Numbers don’t lie — or do they? Uncovering Earnings Manipulations
It’s said that numbers don’t lie. But they don’t always tell the whole truth, either, especially when they’re being manipulated by someone with an ulterior motive. An Indiana University economics and accounting professor — Messod D. Beneish — has identified several ratios that raise red flags about potential fraudulent manipulation of earnings in financial statements. These ratios can help uncover suspicious patterns that have developed over time.
The Research
Professor Beneish studied 74 public companies that manipulated their earnings. Using data from these companies, he constructed variables that could capture both the effects of earnings manipulation and some preconditions that might prompt companies to engage in manipulation.
Beneish found that earnings manipulation typically involves the artificial inflation of revenues or deflation of expenses. Thus, he attempted to develop variables that take into account the bloating of asset accounts and high growth.
The Results
Beneish developed several ratios, or indices, that reveal troubling variables by comparing a company’s financial data in two consecutive reporting periods.
Days sales in receivables index. The ratio of days sales in receivables in one period to the same figure for the previous period shows whether receivables are in or out of balance. While a disproportionate increase in receivables could result from something innocent like a change in credit policy, it also might suggest inflated revenues and, in turn, overstated earnings.
Gross margin index. Declining gross margins may reflect poorly on the company’s prospects. This type of threat to a company’s future can make manipulation more likely. Of course, expanding gross margins could indicate that inventories and production costs are already being manipulated, so any inconsistency between consecutive gross margins, positive or negative, merits further examination.
Asset quality index. Asset quality is measured by the company’s ratio of noncurrent assets (excluding property, plant, and equipment) to total assets. The figure shows the proportion of total assets for which future benefits are potentially less certain. If the ratio of asset quality from one period to the next is greater than 1, it may evidence a propensity to improperly capitalize and defer costs. Note, however, that increased asset quality could be partly attributable to acquisitions involving goodwill.
Sales growth index. Sales growth alone doesn’t imply manipulation, but Beneish found high-growth firms were more likely to commit financial statement fraud because of pressure to achieve earnings targets.
Depreciation index. If the rate of depreciation falls over two periods, it raises the possibility that the company has boosted its estimates of assets’ useful lives or adopted a new depreciation method that increases income.
Sales, general and administrative expenses index. Disproportionate increases in sales expenses can undermine a company’s future prospects, again making manipulation tempting.
Total accruals to total assets. TATA looks at the change in working capital accounts other than cash less depreciation. It discerns the extent to which cash underlies reported earnings. Higher positive accruals (in other words, less cash) signal a greater likelihood of manipulation via discretionary accounting choices.
Suspicion vs. Guilt
While Beneish’s ratios can be valuable tools, they are only indicators of potential manipulation — they’re not determinative. At the same time, bear in mind that the absence of these indicators doesn’t automatically eliminate the possibility of fraud. If earnings were manipulated just one time, for example, the ratios wouldn’t catch it. Financial experts can dig deeper into a company’s financial data to resolve suspicions about earnings manipulation.
For additional information, contact Leo J. Zatta, CPA, ABV, CVA, CFE, Partner-in-Charge of the Law Firm Services Group at WISS & Company, LLP. Mr. Zatta can be reached at 973-994-9400 or lzatta@wiss.com.
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