• 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.

How Pervasive is Corporate Fraud?

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 Fraud Survey

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.

Survey of CFOs

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.”

Auditor Deficiencies

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: