpetrators regularly allocate accounts receivable to various debtors
or artificially alter their underlying age structure (Hofmann, 2008). Receivables which
become due are either derecognised by fictitious payments or cancelled and newly booked
(Hofmann, 2008). When asked about the recoverability of receivables, fraudsters lie to the
external auditors about the creditworthiness of the customers (Hofmann, 2008).

2.3.3.5 Fictitious Bank Accounts

Accountants fraudulently increase the bank deposits of foreign subsidiaries, by
forging account statements and create fictitious balance confirmations (Hofmann, 2008).
The strategy is to gradually raise the balances such that auditors do not become suspicious
(Hofmann, 2008).

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 2.3.4 Misstatement of liabilities
An essential characteristic of a liability is that the enterprise has a present obligation
leading to the giving up of resources embodying economic benefits (F.60, F.62). Thus,
fraudsters are motivated to undervalue liabilities or alternatively delete them off their books
(Sauer, 2002). This can be done by misleading about payment transactions and the amounts
due, postponing liabilities into later periods or simply destroying invoices (Sauer, 2002). The
overall aim is to improve the company’s financial position and to create the illusion of a
strong balance sheet.

2.3.4.1 Accounts Payable

The commonplace liability is the accounts payable (Sauer, 2002). In most cases the
amounts on the accounts payable ledger and the inventory ledger are closely related as it is
usual business practice to acquire inventory by credit purchase (Mulford & Comiskey,
2002). This means when accountants aim at understating accounts payable, inventory costs
are also recognised below actual value in order to comply with the balance sheet equation
(Mulford & Comiskey, 2002). The consequence of this procedure is the understatement of
cost of goods sold effecting an overstatement of net income (Mulford & Comiskey, 2002).
Consequently, it can be stated that the improper reporting of accounts payable not only has
an impact on the presentation of the financial position but also on the financial performance
(Mulford & Comiskey, 2002).

2.3.4.2 Off balance sheet financing

Off balance sheet financing is a common method to avoid the recognition of liabilities
in order to maintain a strong balance sheet (Jones, 2011). This accounting treatment is
especially interesting for companies which are in danger of breaching loan covenants as it
has a positive effect on the debt to equity ratio and does not necessarily violate GAAP (Jones,
2011).
The use of operating leases in contrast to finance leases for example has guaranteed
lessees a legitimate possibility to keep debt of the balance sheet. As typical operating lease
assets include real estate and aircrafts, high amounts of assets and liabilities had not been
recorded in the balance sheet, but only referenced in the footnotes and explanatory
disclosures in the notes. However, this explains that IASB and FASB revised the leasing
accounting in order to “have a complete picture of the financial position of a company (…)
without making adjustments” (IFRS Project Summary and Feedback Statement, p. 3).

32
 Alternatively, fast growing companies, which heavily rely on external funds may
establish special purpose entities. The objective of a special purpose entity is “to narrow the
scope of risk to the assets and liabilities placed in the SPE, such that potential investors’ or
equity holder’ fortunes or misfortunes will be based entirely and exclusively on what occurs
with respect to the assets and liabilities placed within the SPE” (Newman, 2007, p 99). In
general, the foundation of a SPE results from legitimate business purposes and complies
with GAAP. But companies may violate GAAP when avoiding the consolidation of SPEs in
their financial statements. In case SPEs are organised as separate entities, they rather
constitute shell companies whose only reason for existence is the hiding of debt, which
should be orderly reported on the consolidated balance sheet (Jones, 2011, Feng et al., 2009).

2.3.4.3 Reclassifying Debt as Equity

Modigliani and Miller (1958) proved that in perfect capital markets leverage has no
effect on the cost of capital. But including taxes, information asymmetries and agency costs,
the composition of external borrowing and equity financing becomes significant (Myers,
2001). Although “there is no universal theory of the debt-equity choice” (Myers, 2001, p.
81), financial leverage is one of the company’s core issues. As companies have to observe
their loan covenants, managers have incentives to reclassify debt as equity (Jones, 2011). A
common fraud scheme in this context is to misuse the instrument of convertible bonds which
includes debt and equity-like features (Jones, 2011, Batten et al. 2014). Similar to a straight
bond, the investor receives regular fixed coupon payments and the principal repayment upon
maturity (Batten et al., 2014). The only difference is that the investor can convert it into a
predetermined amount of company’s equity at a future time (Jones, 2011). The fraudster’s
objective is to mislead financial statement users by classifying actual loans as convertible
bonds and by afterwards recognising them as equity on the balance sheet (Jones, 2011).

2.3.5 Increasing operating cash flows

According to IAS 7, a statement of cash flows provides financial statement users
information about the company’s ability to generate cash and cash equivalents as well as its
needs to utilise those cash flows. The amount of cash flows arising from operating activities
in particular indicates whether a company performs its respective duties without external
financing and is capable of repaying loans and distributing dividends (IAS 7, Mulford &
Comiskey, 2002). As operating cash flows are fundamental basis of company valuation and
highly monitored by shareholders and creditors, fraudsters have incentives to manipulate
their amounts stated (Mulford & Comiskey, 2002). However, due to their underlying

33
characteristics, it is without any doubts more difficult to manipulate cash than earnings
(Jones, 2011). This is also shown by the fraud schemes mentioned in the previous chapters.
Considering the method of overstating revenue for example, an inflation of accounts
receivable is achieved, but an impact on the generation of operating cash flow cannot be
observed. Nevertheless, fraudsters find ways to misstate cash flows (Jones, 2011). They
exploit the presentation format which divides cash flows by its activities and misclassify the
cash inflows and cash outflows (Mulford & Comiskey, 2002). This procedure does not
change the total cash flow, but allows accountants to mislead about the amount of operating
cash flow generated (Mulford & Comiskey, 2002). In this context, accountants try to allocate
as much inflows as possible under the heading of operating cash flows (Jones, 2011). For
this purpose, non-recurring cash inflows and bank loans are classified as operational cash
inflows (Jones, 2011). Additionally, operating cash outflows are minimised by transferring
operating losses or expenses to the disclosure of investing and financing activities (Jones,
2011).

2.4 Costs of Financial Statement Fraud

2.4.1 Capital Market Reaction
In order to measure the impact of fraud detection, accounting research has
investigated the reactions of capital market participants on the filing of restatements (e.g.
Hribar et al., 2004, Anderson & Yohn, 2002, Palmrose et al., 2004). The filing of
restatements in the US can be initiated by the company, the SEC or an independent auditor
and serves the purpose of correcting “inaccurate, incomplete, or misleading disclosures”
(Securities Act, Palmrose et al.). In this context, it was examined whether the necessity of
corrective actions has an impact on information asymmetry and investors’ perception of
financial performance (Anderson & Yohn, 2002).

Firstly, researchers have been interested in a possible change in bid-ask spreads

around the restatement announcements (Hribar & Jenkins, 2004). Dechow et al. (1996) show
in their study that market makers significantly increase their bid-ask spreads once
manipulation is revealed. This can be explained by the fact that external investors in contrast
to informed traders are unaware to what extent financial information is misstated and
therefore want to be compensated for their increased risk (Dechow et al., 1996). Whereas
Palmrose et al. (2004) do not report any deviation, Andersen and Yohn (2002) in particular
find evidence of an increase in spreads of firms having announced restatements resulting
from revenue recognition issues.

34
 Secondly, it was observed that sophisticated investors are capable of outperforming
the market, which is represented by a growing number of short sales two months before
earnings manipulation is initially made public (Dechow et al., 1996). After the
announcement a wider dispersion of analysts’ forecast can be monitored, continuing even
three years later (Dechow et al., 1996). These findings emphasise the markets’ loss of
confidence concerning the truthfulness of financial disclosure (Dechow et al., 1996). Once
investors are informed about misstatements, they correct downwards their previous
estimates. As a consequence, companies substantially lose market value, showing abnormal
return estimates (Dechow et al., 1996, Hribar & Jenkins, 2004). Market returns range from
-4 to -12 % depending on the sample examined (e.g. Dechow et al., 1996; Anderson & Yohn,
2002, Palmrose et al., 2004). Anderson & Yohn (xxxx) find a relatively more negative
market reaction with regard to revenue recognition problems. Palmrose et al. (2004)
emphasise the impact of fraud issues on the share price movement. This is due to the fact
that the integrity of companies which were deliberately misleading market participants is
seriously called into question (Palmrose et al., 2004).
The significant negative returns after announcing restatements prove that capital
market directly penalises companies in case their fraudulent behaviour is detected. On the
downside it suggests that managers are initially able to successfully boost the firms’
perceived value by misstating financial statements, at least in the short run (Gerety & Lehn,
1997, Dechow et al., 1996).
In order to complement the previous research findings, which investigated
characteristics associated with cost of capital, the objective of Hribar and Jenkins (2004) is
to directly estimate the cost of capital effect. Their study shows a relative percentage increase
in the cost of capital ranging between 7 and 19 % which depends on the estimation model
used (Hribar & Jenkins, 2004). Moreover, they report the largest increase in cost of capital
in case the restatements are upon auditor’s request (Hribar & Jenkins, 2004). Interestingly,
after a restatement investors expect the company’s earnings inferring from prices to increase
at a higher rate, which is due to the downwards revised past earnings (Hribar & Jenkins,
2004). Nevertheless, the expected future earnings are discounted at a higher rate which is
the outcome of investors’ increased risk awareness resulting from past misstatements (Hribar
& Jenkins, 2004).

Misstatements which are successfully concealed by fraudsters are as well costly.

Companies having a high likelihood of earnings manipulation experience lower future

35
earnings (Beneish & Nichols, 2005). This can be explained by the fact that overstated
earnings mislead about the base from which prospective earnings will grow (Melumad &
Nissim, 2009). However investors expect these companies to have higher future earnings
(Beneish & Nichols, 2005). They overestimate next-period return on assets by 490 to 690
basis points (Beneish & Nichols, 2005).

