Fraud Detection and Expected Returns

Messod D. Beneish, Charles M.C. Lee, D. Craig Nichols**

January 31, 2012

Abstract An accounting-based model has strong out-of-sample power not only to detect fraud, but also to predict cross-sectional returns. Firms with a higher probability of manipulation (MSCORE) earn lower returns in every decile portfolio sorted by: Size, Book-to-Market, Momentum, Accruals, and Short-Interest. We show that the predictive power of MSCORE is related to its ability to forecast the persistence of current-year accruals, and is most pronounced among low-accrual (ostensibly high earnings-quality) stocks. Most of the incremental power derives from measures of firms predisposition to manipulate, rather than their level of aggressive accounting. Our evidence supports the investment value of careful fundamental analysis, even among public firms.

**

Beneish (dbeneish@indiana.edu) is Sam Frumer Professor of Accounting at Indiana University, Lee (clee8@stanford.edu) is Joseph McDonald Professor of Accounting at Stanford University, and Nichols (dcnichol@syr.edu) is Assistant Professor of Accounting at Syracuse University. An earlier version of this paper was presented at the June 2007 Corporate Ethics and Investing Conference of the Society of Quantitative Analysts, the May 2008 LSV-Penn State Conference, and workshops at Cornell University, Indiana University, the University of Maryland, Notre Dame University, the University of Arizona, and Stanford University. The authors would like to thank the participants at these workshops, as well as C. Harvey, P. Hribar, J. Salamon, and C. Trzincka, S. Bhojraj, D. Givoly, J. Lakonishok, M. Lang, A. Leone, R. Morton, B. Swaminathan, P. von Hippel, N. Yehuda, and X. Zhang, for helpful discussions and comments. We also thank M. Drake, L. Rees, and E. Swanson, for kindly sharing their short-selling data with us.

Electronic copy available at: http://ssrn.com/abstract=1998387

1. Introduction Financial economists have long recognized that when information is costly, mispricing and arbitrage must co-exist in equilibrium. On the one hand, the pricing efficiency of markets depends on the forces of arbitrage. On the other hand, sufficient mispricing must remain in equilibrium to ensure arbitrageurs are rewarded for their efforts. As Grossman and Stiglitz (1980) show in a rational expectation framework, the cost of information determines the equilibrium ratio of information quality between informed and uninformed traders.

While the distinction between informed and uninformed traders is often invoked in the literature, far less is known about the nature of the information that distinguishes the two. In particular, academics and practitioners seem sharply divided on the investment value of financial analysis. If markets for public equity are semi-strong efficient (Fama (1965)), attempts to best a passive index with publicly available financial information are futile. Yet each year trillions of dollars continue to be controlled by professional asset managers who claim to do exactly that. Is there any investment value to careful financial analysis? And if so, what type of financial information is particularly valuable to investors? Answers to these two questions remain surprisingly elusive.

This study investigates the investment value of a particular form of financial analysis known as Forensic Accounting. In recent years, this phrase has acquired currency as a moniker for the art and science of carefully parsing a companys financial records with a view toward forecasting its future prospects. Closely related to the Quality of Earnings analysis popularized by OGlove (1987), Kellogg and Kellogg (1991) and Siegel (1991), forensic accountants pour over companys financial statements looking for inconsistencies, irregularities, and other signs of trouble. While these efforts have yielded individual success stories, the evidence to date has been largely anecdotal.1

The statistical model we examine (Beneish (1999)) represents a systematic distillation of forensic accounting principles described in the practitioner literature. Using model coefficients that were estimated in a prior time period, we provide clear out-of-sample evidence that between 1998 and 2009, these techniques have had substantial investment

See Schilit (2002) for a list of case studies. Foster (1979) provides similar evidence in an earlier era.

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Electronic copy available at: http://ssrn.com/abstract=1998387

value.2 Specifically, we show that this model correctly identified, in advance of public disclosure, a large majority (71%) of the most famous accounting fraud cases that surfaced subsequent to the models estimation period.3

While relatively few firms are actually indicted for accounting fraud, the probability of manipulation generated by the model (MSCORE) should be informative of a firms future prospects. This is because the profile of a typical earnings manipulator as defined by Beneish (1999) is a firm that: (1) is growing quickly (extremely high year-over-year sales); (2) is experiencing deteriorating fundamentals (as evidenced by a decline in asset quality, eroding profit margins, and increasing leverage); and (3) is adopting aggressive accounting practices (receivables growing much faster than sales; large income-inflating accruals; decreasing depreciation expense).

In this study, we conjecture that firms which share common traits with past earnings manipulators (i.e. those who look like manipulators) represent a particularly vulnerable type of growth stock to investors. Because of their high recent growth trajectory, these firms are more likely to be richly priced. At the same time, they exhibit a number of other potentially problematic characteristics (either lower earnings quality or more challenging economic conditions).4 Although the accounting games they engage in might not be serious enough to warrant prosecution, we posit that their earnings trajectory is more likely to disappoint investors (i.e., they have lower earnings quality). To the extent that the pricing implications of these accounting-based indicators are not fully transparent to investors, firms that look like past earnings manipulators will also earn lower future returns.

By using the originally published coefficients, we avoid data-snooping and peek-ahead issues. Although these weights are unlikely to be optimal for either fraud detection or returns prediction, our goal is not so much to optimize these outcomes as to demonstrate the out-of-sample efficacy of forensic accounting techniques. 3 On average, the model flags 17.7% of all firms as potential manipulators; therefore, the hit rate of 71% among these large fraud cases is highly statistically significant. 4 The term earnings quality has been used in academic literature to describe seemingly divergent ideas, such as the ability of earnings to faithfully represent past performance, or to more accurately predict future performance. In this paper, we use earnings quality to describe its persistence. To us, higher quality refers to earnings that are less transitory, and more likely to persist (or endure) in the future. Consistent with common usage among analysts, higher quality earnings by our definition deserve a higher price-to-earnings multiple.
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We find that firms with a higher probability of manipulation (MSCORE) earn lower returns in every decile portfolio sorted by Size, Book-to-Market, Momentum, Accruals, and Short-Interest. These returns are economically significant (averaging just below 1% per month on a risk-adjusted basis), and survive the usual risk controls. We further show that a large proportion of the abnormal return is earned in the short three-day windows centered on the next four quarterly earnings releases, suggesting our results are due to a delayed reaction to earnings-related news rather than risk-based factors. The robustness of these results, even among highly liquid firms, suggests they are unlikely to be fully explained by transaction costs.

