Journal
of
Administrative
Management,
Education and Training (JAMET)
ISSN: 1823-6049
Volume (12), Special Issue (2), 2016, 189-198
Available online at http://www.jamet-my.org
Citation:
S.A.Khalifeh.S, B.Madadi.V, S.Ahmadi, Accrual Earning Management and Fraudulent Financial
Statements, Journal of Administrative Management, Education and Training, Volume (12), Special Issue
(2), 2016, pp. 189-198
Received: 12.05.2016
Accepted: 16.05.2016
Accrual Earning Management and Fraudulent
Financial Statements
Seyed Ahmad Khalifeh Soltani, Bahareh Madadi Varzeghani,
Shima Ahmadi
ABSTRACT
Empirical evidence shows when corporates inflate the reported income through revenue
management, they will face with the outcomes of reversed accruals developed by
management in the future. Thus, they commit fraud to swap these reversed accruals.
Accordingly, the goal of this paper is to examine the relationship between accrual earning
management and fraudulent financial statements in some of the companies listed in
Tehran Stock Exchange. Due to not announcement of the names of fraudulent companies,
we have defined criteria to identify the companies suspected of fraud. Statistical Sample
consists of 108 companies (54 companies suspected of fraud and 54 non-fraudulent
companies) listed in the Tehran Stock Exchange. Fraud index including Aggregated Prior
Discretionary Accruals has been used in this research in order to measure the inflation
of income. The results indicate that there is a positive and significant relationship between
prior earning management and fraudulent financial statements.
Keywords: fraud, earning management, financial statements, accruals
Introduction
Fraudulent financial accounting and reporting fraud has grown considerably in recent years. Fraud
is not new, but there has been since 1960 in various types in business circles. In recent years,
corporate fraud has led to exorbitant costs. The fraud reported only in the US and UK reaches to
the billions of dollars. By the financial crisis in companies such as Enron and World Com, the
problem of fraudulent financial reporting was also entered to politics. Today, legislative bodies
pay particular attention to the causes of fraud and the ways to prevent fraudulent behavior in
financial reporting. While many people have committed fraud in financial reporting, most studies
have shown that director, member of the board of directors and financial managers have a greater
role in the fraud. Fraudulent Financial Statements affect a wide range of users of financial
statements. Staff, shareholders, creditors and market participants are among those affected by the
fraudulent financial statements. Extensive scandals and frauds in financial markets reduce the
reliability of financial statements that ultimately leads to inefficient capital market and nonoptimal resource allocation and may undermine the whole economy in case of extensive
occurrence. Research about fraud antecedents and detection is important because it improves the
understanding about fraud, which has the potential to improve auditors 'and regulators' ability to
detect fraud either directly or by serving as a foundation to future fraud research that does.
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Journal of Administrative Management, Education and Training (JAMET)
Improved fraud detection can help defrauded organizations, and their employees, shareholders,
and creditors curb costs associated with fraud, and can also help improve market efficiency. (Perol
& Lougee, 2011) Despite multiple studies in different countries on the discovery of fraudulent
financial reports, Iranian researchers have not shown much attention to this area. Regarding the
importance of this area and considering the fact that one of the ways of fraud in financial
statements is revenue management, we have tried to investigate the relationship between revenue
management and fraudulent financial statements in this study. The following questions will be
answered: is there any relationship between the prior revenue management and fraud regardless
of inflated earnings? Is there any relationship between the inflated earnings and fraud regardless
of prior revenue management? And is there any relationship between the fraud and inflated
revenue in the companies that have managed their prior revenue?
