Accounting Variables, Deception, and a Bag of Words: Assessing the Tools of Fraud Detection

46 Pages Posted: 5 Sep 2010 Last revised: 26 Sep 2012

Date Written: September 26, 2012

Abstract

We compare the effectiveness of financial statement variables and pre-determined lists of suspicious words with an alternative approach to fraud detection. Using the text of the Management Discussion and Analysis section from 10-Q and 10-K reports, we allow the data to identify words most strongly associated with financial misrepresentation. Based on the identified words, we assign a probability that a particular financial report is truthful within the time series of reports for the same firm. We compare this probability of truthfulness to predictions of fraud based on the F-Score from Dechow et al. (2011) and pre-defined word lists designed to capture deception, negativity, uncertainty and litigious activity. We establish that the data-generated word list can be a useful complement to detection methods based on financial statement variables by dramatically reducing the number of false positive predictions. In addition, our approach produces higher correct classification rates than textual analysis using alternative pre-determined word lists. Particularly interesting is our finding that word lists designed to reflect conscious deception have virtually no ability to correctly identify financial misrepresentation. This suggests that many of the individuals involved in drafting financial reports, including employees, auditors, and legal counsel may be completely unaware that the fraud is occurring. The data-generated word list continues to outperform alternative detection methods in a second sample representing a broad cross-section of firms.

Keywords: corporate fraud, financial disclosure, textual analysis

JEL Classification: G3, M4, K4

Suggested Citation

Purda, Lynnette D. and Skillicorn, David, Accounting Variables, Deception, and a Bag of Words: Assessing the Tools of Fraud Detection (September 26, 2012). Available at SSRN: https://ssrn.com/abstract=1670832 or http://dx.doi.org/10.2139/ssrn.1670832

Lynnette D. Purda (Contact Author)

Smith School of Business ( email )

Smith School of Business - Queen's University
143 Union Street
Kingston, Ontario K7L 3N6
Canada
613-533-6980 (Phone)

David Skillicorn

Queen's University ( email )

Kingston, Ontario K7L 3N6
Canada

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