Having documented MSCOREs ability to predict risk-adjusted returns, we aim to better understand the nature of the information it conveys. In particular, extensive evidence exists that Accruals, as well components and variants of Accruals, predict one-yearahead returns (e.g., Sloan 1996; Fairfield, et al. 2003; Richardson, et al. 2005; Cooper et al. 2008; Hirshleifer, et al. 2010). Given its close ties to Accruals, we wish to better understand: (1) How is MSCORE different from Accruals in terms of each variables predictive ability; and (2) What is the source and nature of MSCOREs incremental predictive power over Accruals?

We perform three sets of analyses. First, we conduct detailed tests on the joint ability of Accruals and MSCORE to predict returns. We find that the dominance of MSCORE over Accruals is evident in both independent sorts and nested sorts. When firms are sorted on these two variables independently, MSCORE is particularly effective in predicting returns among low Accruals firms (i.e. firms that have high earnings quality according to their accrual ranking). In the lowest Accrual quintile, the spread in sizeadjusted returns between high MSCORE firms and low MSCORE firms is -19.9% over the next 12 months. Among firms in the second lowest Accrual quintile, the spread is 10.8% per year. In general, after controlling for MSCORE, Accruals exhibits limited predictive power, which is concentrated primarily in the mid-MSCORE quintiles.

Second, we analyze individual components of the model in specific subpopulations. Noting that MSCORE is particularly effective in separating future winners from losers among low accrual firms, we design a difference-in-difference test that sheds light on the element(s) of the model that most contributed to this effect. Our analysis shows that the variables relate to the predisposition to commit fraud, rather than the variables associated with the level of aggressive accounting, are the primary drivers of the incremental power of the model. Specifically, the models incremental predictive power in the low-accrual group is most directly related to its ability to identify fast-growing firms that have recently experienced some recent economic headwind. Elements of the model associated with aggressive accounting (i.e. those components most closely aligned with Accruals), provide no incremental predictive power.

Third, we show that the Beneish models efficacy is associated with its ability to predict the persistence of firms current year accruals (i.e. whether the accrual component of this years earnings will continue into next year, or will disappear). Specifically, we find that high MSCORE firms (firms that look like manipulators) have incomeincreasing accruals that are much more likely to disappear next year, and incomedecreasing accruals that are much more likely to persist, or re-appear, next year. We observe the exact opposite among low MSCORE firms (firms that look least like manipulators). In other words, MSCORE is providing useful information about the future change in accruals i.e. it is informative about the quality of the accrual component of current-year earnings.

This study is related to several strands of existing research. First, our findings help to shed light on a persistent puzzle in financial markets i.e., the role and value of fundamental analysis in active investing. Our evidence shows that in recent years, careful fundamental analysis can provide investment value, even among pubic firms. To the extent that some of the strategies used by informed traders are correlated with the model we test, our findings help to explain the continued existence of active managers who practice this form of analysis.

Second, our study is related to a growing literature on the effective use of firms financial information. Aside from fraud detection, academics have used financial information in different
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contexts to better understand: earnings quality (e.g., Lev and Thiagarajan (1993), Sloan (1996)), Richardson et al. (2005)), bankruptcy risk (e.g., Altman (1968), Ohlson (1980)), the direction of future earnings (e.g., Ou and Penman (1998)), and future returns (e.g., Holthausen and Larcker (1992), Piotroski (2000), Beneish, Lee and Tarpley (2001), Mohanram (2005)). We build on, and extend, this line of research by documenting the usefulness of fraud detection techniques for both earnings quality assessment and returns prediction. In addition, by parsing the different elements of the model, we provide new insights on how and why fraud detection techniques work. These insights point to new directions for assessing firms earnings quality, and should enhance future efforts to identify potential over/under valuations.5

Finally, our findings extend the literature on market learning and the limits of arbitrage (e.g., Berk and Green (2004), Bebchuk et al. (2011), Green et al. (2011)). At the heart of issue is the definition of publicly available information. While all the individual components of the model are publicly available, our evidence suggests that public availability alone does not ensure these elements are fully integrated into price in a timely manner. Learning takes time. Indeed, our results suggest that even publication in a journal does not guarantee the usefulness of a strategy is transparent to the market immediately.6

Overall, our analyses provide substantial support for the use of forensic accounting in equity investing. We show a model built and estimated in the early 1990s has been effective in detecting some of the most famous fraud cases that occurred in a subsequent period. Moreover, we find this model has incremental ability to predict stock returns out-of-sample, beyond the usual suspects. Our evidence indicates the efficacy of the model derives from its ability to separate firms whose accruals are more likely to persist from those whose accruals are more likely to reverse. Since Beneish developed this model using forensic accounting principles, and the parameters for the model were estimated in a prior period, our findings offer out-of-sample validation for the approach advanced by forensic accountants.

In Section 2, we provide a more detailed discussion of how our research is related to, but distinct from, these prior studies. 6 A similar pattern was observed with the original Accrual anomaly documented by Sloan (1996), which had strong out-of-sample predictive power for returns for a number of years after publication.
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The remainder of the paper proceeds as follows. In the next section, we discuss related literature. In Section 3, we examine the Beneish model and its conceptual underpinnings. In Section 4 we explore its ability to predict cross-sectional returns. Finally, in Section 5, we summarize and discuss the implications our findings.

2. Related Literature Our paper is related to two main bodies of work: (1) the large literature on Accruals and future returns, and (2) studies that use financial statement variables in other decision contexts. In this section we relate the Beneish (1999) fraud detection model, in broad terms, to these prior studies. In Section 3, we discuss the model in more detail.