2.4.2 Lawsuits, delisting and bankruptcies

Non-GAAP reporting increases both the likelihood of lawsuits and payments to
resolve these legal disputes (Palmrose & Scholz, 2004). In case of inadequate controls
enabling the occurrence of fraudulent actions, organisations may additionally receive
financial fines on top of any fraud losses (Deloitte Report, 2008). Furthermore, companies
with serious shortcomings concerning financial disclosure have higher frequencies of
delisting (Palmrose & Scholz, 2004). When companies fail to meet the exchanges’ criteria,
this does not only have an impact on the company itself but as well on investors holding
those shares (Macey et al., 2008). In case of a delisting the liquidity of the shares will be
reduced increasing the cost of capital (Macey et al., 2008). It has to be stated that not all
companies are capable of surviving the aftermaths associated with the detection of financial
statement fraud (Brennan & McGrath). The Deloitte Report (2008) found that companies
engaged in complex fraud schemes are more than twice as likely to file bankruptcy as non-
fraudulent companies.

2.4.3 Discipline of the labour market

The question arises to what extent managers who are involved in fraud schemes face
consequences. Because of the fact that in most large organisations security ownership and
control are separated, there must be an efficient form of incentivising managers to act in the
shareholder’s interest (Fama, 1980). According to Fama (1980) managers who are not
responsibly operating as agents for the company have to cope with the discipline of the
labour market. Agrawal et al. (1999) show that in some cases the detection of fraudulent
financial reporting results in the dismissal of the respective manager. However, fraud does
not always incur immediate changes in top management (Agrawal et al., 1999). Although,
Agrawal (1999) hypothesize that the discovery of fraudulent actions might create incentives
to reconstitute company’s management board in order to strengthen investors’ confidence,
they find only little systematic evidence of an unusually high turnover among senior
managers or directors. In a later study, Desai et al. (2006) show different research findings
determining the reputational penalties to managers who have announced earnings

36
restatements. They find that 60 percent of restating firms experience a turnover of at least
one top manager within 24 months after the announcements compared to 35 percent among
age-, size-, and industry-matched firms (Desai et al, 2006). Furthermore, managers of
companies which were obliged to restate their financial statements have subsequently poorer
employment prospects than managers terminated due to other reasons (Desai et al, 2006).

2.4.4 Auditor-Client relationship

Financial restatements, especially those which involve fraud, have serious impact for
the auditor-client relationship (Huang & Scholz, 2012). The auditor who is responsible for
obtaining reasonable assurance that financial statements are free from material misstatement,
infringes his obligation by not detecting fraud. As both sides, auditor and client failed in
their responsibilities, it increases the likelihood of an auditor change (Huang & Scholz,
2012). Appointing a new audit engagement team might be difficult for the fraudulent
company. Even though the newly engaged auditor cannot be held responsible for past GAAP
violations, larger audit firms have a negative attitude against companies which have prior
announced serious restatements (Huang & Scholz, 2012). Although, not all auditors
withdraw from the engagement due to fraudulent actions, companies in any case face
increased costs as auditors raise their fees due to additional audit work and a higher audit
risk (Melumad & Nissim). Provided that an auditor was not capable of detecting financial
statement fraud he can be held responsible under certain conditions. Palmrose and Scholz
(2000) investigated lawsuits against auditors due to restatements of financial statements.
They show that the impact of fraudulent financial reporting should not be underestimated as
more than half of the examined restatements with auditor litigation were due to fraud
(Palmrose & Scholz, 2000). By examining different fraud types, Bonner et al. (1998) find
that the incidence of auditor litigation is even higher provided that the company’s financial
statements contain a fraud that is commonly occurring or that involves fictitious transactions
and events. Although auditors are not expected to detect all fraud schemes because these can
involve sophisticated and carefully organised schemes with the purpose to deceive (ISA),
auditors should be able to uncover repeatedly occurring schemes (Bonner et al., 1998).

2.5 Auditor’s responsibility

In the wake of the latest accounting scandals, especially, the audit profession was
seriously called into question (Ruhnke & Schwind, 2006, Hofmann, 2008). Along the lines
of “It’s always nice to have someone who shares the blame” (Böckli, 2003, p. 568), mainly
the auditor was accused by media and general public of not preventing the damage caused

37
(Hofmann, 2008). However, critics forget that not the auditor is primarily responsible of
inhibiting and detecting fraud but rather “those charged with governance of the entity and
management” (ISA 240).
Company’s executive board for example is obliged to take certain organisational
measures such as the implementation of both internal control system and internal audit. In
this context, it has to be ensured that controls are operating effectively and are capable of
reducing the risk of fraudulent actions. Furthermore, executives should set a good example
by creating “a culture of honesty and ethical behaviour” (ISA 240). In addition, executive
board bears responsibility of preparing a code of conduct in order to regulate how to deal
with actual or suspected infringements within the organisation (Schindler & Gärtner, 2004).
Besides, supervisory board is authorised to monitor the operations of the entity’s
management and to approve significant business decisions. With regard to German stock
corporation, this obligation derives from § 111 Abs. 1 AktG and § 90 AktG. Especially,
where legal representatives are involved in fraud schemes (management override of
controls), supervisory board is responsible of intervening and detecting such unlawful
actions, as oversight and supervision can only be exercised by a higher company level
(Schruff in Schindler & Gärtner, 2004).
Nonetheless, the auditor has a certain responsibility empowered by law. According
to § 317 Abs. 1 Satz 3 HGB, an audit has to be conducted such that misstatements materially
affecting the presentation of the net assets, financial position and results of operations in the
annual financial statements are detected with reasonable assurance. Nevertheless, there
remains a residual risk of not uncovering infringements “even though the audit is properly
planned and performed in accordance with the ISAs” (ISA 240.5).
Firstly, this can be explained by the underlying nature of the audit which in contrast
to embezzlement audits for example does not aim at criminal investigations (Ruhnke &
Schwind, 2006). In fact “the auditor may accept records and documents as genuine” (ISA
240.13) provided there is no indication for fraud. By critically evaluating the correct
application of accounting principles and the appropriateness of estimates made by
management (Schindler & Gärtner, 2004), auditors can preclude with moderate assurance
the occurrence of fraudulent reporting. However, foolproof security cannot be guaranteed.
This emerges as well from the limited period and resources of an audit forcing the auditor to
examine samples and not to investigate all transactions of an entity (Schindler & Gärtner,
2004).

38
 Secondly, the inherent characteristics of fraud impede auditors to detect possible
violations of law. As fraud regularly consists of highly complex fraud patterns involving
“forgery, deliberate failure to record transactions, or intentional misrepresentations” (ISA
240.7), the risk of overlooking manipulations, is higher than with regards to errors.
Therefore, the auditor’s detection rate is dependent on external factors such as criminal
energy of the fraudster and the frequency and extent of the misstatements (ISA 240.6).
Although the auditor is not responsible of preventing fraud it should be in the interest
of the audit profession to avoid further accounting scandals (Schruff, 2005). The audit
profession is deemed as “last line of defence” which is why investors rely on the
trustworthiness of an audited financial statement. Therefore, the auditor has the duty to
constantly improve the audit approach and apply effective methods to detect fraudulent
financial reporting (Schruff, 2005).

2.6 Auditors’ approach of fraud detection

In the following, detection methods will be presented which are commonly applied by
auditors to uncover fraudulent financial reporting. These measures include red flags
checklists, fraud interviews, analytical review procedures and digital analysis.

2.6.1 Red Flags Checklists

Accounting research has intensively discussed “potential symptoms existing within the
company’s business environment that would indicate a higher risk of an intentional
misstatement of the financial statements” (Price Waterhouse, 1985, p. 31). These risk
indicators referred to as red flags are certain issues or conditions signalling the incentive,
pressure and opportunity of the potential perpetrator to commit fraud (Ruhnke & Schwind,
2006). Due to the development of increasing auditor’s scepticism with regards to fraud,
auditors have been obliged to integrate red flags questionnaires into their audit approach
(Terlinde, 2005, Pincus, 1989).
Already in the 1970s the big accounting firms at that time verified certain fraud risk factors
based on analyses of corporate structures and economic development (Coopers & Lybrand,
1977, Touche Ross in Pincus, p. 154). In the following many studies concentrated on the
identification of red flags by reviewing known fraud cases (Albrecht et al, 1980, Romney et
al., 1984, Albrecht & Romney, 1986).
Loebbecke et al. (1986) conducted a survey with 277 US audit partners of KPMG to gain
information about their experience with material irregularities. In this context, the
participants were asked to explain their client’s fraud schemes and to illustrate the factors

39
namely, fraudulent financial reporting and misappropriation of assets. It is orientated
towards the fraud triangle model classifying red flags into the categories
incentives/pressures, opportunities and attitudes/rationalisation. In addition, ISA
240.appendix3 lists examples of circumstances that indicate the possibility of fraud.
Examples are provided with regard to discrepancies in the accounting records, conflicting or
missing evidence and problematic or unusual relationships between the auditor and
management.

2.6.2 Fraud Interviews

Both IDW PS 210 as well as ISA 240 intend the auditor to make inquiries with
management and others within the entity. The objective of such inquiries is to obtain
comprehensive information about “the risks of material misstatements in the financial
statements” (ISA 240.A15). Insiders estimate that approximately 80% of all fraud schemes
were detected by oral comments, tips and complaints resulting from personal conversations
with company employees (Wells, 2001).