Related research and hypothesis development
Earning management and fraud definitions
There are various definitions of fraud and earning management in the literature however they all
have common facts. Healy and Wahlen (1999) define earning management as: '' earnings
management occurs when managers use judgment in financial reporting and in structuring
transactions 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 number. ''
They also refer to various incentives of managers to manage revenue:
Capital market motivation
Stock market purposes
Contracting motivations
Lending contracts
Management compensation contracts and Regulatory motivations
There are several definitions of fraud in the various sources. A number of these definitions are
listed below:
According to American Heritage Dictionary, fraud is intentional deceptive practices in order to
gain illegal or unfair profit. Statement on Auditing Standards No. 99 (SAS No.99) defines fraud
as "an intentional act that results in a material misstatement in financial statements that are the
subject of an audit" (Auditing Standards Board, 2002). Association of Certified Fraud Examiners
adopted a pervasive definition of fraud and says: Fraud includes all various tools made by human
by which an individual gains an advantage to others through false recommendations or concealing
the truth. And it includes all sudden events, manipulations, secrecies or other unfair ways to
deceive people. Wells (2009) mentioned that four elements must exist in any fraud case: A
material false statement, intent to deceive, reliance on the false statement by the victim, and
damages as a result. Stolowy and Breton (2003) however, stated that fraud differs from earnings
management. Fraud is outside the limits of GAAP and occurs when somebody commits an illegal
act. However, earnings management is within GAAP and is one form of accounts manipulation.
They defined accounts manipulation as: The use of management's discretion to make accounting
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choices or to design transactions so as to affect the possibilities of wealth transfer between the
company and society fund providers or management (2003, p20)
Generally, fraud is done in three forms:
 Corruption: it is defined as a fraud where fraudsters misuse their influence in a business
transaction to process for personal interests or someone else; such as accepting commission and
engaging in conflicts of interest, bribery, economic blackmail and extortion.
 Misuse of assets: including theft or misuse of assets of an organization.
 Fraudulent financial reporting: it is deliberate falsification of financial statements in order to
provide false image of the company.
Most of fraudulent financial statements have a number of common features and usually performed
with one of the following methods or a combination of them:
Fraud through misidentification of income: revenues and receivable accounts are among the
accounts manipulated easier and more in the fraudulent financial statements.
Fraud through inventory and cost of the goods sold: this type of fraud occurs by management
on inventory and cost of the goods sold. For example, when the company declares the inventory
more than real, or the cost of goods sold is expressed less than real, and it increases the profit.
Fraud by exaggerating the assets: when the company shows its assets more than real, because it
doesn’t recognize the cost of damage or loss in offices and provides the context to increase net
profit more than real.
Improper use of off-balance sheet items: off-balance sheet items often used to manage items
such as credit risk, finance, market and liquidity in rent contracts and research and development
activities. It might lead to fraudulent financial statements through the transfer of assets and hidden
liabilities in different companies and in different years.
Fraud by inadequate disclosure: inadequate disclosure includes the disclosure of misleading and
non-transparent financial statements and non-disclosure of important items listed in the financial
statements. In other words, the management provides the context to commit fraud by removing
some of important realities in the financial statements that may affect the users’ decision-making
in case of disclosure.
Fraud through manipulation of debts: One way to manipulate the debts is incorrect
restructuring and use of reserving tools for debts. Creating Reserve Account, either to merger or
restructure litigations or other factors, usually causes the creation of cost, debt or lowering assets
asset in the books of the company. Although creating Reserve Account is a useful tool to prevent
from incorrect transfer of the costs in different years (correspondence principle); but
unfortunately, the companies use these tools incorrectly to manage their earnings (Vakili Fard et
al., 2009). Zabihullah Rezai in 2005, in a research called “causes, consequences and prevention
from fraudulent financial statements”, evaluates the factors fraud. He also provided the strategies
to detect and prevent from fraud for decreasing the fraudulent financial statements. In his view,
fraudulent financial statement is a serious threat to the confidence of market participants to the
audited financial statements. In his opinion, fraud in financial statements can be equivalent to the
word “crime”. Reviewing the literature of revenue management indicates the researchers’ struggle
to understand why managers manipulate revenues, how they manage revenue and what the
consequences of this behavior are. When the companies inflated the financial reports by revenue
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Journal of Administrative Management, Education and Training (JAMET)
management, they will face with the consequences of the reversal of accruals made by revenue
management in the coming years. Thus, they commit fraud for the exchange of the accruals
reversed. Thus, a positive relationship between prior accruals and fraud is expected.