2.1 Accruals and Future Returns In a seminal study, Sloan (1996) shows that firms with higher (more income inflating) accruals earn lower returns than firms with lower accruals. He provides evidence that the predictive power of accruals derives from the fact that the cash-based component of earnings is more persistent i.e., is of higher quality, than the accrual-based component. Sloans original study spawned a large literature seeking to explain, confirm, refute, or recast, his findings.7 Although most of these studies confirm or extend the original findings, a few raise questions as to its robustness or interpretation.8 Most recently, the focus has shifted to limits to arbitrage and market learning related explanations.9

Although our study is related to the accrual literature, the model we test was designed for a different purpose, and the individual components of the model reflect this broader mandate. In the Appendix and in the next section, we present a detailed description of the Beneish (1999)) model, as well as the intuition behind each of the eight accounting-based variables used in its estimation. In broad terms, the profile of an earnings manipulator that emerges from the Beneish
7 For example, Chan et al. (2001), Collins and Hribar (2002), Fairfield, et al. (2003), Hirshleifer, et al. (2004), Richardson, et al. (2005), Cooper et al. (2008), and Hirshleifer et al. (2011). Other related studies examine whether
different market constituents understand the implications of Accruals (e.g., Bradshw et al. (2011), Collins et al. (2003), Barth and Hutton (2004), and Beneish and Vargus (2002)). See Zach (2011), chapter 2, for a good summary. 8 For example, Desai et al. (2004) question whether the accrual anomaly is a manifestation of the value-glamour anomaly, and Khan (2005) examines a model misspecification explanation for accrual mispricing. 9 For example, Mashruwala et al. (2006), Lev and Nissim (2006), and Green et al. (2011).

model is a firm that is: (1) growing extremely fast (Sales Growth Index); (2) experiencing some economic headwind (Asset Quality Index; Gross Margin Index; SGA Index; Leverage Index); and (3) practicing aggressive accounting (Days in Receivables; Depreciation Index; Accruals to total assets).10

Of these three categories, only the last group is aligned with the Accrual measures. Explanatory variables from the first two groups are designed primarily to detect the propensity to commit fraud (i.e., exceptionally high year-over-year sales growth, eroding profit margins, a decline in asset quality, and an increase in leverage), rather than the effect of aggressive accounting. In other words, five out of eight variables in Beneishs fraud detection model are actually not associated with various manifestations of accruals.

In fact, our test results show that the incremental power of the model over Accruals stem mainly from variables in the first two categories, and is not a function of aggressive accounting per se. Specifically, our findings show that the efficacy of MSCORE is associated with its ability to predict changes in current-year Accruals. In other words, MSCORE is providing additional information about the quality of earnings beyond the current year level of reported Accruals.

2.2 Other Financial Analysis Research Our study is also related to prior studies that examine the usefulness of financial statement information in other decision contexts. Broadly speaking, these studies fall into three categories: (1) Distress Analysis: studies that aim to predict bankruptcy risk and financial distress (e.g., Altman (1968), Beaver (1966), Ohlson (1980), Beaver et al. (2005)); (2) Basic Ratio Analysis: studies that combine a large set of financial ratios in a less structured manner, to predict either future earnings or stock returns (e.g., Ou and Penman (1989), Holthausen and Larcker (1992)); and (3) Contextual Analysis: studies that apply financial analysis in targeted settings, such as among value stocks (Piotroski (2000), growth stocks (Mohanram (2005)), or extreme performers

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We use three broad, and not necessarily mutually exclusive, categories to help explain the main motivations behind the eight variables. In fact, some variables (such as Days in Receivables and Asset Quality) could be indicators of either economic challenges or aggressive accounting, and probably contain elements of both.

(Beneish et al. (2001)). While all these studies use accounting information, each group is designed for a different purpose, and feature different financial variables.11

The primary distinguishing characteristic of Beneish (1999), compared to these studies, is its close allegiance to the fraud detection literature espoused by financial practitioners. For example, the model is related to Foster (1979)s analysis of Abraham Briloff, an accounting professor who successfully used public reports to identify accounting irregularities. Other sources that influenced the original model include OGlove (1987), Kellogg and. Kellogg (1991), Siegel (1991), and an earlier edition of Schilit (2010). Unlike Ou and Penman (1989) and Holthausen and Larcker (1992), Beneish (1999) does not use a large number of ratios; and unlike the contextual studies, this model was not designed to predict returns in particular subpopulations of firms. Rather, the model was built by carefully observing the financial information most often discussed by experts in forensic accounting, who are concerned with detecting accounting irregularities, particularly among fast growing companies.12

In sum, prior studies have examined both the usefulness of financial information in a variety of contexts. Our study extends this literature by focusing on a model built on forensic accounting principles, and demonstrating its strong out-of-sample ability to both identify famous fraud cases and predict cross-sectional stock returns. We also provide new evidence on why forensic accounting techniques work, and how they inform us about firms quality of earnings.

3. The Earnings Manipulation Detection Model Beneish (1999) profiles firms that manipulate earnings (firms either charged with manipulation by the SEC, or admitted to manipulation in the public press) and develops a statistical model to discriminate manipulators from non-manipulators. The model presented in Beneish (1999) relies exclusively on financial statement data and is thus useful in assessing fraud potential in firms without appeal to security prices (for example, in pricing an initial public offering). In the

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The bankruptcy prediction models, for example, are concerned with a firms distance from default and feature variables that measure profitability, leverage, and overall health. The contextual analysis studies are concerned with indicators of improving fundamentals for different types of stocks. 12 In taking seriously the work of financial practitioners, Beneish (1999) is similar in spirit to Lev and Thiagarajan (1993) and Abarbanell and Bushee (1997). However, unlike these studies, the Beneish model was built specifically to detect the both the propensity to commit accounting fraud, and the effect of such activities.

original paper, this model was estimated using data from the period 1982-1988 and its holdout sample performance assessed in the period 1989-1992.

Since the publication of the original study, this model has attained some notoriety after flagging Enron well in advance of its eventual demise.13 It has been featured in financial statement analysis textbooks (e.g., Fridson 2002, Stickney et al. 2003) and in articles directed at auditors, certified fraud examiners, and investment professionals (e.g., Cieselski 1998, Merrill Lynch 2000, Wells 2001, DKW 2003, Harrington 2005). However, evidence of its out-of-sample performance is ad hoc and anecdotal.

The Appendix provides a detailed description of each variable, loadings on these variables, and a tabulation of the sample distribution over time and across industries. Table A.1 provides descriptive statistics for these variables and Table A.2 provides information on the incidence of manipulation by time period, as well as by industry. These reveal an increasing frequency of SEC Accounting and Auditing Enforcement Actions over the sample period, and, unsurprisingly, a higher concentration of manipulators in software, hardware and retail concerns (13.5%, 9.5% and 6.8% of the sample manipulators).