2.6.2.1 Content of the interview

By conducting extensive inquiries, the auditor aims to get an impression of the
entity’s internal control system and underlying fraud risks (Leinicke et al., 2005).
The auditor has to ask legal representatives and management about their personal
appraisal regarding the occurrence of fraud (ISA 240). It is questioned whether there are
processes implemented to effectively identify and report manipulations and whether there is
any indication of actually existing infringements (Schindler & Gärtner, 2004). Furthermore,
it is recommended to make inquiries with regard to the communication and understanding
of ethical values within the entity (IDW PS 210.26).
Additionally, it might be beneficial to ask if certain subsidiaries, business units,
transactions or financial statement items are especially prone to manipulation (IDW PS
210.27). In relation to the work of the internal audit, it is discussed whether fraudulent
actions were detected during the reporting period and if so, whether management reacted
appropriately being faced with the results of the internal audit (IDW 210.29).
Moreover, the auditor is intended to develop an understanding of the supervisory
board carrying out its monitoring duties (IDW PS 210.30). In this context, the auditor should
enquire about how management’s processes and the functioning of the internal control
system are supervised (IDW PS 210.30). It is not necessary to arrange meetings with all

41
members of the supervisory body, but at least the chairman should be interviewed (Schindler
& Gärtner, 2004).
Somehow, with regard to the information quality, inquiries of others within the entity
should not be underestimated as these provide a different perspective (Schindler & Gärtner,
2004). Through this, employees of a lower level of authority are given the opportunity to
uncover violations which would otherwise have not been detected (ISA 240.A16).

2.6.2.2 Interview Technique

Interviews can be a useful instrument to detect fraud provided that the interviewer is
capable of combining “observation, empathetic sensitivity, and intellectual judgment”
(Buckhoff & Hansen, 2001). In order to obtain information about potential misstatements
and manipulations the auditor has to ask specific questions, appearing self-confident but not
accusing (Wells, 2001).
The objective of a fraud interview is to motivate the interviewee of answering more
questions than he or she actually intended to and to disclose the relevant information needed
(Hofmann, 2008). Nevertheless, the auditor should keep in mind that an interview in contrast
to an interrogation is conducted on a voluntarily basis and a legal violation has not been
identified yet (Leinicke et al., 2005). Therefore, it is important to create a pleasant discussion
atmosphere and to friendly explain the purpose of the interview (Leinicke et al., 2005). The
inquiry should be carefully planned by organising the sequence of questions asked (Wells,
2001). The interviewer should begin with general questions for the sake of initially gaining
the interlocutor’s trust (Wells, 2001). It is recommended to start with “icebreaker” questions
which are of no great significance but promote the flow of conversation (Wells 2001,
Hofmann, 2008). Subsequently, the auditor can ask more specific and sensitive questions in
order to reach a comprehensive understanding of the entity’s fraud risk (Wells, 2001).
Furthermore, experts advise interviewers to ask open-ended questions as hereby
interviewees are prompted to provide more detailed responses (Leinicke et al., 2005). In this
context, the questioner has to carefully listen not interrupting the speech flow of the
respondent (Leinicke et al., 2005).
Joseph T. Wells even suggests to directly ask at the end of the interview whether the
interviewee has committed fraud (Wells, 2001). This last question could be very valuable as
on the one hand, many people are afraid of lying when asked openly and on the other hand,
it protects the auditor in case of a lawsuit (Wells, 2001, Leinicke et al., 2005).

42
 2.6.3 Analytical Review Procedures
Over the last decades, auditors have commonly applied analytical review procedures
in order to assess the credibility of their clients’ financial figures (Glover et al., 2015).
Adopting an indirect approach, these measures evaluate financial statements on a high level
ignoring the inspection of individual journal entries (Hitzig, 2004). In fact, economic
plausibility is examined by comparing expected relationships among data items to actual
observed relationships (Busta & Weinberg, 1998). Although, the concept of analytical
review procedures can be compared to the approach of financial statement analysis, one
should be aware of a significant difference between these two methods (Hitzig, 2004). In
case of analytical review procedures, the analysis of certain ratios is on the basis of unaudited
financial figures, meaning accuracy of amounts cannot be guaranteed (Hitzig, 2004).

2.6.3.1 Application
Generally speaking, the auditor can apply analytical review procedures during all
phases of the audit engagement (ISA 520, Calderon & Green, 1994). At the beginning and
the final stage of the audit, analytical review procedures might be useful for giving the
auditor an overall, more general impression (Glover et al., 2005). The auditor is able to get
a deepened knowledge of the client and the underlying industry and can identify certain
dependencies and developments (ISA 520). In order to investigate whether companies’
accounts are free from error or fraud, analytical review procedures are part of evidence
gathering activities and implemented in the execution phase (Glover et al, 2005).

The application of analytical review procedures follows a specific operational

structure (figure 2). It begins with Phase 1 in which the auditor develops an estimation of
the financial figures which are anticipated to be published by the client (Messier et al., 2013).
The exact performance of this step is essential as later evaluations are based on this initial
expectation made (Messier et al., 2013). Therefore, auditors are required to evaluate
“whether the expectation is sufficiently precise to identify a material misstatement at the
desired level of assurance” (ISA 520.12). In order to form an expectation, auditors can
choose from a handful of different methods, including time-series analysis, ratio analysis
and benchmarking (Marten, Quick, Ruhnke, 2011, Blocher & Patterson, 1996). (see Types
of analytical review procedures).
In phase 2, the auditor establishes a tolerable difference between the previously stated
level of expectation and the client’s actual data (ISA 520.12f). Herby the auditor determines

44
balance or ratio results from a misstatement” or is triggered by economic changes (Blocher
& Patterson, 1996, p. 54). Changes in value can stem from various negligible reasons,
including for example extraordinary transactions or events, changes in the field of financial
reporting, new business areas or temporary, random fluctuations (Sell, 1999, Gärtner, 1994).
A preferred method chosen by auditors to detect potential material misstatements is
the so called time-series analysis. Time-series analysis evaluates the development of a
company over the years concerning its financial position, financial performance and its
ability of generating cash flows (Baetge et al., 2004). By comparisons with the previous year,
the difference between financial statement items of the current accounting period and the
corresponding previous years’ figures are calculated (Gärtner, 1994). In addition to
comparisons including two years, data can also be collected and analysed over several
periods (Marten, Quick, Ruhnke, 2011). The more extensive trend analysis allows users to
determine whether certain annual accounts figures are plausible on the basis of its evolution
over time (Marten, Quick, Ruhnke, 2011). Although there is no universal rule for the
optimum reference period, a five year period is recommended in order to be capable of
discovering even gradual changes (Baetge et al., 2004). The amounts of the actual financial
figures can be represented graphically by using a scatterplot (Marten, Quick, Ruhnke, 2011).
By means of a trend line, the development of the observed item is shown (Marten, Quick,
Ruhnke, 2011).
In contrast, ratio analysis neglects the time component and concentrates on the strong
correlation between the particular financial statement line items (Marten, Quick, Ruhnke,
2011). The approach is based on the concept of double-entry book-keeping hypothesising
that an increase or decrease of one account causes an increase or decrease of another account
(Marten, Quick, Ruhnke, 2011). The objective of the ratio analysis is to detect material
misstatements by assessing selected financial key figures of a company and analysing them
with regard to their development over time (Sell, 1999, Gärtner, 1994). Conspicuous
deviations which exceed the predetermined limits of tolerance can be a sign for errors or
fraud.
Besides an internal analysis, financial ratios can be assessed by an intercompany
comparison (benchmarking) (Gärtner, 1994). Benchmarking squares financial ratios of one
company with those disclosed by entities in the same industry (Baetge et al., 2004). An
intercompany comparison can be difficult in some cases as comparability can be insufficient
(Baetge et al., 2004). Benchmarking requires that all characteristics of the observed
companies except one have to be similar (Baetge et al., 2004). As structural equality rarely

46
occurs, the interpretation of different financial ratios in connection with other companies
might be difficult (Baetge et al., 2004). Even if companies are serving the same markets,
resemblance is for example limited in case different reporting dates or periods are used or
capital structure and sizes of enterprises are diverging (Gärtner, 1994, Baetge, 2004).
Nevertheless, intercompany comparisons are preferably applied for simple plausibility
checks (Sell, 1999). In case a company reports large revenue increases although both the
economy and the industry is in the midst of a recession, the probability of an overstatement
is high (Coglitore & Berryman, 1988).

2.6.4 Digital Analysis

Digital analysis is an approach to detect data anomalies by examining whether digit
patterns of numbers in a sample are in compliance with those of a population (Geyer &
Drechsler, 2014, Ettredge & Srivastava, 1999). Following the observation that “human
tampering leaves traces in the digits of the resulting numbers” (Ettredge & Srivastava, 1999,
676), digital analysis provides auditors a useful tool to identify manipulations in accounting
datasets (Da Silva & Carreira, 2013). It is applied to test the client’s journal entries. Its
application is based on a mathematical phenomenon called Benford’s law (Nigrini &
Mittermaier, 1997).

2.6.4.1 Benford’s Law

According to Benford’s law the distribution of digits in lists of naturally occurring
numbers follows a specific pattern (Busta & Weinberg, 1998). Although, intuitively one
would guess that all digits are equally distributed, Benford’s law states that more numbers
are starting with lower digits than with higher digits (Nigrini & Mittermaier, 1997).
In his study, Benford distinguishes between a digit, which is one of the nine natural
numbers 1, 2, 3, 4, 5, 6, 7, 8, 9 and a number, consisting of one or more digits (Benford,
1937). Except for the first digit, a number can comprise a 0 as any other position, for example
as second or third digit (Benford, 1937). In case that a decimal point or zero occurs before
the first natural number, the first digit of the number is the leftmost digit (Benford, 1937,
Nigrini & Miller, Data Diagnostics using second-order tests). Benford’s empirical results
show that the frequency of digits in the first position of a number is inversely proportional
to its growth (Geyer & Drechsler, 2014). While the probability for a number beginning with
a first digit 1 is 30.1 percent, it is only 4.6 percent for the occurrence of a 9 (Benford, 1937).
By further analysing this data, Benford hypothesised that naturally occurring data falls into
geometric series (Benford, 1937). On the basis of integral calculus, Benford gives equations

47
distribution.” According to Hill (1998, p. 3), there are “many natural sampling procedures
that lead to the same log distribution”.

