Predicting the likelihood of Financial Statement Fraud through Financial Distress in India

Abstract

The objective of the paper is to illuminates the intricate relationship between financial distress and the probability of financial statement fraud. The profound implication of the financial distress on the probability of the financial statement fraud within emerging economies like India is presented through this study. The research employs a dataset consisting of 3198 firms listed on NSE and BSE, comprising 36,947 firm-year observations spanning from 2006 to 2022.  Panel regression analysis is applied to evaluate the study’s findings, with data sourced from the CMIE Prowess database. The Beneish M-score serves as a robust tool for quantifying instances of financial statement fraud, while the Altman Z-score stands as a stalwart metric utilized to assess the levels of financial distress, providing valuable insights into the solvency and stability of a company’s financial health. The study reveals a substantial positive relation among financial distress and the probability of financial statement fraud. In credit markets featuring financially distressed firms, this connection highlights an underlying agency problem. Consequently, when a firm experiences financial distress, the probability of financial statement fraud escalates, as it creates pressure to resort to such measures. The study is helpful to policymakers, academic researchers, and regulators with the predictive probabilities of financial statement fraud and financial distress. Policy makers and regulators can restructure the financial distressed firms to reduce the chances of financial statement fraud.