The relation between earning management and fraud
There is a debate in the audit literature on what should be considered as fraud or in other words,
is earnings management another form of fraud. Reviewing the literature showed mixed results
regarding whether earnings management is an ethical act. Some researchers argue that there is
nothing wrong with earnings management because it is within the boundaries of GAAP, while
believe earnings management is not just an unethical act but another form of financial reporting
fraud. By and the debate on earnings management and fraud will continue unless there is a proper
way to help auditors identify the difference between them. (Kassem, 2012). When firms inflate
reported financial information by managing earnings, they generate income-increasing accruals
that reverse over time (Healy, 1985). Firms with income increasing accruals in prior years must,
therefore, either deal with the consequences of the accrual reversals or commit fraud to offset the
reversals (Dechow et al., 1996; Beneish, 1997, 1999; Lee et al., 1999). When confronted with
earnings reversals and decreased earnings management flexibility, managers might resort to
fraudulent activities to achieve objectives that were previously accomplished by managing
earnings. We, therefore, expect a positive relation between prior discretionary accruals and fraud,
and refer to this relation as the earnings management reversal and constraint hypothesis (Perols &
Lougee, 2011).
Fraud in revenue account
One common objective for manipulating financial statements is to inflate reported revenue. In
order to inflate revenue, firms can either manage earnings or commit fraud. Firms that have
managed earnings in prior years are, as discussed earlier, constrained in their ability to manage
earnings. These firms are, therefore, more likely than firms that have not managed earnings in
prior years, to inflate revenue by committing fraud. We next discuss measures used to detect
inflated revenue and then formally state a hypothesis related to the interaction between prior
earnings management and inflated reported revenue.
Accordingly, the first hypothesis will be as follows:
Hypothesis 1.Prior revenue management has a positive relationship with committing fraud.
Dechow, J, Larson and Oslo in 2011 conducted a research in relation to prediction of important
accounting misstatements. The results showed that the quality of accruals is poor at the time of
misstatement and the financial and non-financial performance is diminishing. Financing activities
and off-balance sheet activities are higher in the course of fraud. The management of these
companies is very sensitive to stock prices. These companies have experienced high financial
performance and profit. Apparently, the misstatements occur in order to cover up poor financial
performance and remain the stock value higher.As stated before, we argue that there is an
interaction between prior earnings management and inflated reported revenue. More specifically,
firms that artificially increase revenue, have relatively high unexpected revenue per employee.
The artificially high revenue, as indicated by unexpected revenue per employee, can be due to
earnings management or fraud. However, firms that have managed earnings in prior years are
192
constrained in their ability to manage earnings and these firms are, therefore, more likely to exhibit
artificially high revenue due to fraud. Thus, while we expect a positive relation between
unexpected revenue per employee and fraud in general, we also expect that this relation is stronger
when firms have managed earnings in prior years. This discussion leads to our hypothesis:
Hypothesis 2.Inflating the income is positively related with committing fraud.
Hypothesis 3.The relationship between prior revenue management and fraud increases by inflating
the income.
Research design
For this purpose, two indicators of fraud are developed. Using a sample of a number of companies
suspected of fraud and non-fraudster companies, the relationship between fraud and revenue
management in prior years is investigated. Research variables include Aggregated Prior
Discretionary Accruals and Unexpected Revenue per Employee. To measure revenue
management, discretionary accruals are considered as the best indicator. Also, in order to measure
the inflation of income, unexpected revenue per employee index is used.
Jones model is used to calculate discretionary accruals.
