By James A. Kaplan and Lev Janashvili
Last year, we wrote extensively about the rising relevance of forensic accounting to the daily decisions of institutional investors, insurers and other market participants. Several reports in the first week of the New Year suggest that forensic measures of issuer risk will continue to gain prominence in 2013.
Crisis of Trust Fuels Heightened Skepticism about the Reliability of Reported Financial Results
The crisis of trust in the integrity of the financial system will likely serve as the main catalyst for the broader application of forensic analysis to decisions about stock selection and rejection, portfolio management and benchmarking. Despite the shared hopes investors, regulators and government elites, the goal of restoring trust remains elusive, on Wall Street and Main Street alike.
For example, in the latest Chicago Booth/Kellogg School Financial Trust Index survey, only 23 percent of Americans say they trust the country’s financial system. Compared to other pillars of the financial system (i.e., banks, mutual funds and the stock market), “large corporations” received the poorest vote of confidence in the survey (15 percent). Based on a representative sample of 1,000 American adults, the survey expresses Main Street’s deep dissatisfaction about the decline of Modern Finance.
Apparently, finance professionals overwhelmingly agree with this bleak assessment. In the CFA Institute’s “Global Market Sentiment Survey 2013″ (released last month), 98 percent of the 6,783 respondents worldwide acknowledged a lack of trust in the finance industry. Importantly, a majority of the respondents (56 percent) agree that a “lack of ethical culture within financial firms” has “contributed the most to the current lack of trust in the finance industry.” By contrast, a significantly lower percentage of respondents attributed the lacking trust to “market disruptions” (16 percent), “poor government regulation and enforcement” (16 percent), and “other” factors (9 percent).
Along with the scathing assessment of the status quo, respondents to the CFA Institute survey also delivered a dispiriting prognosis for renewed integrity in financial markets. Sixty-seven percent of the respondents (up from 56 percent in last year’s survey) see no likely improvement in the integrity of global capital markets.
The CFA survey did yield at least one mildly encouraging finding. The researchers asked survey recipients to identify “regulatory/industry actions most needed to improve investor trust and market integrity”. In the last three surveys, a growing percentage of respondents have pointed to the need for “improved corporate governance practices”. Still, this number also only increased to 21 percent.
Having followed these trends for years, we know that these are not outlying data points that capture bursts of skepticism and institutional resistance to change. These are not negligible downticks in sentiment that punctuate an otherwise healthy trend. These are not normal cycles of discontent that rise and fall with the rise and fall of good things such as economic growth and bad things such as financial crises. The recent sentiment surveys represent snapshots of a multi-year or multi-decade descent into broad-based “structural” distrust.
Aggressive Accounting Practices Remain Widespread
Last year, we reviewed academic research which found that “about 20% of firms manage earnings to misrepresent economic performance, and for such firms, 10% of EPS is typically managed.” These findings were based on a survey of corporate finance chiefs who opined about the prevalence of aggressive accounting in the market, not at their own firms.
However, the current ratings of more than 18,000 companies worldwide in GMI Ratings’ forensic accounting database (AGR®) dovetail closely with these survey-based findings. AGR is a statistical/algorithmic model that rates the reliability of reported financials on the basis of well-established forensic measures in the areas of expense and revenue recognition, asset and liability valuation, high-risk events and other inputs.
Statistically, we have shown that investors in these companies face a significantly elevated risk of adverse events including regulatory enforcement actions, securities litigation, major drops in share prices and long-term equity underperformance. Without a consistent application of forensic analysis, these risks will remain mispriced.
Sadly, U.S. and European regulators will not provide much relief. Over the past few weeks, investors have expressed understandable concern about the transatlantic regulatory impasse over the need to fix the accounting rules that continue to enable accounting practices that result in systemic opacity around material risks. The latest commentary on this subject reaffirms the truism that “dangerously flawed” accounting rules can enable large-scale distortions that “harm shareholders, destabilize banks and the economy”.
Greater Regulatory Support for Whistleblowers May Increase the Frequency of Corporate Scandals
The Securities and Exchange Commission (SEC) has published its Annual Report on the Dodd-Frank Whistleblower Program based on the first full year of results. The Dodd-Frank whistleblower law created financial incentives and legal protection for whistleblowers who provide evidence of fraud, securities law violations, and other corporate misconduct.
In total, the SEC received more than 3,000 whistleblower tips. The agency notes that “The most common complaint categories…were Corporate Disclosures and Financials (18.2%), Offering Fraud (15.5%), and Manipulation (15.2%).” In fact, this statement is somewhat misleading because the highest number of whistleblower tips (23.4%) were classified as “other”, which “indicates that the submitter has identified their WB TCR as not fitting into any allegation category that is listed on the online questionnaire.” This may seem like a trivial point, but it does illustrate the elusive nature of risks stemming from corporate/human behavior.
The important conclusion for investors is that, as the Whistleblower program gains momentum, it may contribute to the jarring frequency of value-crushing corporate scandals.
In view of these trends, investors increasingly recognize that stock rejection may affect portfolio performance at least as heavily as stock selection. With this idea in mind, we recently started publishing our “Black Swan Risk List” (BSRL) which identifies companies with the most aggressive accounting practices and the highest risk of precipitous contractions of shareholder wealth. We expect to publish our next BSRL during the week of January 14.