What's Your Fraud Score?

Receive the wrong grade on this test, and your auditor may be scouring your company's financial statements for evidence of earnings management.

Marie Leone, CFO.com

August 20, 2007

A new research report contains formulas to help auditors and investors predict the likelihood that a public company is playing earnings management games. Sponsored by the Big Four accounting firms, the report, "Predicting Material Accounting Manipulations," explains how to calculate a "fraud score" for public companies, thereby identifying which corporate books deserve further scrutiny.

A fraud score that exceeds 1.00 is a "red flag" indicating that a company may be toying with how it accounts for cash and accruals so that it can ultimately boost stock prices, says study co-author Weili Ge, an accounting professor at the University of Washington. The mathematical model, presented in the paper released in late June, hunts for abnormal patterns in five key areas where manipulation likely takes place: accrual quality (in terms of the number of accruals being booked), financial performance (including earnings growth, cash margins, and transaction management), nonfinancial performance (order backlog and employee head count), off-balance-sheet activities (operating leases and pension assumptions), and market-based measures (valuations and price-to-earnings ratio).

Essentially, the model detects mismatched metrics in each key area. For example, the math may flag a company that has recorded an atypical increase in the number of accruals even though it has declining cash margins, a situation that can occur when receivables and inventory numbers are manipulated. Similarly, the model draws attention to unusual increases in the number of operating leases a company carries. Since leases allow companies to record lower expenses early on in the life of the contracts, an abnormal spike may indicate that a manager is focused on "financial statement window-dressing," says the report.

The model also notes changes in employee head count and total assets. Managers attempting to mask deteriorating financial performance often reduce the number of workers to boost the bottom line. But if they also overstate assets, the drop in workforce numbers will seem out of sync with economic reality.

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