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Fundamental investment analysis typically assumes the reliability of corporate financial reports. But a growing body of empirical research characterizes this assumption as dangerously naïve, especially for investment portfolios pegged to broad market indices.

In How Pervasive is Corporate Fraud? (February 22, 2013), 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.”

Importantly, surveys of corporate finance chiefs and other employees generally corroborate this finding. 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. About 20% of almost 3,500 respondents said that “have seen financial manipulation of some kind occurring in their own companies.” In addition, 42 percent of board directors and top managers who responded to the survey said they were aware of “some type of irregular financial reporting.” 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.

Similarly troubling findings emerge from another recent survey of 169 public company CFOs. Conducted by a team of researchers from Duke and Emory, the survey — Earnings Quality: Evidence from the Field (February 21, 2013) — finds that “About 20% of firms manage earnings to misrepresent economic performance, and for such firms, 10% of EPS is typically managed.” This is an important finding, not only because it points to the scope and severity of the problem, but also because it comes from respondents (i.e., CFOs) who understand the problem well.

Many recent news stories have chronicled material shortfalls of auditors in detecting and mitigating earnings manipulation. According to a news report based on a study by University of Tennessee accounting professor Joseph Carcello, auditors sanctioned in fraud cases from 1998 through 2010 “sometimes did not question documents that appeared to be fabricated,” and they “overlooked discrepancies between real inventory and amounts on the books.”

In sum, accounting practices that distort the value of underlying assets remain widespread. Pressures to sustain growth continue to mount. Accounting standards still provide significant leeway for earnings manipulation, even within legal boundaries. Regulatory enforcements remain handicapped by limited resources. Investors remain exposed to mispriced and inadequately disclosed risks.

Given the incidence of earnings manipulation, investors will increasingly recognize that stock rejection may affect portfolio performance at least as heavily as stock selection, and forensic accounting will need to become an essential part of every investor’s analytical arsenal. The discipline continues to evolve. It no longer relies primarily on the work of a small team of sleuths investigating a single suspect, ferretting out inconvenient truths veiled in accounting conventions. Today, investors can apply sophisticated forensic algorithms to broad indices, industry groups, focusing on tested and validated markers of fraudulent accounting.

Early next week, we will share summaries of the presentations at our seminar on May 14, where we introduced our new Quantitative Equity Model (QEM), which uses forensic measures of risk to predict equity performance. This model builds on the research we’ve conducted since the founding of Audit Integrity, one of the GMI Ratings predecessor firms. The QEM has shown a strong out-of-sample ability to predict equity returns globally, across industries, large-cap and small-cap portfolios.

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Presented on May 14, 2013 at GMI Ratings seminar New Frontiers in Risk Modeling: ESG and Forensic Accounting

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Presented on May 14, 2013 at GMI Ratings seminar New Frontiers in Risk Modeling: ESG and Forensic Accounting

The post After Enron: The Fingerprints of Fraud appeared first on GMI Ratings.

Presented on May 14, 2013 at GMI Ratings seminar New Frontiers in Risk Modeling: ESG and Forensic Accounting

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