… Still, the damage done to the defrauded is too often too real. A unsettling report from the front lines of financial accounting…
The level of corporate earnings manipulation is similar to that of past pre-recessionary periods, according to research by professors at the University of Missouri and Indiana University.
Their finding is based on the M-Score, a screening model that catches fraud in corporate earnings reports. Messod Daniel Beneish, a professor at the Indiana University Kelley School of Business, created the M-Score in the 1990s. The “M” stands for manipulation, and the measure is also sometimes referred to as the Beneish M-Score.
Based on known examples of past financial misreporting, the M-Score combines eight ratios on a company’s balance sheet to assess its fraud risk. A higher M-Score means a company is more likely to be manipulating its earnings.
“It allows us to assess fraud risk in real time,” said Matt Glendening, an accounting professor at the University of Missouri. “The advantage of using a measure such as the M-Score is that if you use actual instances of accounting fraud, not all cases are caught, especially the less severe cases. And also, there is a delay between the misreporting period and the time at which the fraud is actually revealed.”
One notable M-Score success came in 1998, when a group of Cornell students used the M-Score to flag Enron as having an elevated fraud risk. This was three years before the public learned that the company was inflating its profits, resulting in what was then the largest corporate bankruptcy in history and several executives going to jail.
…
Corporate earnings are traditionally manipulated either by overstating revenues or understating expenses. How companies do this varies, but it could include recognizing sales revenues early or understating inventory.
“There are all sorts of capital market pressures on firms to maintain stock price, maintain earnings growth,” Glendening said. “There could also be some compensation incentives at play.”
In 2019, Beneish expanded the M-Score, creating a new measure that goes beyond individual companies to the economy as a whole. With the help of Glendening and two other co-authors, Beneish created the aggregate M-Score, which now compiles the M-Scores of 2,004 companies to measure the likelihood of earnings manipulation across the economy. Earlier in 2023, the aggregate M-Score was at its highest level in 40 years.
“Accounting manipulation matters for the economy at large,” Glendening said. Companies use other business’ earnings data to inform hiring, purchasing, and production decisions. “What we are finding is that the level of aggregate misreporting is very similar to what we’ve observed in pre-recessionary periods.”
As we look more closely, we might recall that it was on this date in 1974 that the House Judiciary Committee voted to recommend that America’s 37th president, Richard M. Nixon, be impeached and removed from office for a variety of offenses that arose from the Watergate Affair. Several days later (August 5), as the full house discussed the trial, the “Smoking Gun” tape was released, demonstrating that Nixon was in fact involved in the cover-up. His political capital destroyed, Nixon resigned– in a nationwide television address– on August 8, effective the next day.
Mischief is cyclical—it is bred in good times and uncovered in bad times…
The bad news just keeps coming. Ten months after America’s stock market peaked, its big technology companies have suffered another rout. Hopes that the Federal Reserve might change course have been dashed; interest rates are set to rise by more than previously thought. The bond market is screaming recession. Could things get any worse? The answer is yes. Stock market booms of the sort that crested in January tend to engender fraud. Bad times like those that lie ahead reveal it.
“There is an inverse relationship between interest rates and dishonesty,” says Carson Block, a short-seller. Quite so. A decade of ultra-low borrowing costs has encouraged companies to load up on cheap debt. And debt can hide a lot of misdeeds. They are uncovered when credit dries up. The global financial crisis of 2007-09 exposed fraud and negligence in mortgage lending. The stockmarket bust of the early 2000s unmasked the deceptions of the dotcom bonanza and the book-cooking at Enron, Worldcom and Global Crossing. Those with longer memories in Britain will recall the Polly Peck and Maxwell scandals at the end of the go-go 1980s.
The next downturn seems likely to uncover a similar wave of corporate fraud…
The archetypal sin revealed by recession is accounting fraud. The big scandals play out like tragic dramas: when the plot twist arrives, it seems both surprising and inevitable. No simple formula exists to sort the number-fiddlers from the rest. But the field can be narrowed by searching within the “fraud triangle” of financial pressure, opportunity and rationalization…
As we contemplate criminality, we might recall that it was on this date in 1997 that MCI and Worldcom announced what was then the largest merger in history, valued at $37 Billion, creating the second largest telecom company in the U.S. (after ATT).
Worldcom, the acquirer, completed the deal in 1998, then continued to grow via acquisition. MCI Worldcom (as then it was) filed for bankruptcy in 2002 (the Dot Com Bust) after an accounting scandal (as referenced above), in which several executives, including CEO Bernard Ebbers, were convicted of a scheme to inflate the company’s assets… which were ultimately acquired by Verizon.
It seems that money can trump sin, at least in the professional services arena in Italy…
We investigate if organized crime groups (OCG) are able to hire good accountants. We use data about criminal records to identify Italian accountants with connections to OCG. While the work accountants do for the OCG ecosystem is not observable, we can determine if OCG hire “good” accountants by assessing the overall quality of their work as external monitors of legal businesses. We find that firms serviced by accountants with OCG connections have higher quality audited financial statements compared to a control group of firms serviced by accountants with no OCG connections. The findings provide evidence OCG are able to hire good accountants, despite the downside risk of OCG associations. Results are robust to controls for self-selection, for other determinants of auditor expertise, direct connections of directors and shareholders to OCG, and corporate governance mechanisms that might influence auditor choice and audit quality.
The authors suggest that when the mafia chooses an accountant, they have to choose between two mutually exclusive strategies:
I. Hire a stupid accountant that you can trick into signing off on dirty books; or
II. Hire a smart accountant who can turn your dishonest business into one that is honest on paper, even if that erodes your profits.