As evidenced by Table A.1, compared to a same-industry control group, potential manipulators are growing extremely fast (58.1% year-over-year sales growth; compared to 13.0% for control firms). Yet despite this ultra-fast sales growth, receivables as a percentage of sales have increased even faster (average growth in Days in Receivables of 41.2%; compared to 3.0% for control firms). Manipulators also have deteriorating fundamentals (for example, their Asset Quality Index shows, on average, a 22.8% increase in the proportion of soft assets to total assets, compared to 3.0% for control firms; their Gross Margin Index shows gross profit margins declined by an average of 15.9%, compared to 1.7% for the control firms). Finally, they exhibit more aggressive accounting (Depreciation expense as a percentage of gross PP&E decreased by 7.2% compared to 0.7% for control firms; Accruals are income-inflating to the tune of 4.9% of

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The model gained widespread recognition when a group of MBA students at Cornell University posted the earliest warning about Enrons accounting manipulation score using the Beneish (1999) model a full year before the first professional analyst reports (Morris 2009). This episode in American financial history is preserved in the Enron exhibit at Museum of American Finance, New York (www.moaf.org) and is also recounted in Gladwell (2009).

total assets, compared to 1.5% for control firms). In short, the manipulators as a group appear to be growth firms that are running into some potential problems.

To compute a probability of manipulation (MSCORE), Beneish estimated a Probit regression using a portion of his sample, and validated the models efficacy through a holdout sample.14 As in all statistical discriminate analyses of this genre, Type I classification error (the probability of missing a culprit) needs to be traded off against Type II classification error (the probability of nabbing an innocent firm). Beneish (1999) contains an extensive discussion of the relative implicate cost of the two error types for alternative MSCORE threshold (or cutoff) values. His results show that the model performs best relative to a nave model when the relative cost of Type I to Type II error is between 20:1 and 30:1 (Beneish; Table 5). This relative cost function corresponds to a MSCORE cut-off value of -1.78 (i.e. firms with a MSCORE that exceeds -1.78 would be flagged as potential manipulators).15 Using this cut-off value, the author demonstrated that the model flagged approximately 13% of the holdout sample firms as manipulators. Strikingly, those 13% of the sample firms that were flagged actually included approximately half of all manipulators.

In this study, we closely replicate the model as published in Beneish (1999). We use the exact coefficients as estimated for the model (Beneish; Table 3). We also used the same cut-off value implied by the original study to classify firms as manipulators (i.e. MSCORE values exceeding 1.78). For seven of the eight explanatory variables, we follow exactly the same construction as the original paper. For the Accruals variable, the original paper used a Balance Sheet estimation method (i.e. Sloan (1996)). For this study, consistent with the evolution in the accruals literature since 1999, we derived the same conceptual measure as Beneish (1999), but used information from the Statement of Cash Flows rather than the noisier Balance Sheet estimate.16

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Beneish (1999) estimated an unweighted and weighted Probit regression. Our discussion refers to the unweighted Probit model. 15 The issue of classification errors is less pertinent to this study as for the purpose of return prediction, MSCORE often appears as a continuous variable. Nevertheless, it seems to us that a cost ratio of Type I to Type II error in the neighborhood of 20:1(or 30:1) is quite reasonable for investment purposes as well. This is because to most active asset managers, the cost of erroneously including an earnings manipulator in a given portfolio is much higher than the cost of erroneously omitting an innocent firm. 16 This option was not available to Beneish (1999) because the Statement of Cash Flows only became required disclosure in the U.S. in 1987, and much of his sample pre-dates the adoption of the statement. As a practical matter, in the absence of major business acquisitions, the two methods yield very similar estimates.

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In Table 1, we demonstrate the continued relevance of the model to detect fraud by examining its performance for well-known fraud cases from 1998-2002 (as reported by auditintegrity.com). This period was marked by an unusual number of high profile fraud cases that helped spur forensic accounting to prominence. In its aftermath, Auditintegrity.com listed 20 firms that it deemed to be the most egregious examples of accounting earnings manipulation. Two of these firms are financial stocks (to which this model does not apply); one is not an actual fraud case (Motorola did not manipulate its own earnings, it only abetted Adelphia). Since the holdout sample for the original Beneish model ended in February 1993, the remaining 17 firms identified by Auditintegrity.com represent an entirely out-of-sample test for the model.

As Table 1 shows, the model predicted the fraud in 12 of the 17 firms, including Cendant, Enron, Global Crossing, Qwest and several other famous cases. On average, the model detected the fraud using financial information that was available a year and a half before the public revelation of its problems. Of particular note, the model received attention subsequent to the Enron scandal as the investing public discovered that the model had flagged Enron prior to the debacle.17

In sum, the model appears to have performed quite well in identifying the most famous accounting fraud cases that surfaced after its publication. In the next section, we examine its ability to predict one-year-ahead stock returns in a broad cross-section of firms.

4. Does MSCORE predict future returns? 4.1 Sample We select the initial sample from the Compustat Industrial, Research, and Full Coverage files for the period 1993 to 2007. We eliminate (1) financial services firms (SIC codes 6000 6899), (2) firms with less than $100,000 in sales (Compustat #12) or in total assets (Compustat #6), (3) firms with market capitalization of less than $50 million at the end of the fiscal period preceding portfolio formation, and (4) firms without sufficient data to compute the probability of

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On January 25th, 2002, the Wall Street Journal reported that in seizing e-mails at Arthur Andersen, Congress found evidence that the Chicago office of Arthur Andersen had issued two alerts to the Houston office in the spring of 2001 with respect to earnings manipulation at Enron. The alerts came from a tailored version of the model that Beneish had estimated under a consulting relationship with Andersen. (Andersen Knew of `Fraud' Risk at Enron --- October E-Mail Shows Firm Anticipated Problems Before Company's Fall, 01/25/2002, A3).

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manipulation. Following Beneish (1999), we winsorize the predictive variables in the model at the 1 percent and 99 percent levels each year in our sample period to deal with problems caused by small denominators and to control for the effect of potential outliers.

