Financial fraud and the use of ratios in corporate collapse prediction models

This paper highlights the prevalence and extent of financial fraud amongst collapsed corporations. In doing so, it examines the recent spectacular corporate collapses of Parmalat in Europe, Enron and WoridCom in the USA and HIH in Australia. A new methodology that provides empirical evidence to the financial fraud claims found in the literature, is then put forward. The proposed methodology argues that if financial fraud was a possibility amongst collapsed corporations, then two premises ought to be observed in the literature on ratio based multivariate modelling for predicting corporate collapse. First, in the absence of financial fraud, we expect the models to consistently predict corporate collapse with a high degree of accuracy; particularly, as one approaches the incident of collapse. Second, if financial fraud takes place and statement figures are distorted, then we expect the financial ratios, which are the predictor variables in these models, to lose relevance and therefore their use in models will be short-lived. Empirical support from Hossari and Rahman (2004) and Hossari and Rahman (2005) is presented as evidence to the two premises.