Aggregated Prior Discretionary Accruals: ∑𝑡−1
𝑡−2 𝜀𝑖𝑡
𝛼0
𝑇𝐴𝑗,𝑡−1
+
𝛼1 (∆𝑅𝐸𝑉𝑗𝑡 −∆𝐴𝑅𝑗𝑡 )
𝑇𝐴𝑗,𝑡−1
+
𝛼2 .𝑃𝑃𝐸𝑗𝑡
𝑇𝐴𝑗,𝑡−1
𝐴𝐶𝐶𝑗,𝑡
+𝜀𝑖𝑡 = 𝑇𝐴
𝑗,𝑡−1
Change in income from year t-1 to t =∆𝑅𝐸𝑉𝑗𝑡
Change in receivable accounts from year t-1 to t = ∆𝐴𝑅𝑗𝑡
Property, machinery and gross equipment (tangible fixed assets) = 𝑃𝑃𝐸𝑗𝑡
Representative of discretionary accruals = 𝜀𝑖𝑡
TA = Total assets
ACC is the accruals calculated as follows:
Accruals = Change in current assets - Change in current liabilities - Change in cash- Depreciation
expense
Change in current assets: current assets in year t minus current assets in year t-1
Change in current liabilities: current liabilities in year t minus current liabilities in in year t-1
Change in cash: cash balance in year t minus cash balance in year t-1
Depreciation expense: Depreciation expenses in year t
Unexpected revenue per employee = ∆𝑅𝐸𝑉𝑗,𝑡
Unexpected revenue per employee j, t is equal to the change percentage in income per employee
in the company j in year t-1 and t0.
RE = (Total revenue) / (number of employees)
Control variables
Control variables include debt to capital, sale to assets, receivable accounts growth, gross profit
margin growth, sales growth, and return on assets, total assets and total sales.
The ratio of sales to assets: the ratio of sales to assets is an indicator of the financial crisis
predicting the negative relationship between this index and fraud.
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Journal of Administrative Management, Education and Training (JAMET)
Receivable Accounts Growth: it is a dummy variable that is equivalent to 1 when receivable
accounts are greater than 110% of the last year; otherwise it is zero. Since most of the receivable
accounts grew as a result of fraud, a positive relationship is expected between receivable accounts
and fraud.Gross profit margin growth: it is a dummy variable that is equivalent to 1 when gross
profit margin percentage is greater than 110% of the last year; otherwise it is zero.Sales growth:
it is measured as the change percentage in income from t-2 to t-1 and used to measure income
growth rather than income manipulation. The reason to consider the year t-2 to t-1 is that if a
company is fraudster, it probably manipulates its income in the year t-1. Thus, the income
difference in the two years before and a year before is calculated. ROA: Assuming that the
companies that have poor performance are under pressure to improve financial results artificially,
a negative relationship is expected between return on assets and fraud.
Total assets and total sales: these two variables were entered the model for controlling the firm’s
size; and it is likely that there is a negative relationship between these two variables and fraud.
Model for hypothesis testing
To evaluate our hypotheses in Iran, we use Perol & Lougee (2011) model. The model is as follows:
Froud = β0 + β1 * Aggregated Prior Discretionary Accruals + β2 * Unexpected Revenue per
Employee + β3 * (Aggregated Prior Discretionary Accruals * Unexpected Revenue per Employee)
+ Control variables * βn + ε
Where Fraud is a dependent dichotomous variable, equal to 1 if the firm was investigated for fraud
and 0 otherwise, Aggregated Prior Discretionary Accruals are the total of discretionary accruals
in years t-1, t-2, and Unexpected Revenue per Employee is the difference between a firm and its
industry in the percentage change in revenue per employee from year t-1to t0. We also include
previously described control variables.
Sample selection
The sample of this study consisted of 108 companies (54 companies suspected of fraud and 54
non-fraudster companies) listed in the Tehran Stock Exchange for the period 2006-2012. Given
that the names of fraudster companies in Iran are not disclosed, the companies are classified using
indicators for fraudulence. The fraudster companies were selected based on inclusion in the
companies listed in the stock exchange for which unacceptable comment has been issued,
consisting the income-expense article (i.e. the income has been recognized more than or the
expense lower than reality), having delay in information disclosure, their symbol is stopped more
than six months, including important annual adjustments, the continuation of their activity is
questioned for 2 years but the financial statements were prepared assuming the continuation of
their activities.