2.6.4.2 Application in Auditing

The first accounting application of Benford’s law was in the late 1980s (Durtschi et al., 2004,
Nigrini & Mittermaier, 1997). Carslaw (1988) found that earnings numbers of New Zealand
companies have a much higher frequency of zeros and simultaneously a less frequency of
nines in the second digit than expected. From this findings, he concluded that managers
routinely round up key financial figures in order to mislead financial statement users
(Carslaw, 1988). In this context, managers derive benefit from the phenomenon that most
people are limited in remembering numbers which contain several digits and thus mostly
concentrate on the first one (Carlaw, 1988). Carslaw’s study was followed by Thomas (1989)
who discovered a similar second digit deviation in earnings numbers of US entities. When
he further analysed companies reporting losses, he could as well observe earnings
manipulations (Thomas, 1989). The only difference was that these published earnings
numbers showed the exact opposite pattern, namely containing fewer zeros and more nines
as second digit (Thomas, 1989). As authentic numbers are distributed in a specific pattern,
both studies show that deviations from the expected distribution are possibly signs for
misstatements (Nigrini & Mittermaier, 1997). Against this background, Nigrini (1994)
suggested to apply Benford’s law as an indicator for detecting fraud. According to his study,
individuals are not capable of faking numbers which are in conformity with the expected
digital frequencies (Nigrini, 1994). In a laboratory experiment it was found that subjects are
even unable to undertake manipulations complying with Benford distribution when being
informed about its systematic (Watrin et al., 2008). Diekmann (2007) further states that
especially second, third and fourth digits of falsified numbers are deviating from the Benford
distribution.

2.6.4.3 First-Order-Tests
Auditors who aim at testing whether data follows the assumptions of Benford’s law can
apply numerous digital analysis tests to test journal entries (Nigrini & Mittermaier, 1997).
First-order tests constitute basic tests, including tests of the first digits, second digits and
first-two digits (Nigrini, 2011). The first-order tests are usually applied separately for
positive and negative numbers as fraudsters take different actions depending on whether they
want to mislead about the amount of positive earnings or to cover up the extent of losses
(Nigrini, 2011). Generally speaking the first digit and the second digit test are only high-

49
level tests of reasonableness and not suitable for selecting audit samples (Nigrini, 2011,
Nigrini & Mittermaier, 1997). For example, if companies’ observed data perfectly fits to
Benford’s law in the first three quarters but shows deviations in the fourth quarter, this might
be an indicator of a misstatement (Nigrini, 2011).
The first-two digit test contains more focused testing and targets the detection of abnormal
digit distribution for example number duplication and possible bias (Nigrini, 2011).
According to Benford’s law the expected frequency for the first-two digits 10 for example
is 4.14 percent and for the first-two digits 99 it is 0.44 percent. By calculating all frequencies
of the first-two digit combinations pertaining to the observed sample, an auditor can compare
these to the expected Benford distribution. Auditors can use z-statistics in order to determine
whether the deviations from actual and expected frequencies are significant (Nigrini &
Mittermaier, 1997). A graph can show the differences between the actual and the expected
distribution (Nigrini & Mittermaier, 1997). In case that certain digit combinations of the
observed sample are overused it will be visible on the graph, in form of significant spikes
(Nigrini & Mittermaier, 1997).

2.6.4.4 Number Duplication Tests

The number duplication test can be applied in order to identify the specific numbers
triggering the occurred spikes (Nigrini, 2011). It is described as “numbers hit parade”
because it tabulates the frequencies of numbers causing the deviation from the expected
Benford distribution (Nigrini, 2011, p. 154). Auditors receive a report showing (a) a rank,
(b) the amount that was duplicated, and (c) count for each amount (Nigrini, 2011). The report
is usually listed in descending order beginning with the number that appears most frequently
in the data set (Nigrini, 2011). On the basis of this tabulation, auditors can choose further
subsets as audit targets in order to investigate certain anomalies (Nigrini & Mittermaier,
1997, Nigrini, 2011). Firstly, the numbers linked to the large positive spikes observed by the
first-order tests can be audited (Nigrini, 2011). In addition, numbers just below
psychological thresholds or close to control amount levels and odd numbers occurring
unusually often can be investigated (Nigrini, 2011). However, not only fraudulent behaviour
can be detected through number duplication tests, but inefficiencies as well (Nigrini &
Mittermaier, 1997). If items, which could actually be included in a collective purchase order,
are separately ordered in large amounts, it will be not surprising that the digit combination
of these invoice sums occurs with abnormal frequency (Nigrini & Mittermaier, 1997).

50
 However, some duplications do not constitute fraudulent misstatements but rather
result from rental payments and fixed payments or from obligations due to instalment
contracts (Kronfeld & Krenzin, 2014). By analysing the frequency of the duplicated
amounts, it can be proofed whether the recognised transactions truly reflect recurring
obligations (Kronfeld & Krenzin, 2014). For example a duplication of 4 can reflect a
quarterly payment and an appearance of 12 may stand for a monthly payment.
If necessary, additional tests can be applied in order to analyse the number
duplications (Kronfeld & Krenzin, 2014). The same-same-same test for example is capable
of identifying exact duplicates (Kronfeld & Krenzin, 2014, Nigrini, 2011). Another approach
is the same-same-different test which is effective in identifying errors and fraud in accounts
payable data (Nigrini, 2011). By concentrating on near-duplicates, it can detect when a
wrong vendor is paid first and then the correct vendor is payed afterwards (Nigrini, 2011).

2.6.4.5 Tests for rounded numbers

Against the background that operational transactions rarely comprise convenient
amounts, the appearance of rounded numbers can be an indicator for manipulation (Kronfeld
& Krenzin, 2014, Nigrini, 2011). In order to detect roundings, the actual frequencies of
numbers which are multiples of 10, 25, 100 and 1000 are analysed (Nigrini & Mittermaier,
1997). In case that these frequencies significantly deviate from the expected Benford
distribution (10%, 4%, 1%, 0.1%), specific audit attention will be required (Kronfeld &
Krenzin, 2014). Evidence shows that rounded numbers are often numbers which have been
negotiated (Nigrini, 2011). These contain for example fees for professional services or
donations carried out on personal ground of executives not necessarily representing
shareholders’ interest (Nigrini, 2011). By auditing these amounts, abusive behaviour may be
identified (Nigrini, 2011). Furthermore, a test for rounded numbers can be important to
detect estimations in areas in which it is not admissible to estimate amounts (Nigrini &
Mittermaier, 2014). This applies to inventory counts and daily sales volume (Nigrini &
Mittermaier, 2014). A high frequency of rounded numbers can be an indicator for the
invention of totals instead of exact calculations (Nigrini & Mittermaier, 2014).

2.6.4.6 Last-Two Digit Test

The last-two digit test is powerful when examining number inventions in data sets
(Nigrini, 2011). By reviewing the last two digits, auditors are capable of detecting certain
fraud schemes which are not visible at first glance (Nigrini & Mittermaier, 1997). For
example, fraudsters might create distinctive last two digits of data sets in order to flag their

51
own falsified numbers (Nigrini & Mittermaier, 1997). The application of the last-two digit
test requires caution as in general the last two digits of a number cannot be clearly specified
(Nigrini, 2011). A number such as 1,545 could have 45 or 00 as last-two digits, when writing
it as 1,545.00. It depends on the purpose of the analysis, how to define the last two digits
(Nigrini, 2011). In connection with currencies, it will be most appropriate to choose the two
digits right of the decimal point and for data comprising integers one should review the tens
digit and unit (Nigrini, 2011). Against the background that the last-two digits have almost
same frequencies, a significantly higher frequency of occurring might be an indicator for
manipulation (Nigrini, 2011). Deviations can result from rounding up or down of numbers,
the payment on account or the uniform splitting of higher invoice amounts (Odenthal, 2002).
The splitting of invoices or orders is a popular way to misuse the power to sign and
(Odenthal, 2002). In case that there are many payments just below the limit in which
employees are allowed to order items without asking the head of department for permission,
the invoice amounts should be further audited (Odenthal, 2002). Auditors should analyse
whether accumulations exist concerning certain suppliers or individual employees
(Odenthal, 2002).

2.6.5 Specific audit procedures

In addition to the before mentioned methods, the auditor applies specific audit
procedures to address the risk of financial statement fraud. A number of examples is listed
in ISA 240.appendix2. It provides the auditor recommendation for action in order to detect
frequently occurring fraud schemes. In this context, a particular focus is on the risks
associated with revenue recognition and the reporting of inventory. In the area of revenue
recognition it is for example recommended to confirm with customers certain relevant
contract terms and the absence of side agreements. Furthermore, the auditor should make
observations at period end to assess the amount of goods shipped and readied or being
returned. With regard to inventory, the auditor inter alia, has to conduct inventory counts
and to inspect the content of the boxes stored. Supplementary, the quantities for the current
periods can be compared with prior periods regarding class or category of inventory.
Moreover, a meaningful approach is to implement “elements of unpredictability”
such that the client cannot anticipate the audit procedures and prepare acts of deception
(Schindler & Gärtner, 2004). This means, it should be considered to regularly alter the audit
approach (ISA 240.appendix2). Auditors for example could modify sample selections,
observe inventory at locations without preannouncement or inspect control systems on

52
surprise (ISA 240.appendix). Additionally, the dates for requesting external balance
confirmations can be varied and transactions with related parties can be checked (Hofmann,
2008).
Independent of respective risks concerning single financial statement line items,
auditors should think of the following issues when applying audit procedures (ISA 240.32):
First of all, auditors have to evaluate whether journal entries recorded in the general
ledger and adjustments made after closure of accounts are appropriate. For this purpose, the
engagement team can make inquiries about the underlying transactions and test journal
entries if necessary. Secondly, it has to be assessed whether accounting estimates are applied
carefully and in compliance with financial reporting principles. Auditors have to examine if
assets are overstated or liabilities understated. In this context, the team has to review
accounting estimates by performing own calculations. Thirdly, the auditor has to follow up
on unusual transactions or developments. In order to uncover these issues, it is required to
extensively understand the entity and its environment.
All things considered, “the auditor shall maintain professional scepticism throughout
the audit, recognizing the possibility that a material misstatement due to fraud could exist,
notwithstanding the auditor’s past experience of the honesty and integrity of the entity’s
management and those charged with governance” (ISA 240.12).