We compute size-adjusted returns following a slightly modified version of the procedures outlined in Lyon, Barber, and Tsai (1999).18 To form reference portfolios, we first identify decile portfolio breakpoints based on all NYSE firms. We then assign all NYSE, AMEX, and Nasdaq firms to portfolios based on those breakpoints. The smallest portfolio has a disproportionately large number of stocks, so we further sort those stocks into five portfolios based on market cap. The end result is 14 size-based portfolios. We then accumulate returns for 12 months starting with the first day of the next month following portfolio assignment. If a firm delists, we include returns to the delist date as well as any delisting return reported by CRSP. If a delist return is missing, we estimate it using the procedures outlined in Beaver, McNichols, and Price (2007). As in Lyon, Barber, and Tsai (1999), from the month following delisting to the end of the holding period, we assume the proceeds from delisting, if any, were invested in the CRSP size-based portfolio to which the firm belongs.

To compute size-adjusted returns, we accumulate returns for twelve months starting with the fifth month after year end using the same delisting procedures described above, if necessary. We use the stocks market cap at the end of the fourth month following the fiscal year end to identify its reference portfolio. We then subtract the return for the reference portfolio from the return for the firm.

To ensure that the trading strategies that we examine are implementable, we require all firms used in our rankings to have stock return data available in the CRSP tapes at the time rankings are made, and use prior year decile cut-offs to assign firms to deciles of the ranking variable (e.g., the probability of manipulation, accruals, momentum, etc.) in the current year. Our trading

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Although Lyon, Barber, and Tsai (1999) form reference portfolios once per year, we perform our sorts and form reference portfolios monthly. This is because the return windows for our stocks are not aligned by calendar date (i.e. they begin in the fifth month after the end of the fiscal year for each stock).

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strategy return computations are based on taking positions four months after the end of the fiscal year. The final sample consists of 41,544 firm-year observations from 1993 to 2009.19

4.2 MSCORE and future returns Although Table 1 and prior research (e.g., Beneish 1999) demonstrate the ability of the Beneish model to identify firms that commit fraud, very few fraud cases actually lead to indictment.20 The Beneish model, however, flags 17.7% of firm-year observations as potential frauds. As discussed earlier, the much higher number of potential frauds flagged by the model is a function of a trade-off between the costs of Type I and Type II errors. Based on results reported in the original study, as well as an intuitive assessment of costs to an asset manager of missing a manipulating firm, we adopted a threshold (cut-off) value for MSCORE of -1.78.21

Table 2 compares returns for firms that are flagged as probable manipulators to the returns of firms that are not flagged using this cut-off value. Overall for the full sample, flagged firms generate one-year-ahead size-adjusted returns of -7.5%, while firms that are not flagged experience positive returns of 3.2%. Both of these average returns are statistically significant. Firms that are not flagged outperformed flagged firms by 10.7% on average, and this is also statistically significant.

Table 2 also compares flagged and not-flagged firms by year. The spread in returns across notflagged and flagged firms is negative in only four years (1994, 2002, 2004, and 2008), but is not significantly negative in any year. Firms that are not flagged significantly outperform flagged firms in eleven years. Overall, Table 2 suggests flagged firms (firms that merely look like a manipulator) are associated with lower expected returns.

Returns from CRSP are not available after December 2010. A one year return window along with a four month period between fiscal period end and the start of the holding period results in August, 2009 as the latest date for financial statement data. Thus, 2009 has only 428 observations. 20 Beneish (1999) examines 74 cases of fraud from 1982 to 1993. Dechow, Ge, Larson, and Sloan (2011), who investigate Accounting and Audit Enforcement Actions (AAERs), report less than 0.5% of the firm-years in their sample are associated with fraud. 21 We also computed results for a wide range of cut-off values around -1.78, and the results are quite similar. In later tests, we use MSCORE as a continuous variable and find robust predictive power.
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4.3 Distinguishing MSCORE from other predictors of future returns Prior research shows that a number of characteristics are correlated with subsequent returns: (1) the difference between earnings and cash flows from operations (Accruals), following Sloan (1996); (2) price momentum (Momentum), following evidence in Jegadeesh and Titman (1993) that past 3 to 12 month returns tend to continue in the subsequent year; (3) firm size (MVE), following evidence in, among others, Fama and French (1992); (4) the book-to-price ratio (BTM), following evidence in Davis (1994), Haugen and Baker (1996), and Fama and French (1992); and (5) the short interest ratio (SIRatio) following evidence in Drake et al. (2011) that firms with high short interest ratios subsequently earn lower returns.

In Table 3, we report the correlation matrix for these characteristics. Pearson correlations are above the diagonal and Spearman correlations are below the diagonal. Correlations of MSCORE with three variables are noteworthy. First, MSCORE and Accruals are highly correlated (correlation = 0.444, p < 0.001). Many observers speculate that earnings management is an important reason why the persistence of accounting accruals differs from those of cash flows, suggesting that earnings management misleads investors. Thus, it is possible that both MSCORE and Accruals measure earnings manipulation and that little incremental value exists in studying MSCORE. Second, the negative correlations between MSCORE and both Momentum and BTM suggest that firms with high probability of earnings overstatement have momentum (-0.039, p-value<0.001) and glamour characteristics (low BTM, -0.021, p-value<0.001)). Third, the correlation between MSCORE and Short Interest Ratio is positive and significant (0.038, p-value<0.001), consistent with high MSCORE firms attracting the attention of short sellers.

To examine whether the returns to a strategy based on MSCORE are subsumed by other potential predictors of future returns, we estimate Fama-MacBeth cross-sectional regressions of one-year-ahead buy and hold size-adjusted returns (BHSARt+1) on scaled decile ranks of several predictors:

BHSARt+1 = a0 + a1MSCOREt + a2 Accrualst + a3Momentumt + a4MVEt + a5BTMt + a6 SIRatiot + et+1

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(1)

In Table 4 Panel A, we report the coefficients from 17 annual cross-sectional regressions based on equation (1), as well as their time-series average. The dependent variable is one-year-ahead size-adjusted returns computed using reference portfolio returns computed as outlined in Lyon et al. (1999). The independent variables are scaled decile ranks, so the values range from 0 to 1.

