Diagnosing Fragility: The Promise of Forensic Accounting

By James A. Kaplan and Lev Janashvili

Nassim Nicholas Taleb’s latest book (Antifragile: Things that Gain from Disorder) delivers pointed awareness-raising insights into systemic vulnerabilities that threaten the sustainability of social and economic institutions. Just as his earlier work that turned the phrase “Black Swan” into a viral meme, Antifragile convincingly reinforces many of the concepts underlying GMI Ratings’ approach to measuring and mitigating issuer risk.

First, modern capital markets mask fragility (i.e., risk) with remarkable efficiency. They render naïve the lingering assumption that reported financial results faithfully reflect economic realities. In the increasingly complex, mechanized, technology-driven, inconsistently regulated markets, risk detection requires much more probing scrutiny, and failure to detect risk exacts a much higher price.

We recently reviewed academic research on the prevalence of very aggressive accounting practices that materially distort economic reality. Our own AGR® rating model tracks hundreds of companies around the world whose reported financials exhibit telltale patterns statistically associated with the probability of fraud. Viewed through the lens of classical financial theory, many of these companies can appear “antifragile”. But our research shows that these companies face a staggeringly elevated risk of 70%+ drops in share prices, not to mention other events with massive value-destruction potential.

Aggressive accounting remains rampant – often neglected by resource-challenged regulators, enabled by bureaucratic standard-setters, exploited by corporate executives operating under perverse incentives. Ironically, this status quo often aligns with current securities law and SRO regulations. So far, we have not seen a sufficiently potent catalyst for change. For investors, insurers and anyone exposed to issuer risk, the conclusion is clear: buyer beware.

Second, incentives matter. In Taleb’s recent Wall Street Journal op-ed, Rule 5 (“Decision makers must have skin in the game”) is particularly noteworthy for students of corporate governance. Taleb writes:

“At no time in the history of humankind have more positions of power been assigned to people who don’t take personal risks. But the idea of incentive in capitalism demands some comparable form of disincentive. In the business world, the solution is simple: Bonuses that go to managers whose firms subsequently fail should be clawed back, and there should be additional financial penalties for those who hide risks under the rug. This has an excellent precedent in the practices of the ancients. The Romans forced engineers to sleep under a bridge once it was completed.”

Brilliant and true. But until our financial system rises to a higher standard of integrity, market participants will find no better way to manage risk than to study it with more disciplined skepticism, and without seeking false comfort in the crumbling assumptions of classical finance.

Third, prediction is always difficult. Depending on the definition of the idea, it is even impossible. But there is no escape from choice. Against the backdrop of daunting uncertainty, we still need to decide how to manage our money, which stock to buy or sell, which analyst to believe, which risk to guard against and which one to discount. One of Taleb’s bottom-line conclusions is that, instead of trying to predict Black Swans, we should use public policy to foster antifragility: “We should try to create institutions that won’t fall apart when we encounter black swans—or that might even gain from these unexpected events.”

This conclusion makes perfect sense for policymakers, but it offers little help to risk-weary investors. The latter group can certainly influence corporations as well as policymakers, but investors have to go a step further. They have to refine their analytical toolkit for diagnosing and avoiding fragility. Investors do not bear the primary responsibility for building antifragile companies. But they have a fiduciary duty to do their best to build antifragile portfolios.

As part of this mission, they have to incorporate forensic accounting into their analytical arsenal. Just in the past decade, the discipline has evolved greatly. It no longer relies primarily on the work of a small team of sleuths investigating a single suspect, ferretting out inconvenient truths veiled in accounting conventions. Today, investors can easily apply sophisticated forensic algorithms to broad indices, industry groups, focusing on tested and validated markers of fraudulent accounting. This is not a guarantee of antifragility but certainly a step in the right direction.

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