3. Existing Research and Hypothesis Development

Given the tremendous costs associated with financial statement fraud, it is of high
importance that auditors implement effective and efficient methods to uncover fraudulent
financial reporting. The power of those methods will be mainly measured in terms of
detection rate, costs and frequency of errors. In order to guarantee the efficient functioning
of capital markets and strengthen stakeholders’ trust, all of these methods should have one
thing in common: the earliest possible detection of misstatements (Bolton & Hand, 2002).
The prior detection methods which are commonly applied by auditors have been
intensively researched and evaluated over the last decades.

3.1 Empirical findings and practitioner’s experience on Fraud Detection

3.1.1 Red Flags Checklists
According to Pincus (1989), the objective of implementing red flags checklists is to
enhance the auditor’s risk awareness with regard to fraud and to provide the profession a
useful tool to detect potential manipulations. Pincus (1989) emphasizes that the red flags
approach would structure fraud detection as it enables the audit team to easily collect data

53
about the client by simply working off the indicators listed. In Pincus (1989) it is stated that
the approach would need little effort or additional costs due to the fact that the results can be
clearly summarised according the red flags published. Furthermore, auditors will be
sensitised towards fraudulent situations for the purpose of efficiently recognising
misstatements in the financial statements (Pincus, 1989).
However, critics warn that the presence of a red flag does not automatically mean
that the client committed fraud, as for example Elliott & Willingham (1980, p. 8) state:

“Red flags do not indicate the presence of fraud. They are conditions believed to be
commonly present in events of fraud and they therefore suggest that concern may be
warranted. For instance, insufficient working capital (…) may predispose some
managements to misstate financial statements. To an honest businessperson the some
conditions would simply be a harsh fact of business life.”

This means the active search for the occurrence of red flags still needs further
interpretation by the auditor in order to decide if and to what extent additional procedures
are required. Moreover, there is a danger that red flags checklists do not the support auditor’s
professional scepticism but rather weaken it (Ruhnke & Schwind, 2006). Auditors might
consider the applied list as conclusive and just tick off the indicators listed (Pincus, 1989,
Ruhnke & Schwind, 2006). As a consequence, specific fraud risks of the respective clients
are not extensively discussed but treated like a “check-the-box-exercise” (Ruhnke &
Schwind, 2006).

3.1.2 Fraud Interviews

In the past, many auditors were sceptical with regards to the added value of fraud
interviews as usually only management was interviewed (Hofmann, 2008). Nowadays,
especially the inquiry of others within the entity offers additional opportunities. Regularly,
employees who are part of day-to-day business dealings know best about weaknesses in their
departments (Leinicke et al., 2005). Therefore, they can in detail explain the internal controls
implemented and discuss the risk of overriding these controls (Leinicke et al., 2005).
Evidence shows that most interviewees are cooperative and willing to answer questions
(Wells, 2001). Afraid of being convicted as liar, people answer truthfully or can be otherwise
found guilty by constantly circumventing the topics discussed (Wells, 2001). Even though,
the majority of employees or members of supervisory board are not involved in fraud, they

54
get the opportunity to talk about assumptions and share their knowledge with regards to
possible infringements (Leinicke et al., 2005).
However, the detection rate of a fraud interview is highly dependent on the
competency of the interviewer (Hofmann, 2008). Auditors have to be trained in order to
learn how to ask the right questions and to accurately interpret the non-verbal expressions of
the interviewee (Leinicke et al., 2006). Interviewers have to recognise whether conversation
partners are acting nervously due to the unfamiliar situation or because they are trying to
hide something (Leinicke et al., 2006). Moreover, it has to be considered that a skilled
fraudster with high criminal creativity could be unaffected by a fraud interview and might
mislead the auditor. Nevertheless, evidence shows that many violations were uncovered by
communication with insiders and not through alternative review procedures (Schindler &
Gärtner, 2004).

3.1.3 Analytical Review Procedures

As analytical review procedures have been an important, perhaps even the most
important component of auditing theory and practice over the last decades, researchers
extensively evaluated their ability to detect financial misstatements by conducting both
survey and simulation studies (Glover et al., 2005, Glover et al., 2015, Calderon & Green,
1994).
One important survey study was undertaken by Kreutzfeld and Wallace (1986) who
examined the patterns of 260 audit engagements with regard to recurring error characteristics
and the impact of environmental factors. Analysing financial data provided by Arthur
Andersen & Co., the authors find that 40 percent of all errors in the sample could be detected
by analytical review procedures (Kreutzfeld & Wallace, 1986). Along the same lines, Hylas
and Ashton (1982) assessed the success rate of certain audit techniques. In this context, they
investigated 152 audits, which were executed by a Big Eight public accounting firm and
contained 281 errors resulting in financial statement adjustments (Hylas & Ashton, 1982).
Hylas and Ashton (1982) come to the conclusion that analytical procedures seem to be most
suitable for an effective and efficient audit approach, as these signalled more errors
compared to other procedures. In measurable terms: 27.1 percent of misstatements were
detected by analytical review procedures (Hylas & Ashton, 1982). The findings by Wright
& Ashton, 1989 and Coglitore & Berryman, 1988 as well suggest analytical review
procedures as effective and efficient instrument to be applied during an audit.

55
 In addition to the before mentioned survey studies, a number of simulation studies
has been undertaken with the purpose of identifying “the relative frequency of correct or
incorrect signals that result from analytical procedures” (Calderon & Green, 1994).
Knechel highly supports the application of analytical review procedures according to
his studies in 1988. Firstly, Knechel (1988a) evaluated the usefulness of seven different
regression analysis methods by applying them on two samples of simulated accounting data.
He found that these measures were able to detect more frequently occurring errors than an
audit strategy relying on other approaches (Knechel, 1988a). In addition, Knechel (1988b)
assessed the value of non-statistical analytical review procedures, based on simple models
such as ratio and trend analysis. Due to the strong performance within the study, the author
states their efficiency as less other tests are needed in order to guarantee overall assurance
(Knechel, 1988b).
Wheeler and Pany (1990) created a sample, consisting of actual financial data from
five companies seeded with “commonly encountered accounting errors” to test whether these
can be accurately identified by analytical review procedures. They report that the error
signalling of analytical review procedures was very defective, showing an error rate of 96
percent (Wheeler & Pany, 1990). This means in 96 out of 100 cases, the need for an
investigation was signalled although the financial figures of the sample were correctly stated
(Wheeler & Pany, 1990). As a consequence, the workload of the auditors would highly
increase within the framework of the audit procedures leading to large inefficiencies
(Calderon & Green, 1994). Examining analytical review procedures’ capability to detect
misstatements in annual data, somehow, the research findings were more positive (Wheeler
& Pany, 1990).
Similarly, Loebbecke and Steinbart (1987) investigated whether analytical review
procedures accurately detect financial misstatements. The authors criticise that previous
survey studies certainly prove that analytical review procedures are capable of identifying
errors but do not provide evidence about the percentage of undetected errors (Loebbecke &
Steinbart, 1987). Therefore, they conducted four experiments in order to test the “reliability
and effectiveness” of analytical review procedures (Loebbecke & Steinbart, 1987). Finding
very high error rates, the authors reject the application of the tested methods (Loebbecke &
Steinbart, 1987).
Kaminski et al. (2004) examined whether specifically ratio analysis is able to identify
material misstatements in actual accounting data. By comparing 21 financial ratios for
matched fraudulent and non-fraudulent companies for a seven-year time period, Kaminski

56
et al. (2004) could not find significant differences between financial ratios calculated on the
basis of misstated data and financial ratios derived from clean data.
Current research criticises the application of analytical review procedures as a whole
arguing that auditors would “over-rely on weak analytical procedures” (Glover et al., 2005).
During an experiment with participants from a Big 4 accounting firm, Glover et al. (2005)
found that auditors have greater trust in imprecise analytical review procedures that result in
an expectation close to the client’s data than in procedures which are more precise but lead
to a significant difference. As reported by Glover et al. (2005), auditors subconsciously
overestimate the quality of analytical review procedures which display corresponding results
as they want to avoid the extra work needed for additional testing. These findings are in
accordance with a series of papers in accounting and psychology, stating that human beings
have difficulties to reach an objective decision, instead of conclusions are highly influenced
by motivation (Kunda, 1990).
However, evidence shows that a series of “high-profile accounting frauds” could
have been flagged by the accurate application analytical review procedures (Glover et al.,
2015, p. 165, 10, Sell, 1999, p. 185). In case of Parmalat for example, revenue from sales to
Cuba were massively overstated. Auditors could have noticed this as according to Parmalat’s
manipulated exports every Cuban would have drunken 490 litres of milk during that financial
year. (Peemöller & Hofmann, 2005 in Hofmann, 2008, p. 549). Same applies to the German
fraud case of Flowtex. The company reported more than 3400 horizontal drilling machines
in their accounts although the yearly demand of such equipment was estimated at
approximately 400 machines per year (Peemöller & Hofmann, 2005 in Hofmann, 2008).