The results indicate that scaled MSCORE ranks are negatively correlated with one-year-ahead abnormal returns (-0.093, t-statistic=-2.62), and that Momentum is positively correlated with one-year-ahead abnormal returns (0.091, t-statistic=2.63). BTM is also positively correlated with future abnormal returns (0.075, t-statistic=2.00). The remaining variables, including Accruals, MVE, and SIRatio do not attain significance. This suggests that after controlling for Accruals and other variables associated with future returns, a long-short portfolio strategy based on extreme MSCORE deciles earns a 9.3% abnormal return one-year-ahead.22

To better understand the source of the abnormal return from a MSCORE strategy, we also estimate time-series regressions of monthly excess returns on the Fama-French (1993) factors as well as the momentum factor from Carhart (1997):

ExRett = a0 + a1MKTt + a2 SMBt + a3HMLt + a4WML + et+1

(2)

Where ExRet is the monthly value-weighted MSCORE portfolio return in excess of the return on the one-month T-Bill, MKT denotes the value-weighted market index return in excess of the one-month T-Bill, SMB denotes returns on a factor mimicking portfolio for the size factor (small minus big), HML denotes the book-to-market factor (high minus low), and WML denotes the momentum factor (winners minus losers). To calculate ExRet, firms are sorted into portfolios each month based on the firms most recent MSCORE and the prior year MSCORE cutoffs. We calculate value-weighted returns for each portfolio each month using market value of equity at the beginning of the month. We then subtract the return on the one-month T-Bill to calculate the

22

As with all of our analyses, we do not explicitly incorporate transactions costs and short-selling constraints. These costs vary by market participant, so we leave it to the reader to consider their impact.

15

excess return (ExRet). Each portfolio consists of 210 monthly observations from July 1993 to December 2010.

In Table 5 Panel A, we report results for the three Fama-French factors and we augment the model with the momentum factor in Panel B. The results are similar for both panels. Focusing on Panel B, our results show that, on average, a MSCORE strategy involves a negative bet on market beta (average coefficient on MKT of -0.20) as well as a positive exposure to differential expected returns based on firm size (average coefficient on SMB of 0.70). On average, a MSCORE strategy has no significant exposure to either the Value (HML) or Price Momentum (WML) factor.

More importantly, after controlling for monthly correlations with all four factor mimicking portfolios, a hedged portfolio of extreme MSCORE decile firms (D1-D10) has a positive intercept (i.e. monthly alpha) of around 0.94% (11.3% per annum), which is highly statistically significant. This effect is most pronounced in the highest MSCORE decile i.e. most of the return derives from a negative bet against growth firms that subsequently perform much worse than expected. As a group, these firms underperform their size peers by around 75 basis-points per month.

To further evaluate MSCOREs ability to predict returns in various sub-populations of stocks, we separate the firms in each decile of MVE, BTM, Momentum, SIRatio and Accruals into high and low MSCORE, where high MSCORE includes the 7,357 observations in our sample that are flagged as potential manipulators. The results, reported in Table 6 and Figure 1, are striking. The performance of the flagged sub-sample is worse than that of its not-flagged counterpart in all 50 decile breakdowns. Furthermore, the average size-adjusted return of the flagged firms is negative in 48 of the 50 deciles.

In Panel A, a size-based trading strategy that buys small firms (decile 1) and shorts large firms (decile 10) yields 2.7% per year. By combining MSCORE with size, e.g., buying small notflagged firms and selling short large flagged firms, the strategy yields 15.2% per year. Similarly, in Panel B, we show that the improvement to a BTM strategy is also quite substantial. Buying
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Value (decile 10) and shorting Glamour (decile 1) yields 9.2%. By combining with MSCORE i.e., buying Value firms that are not-flagged and selling Glamour firms that are flagged firms the strategys yield improves to 16.7% per year.

In Panel C, a momentum based trading strategy that buys high (decile 10) and shorts low (decile 1) yields 10.7%. Combining with MSCORE i.e. buying high momentum firms that are notflagged and selling short low momentum firms that are flagged the strategys yield improves to 25.3%. Similarly in Panel D, trading on extreme short interest ratio deciles yields an abnormal return of 5.3% per year, which improves to 15.8% per year by superimposing MSCORE.

Finally in Panel E, Accruals alone returns 8.0% and this yield can be improved to 14.1% per year by selling short high accrual flagged firms and buying low accrual firms that are not flagged. Note that MSCORE is especially helpful when accruals provide a positive signal of earnings quality but MSCORE offers a conflicting signal. When low accrual (generally regarded as high quality) firms are flagged, they return an average abnormal return of -19.8%. As a group, they underperform low accrual firms that are not flagged by 26.1%.

Given MSCOREs high correlation with Accruals (Pearson Correlation of 0.444, per Table 3), we conduct more detailed tests to assess the joint ability of Accruals and MSCORE to predict returns. In Table 7 Panel A, we report average size-adjusted returns when firms are sorted independently into quintiles by both Accruals and MSCORE. In Panels B and C of the same table, we report the results of nested (i.e. sequential) sorts. The strong correlation observed in Table 3 is apparent in Table 7 Panel A, as approximately 25% of the sample observations reside in two of the twenty-five portfolios (upper-left and bottom-right).

Again, we see that MSCORE is particularly effective in predicting returns among low accrual firms. The positive returns for firms with low accruals are concentrated among the low MSCORE firms. Firms with low accruals and low MSCORE generate returns of 6.4%. In contrast, firms with low accruals but high MSCORE have strong negative returns (-13.5%). For firms in the lowest accrual quintile, firms with low MSCORE outperform high MSCORE firms by 19.9%. In quintile 2, low MSCORE firms outperform by 10.8%. On the other hand, accruals
17

do not distinguish firms in any of the MSCORE quintiles. The only exception is the high MSCORE quintile, where the high accrual firms actually outperform low accrual firms.

In Panel B, we further isolate the effect of Accruals and MSCORE by sorting firms on MSCORE within each Accruals quintile. This allows us to spread-out the variation in MSCORE across firms that have relatively similar Accruals rankings. For low (income-decreasing) accrual firms, low MSCORE firms outperform high MSCORE firms by 10.4%. For high accrual firms, the spread is smaller, such that low MSCORE firms outperform high MSCORE firms by 8.1%. Returns are also significant for the second and fourth accrual quintiles. Interestingly, firms with large differences in accruals do not have differences in returns when MSCORE is extremely high or low, but we do observe differences in returns for the three intermediate quintiles.

