The Difference between Earnings and Operating Cash Flow as an Indicator of Financial Reporting Fraud*

Abstract

This paper examines the relation between earnings and operating cash flow to derive and test an indicator of financial statement fraud. Accrual measurement concepts indicate that financial statement fraud should be associated with high levels of earnings relative to operating cash flow. We demonstrate that the excess of earnings over operating cash flow is extreme in most fraud cases in years immediately prior to the fraud discovery based on a sample of 56 fraud cases from 1978 to 1991. We compare the distribution of the earnings minus operating cash flow variable for fraud firms with that for a sample of 60,453 firm‐years for firms listed on COMPUSTAT. We test a logistic regression model in which the discovery/nondiscovery of fraud is the dependent variable, and earnings minus operating cash flow is the explanatory variable. Other control variables are included in the model based on prior studies. Results are consistent with expectations derived from accrual measurement theory. We then examine the predictive ability of the model using our sample of fraud firms and a sample of nonfraud firms in the same four‐digit SIC code industries. Observations for the fraud firms are for the fiscal year prior to the discovery of fraud. Observations for the nonfraud firms are for the same fiscal years as the fraud firms in the same industries. The predictive ability of the model, including the excess of earnings over operating cash flow, is substantially higher than the predictive ability of the model omitting this variable. We conclude that the earnings‐operating cash flow relation provides important information for those interested in identifying financial statement fraud, especially when considered in conjunction with other factors associated with fraud risk.

Earning Management dan Expected Future Earning di Bursa Efek Indonesia

“…Lebih lanjut perilaku manajamen ini bermetamoforsis menjadi financial fraud (Marai dan Pavlovic, 2013 (Healy, 1985). Karenanya perusahaan yang menggunakan income increasing Accruals di tahun akan datang harus menerima konsekuensi dari penyesuaian Accruals atau melakukan fraud untuk mengatasi penyesuaian yang dibutuhkan (Dechow et al (1996); Beniesh (1997), Lee et al (1999)). …”

Characteristics of companies with a higher risk of financial statement fraud: A survey of the literature

“…Articles discussing the detection and identification of fraud tend to be geared towards the auditor's responsibility for detecting and identifying fraud, for example, Connelley (2003), Daroca and Holder (1985), Glover and Aono (1995) Heiman-Hoffman, Morgan and Patton (1996), Holder (1983), Hylas and Ashton (1982), Kaminski, Wetzel and Guan (2004), Kinney (1979), Krambia-Kapardis (2002), Lee, Ingram and Howard (1999), Lendez and Korevec (1999), Moyes and Hasan (1996), Nieschwietz, Schultz and Zimbelman (2000) and Persons (1995).…”

“…Company size Baucus & Near (1991) Large finns Beasley (1996) Cresse~(1986) Finns in smaller towns violate the law more Davia, Coggins, Wideman, Kastantin (2000) Smaller companies are the largest fraudsters DeFond & Iiambalvo (1991) Smaller companies Fridson & Alvarez (2002) Small and large companies Errors in revenue cycle, property, plant and equipment, prepaid Hylas and Ashton (1982) expenses, deferred charges and other assets occur more in smaller companies while errors in inventory, notes receivable and other liabilities tend to occur more in larger companies Kinne~ & McDaniel (1989) Smaller finns Persons (1995) Smaller finns Rezaee (2002) Large and decentralised Saksena (2001) Larger finns 6. Control Albrecht, Cherrington, Payne, Roe & Ronmey Poor internal control ,i~ Elliot & Willingham (1980) r _~ostolou, Hassell & Webber (200 I) Poor attitude towards internal control Bell & Carcello (2000) Weak internal control Calderon & Green (1994) Weak internal control Davia, Coggins, Wideman, Kastantin (2000) No adaptation of controls to changes Dechow, Sloan & Sweeney (1996) Beneish (1997) More leveraged growth-firms Dechow, Sloan & Sweeney (1996) More leveraged positions DeFond & Jiambalvo (1991) High leverage lAASB (2004) Problems to meet debt repayments or covenant requirements Kinney & McDaniel (1989) Highly leveraged companies Lee, Ingram & Howard (1999) Highly leveraged firms Mitchell (1997) High debt National Commission on Fraudulent Financial…”

“…Fridson & Alvarez (2002) Lack of an audit committee Poor audit committee Lee, Ingram & Howard (1999) More internal than external directors CEO that controls board of directors Mills (2003) Not majority of independent outsiders (audit committee included) Loans to directors Not full-time membership on board of directors Mitchell (1997) Frequent changes to board members National Commission on Fraudulent Financial…”

“…These are arranged in alphabetical order, as the importance of the individual characteristics is not considered in this study. Beneish (1997) Younger finns Fridson & Alvarez (2002) Younger companies Lee, Ingram & Howard (1999) Younger finns Schilit (1993) Recently became public company Shennan, Young & Collingwood (2003) Younger companies often have unconventional methods 5. Company size Baucus & Near (1991) Large finns Beasley (1996) Cresse~(1986) Finns in smaller towns violate the law more Davia, Coggins, Wideman, Kastantin (2000) Smaller companies are the largest fraudsters DeFond & Iiambalvo (1991) Smaller companies Fridson & Alvarez (2002) Small and large companies Errors in revenue cycle, property, plant and equipment, prepaid Hylas and Ashton (1982) expenses, deferred charges and other assets occur more in smaller companies while errors in inventory, notes receivable and other liabilities tend to occur more in larger companies Kinne~ & McDaniel (1989) Smaller finns Persons (1995) Smaller finns Rezaee (2002) Large and decentralised Saksena (2001) Larger finns 6.…”