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Descriptive statistics
Descriptive statistics table is as follows:
Table 1: Descriptive statistics
farud
Aggregated Prior
Discretionary Accruals
Unexpected Revenue per
Employee
Debt to capital
Sales to asset
Account receivable growth
Gross profit growth
Sales growh
ROA
Total asset
Total sales
%25
median
%75
0.50
0.00
Standard
deviation
0.50
0.24
0.00
0.09-
0.50
0.02
1.00
0.11
URPE
0.34
1.24
0.07-
0.14
0.39
𝑋1
𝑋2
𝑋3
𝑋4
𝑋5
𝑋6
𝑋7
𝑋8
5.91
8.55
0.72
0.84
0.23
1.071346
927
5.16
80.29
4.06
6.49
1.01
11.67
2451
1376
2.06
0.48
0.190.200.070.01
352
182
4.09
0.75
0.05
0.09
0.10
0.05
6381
552
8.56
1.06
0.36
0.54
0.28
0.08
1258
1023
Variable
Mean
Froud
APDA
According to the values of above tables showing the descriptive statistics of research variables, it
can be concluded that there is a medium dispersive in all the variables that can be inferred from
the standard deviation.
Results of empirical tests
In this section, we test the research hypotheses. Before testing the hypotheses, the variable of prior
revenue management measured by aggregated accruals is estimated using Jones model. Then,
logistic regression is used to test the first to third hypothesis.
To estimate the aggregated accruals, the regression model is as follows:
𝐴𝐶𝐶𝑗,𝑡
(∆𝑅𝐸𝑉𝑗𝑡 − ∆𝐴𝑅𝑗𝑡 )
𝑃𝑃𝐸𝑗𝑡
1
= 𝛽0 + 𝛽1
+ 𝛽2
+ 𝛽3
+ 𝜀𝑖𝑡
𝑇𝐴𝑗,𝑡−1
𝑇𝐴𝑗,𝑡−1
𝑇𝐴𝑗,𝑡−1
𝑇𝐴𝑗,𝑡−1
In this model, the discretionary accruals are equivalent to the model residuals estimated for a year
ago and two years ago. Aggregated prior discretionary accruals are the total discretionary accruals
of years t-1 and t-2; written as follows:
Aggregated prior discretionary accruals = ∑𝑡−1
𝑡−2 𝜀𝑖𝑡
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Journal of Administrative Management, Education and Training (JAMET)
Table 2: Summary of regression model results
variable
Value
intercept
Coeffic
ient
𝛽0
P-value
0.388
Standard
deviation
0.486
Aggregated Prior Discretionary
Accruals
Unexpected Revenue per Employee
APDA
𝛽1
(0.703)
2.061
0.031
URPE
(Aggregated Prior Discretionary
Accruals * Unexpected Revenue
per Employee
Debt to capital
APDA*
URPE
𝛽2
2.935
0.415
0.043
𝛽3
(** 3.813)
3.028
0.035
𝑋1
𝛽4
2.008
0.066
0.352
Sales to asset
Account receivable growth
𝑋2
𝑋3
𝛽5
𝛽6
(** 3.433)
2.408
0.357
0.082
0.063
0.981
Gross profit growth
𝑋4
𝛽7
(** 3.570)
0.090
0.567
Sales growth
𝑋5
𝛽8
0.061
0.326
0.385
ROA
𝑋6
𝛽9
(2.057)
2.021
0.067
Total asset
𝑋7
𝛽10
0.671-
0.0001
0.041
Total sales
𝑋8
𝛽11
(* 2.902-)
0.0001
0.068
0.638
*** Significant at 1%, ** significant at 5%, * significant at 10%.
Other results are as follows:
Table 3: Continue of regression model results
𝑟2
standard
deviation
0.642
𝑃 − 𝑉𝑎𝑙𝑢𝑒
statistic LR
0.5127
38.962
0.0007
According to the above table, the regression model is significant according to the statistics LR and
P-Value that shows the overall impact of independent variables on the dependent variable. In the
following, coefficient significance test is performed to determine the effect of each variable, and
the model validity is also specified by the determination coefficient. On the other hand, according
to the coefficient of determination (0.642), it can be concluded that about 64.2% of variation in
the dependent variable can be explained by the independent variables. Given the coefficient of the
variable Aggregated Prior Discretionary Accruals which is equal to 2.935 and due to its significant
and positive value, the first hypothesis is accepted; the prior revenue management was positively
associated with committing fraud. Given the coefficient of the variable Unexpected Revenue per
Employee which is equal to 2.008 and due to its significant and positive value, the second
hypothesis is accepted; inflation of income was positively associated with committing fraud.
