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Haas researcher identifies book-cooking tipoffs
Building on her previous work, prof's analysis of SEC documents points out characteristics common to companies that get dinged for accounting fraud

| 11 July 2007

Have you ever bought stock in a fast-growing company, only to learn soon afterward that its management has been caught cooking the books? In fact, growth companies that are suffering deteriorating operating performance are the most likely firms to manipulate their financial numbers, according to a new, comprehensive analysis of Securities and Exchange Commission (SEC) documents by an accounting professor at the Haas School of Business.

More fiscal funny business
In their recent working paper, "Predicting Material Accounting Manipulations," Dechow and her co-authors included other findings from their research:

. Investors have abnormally high expectations about the future growth opportunities of manipulating firms, as evidenced by unusually high price-earnings and market-to-book ratios prior to manipulations.

. Revenue is by far the most commonly manipulated line item on income statements, with 55 percent of sample firms allegedly manipulating revenue.

.  Manipulating firms tended to have abnormally low free-cash flows. Many firms were actively seeking new financing to cover negative operating and investing cash flows.

.  Cash sales, surprisingly, increased during manipulations, because many firms allegedly front-loaded their sales and engaged in unusual transactions at the end of the quarter.

.  More firms issued either debt or equity in years in which they manipulated financials compared with other years. And cash from financing more than doubled during manipulating years compared with other years.

. Companies engaged in abnormally high leasing activities during manipulation periods, consistent with managements' increased use of the flexibility granted by lease accounting rules to manipulate their firms' financial statements.

. Accruals (the difference between reported earnings and actual cash flows) increase in manipulating years, indicating that more accounting adjustments are being made to boost earnings.

Other common characteristics of firms that manipulate financial results include unusually high growth in cash sales but declines in cash profit margins and earnings growth; declines in order backlog and employee headcount; and abnormally high increases in financing and related off-balance-sheet activities, such as operating leases.

Those were the findings from the most comprehensive analysis ever of SEC Commission Accounting and Auditing Enforcement Releases, which the agency issues to document enforcement actions against companies, auditors, and officers for alleged accounting misconduct. The analysis was conducted by Haas' Patricia Dechow; Weili Ge of the University of Washington Business School; Chad Larson of the University of Michigan's Stephen Ross School of Business; and Richard Sloan of Barclay's Global Investors.

In a recent working paper, Dechow and her co-authors examined more than 2,000 SEC releases from 1982 to 2005, which resulted in a final sample of 680 firms alleged to have manipulated financial statements.

"A consistent theme among manipulating firms is that they have shown strong performance prior to the manipulations," the researchers note in their paper. "Manipulations appear to be motivated by managements' desire to disguise a moderating financial performance."

Managers may want to disguise such performance to ensure that their stock-based compensation remains valuable or to raise capital at better prices, Dechow notes.

Based on the research, Dechow and her co-authors devised a so-called Fraud-Score, or F-Score, to be used by investors, auditors, and regulators as a preliminary assessment of "earnings quality" to determine whether further investigation into possible fraud is warranted.

Overall, alleged manipulations are more common in large firms. About 15 percent of the manipulations occur in the largest 10 percent of firms, most likely because of the SEC's incentive to identify only the most material and visible manipulations involving large losses to numerous investors.

In addition, more than 20 percent of manipulating firms were in the computer industry, but the computer industry comprised only 11.9 percent of public companies. Retail firms made up 13 percent of manipulating firms, compared with 9.7 percent of public companies. And service firms such as telecommunications and health care made up 12.4 percent of manipulating firms, compared with 10.4 percent of public companies.

The most manipulations occurred in 1999 and 2000, perhaps because slowing growth during this time gave managers incentive to manipulate earnings.

Dechow's latest research builds on her previous work, which examined how corporate governance is correlated to accounting manipulations. In that work - first published in 1996, years before the most recent round of accounting scandals - she found that manipulating firms have a higher number of insiders on the board and a CEO who is more powerful and entrenched.