3.1.4 Digital Analysis

Using digital analysis to detect financial statement fraud, the practitioner has to take
into account certain limitations. Although, most accounting data will converge to a Benford
distribution, data sets have to show certain characteristics (Durtschi et al., 2003, Nigrini,
2011).
Data sets should measure sizes of the same facts or events, for example revenue or
accounts receivable. It is essential that there are no built-in minimum or maximum values,
meaning that a data set should not be limited by a certain data point (Nigrini, 2011, Watrin
et al., 2008). An example of a minimum would be a data set which only contains transactions
exceeding €500, because smaller transactions are booked through another account (Watrin
et al., 2008). Data sets including calendar months with x days are examples of a maximum.

57
However, a built-in minimum of zero is allowed (Nigrini, 2011). Furthermore, the data set
should not contain data sets used as identification numbers or labels, such as purchase order
numbers, bank account numbers or telephone numbers (Nigrini, 2011). The purpose of their
combination of digits is to place words and solely has meaning to the developers (Nigrini,
2011). A basic assumption is that a data set should have more small items (data elements)
than big items (data elements) in order to comply with Benford’s law (Nigrini, 2011). This
is generally true as there are more towns than big cities, more small cap than large cap
companies and more small financial events than large ones (Nigrini, 2011, Busta &
Weinberg, 1998). Furthermore, the account size, meaning the volume of entries is important,
as the results are more reliable when an entire account is analysed rather than a selected
sample (Durtschi et al., 2003).
Considering a company whose revenue is recognised from customer contracts,
including the same small monthly payments for example, digital analysis would not provide
valid results. Same applies for the application on the expense account, in case the client has
to repeatedly pay the same invoice amounts due to specific contracts.
It is evident from this that, the application of digital analysis to detect financial
statement fraud is only beneficial to a certain extent.

3.2 Accounting research’s approach of fraud detection

Over the last decades, accounting research has been intensively interested in
understanding the characteristics of companies that manipulate financial statements
(Dechow et al., 2011). In the beginnings, researchers particularly considered discretionary
accruals as indicators for earnings manipulations (Dechow et al., 1995)1.

Later on, the two professors Messod D. Beneish (1997, 1999) and Patricia M.
Dechow (2011) expanded these key findings. Besides the consideration of accruals and
future returns, the researchers assessed studies applying financial statement data in other
decisional contexts, including distress analysis (e.g. Altman Z-Score), basic ratio analysis
and contextual analysis (Dechow et al., 2011, Beneish, 2013). They each developed an
accounting-based earnings manipulation detection model, which can be applied by auditors

1
There has been widespread agreement in the literature that the most popular six models are the DeAngelo
(1986) Model, Healy (1985) Model, the Jones (1991) Model, the Modified Jones Model (Dechow, Sloan and
Sweeney 1995), the Industry Model (Dechow, Sloan and Sweeney 1995), and the Cross-Sectional Jones
Model (DeFond and Jiambalvo 1994).

58
to investigate whether the client committed financial statement fraud or by investors to
evaluate the expected return of a share.

3.2.1 Beneish’s M-Score

Beneish (1999) developed a statistical model to discriminate manipulators from non-
manipulators by profiling companies that had misstated earnings. For this purpose, 74
companies publishing manipulated financial figures were matched to 2332 COMPUSTAT
non-manipulators on the basis of two-digit SIC industry and year over a period of ten years
from 1982 to 1992. The outcome was a model consisting of eight accounting-based
variables, estimating the probability of manipulation (M-Score). The variables can be drawn
from the financial statements and are designed that “higher values are associated with a
greater probability of earnings manipulation” (Beneish et al., 2013, p. 76). Beneish (1999)
created the formula against the background of his empirical research on manipulation firms.

According to Beneish (1999, 2013, p. 57), a “typical earnings manipulator” is a

company that is:

a. Growing quickly (extremely high year-over-year sales growth),

b. Experiencing deteriorating fundamentals (as evidenced by a decline in asset quality,

eroding profit margins, and increasing leverage), and

c. Adopting aggressive accounting practices (e.g., receivables growing much faster

than sales, large income inflating accruals, and decreasing depreciation expense).

The probability of manipulation (M-Score) increases with (1) increasing receivables

(Days Sales Receivables Index), (2) deteriorating gross margins (Gross Margin Index), (3)
increasing expenditure capitalisation (Asset Quality Index), (4) increasing sales (Sales
Growth Index), (5) Declining depreciation rates (Depreciation Index), (6) decreasing
administrative and marketing efficiency in the form of larger fixed SGA expense (Sales,
General, and Administrative Expenses Index), (7) increasing accruals (Total accruals to total
assets) and (8) increasing debt (Leverage Index).
Hence, the following formula was created:

− = −4.84 + 0.920 + 0.528 + 0.404 + 0.892

+ 0.115 − 0.172 + 4.679 !" − 0.327 $ %

A detailed explanation of the individual variables is provided in 4.5 Model

Description.
59
study concentrates on Model 1 which solely contains variables which can be directly drawn
from the financial statements (Dechow et al., 2011). These constitute:

a) Accruals quality related variables (RSST accruals, Change in receivables, Change

in Inventory, % Soft assets)

b) Performance variables (Change in cash sales, change in return on assets)

c) Market-related incentives (Actual Issuance)

The variables are selected on the hypothesis that the probability of accounting
misstatements increases with (1) increasing accruals, (2) declining performance and (3)
increasing market-related incentives.

The F-Score is computed as follows:

' '(!()*
&− =
+, ,-()( , ! ' '(!()*

./0123401 56780
' '(!()* = ./0123401 56780
1+

-( ) - % !
= −7.893 + 0.790 "") + 2.518 ℎ + 1.191 ℎ (,:
+ 1.979 " ;) "" )" + 0.171 ℎ " + −0.932 ℎ +

+, ,-()( , ! ' '(!()* = 0.0037

A detailed explanation of the individual variables is provided in 4.5 Model Description.

As a first step, the predicted value is calculated by filling the respective variables into
the formula and multiplying them with the estimated coefficients. Secondly, the probability
is derived by inserting the predicted value into the formula. Thirdly, the probability is
divided by the predefined unconditional probability of 0.0037.
An F-Score of 1 means that the firm has the same probability of misstatement as the
unconditional expectation (Dechow et al., 2011).
Similar to M-Score, two types of errors can arise when calculating F-Score. A type
II error occurs when the model incorrectly classifies a misstating firm as non-misstating, and
a type I error arises in case a non-misstating firm is classified as misstating (Dechow et al.,
2011). Generally speaking, although a type I error has as well consequences for the auditor,
a type II error is more costly (Dechow et al., 2011).

61
uncover fraudulent financial reporting? Or do the accounting-based detection methods
developed by researchers give better results and thus should be integrated into the audit
approach?
Therefore, the power of Beneish’s M-Score and Dechow’s F-Score will be tested.
During the last years, it has been indicated that especially M-Score is an extraordinary useful
tool. A group of MBA students at Cornell University applied M-Score for Enron Corporation
and detected its accounting fraud one year before the first professional analysts did (Morris,
2009). However, “evidence is ad hoc and anecdotal” (Beneish et al., 2013).
In order to take this situation into account, initially, it is assessed whether the M-
score as well as the F-score can even today flag fraudulent companies. For this reason, it is
necessary to first check if the two scores are capable of accurately identifying manipulated
financial statements, by applying them on financial statement data of manipulation firms.
Thus the hypotheses of the first research question are formulated as follows:

H1: The cut-off value of M-score discriminates manipulators from non-manipulators.

H2: The cut-off value of F-score discriminates manipulators from non-manipulators.

Secondly, it is tested whether the detection rate of the two scoring models is superior
to the methods applied by German professionals during the audit engagement. In order to
evaluate their potential added value, it will be examined if the M-score or the F-score flag
audited financial statements which have not been identified by auditors as fraudulent. Thus,
the following hypotheses concerning the second research question will be tested:

H3: Audited financial statements are flagged by M-Score.

H4: Audited financial statements are flagged by F-Score.

4. Methodology and Data

4.1 Research Approach and Research Design
This study follows a deductive approach (Saunders et al., 2009). At first, literature on fraud
detection was reviewed in order to identify theories and concepts. Based on this, hypotheses
were formulated and tested by using quantitative data.
The hypotheses are tested by conducting two short-term time series analyses. At first,
M-Score and F-Score are calculated for a sample consisting of different misstating firms.
This is done for the purpose of collecting evidence that the two models are capable of
discriminating manipulators from non-manipulators (model verification). In this context, the

63
objective is not to statistically test the models as such but rather assess their underlying
design and functioning declared by the developers. From the practitioner’s point of view it
will be examined whether the two scores are useful instruments to be implemented into the
audit approach.
Secondly, audited financial statement data of German corporations is collected to
compute the probability of accounting misstatements. It will be examined whether M-Score
or F-Score flag some of these companies as manipulating.

4.2 Data Collection

This research relies almost exclusively on secondary sources. The data was mainly
collected from the following databases:

• COMPUSTAT North America from Standard & Poor’s (WRDS),

• COMPUSTAT Global from Standard & Poor’s (WRDS) and

• EDGAR.

In exceptional cases, data was directly drawn from the financial statements published
by the respective companies on the investor relations pages. Furthermore, existing literature
related to the research on M-Score and F-Score was collected from the online reference
search tool Disco provided by Münster University.

4.3 Quantitative Data

To draw data from the COMPUSTAT databases, the ISIN and CUSIP of the sample
companies had to be identified. Furthermore, the COMPUSTAT codes of the variables in
the M-Score and F-Score formula needed to be collected.
In the first step, four lists were set up containing the firms to be tested. The first list
consists of North American financial securities which had been identified by the SEC for
publishing misstated financial statements and contains three columns: name of the company,
CUSIP, misstatement years. The second list comprises international misstating companies
(except the North American ones) and includes the following columns: name of the
company, ISIN, misstatement years. The third list holds MDAX listed companies and the
fourth list consists of SDAX listed companies. Both are structured in the same way,
containing one column with the company name and one with the respective ISIN.
Afterwards, two spreadsheets were set up listing the variables to be inserted into the
M-Score formula and the F-Score formula. The first spreadsheet contains the single financial

64
statement line items and their respective COMPUSTAT codes necessary for calculating the
variables of the M-Score. The second spreadsheet includes the items and their related
COMPUSTAT codes needed in order to measure the F-Score.
On the basis of both the lists and the spreadsheets, the financial data required for
conducting the research could be drawn from COMPUSTAT. The financial data for the
North American companies was extracted from COMPUSTAT North America;
COMPUSTAT Global was used for all other companies.

