Fall 2007

Power of Ideas

Finding Red Flags for Companies that 'Cook the Books' 

Prof. Patricia Dechow exposes indicators of accounting fraud


By Ronna Kelly

Enron, the poster child of accounting fraud, showed several signs of impending disaster before its meltdown, including ballooning cash sales accompanied by declining earnings and unusually large employee cutbacks, Accounting Professor Patricia Dechow showed in a recent working paper.

These are among many red flags that a company is cooking its books, Dechow found in the most comprehensive analysis ever of Securities and Exchange Commission (SEC) enforcement releases. Other common characteristics of firms who manipulate financial results include declines in cash profit margins, order backlog, and employee headcount as well as abnormally high increases in financing and related off-balance sheet activities.

Those findings stemmed from an analysis of more than 2,000 SEC enforcement releases from 1982 to 2005, which resulted in a final sample of 680 firms alleged to have manipulated financial statements. The SEC issues such releases to document enforcement actions against companies, auditors, and officers for alleged misconduct.

Dechow, who joined the Haas Accounting Group in July, conducted the analysis with coauthors 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.

They outlined their results in a recent working paper titled "Predicting Material Accounting Manipulations," which has drawn interest from ratings firm Moody's Investors Service and the Public Company Accounting Oversight Board, a nonprofit corporation created by the Sarbanes-Oxley Act to oversee auditors.

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

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

From their analysis, Dechow and her coauthors devised a new tool – called a Fraud-score, or F-score – to help investors and auditors more easily predict if a company is engaging in fiscal funny business.

"Enron, for instance, comes up as a very high-risk firm," Dechow says, noting that the energy company received an F-score almost twice as high as the average firm.


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Patricia Dechow

Accounting Professor Patricia Dechow