In panel C, we first sort on MSCORE and then sort on Accruals. Results are consistent across all MSCORE portfolios: extreme differences in accruals do not result in differences in returns once firms are sorted on MSCORE. The only exception is the fourth quintile. In contrast, low MSCORE firms outperform high MSCORE firms across all accrual sorts, and the spread in returns is strikingly consistent. Overall, Table 7 confirms the findings in Table 5, Panel E (as well as the evidence on accruals and future returns in Table 4), and demonstrates that MSCORE dominates accruals as a predictor of future returns.

4.4 The incremental usefulness of individual MSCORE components The evidence presented thus far indicates that MSCORE has significant ability to predict oneyear-ahead cross-sectional returns. Our results show that this predictive power does not come from its correlation with Value, Momentum, Size, Accruals, or Short Interest. In the next three sections, we seek to provide more direct evidence on the nature of the information contained in MSCORE.

Table 8 compares the mean for each of the seven components of the Beneish model (other than accruals) in various subpopulations of our sample. To construct this table, we independently sorted firms into quintiles according to Accruals and MSCORE (same as Table 7 Panel A). We have seen from Table 7 that the Beneish model is particularly effective in separating out winners
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from losers among low accrual firms. In Table 8, we focus sharply on firms in the top right and top left corners of Table 7 Panel A, to better understand which individual component of the model is contributing to the efficacy of MSCORE for return prediction among low accrual firms.

The first two rows of Table 8 report the means for each variable for firms in the lowest Accrual quintile that are also either in the highest or the lowest MSCORE quintile. We then subtract the mean of the high MSCORE firms from the mean of the low MSCORE firms, and report the results in row three. As expected, we find that high MSCORE firms have higher means for variables entering the model with a positive coefficient (DSR, AQI, GMI, SGI, and DEPI), and have lower means for the variables entering the model with a negative coefficient (SGAI, LEVI). On their own, these findings are not particularly informative, because we formed the two portfolios on the basis of MSCORE.

For comparison, we employ a difference-in-difference test design. Specifically, Table 7 shows that MSCORE has little incremental predictive power for firms in the highest Accrual (quintiles 3, 4, and 5). Exploiting this fact, we first group firms in these three Accrual quintiles, then further separate them according to their MSCORE score. Once again, we compute the mean for the same seven variables, and report the results in rows four through six of Table 8. Finally, in the bottom row, we report descriptive statistics and the result of a statistical significance test for the difference-in-difference across the two high-low MSCORE portfolios.

The results show that, compared to their counterparts in the bottom half of the table, the high MSCORE firms in the upper half of the table had significantly higher sales growth (SGI), change in asset quality (AQI), and increase in leverage (LEVI). In other words, the incremental predictive power of MSCORE among low accrual firms is driven largely by these three factors.23

23 Of the three, perhaps the LEVI result is least intuitive, and therefore merits an explanation. When we compute
coefficients for High MSCORE minus Low MSCORE firms, SGAI and LEVI should be negative, because they have negative coefficients in the model. Our difference-in-difference test asks whether LEVI is more negative when we are better able to predict returns. The answer is no. In fact, we have greater prediction power in the sample where LEVI is relatively more positive. In other words, the model is more effective in predicting returns when LEVI is relatively more positive for the firms we long (as compared to the firms we short). In short, a sharper increase in a firms leverage is bad news, controlling for other factors.

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Interestingly, all three factors are primarily indicators of a predisposition to misstate earnings, rather than the result of the misstatement itself.

4.5 MSCORE and the persistence of earnings components Many researchers and practitioners speculate that the Accruals variable predicts returns because it provides information about earnings quality that market participants fail to fully utilize. In this section, we pursue this line of reasoning, and examine the extent to which MSCORE is an indicator of a firms earnings quality. Specifically, we examine whether and how MSCORE might help us forecast firms future earnings.

The notion that MSCORE might be useful in predicting future earnings is intuitive. As we have seen, high MSCORE firms are growing rapidly in terms of top-line sales. Moreover, these firms face operating environments that are becoming more challenging (e.g., declining margins and decreasing asset quality). Finally, these firms have adopted more aggressive accounting practices in the most recent reporting period (higher receivables to sales, more income-inflating accruals, lower depreciation expense). Future earnings for these firms will be lower (i.e. current earnings will be less persistent) if either of two conditions occurs: (a) current period accounting distortions are corrected or reversed; or (b) the firm succumbs to the difficult economic conditions that are beginning to appear in its financial results.

We focus on the incremental ability of MSCORE to predict the persistence of firms earnings. Prior studies have demonstrated that the cash flow component of earnings is more persistent than the accruals component (see, for example, Sloan (1996) and Richardson et al. (2005)). We extend this analysis by exploring the differential persistence of one-year-ahead accruals for high and low MSCORE firms. If the forensic accounting principles that underpin this model are useful in separating firms with relatively high/low quality earnings, this fact should be evidenced in a difference in the persistence of future accounting accruals.

Specifically, we predict that income-increasing accruals for firms with high (low) MSCORE should be less (more) persistent, while income-decreasing accruals for firms with high (low) MSCORE should be more (less) persistent. In other words, for firms whose accrual component
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increases current year income, we expect higher MSCORE to be associated with decreased accrual persistence (leading to lower income next year). Conversely, for firms whose accrual component decreases current year income, we expect higher MSCORE to increase accrual persistence (leading to lower income next year).

To examine whether MSCORE contains such incremental information, we estimate the following relation between future earnings and current earnings components

EARNt+1 = a0 + a1CFOt + a2 ACCPOSt + a3ACCNEGt + a4ACCPOSt*SPMt + a5ACCNEGt*SPMt + a6SPMt + et+1 Where EARN denotes operating earnings before depreciation, CFO is cash flows from operations, ACCPOS (ACCNEG) is working capital accruals when these are positive (negative) and zero otherwise, SPM denotes MSCORE ranked into deciles and scaled to range from 0 (lowest MSCORE) to +1 (highest MSCORE), and all earnings and earnings components are deflated by average assets in year t.24 (3)

We begin Table 9 by providing a frame of reference. In the first two columns, we report that the current years earnings have a persistence coefficient of regression of 0.796 and that cash flows are more persistent than accruals (0.938 and 0.493). The results for cash flows are similar to those documented by Sloan (1996) [0.860] but the persistence of accruals is smaller than his [0.765], largely due to the fact that we use working capital accruals and thus exclude depreciation. In the third column, we partition accruals into positive and negative samples. Our results show that, consistent with Beneish and Vargus (2002), the persistence of both positive and negative accruals are significantly lower than that of cash flows.

