Peeling away financial reporting issues one layer at a time

Researchers Study Signs of Financial Manipulation

Mechanical measures of earnings quality, though far from perfect, can direct the attention of audit committee members and others to matters that may require their attention.  The authors of an academic paper (funded by the Big Four accounting firms) entitled "Predicting Material Accounting Manipulations" have identified approximately 700 cases of quarterly or annual accounting manipulation from SEC Accounting and Auditing Enforcement Releases, and combined them with a sample of other firms to develop a statistically-based index of the likelihood of accounting manipulation—a so-called "fraud score."  As an indicator of the accuracy of the fraud score, 80% of the 700 fraud cases scored among the highest 20% of firms for which a score was calculated. 

The researchers found the following variables to be significant contributors to a company’s fraud score:

  • Financial statement variables—the quality of reported earnings and accounting return on investment.  The researchers used mechanical indices of earnings quality that were published elsewhere.  (For example, see Richardson, et al., Journal of Accounting and Economics, Vol. 39, 2005)
  • Off-balance sheet variables—the existence and use of operating leases, changes to order backlogs and number of employees.
  • Market-related variables—market-to-book ratio, PE ratio, prior stock price performance, amount of new financing.  High levels of these variables may increase pressure on management to meet investors’ performance expectations.

An abstract and free copy of the July 2007 version of the unpublished manuscript is available at http://ssrn.com/abstract=997483.  As always with academic papers, one should be aware that a ‘working paper’ could be altered significantly prior to publication in a journal.

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