This paper illustrates the application of artificial neural networks (ANNs) to test the ability of selected SAS No. 53 red flags to predict the targets of the SEC investigations. Investors and auditors desire to predict SEC targets because substantial losses in equity value are associated with SEC investigations. The ANN models classify the membership in target (investigated) versus control (non‐investigated) firms with an average accuracy of 81%. One reason for the relative success of the ANN models is that ANNs have the ability to ‘learn’ what is important. The participants in financial reporting frauds have incentives to appear prosperous as evidenced by high profitability. In contrast to conventional statistical models with static assumptions, the ANNs use adaptive learning processes to determine what is important in predicting targets. Thus, the ANN approach is less likely to be affected by accounting manipulations. Our ANN models are biased against achieving predictive success because we use only publicly available information. The results confirm the value of red flags, i.e. financial ratios available from trial balance in conjunction with non‐financial red flags such as the turnover of CEO, CFO and auditors do have predictive value. © 2000 John Wiley & Sons, Ltd.

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Abstract. This paper explores restrictions in private lending agreements to determtne how contractors" status affects (I) the number of limitations on managerial actions and (2) tighttiess (or slack) of contract restrictions at contract inception. The major result of the multivariate tests is that highly leveraged borrowers are forced to negotiate agreements with both more numerous and tighter restrictions. Debt contracts represent a series of rational trade-offs. Firms with higher debt face more restrictions, which are tighter and more likely to restnct managerial actions. Similarly, borrowers are more likely to agree to tighter extensive restrictions in exchange for more substantial loans. The evidence also indicates that larger firms that possess greater resources to avoid default are able to negotiate looser agreements that contain fewer restrictions. Secured loans do not impose a large number of accounting-based restrictions on managements" actions because secured lenders have less need to restrict managements" options. However, longterm agreements, including insurance loans, include more restrictions on dividends and payout options but use covenant ratios to allow managemeni the flexibility needed over the course of a long-term loan.Resume. Les auieurs etudient les clauses resirictives des contrats de pret prives afin de determiner commeni la situation des contractants infiue sur i) le nombre des limites imposees a la direction dans sa marge de manoeuvre et 2) la rigueur (ou la malleabilite) des restrictions contractuelles au debut du contrat. Une constatation principale resulte des tests a plusieurs variables aleatoires : les emprunteurs dont le tevier financier est important se voient contraints de negocier des contrats contenant a la fois des restrictions plus nombreuses et plus rigoureuses. Les contrats d'emprunt sont en quelque sorte une serie de compromis rationnels. Les entreprises dont la dette est plus elevee font face a (lavantage dc restrictions, qui sont plus limitatives ct plus susceplibles de reduirc la marge de manoeuvre de la direction. D'autre part. !es emprunieurs sont plus enclins a accepter que leur soient imposees des restrictions plus rigoureuses et plus nombreuses, en echange de prets plus substantiels. Les resultats de la recherche revelent egalement que les entreprises plus grandes disposant de ressources plus importantes qui diminuent le risque de non-rcmboursement soni en mesure de negocier des ententes plus souples qui contiennent moins de restrictions. Les preis garantis n"iinposent pas beaucoup dc restrictions comptables a la marge de manoeuvre de la direction, puisque les preteurs garantis eprouvent moins la necessite de restreindre les options de la direction. Toutefois. les contrats a long terme, parmi lesquels les prets de compagnies d'assurance, component davantage de restrictions relatives aux dividendcs et aux options de remboursement mais prevoietit dans leurs clauses restrictives des ratios moins severes, de faCcon a assurer a la direction la souplesse qui lui est ncce...