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DETECTING FALSIFIED FINANCIAL STATEMENTS AND THEIR

IMPACT ON COMPANYS PERFORMANCE (PAKISTAN)

Introduction
Financial statements are mandatory to be accurate because creditors and investors use financial
statements as base to make their investment decisions. Financial statements of companies are
considered very important for all stakeholders. Financial statements are useful to evaluate past
and future performance of company. Financial statements are also useful to access the
companys liquidity, solvency and financial flexibility.
Falsified financial statements have become increasingly frequent over the last few years.
Falsified financial statements consists of manipulating elements by overstating assets, sales and
profits or understating the liabilities, expenses or losses. When financial statements contain
falsification then its elements no longer represent the true picture of the financial position of the
company. Falsified financial statements arise from either fraud or error but fraud and error have
different characteristics. Fraud arises through intentional activities and error arises through unintentional activities. According to International Federation of Accountants (IFAC) fraud is
defined as Intentional act by one or more individuals among management, those charged within
governance, employees, third parties, involving the use of deception to obtain and unjust and
illegal advantage.
Fraud can be of two types. One is management fraud and other is employee fraud. Management
fraud can be defined as deliberate fraud committed by management that injures investors
through misleading financial statements. Management fraud is often called fraudulent financial
reporting and is the intentional misstatement or omission of amounts or disclosures by the
management with the intent to deceive users.
Employee fraud can be defined as theft and appropriation of cash stocks or securities. This
group of illegal acts may involve several people in or outside the enterprise. These actions are
intended to erase the traces of the unlawful appropriation of property thereby misleading users of
financial reports. Increasing trend of falsified financial statements in the world not only

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intimidates investors and adversely affect their investment decisions but also damages the
credibility of capital markets around the world. Fraudulent financial statements incur huge cost
for companies. Due to high cost arising from financial statements fraud various countries
establish regulations in order to combat fraud. Many firms go bankrupt each year due to the false
financial statements.
Falsified financial statements can be detected through investigation of financial information.
Auditors opinion can be used to classify the companies as fraudulent or non fraudulent. False
financial statements can be identified on the basis of the quantity and content of the
qualifications filed by the auditors on the accounts. For this purpose, statistical tools are
employed to investigate the usefulness of publicly available variables for detecting FFS. A total
of ten variables are found to be possible indicators of FFS. These include the ratios: debt to
equity, sales to total assets, net profit to sales, accounts receivable to sales, net profit to total
assets, working capital to total assets, gross profit to total assets, inventory to sales, total debt to
total assets, and financial distress (Z-score).

Literature review
Previously many researches had been conducted related to our research topic that are as follows:
Charalambos T. Spathis (2002) detected financial statements by using published data. This paper
examines the published data to develop a model for detecting factors associated with false
financial statements.
Reeve and Warren (2008) defined financial statements as financial reports that summarize the
affects of events on a business. Kieso, Weygandt and Warfield (2007) asserted that financial
statements are useful for the assessment of a companys liquidity, solvency and financial
flexibility. They further stated that Financial Statements also helps in evaluating the past and
future performances of the company.
According to Gibson (2009), users of financial statements (such as companys managers,
stockholders, bondholders, security analysts, suppliers, lending institutions, employees, labor

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unions, regulatory authorities, Government and the general public) uses it to make valued
decisions according to their areas of interest.

Naser and Pendlesbury (1992), Beasley, Carcello and Hermanson (1999), Mulford and Comisky
(2002), Pietesz (2007), and Okoye, Ukenna and Ugwanyi (2009) studied the reasons and motives
behind fraudulent preparation of financial statements.

Ch. Spathis, M. Doumpos and C. Zopounidis conducted the study on detecting falsified financial
statements. They conducted the comparative study using multi criteria analysis and multivariate
statistical techniques.

Ilker Kiymetli SEN and Serkan Terzi (2012) conducted the research on detecting the falsified
financial statements using data mining, empirical research on finance sector in Turkey. In order
to determine the statistical test for variables the normality test is applied. For this purpose the
Kolmogorov Smirnov and Shapiro Wilks test (because there are few samples for FFS) was
performed.
Ata and Seyrek (2009) used ANN and DT methods in order to determine FFSs. The researchers
accessed financial data of 100 listed companies on ISE. As a result, the researchers detected that
some financial ratios are important in detecting the FFSs.
Kotsiantis et al. (2007) used Athens Stock Exchange registered financial statements of 164
companies in Greece. According to auditors views, the financial statements were classified as
fraudulent and non-fraudulent. In this study, there were 41 FFSs and 123 non-FFSs identified.
The researchers used a method of data mining and selected financial ratios for fraud risk factors
in financial statements. As a result of their research, the researchers, using data mining, classified
the fraudulent financial statements with 90% accuracy. In addition, they claimed that certain
financial ratios were important variables for detecting fraud.

Spathis et al. (2002) examined the effectiveness of an innovative classification methodology in

order to detect companies FFSs and the identification of the factors associated to FFSs. The
methodology is based on the concepts of multi criteria decision aid (MCDA) and the application
of the UTADIS classification method (Utilitys Additives Discriminates). Financial ratios were

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determined as the fraud risk factors. The researchers found that the proposed MCDA
methodology outperforms traditional statistical techniques which are widely used for FFSs
detection purposes. In addition, the researcher detected that some financial ratios hold potential
risk of FFSs.

Objectives

Identification of fraudulent or falsified financial statement companies

To examine the impact of fraudulent or falsified financial statements on companies

financial performance

Methodology
Data
The purpose of this research paper is to identify the falsified financial statements and their
impact on companys financial performance and investors decision making. We will select
companies that are listed on Karachi Stock Exchange (KSE) in Pakistan. We will select both
fraudulent financial statements companies and non fraudulent financial statement companies.
Sample
We will collect data from 100 listed companies in Karachi Stock Exchange. 50 fraudulent
financial statements companies and 50 non fraudulent financial statements companies.
Variables
Independent variable
Fraudulent financial statement is independent variable because it is cause for making change in
companys performance. We will detect fraudulent financial statements and see their impact on
company performance.
Dependent variable
Financial ratios or company performance is independent variable because it is affected by
fraudulent financial statements.
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Method
We will use secondary data for our research. We will collect data from the financial reports of
the company/published data. We will identify the falsified financial statements and their impact
on companys financial performance through calculating financial ratios of companies. Firstly
we will identify the falsified financial statements by using the auditors opinion in the published
data. After that we will use the financial ratios to see the impact of the falsified financial
statements on companys performance. We calculates the financial ratios of both fraudulent and
not fraudulent companies and compare the results of both type of companies.
Hypothesis
H0: (Null hypothesis)
Financial ratios are not significantly effective on indentifying falsified financial statements and
to determine their impact on companys financial performance.
H1 :
Financial ratios are significantly effective on indentifying falsified financial statements and to
determine their impact on companys financial performance.

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