The authors make a compelling case that the mafia choose the second strategy. What’s more, they show that even accountants with known mob connections have no trouble finding non-criminal clients (“it is disheartening the Mafia can hire seemingly good accountants who appear to suffer no adverse reputation effects from their Mafia ties”).
Perhaps that’s because the mafia is so crucial to both the Italian and global business world: the authors quote a 2017 ISTAT study that says that 12% of Italian GDP is mafia activity and a 2011 UNODC study that attributes 3.6% of global GDP to Italian mafia groups.
But it would be a mistake to think that just because the mafia has clean books that it runs good businesses. Businesses that are run or colonized by mobsters aren’t good firms – they pay poorly, produce low-quality goods and services, and engage in a variety of crimes and regulatory violations.
This is a fascinating and clever analysis, though it’s short on recommendations. The most concrete policy proposal the authors advance is for police to maintain a public registry of accountants under investigation for mafia ties, and to bar those accountants from practicing until they are cleared…
* Upton Sinclair
###
As we deconstruct the devil’s due, we might note that today is Groundhog Day, rooted in Pennsylvania Dutch lore that if a groundhog emerging from its burrow on this day sees its shadow due to clear weather, it will retreat to its den and winter will persist for six more weeks; if it does not see its shadow because of cloudiness, spring will arrive early.
While the tradition remains popular in the 21st century, studies have found no consistent correlation between a groundhog seeing its shadow and the subsequent arrival time of spring-like weather.
Portrait of Luca Bartolomeo de Pacioli, attributed to Jacopo de’ Barbari
Modern capitalism began among the European merchant families of the early Renaissance—the Fuggers of Augsburg, Medicis of Florence and, in Venice, one Antonio de Rompiasi, who in 1464 hired a tutor in mathematics for his three sons. Like any sensible teacher, young Luca Pacioli aimed to make his lessons memorable and clear. Good humanist that he was, 30 years later he gathered all the world’s knowledge of the subject into a single massive volume.
His “Summa de Arithmetica, Geometria, Proportioni et Proportionalita” was the 615-page work of a mature professor who had spent decades working across northern Italy. The book was revolutionary on more than one count. It integrated computation using Hindu-Arabic numerals with the logic of classic Greek geometry; it was written in the Italian of the marketplace rather than Latin; and it was circulated in large numbers thanks to the new technology of printing. Yet its greatest significance lay in a slim ‘how to’ chapter that described the double-entry accounting system used by Venetian merchants.
With examples from dealers in butter to lemons to silk, Pacioli set out the method for tracking income and expenditure and the calculation of net profit or loss, which for the first time allowed an immediate snapshot of a firm’s financial position. This slim section would facilitate the birth of the modern corporation.
“Without order there is chaos,” Pacioli observed in a breezy style that is still in vogue in business books today. His manual is stuffed with quotes from scripture and Dante and pithy advice such as “Don’t learn from ignoramuses who have more leaves than grapes.” He wrote the accounting chapter to help would-be traders in Venice, then the capital of the financial world, “sleep easily at night”. Without double-entry book-keeping, “their minds would keep them awake with worry”. He could not suspect that what might be called “Book-keeping for Dummies” would become the backbone of business for centuries.
Like many monumental works of 15th-century printing, Pacioli’s treatise has survived in its original form. Some 120 copies still exist, from an initial run of about 1,000. Now today’s moguls have a chance to own this first folio of finance. Christie’s, the auction house, is offering a first edition in its original vellum binding for sale in New York on June 12th. The starting price is $1m for what it unabashedly calls “the most influential work in the history of capitalism.”
Pacioli’s later life augments the glamour of the first printed use of ‘plus’ and ‘minus’ signs. Impressed by the book, Leonardo da Vinci convinced his patron Lodovico Sforza to hire Pacioli to teach at the court of Milan. Pacioli and Leonardo collaborated on the treatise “Divina Proportione,” which married maths with art through the study of perspective. Not one, but two Renaissance masters were thus responsible for the exquisite harmony of “The Last Supper”…
As we count carefully, we might recall that it was on this date in 1902 that a US patent (#701,839) was issued to Americus F. Callahan of Chicago, Ill., which he called the outlook envelope– what we call the window envelope.
“Portrait of Luca Pacioli [the father of double-entry accounting] with a student”
You’ve never heard of Yuji Ijiri. But back in 1989 he created something incredible.
It’s more revolutionary than the cotton gin, the steam engine, the PC and the smart phone combined.
When people look back hundreds of years from now, only the printing press and the Internet will have it beat for sheer mind-boggling impact on society. Both the net and the printing press enabled the democratization of information and single-handedly uplifted the collective knowledge of people all over the world.
So what am I talking about? What did Ijiri create that’s so amazing?
Triple-entry accounting.
Uh, what?
Yeah. I’m serious.
But don’t feel bad if you slept through the revolution. It wasn’t televised or posted on Reddit. When Professor Ijiri died in 2017, most people didn’t catch his obituary. His most famous book, Momentum Accounting & Triple-Entry Bookkeeping, has a grand total of zero reviews on Good Reads. So you’re not alone if you missed it…
As we don our green eye shades, we might recall that it was on this date in 1995 that the longest federal government shutdown in US history took place under former President Bill Clinton while Republicans, led by Speaker Newt Gingrich, controlled both houses of Congress. It lasted over three weeks, until January 6, 1996.
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