Given the coefficient of the variable Aggregated Prior Discretionary Accruals * Unexpected
Revenue per Employee which is equal to 2.408 and due to its significant and positive value, the
first hypothesis is accepted; the prior revenue management and inflation of income are positively
associated with committing fraud. Among control variables in all three hypotheses, total assets
ratio has positive and significant relationship with fraudulent financial statements and also sale to
assets, total sales and return on assets have negative and significant relationship with fraudulent
financial statements. The variable of sales to assets is an indicator of the financial crisis; so this is
196
why there is a negative relationship between this variable and fraud. The companies that have poor
performance are under pressure to improve financial results artificially, a negative relationship is
expected between return on assets and fraud. The control variables debt-to-capital, receivable
accounts growth and gross profit margin growth have also a positive relationship with fraudulent
financial statements. A positive relationship between debt-to-capital and fraud was expected
because higher levels of debt-to-capital impose more pressure on managers to adapt with debt
agreements. Similarly, a positive relationship between receivable accounts growth and fraud was
predictable, because most receivable accounts increases as a result of fraud.
Concluding remarks
We examined the relation between previous earnings management and the propensity to commit
fraud. It is expected that there is positive relationship between prior accrual revenue management
and fraud; because when corporates inflate the reported income through revenue management,
they will face with the outcomes of reversed accruals developed by management in the future.
Thus, they commit fraud for the exchange of the accruals reversed. To address this issue, two
independent variables called Aggregated Prior Discretionary Accruals and Unexpected Revenue
per Employee and a number of control variables were selected. Aggregated Prior Discretionary
Accruals including discretionary accruals two years and one year before the fraud are used to
evaluate revenue management in the previous years. Unexpected Revenue per Employee has been
also used to measure the inflation of income. The results of the study indicate a significant positive
relationship between revenue management and committing fraud. This means that the more the
companies have revenue management in prior years, they are more likely to commit fraud. The
results obtained were consistent with the expectations; because those companies who manage
revenue will face with the reversal of liabilities, and they might commit a fraud to neutralize the
impacts of reversed liabilities. On the other hand, those companies who have increased their
income artificially will have higher unexpected revenue per employee. This unexpected revenue
per employee is positively related to committing fraud; so the second hypothesis is confirmed.
The third hypothesis indicated that the relationship between prior revenue management increases
with the inflation of income. It means that the third showed that profit management association
with inflated revenue increase drastically. This means that companies that have managed earnings
in prior years are likely to commit a fraud when they inflate t their income. Due to the
confidentiality of the information about the fraudster companies listed in the Tehran Stock
Exchange, sampling was conducted based on the criteria representing the possibility of fraud in
the firms; so it was not possible to select more than 54 firms. This restriction may affect the results.
According to the results obtained, it is suggested to the auditors and analyzers to consider the
positive relationship between revenue management and fraudulent financial statements in making
economic decisions and pay attention to the fact that revenue management may not be always
useful. Therefore, the opportunistic aspects of revenue management must be considered. Inflating
the income can be an evidence of fraudulent financial statements. Auditors should consider ratios
such as the ratio of sales to assets and return on assets as negative factors and the ratio of debt to
capital as a positive factor affecting the fraudulent financial reporting.
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Journal of Administrative Management, Education and Training (JAMET)
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SEYED AHMAD KHALIFEH SOLTANI, Assistant professor, Alzahra University, Tehran, Iran
[email protected]
BAHAREH MADADI VARZEGHANI, MSc, Alzahra University, Tehran,Iran
[email protected]
SHIMA AHMADI, MSc .student, Alzahra University, Tehran, Iran
[email protected]
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