Academic journal article Academy of Accounting and Financial Studies Journal

Share Prices and Price/earnings Ratios as Predictors of Fraud Prior to a Fraud Announcement

Academic journal article Academy of Accounting and Financial Studies Journal

Share Prices and Price/earnings Ratios as Predictors of Fraud Prior to a Fraud Announcement

Article excerpt

INTRODUCTION

At the end of the 20th century, some corporate representatives throughout all industries manipulated financial statements (Giroux, 2008). Several representatives of well-known companies, including Enron, WorldCom, and AIG were found guilty of financial scandals resulting from widespread collusion (Rockness & Rockness, 2005). Although the exact amount of loss from fraudulent activities is unknown, the average loss from fraudulent activity is estimated to be 5% of all corporate earnings (Association of Certified Fraud Examiners, 2010).

Financial fraud is incredibly problematic and has many negative consequences including that it negatively affects the share price of a company, creating losses for stockholders, employees, vendors, and customers, and results in an inability to increase corporate capital (Lord, 2010; Murphy & Tibbs, 2010; Rezaee & Riley, 2010). Because fraud is prevalent, laws and oversight committees have been created to curb fraudulent activity (Pinto, 2010) and after major fraudulent episodes, the U.S. Congress enacted laws such as the Securities Act of 1933 and the Security and Exchange act of 1934 to curb specific types of fraud (Buell, 2011). Despite this legislation, financial fraud goes largely undetected, as evidenced by the litigation against 101 companies conducted by the Securities and Exchange Commission (SEC) in the first quarter of 2012 (U.S. Securities and Exchange Commission, 2012). Fraud is primarily detected through the use of quantitative or qualitative indictors (Hogan, Rezzaee, Riley, & Velury, 2008).

White-collar crime encompasses a range of criminal acts including fraud committed by members of the business community (Johnstone, 1998). White-collar crime involves a transition from fraudulent actions damaging a few select individuals to actions damaging a broad range of stakeholders (Agnew, Piquero, & Cullen, 2009). It includes theft by deception and misconduct, negligence, and questionable business practices (Johnstone, 1998). In response to the presence of white-collar crime (and the observed increase), the forensic accounting field has both come into existence as its own branch of accounting and has grown substantially (Agnew et al., 2009).

Stakeholders use fraud indicators to make informed investment and business decisions (Kolman, 2007). Hegazy and Kassem (2010) found that fraud indicators were based on elements of fraudulent financial statements that increased the likelihood of detecting fraud. Members of the public could then use these indicators to monitor and identify potentially fraudulent situations early on to minimize personal financial damage. In addition to law enforcement agencies and organizations, financial professionals also continually develop techniques to identify fraud and potentially fraudulent situations (Kolman, 2007). Fraud indictors include financial ratios and trends, management characteristics, industry changes and characteristics, and linguistic variables (Lundstrom, 2009). Consumers need indicators to educate themselves about fraud and to perform further analyses of corporate information as a basis for making sound decisions (Hogan et al. 2010) prompting a need to examine the relationship between share prices and accounting fraud. Corporate share prices are publicly available and can be easily accessed and evaluated by consumers to identify potential problems when deciding on investments or employment.

Researchers have focused primarily on internal corporate factors to identify fraud (Kaiser & Hogan, 2010; Kranacher, Riley, & Wells. 2011; Maguire, 2010). Fraud indicators based on internal corporate information include efficiency and productivity statistics (Brazel, Jones, & Zimbelman, 2009; Kranacher et al. 2011), performance guidelines linked to management incentives (Anderson & Tirrell, 2004), and personal characteristics of the executive management team (Kaiser & Hogan, 2010; Kranacher et al. …

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