2008 Headlines
Like a Trail of Bread Crumbs, Corporate Executives often Leave Clues of Fraud
New financial model by Johnson School assistant professor tracks accounting practices to predict the likelihood that a company will engage in fraud
November 19, 2008 | Ithaca, NY | Researchers at Cornell University's Johnson Graduate School of Management and Indiana University have created a model that predicts the likelihood that a company will engage in fraud, using changes in firms' accounting, operating, investing, and financing practices. D. Craig Nichols, assistant professor of accounting at the Johnson School, and his co-author Messod D. Beneish of Indiana University, hypothesized that overvaluation of a company—which can result in fraudulent accounting practices—might be identifiable by studying these practices.
The researchers developed a series of models, including one that produces O-scores—a measure that predicts large stock-price declines that accompany overvaluation and often indicate the presence of fraudulent accounting practices. The O-score gives a company one point for each of five characteristics relating to operating, investing, and financing activities from the company's current and historical financial statements. Nichols' work shows that companies with all five characteristics (i.e., an O-score of 5) underperform the market by an average of 27 percent over the twelve months after the release of the financial statements.
"Our models flagged Enron twice—both as a potentially overvalued company and as a likely perpetrator of fraud—using data that was publicly available, before the fraud was announced to the public," Nichols says. "Our research suggests that firms with high O-scores are three times as likely to have committed fraud, according to the data we examined, so the correlation is strong."
Nichols' work builds on a seminal 2005 study of overvaluation by economist Michael Jensen. Jensen argues that when companies become overvalued, managers may engage in earnings management, use access to cheap debt and equity capital to undertake excessive internal spending and value-destroying acquisitions, and eventually, turn to fraudulent accounting practices in an effort to report the results demanded by the market.
"When market expectations outstrip a company's ability to meet them, top-level managers are generally the first to know and the first to act," Nichols says. "Their response, intentionally or not, often is to start making some bad bets, and they leave traces of those bad bets behind that are visible in accounting distortions that show up in the financial statements."
These new models by Nichols and Beneish may be helpful in guiding the ongoing debates on regulation and corporate disclosure in financial markets. The post-Enron clamor for greater transparency in corporate disclosure continues, even though the value of such transparency has not yet been established. As Malcolm Gladwell noted in his January 2007 Enron post-mortem piece in The New Yorker magazine, Enron had practiced transparency—the information reporters ultimately used to call out Enron's overvaluation had all been publicly disclosed.
"One thing our study makes clear is that information is out there than can make a real difference to boards, investors, analysts, and the entire business community," Nichols says.