4.4 Sample Description

According to the research questions defined, the objective of the data collection is
(1) to create a sample of representative accounting misstatements and (2) to construct a
sample containing German companies of interest to financial statement users and capital
market.
4.4.1 Sample of misstating firms
The original sample contained 15 misstating companies, but several companies had
to be excluded due to the following reasons: (1) data was not available at all, (2) validity of
data could not be guaranteed or (3) only restated and not the original data was present. As a
result a sample of 6 out of the previously defined 15 companies was constructed.
The overall aim was to create a sample consisting of both US-GAAP and IFRS
adopters in order to check whether different accounting standards have an impact on the
discriminatory power of the Scores. Companies were chosen which had at least misstated
one annual statement within the last years. Generally speaking, there is no universal
requirement concerning the years to be included into a time-series analysis. Baetge et al.
(2004) recommend at least a period of five years. The author of this study is interested in the
development over the current decade and thus wants to examine financial statement data
from 2010 to 2016. However, the period of time was expanded back to 2008 due to the
following considerations: Some of the sample companies misstated their statements in 2010.
As for calculating M-Score at least financial figures of two consecutive years are required
(t, t-1) and the computation of F-Score requires input data of three consecutive years (t, t-1,
t-2), financial figures from 2009 and 2008 had to be collected as well. Thus, financial
statement data from 2008 to 2016 had been examined during the research.

Nevertheless it should be noted, that COMPUSTAT in some cases could not provide
the accounting data of the latest fiscal years. One reason for this was that some companies
had to file bankruptcy in consequence of the fraud detection.

65
 The selection of the misstating companies was based on the latest press releases by
SEC about firms charged with accounting fraud. Furthermore, a search on Google was
conducted, including the key words “accounting fraud”, “accounting scandal” and “financial
statement fraud”. The financial statements of the sample companies were misstated for the
following reasons: asset overstatement, cost falsification, premature revenue recognition and
fictitious transactions.

4.4.2 Sample of German corporations

This sample consists of companies listed on MDAX and SDAX according to the
index composition report dated Dec 30th 2016 which had been extracted from STOXX
Limited. MDAX is defined as an index “that reflects the price development of the 50 largest
companies from classic sectors in Prime Standard ranking directly below the DAX shares”
(Deutsche Börse). SDAX as well comprises 50 companies from classic sectors in the Prime
Standard “that rank directly below the MDAX shares in terms of size” (Deutsche Börse).
The decision to analyse financial data from exactly these two indices was made due to the
following reasons: Both indices contain a wide range of different industries, e.g. chemical
industry, retail, automotive supply etc. Furthermore, some fast growing companies are
included there, which according to Beneish (1999) have a higher probability of being an
“earnings manipulator” and might be interesting to check. In addition, financial statements
of these companies are audited by a larger number of different audit firms in contrast to
DAX30 which is mainly audited by one of the Big4 audit firms. Moreover, it has to be
considered that less research has been done on MDAX and SDAX, as most researchers solely
concentrate on examining DAX30 which consists of the “30 largest and most actively traded
German equities” (Deutsche Börse).
The original sample comprised 100 companies following the composition of MDAX
and SDAX. However, some companies had to be excluded as M-Score and F-Score are not
applicable to industries such as finance, banking, insurance or real estate. MDAX companies
which had been excluded from the sample are: Hannover Rück SE, Deutsche Euroshop AG,
Deutsche Wohnen AG, TAG Immobilien AG, Areal Bank AG, Talanx AG, Alstria Office
AG, LEG Immobilien AG. The respective companies of SDAX are: Hamborner Reit AG,
Adler Real Estate AG, Deutsche Beteiligungs AG, Wüstenrot & Württembergische AG,
Grenke AG, Patrizia Immobilien AG, DIC Asset AG, Rocket Internet SE, TLG Immobilien
AG, ADO Properties S.A. The recruiting services firm Amadeus Fire SE (SDAX) was
excluded as well, as many financial statement line items for calculating the variables of F-

66
Score were not available. This leads to a sample of 79 companies (MDAX: 41, SDAX: 38).
The financial statement data from 2010 to 2016 of these 79 companies was examined during
the empirical study.

4.5 Model Description

4.5.1 M-Score
In this study, the original model as published in Beneish (1999) is closely replicated.
The same coefficients as estimated for M-Score are applied (3.2.1). It should be noted that
in accordance with Beneish (2013) for seven of the eight variables the same calculation is
used. But with regard to the accruals variable a different construction was implemented
following the latest research findings in the accruals literature.
The studies of Beneish (1999, 2013) preferred a cut-off value of -1.78, meaning that
companies with M-Scores > -1.78 are classified as manipulators and companies with M-
Scores < -1.78 are classified as non-manipulators. This is argued by reasonably trading off
benefits and costs incurred by the typical investor (3.1.1.). However, it has to be stated that
the error of misclassifying a manipulator as non-manipulator is extremely costly for an
auditor. As this study analyses the capability of M-Score detecting financial statement fraud
in order to implement it into the audit approach, a cut-off value of -1.89 is applied (error
rates shown in 3.2.11). Thus, companies exceeding M-Scores of -1.89 are flagged as
potential manipulators and such with M-Scores less than -1.89 are identified as non-
manipulators.
As already shown in 3.2.1, the M-Score model consists of eight accounting-based
variables “each of which is so constructed that higher values are associated with a greater
probability of earnings manipulation” (Beneish et al., 2013, p. 76).
In the following, the calculation of the single variables will be explained. The number
in brackets constitutes the COMPUSTAT data item number.

(1) Days Sales in Receivables Index (DSRI)

(: '! " ) <2=/ ! " ) <12=

=
(: '! " ) − 1/ ! ")−1

The DSRI captures the proportion of receivables to sales in the year in which earnings
manipulation was detected (year t) compared to the days sales in receivables ratio of the
prior year (t-1). This variable displays whether there are distortions between the development
of receivables and sales. A large increase of the ratio could be either a sign for a change in

67
credit policy in order to boost sales or it could also indicate improper revenue inflation
(Beneish, 1999). As shown in chapter 2.3.1., overstating revenue is a commonly applied
fraud scheme.

(2) Gross Margin Index (GMI)

! " ) − 1 <12= − ? ") ; @ -" " !- ) − 1 <41= / ! " ) − 1 <12=

=
! " ) − ? ") ; @ -" " !- ) / ! ")

The gross margin index is calculated by dividing the gross margin in the previous
year (t-1) by the gross margin in the current year (t). The gross margin is a company’s sales
minus its cost of goods sold, divided by sales. In line with the research findings of Lev &
Thiagarajan (1993), Beneish (1999) hypothesises that companies with declining margins are
more likely to manipulate earnings.

(3) Asset Quality Index (AQI)

1−? ,) "" )" ) <4= + ) <8=/ A ) ! "" )" ) <6=

=
1−? ,) "" )" ) − 1 + ) − 1 / A ) ! "" )" ) − 1

The AQI is the ratio of asset quality in the current year (t) to the asset quality of the
prior year (t-1). It captures the proportion of noncurrent assets except for property, plant and
equipment in relation to total assets. Thus, the changing in asset realisation is measured,
meaning that an AQI > 1 indicates that the company capitalised more expenses in order to
defer costs. As already stated in 2.3.2.2, the improper capitalisation of expenses is a typical
strategy to increase profit in the current posting period (Jones, 2011, Mulford & Comiskey,
2002). Therefore, an increased AQI can be an indicator for misstated financial figures.

(4) Sales Growth Index (SGI)

! " ) <12=
=
! ")−1

The SGI measures the development of the companies’ sales growth over a period of
two years. An index > 1 means that the company increased sales, while an index < 1 shows
a sales decline. Although, growth does not automatically imply an overstatement, expansion
will be critically monitored. Explanations for this phenomenon are given in 2.1.3 Meeting
or beating analysts’ forecast.

(5) Depreciation Index (DEPI)

68
 B ( )( , ) − 1 <14 − 65=/ B ( )( , ) − 1 + ) − 1<8=
=
B ( )( , )/ B ( )( , ) + )

The DEPI is the rate of depreciation in the previous year (t-1) divided by the rate of
depreciation in the current year (t). The rate of depreciation is calculated as follows:
depreciation is divided by the sum of depreciation and property, plant and equipment. A
DEPI exceeding 1 indicates a decrease of depreciation. The question is whether this is the
case because of an improper lengthening of useful lives in order to lower expenses (see
chapter 2.3.2.4.). Therefore Beneish (1999) expects “a positive relationship between the
DEPI and the probability of manipulation”.

(6) Sales, General, and Administrative Expense Index (SGAI)

! ", @ , !, ,- -D(,(") )(: EB ," ) <189=/ ! " ) <12=

=
! ", @ , !, ,- -D(,(") )(: EB ," ) − 1/ ! ")−1

The SGAI constitutes the development of the ratio of sales, general, and
administrative expenses to sales in current year (t) compared to the proportion of sales,
general, and administrative expenses to sales in the prior year (t-1). As usually the
relationship between costs and sales is relatively constant, a disproportionate increase of
costs might incentivise companies to misstate financial statements (Beneish, 2013).

