The Alarming Signal from a Little-Known Accounting Measure

The Alarming Signal from a Little-Known Accounting Measure

August 10, 2023

In the fast-paced world of finance, where numbers and data rule, there's a subtle indicator that's been quietly sounding an economic alarm. It's a measure that delves deep into the heart of corporate financial reports, revealing a startling similarity to past pre-recessionary periods. This hidden gem of analysis has been uncovered by none other than the distinguished professors from the University of Missouri and Indiana University.

So, what's this mysterious measure? It's called the "M-Score" – a groundbreaking screening model that sheds light on fraud lurking within corporate earnings. Developed by Professor Messod Daniel Beneish from Indiana University's Kelley School of Business during the 1990s, the "M" stands for manipulation, and the measure is affectionately known as the Beneish M-Score.

But what exactly does the M-Score do? Drawing inspiration from historical instances of financial misreporting, the M-Score amalgamates eight ratios extracted from a company's balance sheet. This blend allows it to evaluate the likelihood of fraudulent activities. The higher the M-Score, the more it signals that a company might be involved in earnings manipulation.

"It's like having a fraud risk radar operating in real-time," explains Matt Glendening, an esteemed accounting professor from the University of Missouri. "The beauty of the M-Score lies in its ability to tap into actual instances of accounting fraud, catching even those that fly under the radar, particularly the less severe cases. Moreover, it bridges the gap between the period of financial misreporting and the eventual exposure of the fraud."

One of the most remarkable successes of the M-Score dates back to 1998. A group of astute Cornell students used this measure to sound the alarm on Enron, flagging the company for having an elevated risk of fraud. Three years before the public was informed about Enron's profit inflation, these students already had an inkling. This event, as history shows, was followed by the colossal corporate bankruptcy that sent shockwaves through the financial world and even led to the incarceration of some high-ranking executives.

However, it's important to clarify that a high M-Score doesn't explicitly brand a firm as fraudulent. Instead, it merely points towards a heightened probability of fraudulent activities, acting as a compass guiding investors' attention.

Corporate earnings manipulation typically stems from either inflating revenues or deflating expenses. While the tactics employed by companies may vary, they all share the underlying intention of maintaining stock prices and earnings growth. "There's an array of market pressures urging firms to keep their stock prices steady, and their earnings on a growth trajectory," Glendening highlights. "Compensation incentives might also be in play, further complicating the landscape."

In 2019, Beneish expanded the horizons of the M-Score. Collaborating with Glendening and two other co-authors, he crafted an aggregate M-Score – a measure that transcends individual companies and extends its scrutiny to the entire economy. By compiling the M-Scores of a staggering 2,004 companies, this comprehensive measure gauges the likelihood of earnings manipulation across the economic spectrum.

In a shocking revelation earlier this year, the aggregate M-Score hit a 40-year high, painting a grim picture of the economic landscape. "Accounting manipulation reverberates far beyond individual companies – it resonates across the entire economy," emphasizes Glendening. The ripple effect of this manipulation influences crucial business decisions such as hiring, purchasing, and production strategies. "What we've unearthed is a disconcerting resemblance between the current level of aggregate misreporting and the ominous signs we've observed in periods preceding economic recessions."*

In the ever-evolving world of finance, the M-Score stands as a beacon of insight. It's a reminder that while numbers can be manipulated, the truth has a way of emerging, often with profound consequences. As investors and stakeholders navigate these waters, the M-Score serves as a valuable tool, offering a glimpse into the murky depths of corporate finances and aiding in making informed decisions.