AN EFFECTIVE FRAUD DETECTION MODEL FOR THE AUDITORS AS AN ANALYTICAL TOOL: APPLICATION ON PAKISTAN FIRMS

Abstract

This study aims to establish a rigorous and effective fraud detection model to assist auditors in mitigating and combating financial fraud. This fraud prediction model provides auditors with an analytical tool for fraud detection. The study uses the stepwise logistic regression technique, individually adding variables to the model. The variable that results in discrimination between the groups of fraud firms and non-fraud firms will then be retained, and others will not be included. There are twenty-one (21) different proxies, which are indirect measures that stand in for other variables that are difficult to measure directly, of which fourteen (14) financial ratios and seven (7) corporate governance parameters are used as metric variables to detect the non-metric variable, i.e., fraud detection, having a value of 1 for fraud firms and 0 otherwise. The study developed a fraud detection model based on financial ratios and corporate governance parameters to predict how firms manipulate financial statements and protect investors' interests. The model uses 21 financial ratios and stepwise logistic regression to identify factors influencing firm management in fraud perpetration. The model found that ownership, receivables, and total accruals to total assets significantly positively impacted fraud perpetration. The model was developed using a pool of 21 financial ratios and showed a decrease in the value of -2 log of likelihood (-2LL) at the third step of the regression, indicating a significant improvement in the model's predictive power. Auditors are the primary source of trust for the firm’s stakeholders, helping them reduce the expectation gap. The essential factors contributing to auditors' fraud prevention include financial integrity, independence, competence, adherence to ethical standards, transparency, and regulatory oversight. Based on these fundamental principles, the proposed model will strengthen auditors' role in detecting fraud risk. This model has vast practical implications. Auditors can incorporate this comprehensive model into their analytical procedures, whether they opted substantive testing or a systematic-based approach. This will enable them to assess fraud risk effectively and enhance firms' financial integrity.