(7) Accruals

!"
, D ' ; E) -(, * () D" <18= − ? "ℎ ; D B )( ," <308=
=
A ) ! "" )" ) <6=

Accruals is calculated by dividing the difference of cash from operations from

income before extraordinary items, by total assets. This variable signals when a company
reports profit in the income statement which is not supported by cash (Beneish, 2013). This
is presumed to be the result of aggressive earnings management or even the commitment of
financial statement fraud.

(8) Leverage Index (LEVI)

$A ) <9= + ? ,) $( '(!()( " ) <5=/ A ) ! "" )" ) <6=

$ % =
$A ) − 1 + ? ,) $( '(!()( " ) − 1 / A ) ! "" )" ) − 1

LEVI is calculated as the ratio of total debt to total assets of the current year (t) divided by
the ratio of total debt to total assets of the prior year (t-1). Total debt consists of long-term
69
debt and current liabilities. According to the debt covenant hypothesis increasing leverage
incentivises the company to manipulate earnings (see 2.1.1.). Thus a LEVI > 1 can be an
indicator for financial statement fraud.

The variables of the M-Score formula were calculated in Excel by inserting the
financial data items which had been previously collected from COMPUSTAT on the basis
of their COMPUSTAT codes. In case elements of the computation were not available
(amortisation of intangibles, COMPUSTAT #65 or SG&A, COMPUSTAT #189), the items
were looked up manually in the respective financial statements published on the investor
relations pages. If the required items could not be found there either, DEPI and SGAI were
set to 1 (its neutral value). This procedure was recommended by Beneish (1999) in order to
avoid a missing observation.

4.5.2 F-Score
This study relies on the F-Score Model 1 developed by Dechow et al. (2011), which
is presented in chapter 3.2.2. In this section, the computation of the single variables will be
described. To test the hypotheses stated, the exact coefficients and same variables as
estimated for F-Score are applied. For the purpose of this study, a cut-off value of 1.85 is
applied in accordance with the research of Dechow et al. (2011) who determined that
companies with F-Scores higher than 1.85 have a substantial risk of being manipulators.
This means, companies with F-Scores > 1.85 are flagged as manipulators and
companies having F-Scores < 1.85 are identified as non-manipulators. The type I and type
II errors with regard to the determination of the cut-off value are explained in chapter 3.2.2.
(1) RSST Accruals
ΔWC + ΔNCO + ΔFIN
"")_ =
: @ A ) ! "" )"

N? = ? ,) "" )" <4= − ? "ℎ ,- ℎ ) ) D (,: ")D ,)" <1=

− ? ,) !( '(!()( " <5= − ') (, ? ,) !( '(!()( " <34=

O?P = A ) ! "" )" <6= − ? ,) "" )" <4= − ,: ")D ,)" ,- -: , " <32=
− A ) ! $( '(!()( " <181= − ? ,) $( '(!()( " <5=
− $ ,@ ) D ') <9=

70
 &O= ℎ ) ) D (,: ")D ,)" <193= + $ ,@ ) D (,: ")D ,)" <32=
− $ ,@ ) D - ') <9= + ') (, ? ,) !( '(!()( " <34=
+ ; - ) Q <130=

Following the research of Richardson et al. (2005), the variable RSST sums up the
change of non-cash working capital (WC), the change of net non-current operating assets
(NCO) and the change of net financial assets (FIN). The objective of this variable is to assess
the change in non-cash operating assets (Dechow et al., 2011).

(2) Change in Receivables (ch_rec)

∆ ,)" (: '! <2=

ℎ_ =
: @ ) ) ! "" )"

This variable is calculated by dividing the change in accounts receivable (t, t-1) by
the average total assets of both years. A large increase of the ratio could be either a sign for
a change in credit policy in order to boost sales or it could also indicate improper revenue
inflation.

(3) Change in Inventory (ch_inv)

∆ ,: ,) * <3=
ℎ_(,: =
: @ ) ) ! "" )"

The variable ch_inv is the change of inventory (t, t-1) divided by the average total assets
(t, t-1). As already stated in chapter 2.3.3.3, fraudsters attempt to overvalue inventory in
order to improve company’s gross margin. Therefore, a disproportionate increase of
ch_inv can be an indicator for misstatement.

(4) % Soft Assets (soft_assets)

A ) ! "" )" <6= − <8= − ? "ℎ ,- "ℎ S (: ! ,)" <1=
" ;)_ "" )" =
A ) ! "" )"

This variable is “defined as the percentage of assets on the balance sheet that are
neither cash nor property, plant, and equipment” (Dechow et al., p. 39). According to the
research of Barton & Simko (2002), the amount of net operating assets indicates the level of
earnings manipulation. Thus, an increase of soft assets is associated with a higher risk of
misstatements in order to meet earnings expectation (Dechow et al., 2011).

(5) Change in Cash Sales (ch_cs)

71
 ℎ_ " = ! " <12= − ∆ ,)" (: '! <2=

This variable is calculated by deducting the change of accounts receivable (t, t-1)
from sales of the current period (t) and dividing it by the corresponding measure of the prior
period (t-1). An increase of this variables can be a sign for earnings manipulation as Dechow
et al. (2011) found out that surprisingly not credit sales but rather cash sales are rising when
companies misstate financial statements. It is anticipated that companies “misstate sales
through transaction management” (Dechow et al., 2011, p. 20). One commonly applied and
controversially discussed accounting procedure in this context is the practice of channel
stuffing (chapter 2.3.1.2.).

(6) Change in return on assets (ch_roa)

∆ = O ) , D ) <18=⁄0.5 E A ) ! "" )" ) − 1 <6= + A ) ! "" )" ) <6=

− O ) , D ) − 1 ⁄0.5 E A ) ! "" )" ) − 2 + A ) ! "" )" ) − 1

This variable is calculated by dividing net income of this year (t) by the average of
total assets from this year and last year (t, t-1). Afterwards the corresponding measure of last
year (t-1) is subtracted from the first calculation. A decrease of this variable is caused by a
fall-off of net income. As management attempts to constantly increase earnings growth (see
2.1.3 Meeting or beating analysts’ forecasts) it is anticipated that in case of a declining
ch_roa the risk of earnings manipulation rises.

(7) Actual Issuance (Issue)

(""
= , (,-( ) : ( '! - - 1 (; )ℎ ;( D ("" -" ()( " - (,@ * ) A 108
>0 A 111 > 0

Actual issuance is a dummy variable, which is coded 1 if the company issued either
common and preferred stock or long-term debt. The reason behind choosing this variable is
explained as follows (Dechow et al., 2011). Companies which are not generating enough
cash flow are in need of external financing which ideally should occur at lowest cost.
Therefore, some companies misstate earnings in order to increase the stock price
simultaneously reducing the cost of equity. For the purpose of decreasing borrowing costs,
perpetrators mislead about profitability as less risky debtors are capable of borrowing money
at lower rates.

72
 5. Empirical Results
5.1 Validity and Reliability
For the purpose of ensuring a high level of validity and reliability with regard to
research, the required data was collected from professional databases. As both Beneish and
Dechow used the database COMPUSTAT from Standard & Poor’s to extract data for
examining and testing their models, this study follows their approach. The financial data of
the companies headquartered in the USA was drawn from COMPUSTAT North America on
the basis of their CUSIP, the financial data of all other companies was collected from
COMPUSTAT Global according to their ISIN.
In order to test the two hypotheses, the provision of original, manipulated financial
data is essential. According to Dechow et al. (2013), who had discussions with Standard &
Poor’s, COMPUSTAT is constantly updating their databases. This means, in case a company
has to restate its financial statements, filing for example an amended 10-K, COMPUSTAT
will backfill the previously uploaded misstated numbers (Dechow et al., 2013). However,
Dechow et al. tested this statement by checking on financial information related to nine
randomly selected companies having published manipulated financial data between 2000
and 2001. They came to the conclusion that COMPUSTAT had replaced financial figures
related to one of the nine companies. Against the background of these results, the author of
this study manually inspected the extracted data of the manipulation companies to guarantee
that only originally published financial figures are included into research. Therefore, the
sample of the fraudulent companies was cross-checked with the SEC filings published on
the database EDGAR. In the event of a replacement, the original financial numbers were
manually drawn from the SEC filings for the respective fiscal years of the companies
concerned.
For testing the hypotheses 3 and 4, financial data of the shares listed in the German
indices MDAX and SDAX was extracted from COMPUSTAT Global. In order to ensure the
completeness of the sample, initially an index composition report of MDAX and an index
composition report of SDAX, in each case dated Dec 30th 2016, was drawn from STOXX
Ltd. On the basis of the included instruments and ISIN listed there, the required financial
figures were collected.
5.2 Research findings

73
 6. Concluding Remarks
The master thesis analyses the occurrence and detection of financial statement fraud.
Especially, the instruments applied by auditors are assessed. It is observed that the quality
of financial disclosure in Germany is high and MDAX and SDAX shares seem to be sound
investments by the majority. However, results of this study show deficiencies as well.
According to the two accounting-based detection models tested, M-Score and F-Score,
irregularities were identified. As some of the audited financial statements were flagged as
misstated it is questioned whether managers had incentives to commit financial statement
fraud and auditors were not capable of detecting the misstatements or whether the models
incorrectly classified the respective firms as manipulators.

According to the findings with regard to the hypotheses 1 and 2 tested, this study
recommends the application of M-Score and F-Score within the scope of the audit. Both
models are capable of identifying irregularities by quite simple mathematical calculations
and can therefore be easily implemented in the planning phase of an audit as they are capable
of highlighting risks. Nevertheless, it has to be taken into consideration that these models as
well misclassified manipulators as non-manipulators.

As perpetrators are acting with high criminal energy and create advanced fraud
schemes, it will be even more difficult in future to detect financial statement fraud. Despite
that, the audit profession is expected to examine the quality of financial information in order
to guarantee the efficient functioning of capital markets. One important step is the increasing
benefitting of digitalisation which supports the auditor to inspect large datasets.

85
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