CSI: Wall Street
August 10, 2011 - Fundamental Valuation
Can investors apply forensic accounting principles (searching for inconsistencies, irregularities and other signs of trouble) to help forecast stock returns? In their July 2011 paper entitled “To Catch a Thief: Can Forensic Accounting Help Predict Stock Returns?”, Messod Beneish, Charles Lee and Craig Nichols investigate the ability of an earnings manipulation model to predict stock returns and detect fraud. The model, which relies exclusively on financial statement data, consists of eight ratios indicative of either financial statement distortions associated with earnings manipulation or a predisposition to engage in earnings manipulation. Specifically, four of the ratios detect unusual buildup in receivables, unusual expense capitalization and dependence of profits on accruals. The other four ratios detect deteriorating gross margins and increasing administration costs, high sales growth and increasing reliance on debt financing. The model calibration period is 1982-1988, and its initial test period is 1989-1992. Using the exact model published in the Financial Analyst Journal in 1999 as applied to accounting data and stock returns for a broad sample of NYSE, AMEX, and NASDAQ over the period 1993 through 2007 (33,848 firm-year observations, excluding financial services firms and small firms), they find that: Keep Reading