Toward Detection of Deception in Fraudulent Annual Reports

This study describes an investigation of deception in financial reporting in real-life organizational contexts. We reviewed Accounting and Auditing Enforcement Releases provided by the U.S. Securities and Exchange Commission to identify cases of firms involved in fraudulent financial misreporting. We distinguish firms guilty of fraud from those firms guilty of fraud and error in financial misreporting. By matching these cases of fraud to firms not involved in fraud, we examined whether language used in shareholder letters in annual reports, signed by firms’ leaders, could predict fraud. We utilized DICTION 7.0 (a computer-aided text analysis software) to analyze shareholder letters contained in fraudulent and non-fraudulent annual reports. Using the theory of deception, we found evidence that verbal cues which have been found to indicate deception correlated with instances of fraud. In particular, shareholder letters of firms guilty of fraud contained wording representative of negative emotions. Additionally, the wording in these shareholder letters indicated the authors attempted to disguise the deception. For parties interested in detecting and possibly preventing fraudulent financial misreporting, we proposed guidelines that can serve as an effective fraud-detection tool.