At the GMI Ratings seminar on May 14, NYU finance professor Dr. Baruch Lev spoke memorably about the decline of traditional accounting and our collective hope for a superior model. The relevance of this topic for investors today continues to become clearer, as evidence accumulates about the incidence and systemic repercussions of corporate fraud and misleading disclosure practices.
The latest research (summarized below) strongly suggests that, under the current regulatory regime, many material risks remain mispriced and inadequately disclosed. Accounting practices that distort underlying economic realities remain widespread. Regulators remain resource-constrained, notwithstanding the report in the Wall Street Journal today that the SEC plans to continue to increase its focus on quantitative forensic fraud detection.
This confluence of trends creates ideal conditions for the rise of forensic finance, a more skeptical version of its traditional predecessor. Recently published research reveals a clear need for stronger forensic sensibilities throughout the ecosystem of capital markets. Academic research and global surveys point to detection-resistant systemic anomalies that distort and destroy value. Below is a summary of recent reports on the incidence and economic cost of undetected risks.
According to a 2012 estimate by the Association of Certified Fraud Examiners (ACFE), organizations lose 5% of their total revenue to fraud, which translates into a global annual loss of $US3.5 trillion. ACFE’s latest global fraud survey also found that:
- Concentrations of power exacerbate the impact of fraud. Perpetrators with higher levels of authority tend to cause much larger losses. Median losses resulting from fraud perpetrated by owners and executives was more than three times higher than the losses resulting from fraud committed by managers and nearly ten times higher than the median economic impact of fraudulent conduct by employees.
- Entrenchments of power exacerbate the impact of fraud. Perpetrators with longer tenures cause greater fraud-related losses. Fraud by perpetrators with more than ten years of experience with the firm cost shareholders ten times more than fraud committed in the first year of employment.
- Fraud is predictable. In 81% of cases, the fraudster displayed one or more behavioral red flags that statistically associated with fraudulent conduct.
- External audits provide inadequate protection against fraud. External audits were the most commonly implemented control at the companies in this study. However, these audits detected only 3% of the reported frauds. External audits also rank poorly in limiting fraud losses.
A team of researchers from Indiana University, Stanford University and Syracuse University, recently reported out-of-sample results of an accounting-based model in predicting both fraud and equity returns.
- Misleading accounting conceals material risks. The study found that “firms with a higher probability of manipulation earn lower returns in every decile portfolio sorted by: Size, Book-to-Market, Momentum, Accruals, and Short-Interest.”
- Forensic analysis can improve fraud detection and portfolio performance. In an earlier paper (To Catch a Thief: Can forensic accounting help predict stock returns?), the authors reported that a forensic accounting model designed to detect earnings manipulation “correctly identified, ahead of time, 12 of the 17 highest profile fraud cases in the period 1998-2002.” The study also found that investors can improve portfolio performance by excluding stocks with characteristics statistically associated with a higher probability of earnings manipulation.
Researchers at the University of Toronto and University of Chicago found that “The probability of a company engaging in a fraud in any given year is 14.5%,” and “on average, corporate fraud costs investors 22 percent of enterprise value in fraud-committing firms and 3 percent of enterprise value across all firms.”
Ernst & Young’s latest Fraud Survey (May 7, 2013) confirmed again that businesses often resort to aggressive and illegal measures to meet increasingly ambitious growth targets. Key findings:
- Financial manipulation is widespread. About 20% of almost 3,500 respondents said that they “have seen financial manipulation of some kind occurring in their own companies.”
- Financial manipulation is often an open secret. 42 percent of board directors and top managers who responded to the survey said they were aware of “some type of irregular financial reporting.”
- Pressure to grow fuels fraud. Respondents from high-growth, emerging and frontier markets were far more likely to report that “financial performance is often exaggerated.” Fifty-four percent of Indian respondents and 61% of respondents from Russia agreed with this assessment.
A team of researchers from Duke and Emory recently made an important contribution to broader research on earnings quality. Their report — Earnings Quality: Evidence from the Field – is particularly helpful in that reflects the perspective of corporate finance chiefs: their views of earnings quality and the prevalence of earnings manipulation. The key finding of this research team is that “About 20% of firms manage earnings to misrepresent economic performance, and for such firms, 10% of EPS is typically managed.”
An academic study sponsored by the Center for Audit Quality examined 87 investigations in which the SEC sanctioned external auditors in connection with alleged fraudulent financial reporting by publicly traded companies. The authors of the study classified six of these cases as “bogus audits” where the auditor did not perform any meaningful level of audit procedure. In the remaining 81 cases, the top five audit lapses cited by the SEC included the following:
- Failure to gather sufficient competent audit evidence (73 percent of the cases)
- Failure to exercise due professional care (67 percent)
- Insufficient level of professional skepticism (60 percent)
- Failure to obtain adequate evidence related to management representations (54 percent)
- Failure to express an appropriate audit opinion (47 percent)
The evidence clearly suggests that, because of shortfalls across the spectrum capital market participants, the value of mandated corporate disclosures continues to diminish. Institutional investors today have few better practical choices than to methodically cultivate greater skepticism, which serves as the organizing principle of forensic analysis.