In the last column, we report the results of tests examining the persistence of accruals conditional on MSCORE. We again find strong persistence for CFO (coefficient = 0.975). The coefficients on ACCPOS and ACCNEG reflect the persistence of positive and negative accruals of firms in the lowest MSCORE decile (SPM=0). For example, the coefficient of 0.996 on ACCPOS means

24

Key results are qualitatively identical when the dependent variable is deflated by year t+1 average total assets.

21

that positive accruals for low MSCORE firms have exceptionally high persistence, indicating they have a much higher likelihood of repeating. Conversely, the coefficient on ACCNEG is 0.213, indicating that for low MSCORE firms, negative (or income deflating) accruals are much less likely to repeat.

The coefficients on ACCPOS*SPM and ACCNEG*SPM capture the incremental effect of MSCORE on accrual persistence as we move from the lowest decile (SPM=0) to the highest decile (SPM=1). ACCPOS*SPM is negative and significant (coefficient = -0.353) suggesting that for firms in the highest MSCORE decile (SPM=1), income-increasing accruals are much less likely to repeat (estimate coefficient= 0.996-0.353= 0.643). For comparison, recall that the income-increasing accruals for firms in the lowest MSCORE decile are highly persistent (0.996).

Similarly, ACCNEG*SPM is positive and significant (coefficient = 0.555), indicating that for firms in the highest MSCORE decile, income-decreasing accruals are much more likely to persist (estimate coefficient = 0.213+0.555= 0.768). In other words, for high MSCORE firms, any income-decreasing accruals this year will have a higher probability of repeating next year, leading to lower future earnings. Finally, SPM itself is positive and significant (coefficient = 0.032), suggesting high MSCORE firms (i.e. high growth firms) have higher future earnings after controlling for differences in accrual persistence. This may reflect the fact that high MSCORE firms, as a group, are continuing to grow more rapidly than the control firms; alternatively, it is possible that their inflated earnings in the current year do not fully reverse oneyear-ahead.

In sum, we find that MSCORE is incrementally informative about the persistence of the accrual component of earnings. First, the one-year-ahead persistence of income-increasing accruals is significantly lower for high MSCORE firms. Second, any income-decreasing accrual reported in the current year is much more likely to persist for high MSCORE firms than for low MSCORE firms. Both results show that MSCORE is useful in predicting future earnings. This is consistent with MSCORE possessing the ability to either: (a) anticipate the reversal of transitory distortions in current years reported accruals, or (b) predict worsening economic conditions that will manifest themselves in subsequent accruals.
22

4.5 Predicting Short-Window Earnings Announcement Returns Finally, to better understand the information content of MSCORE, we examine abnormal returns in three-day windows centered on subsequent earnings announcements. The main purpose of this test is to further discriminate between the market-inefficiency and risk-based explanations for the predictive power of MSCORE. If MSCOREs predictive power is due to a delayed market response to current information about future earnings realizations, and this misperception is corrected when further information about future earnings is released, then subsequent abnormal returns should cluster around the future announcements of earnings news. Conversely, if MSCOREs predictive power is due to omitted risk variables, we should not observe higher abnormal returns concentrated around the release of subsequent earnings news.25

Table 10 reports the cumulative abnormal returns (CAR) around the next four earnings announcements after firms are sorted into MSCORE-based portfolios. Firms are added to portfolios on the first day of the fifth month following the end of the fiscal year. CAR denotes the cumulative raw return over days -1, 0, and +1 relative to the earnings announcement date minus the cumulative return to the benchmark size portfolio to which the firm belongs. To construct Panel A we sort firms into Flagged and Not Flagged categories based on MSCORE. We report short-window announcement period CAR for each of the next four quarters, as well as the total CAR for all four quarterly announcements.

Panel A shows firms that are Not Flagged earn positive CAR over each of the next four quarters, while Flagged firms experience on average negative returns. The quarter-by-quarter results show that short-window returns are reliably more positive for Not Flagged (low MSCORE) firms every quarter. The last column shows that the difference in total CAR over the next 4 quarters is 2.51%. In other words, approximately one-quarter (25%) of the annual hedge return to this simple MSCORE strategy is earned in the 12 trading-days (5% of all trading days) around the next four earnings announcements. This evidence is consistent with a delayed market reaction to earnings-related news contained in MSCORE, and inconsistent with risk-based explanations.

25

Short-window returns are far less susceptible to risk-model misspecifications.

23

Panels B and C report average earnings announcement returns to alternative hedge strategies based on MSCORE deciles. To construct this panel, we first sort firms into deciles based on their current MSCORE and decile cutoffs from the prior year MSCORE distribution. We then calculate CAR for each decile portfolio (Panel B), as well as for alternative hedge portfolios (Panel C). In Panel C, we start with the most extreme portfolios (deciles 1 and 10) and progressively add less extreme MSCORE firms to the long and short positions.

Panel B shows that in each of the next four quarters, earnings announcement returns for low MSCORE firms (Deciles 1 through 5) are consistently more positive than those for high MSCORE firms (Deciles 6 through 10). Over our sample period, firms generally received positive announcement period returns. However, firms in the top two MSCORE deciles experience consistently negative earnings announcement returns over the next two quarters.

The first row of Panel C shows that when we long decile 1 (low MSCORE) firms, and short decile 10 (high MSCORE) firms, we generate CAR of 0.66% to 0.86% over each of the next four quarters. The total CAR over the next four quarters is 2.85%, which is slightly higher than the strategy reported in Panel A. The following 4 rows show that the hedge returns are not sensitive to the decile cutoffs. As expected, the average hedge return decreases as we expand the number of firms included in the strategy. However, the CARs for these hedge strategies are all reliably positive. Moreover, the earnings announcement returns are, once again, disproportionately large relative to total annual returns for every hedge portfolio.

5. Summary Fraudulent financial reporting imposes large costs on financial markets. For example, shareholders of the firms listed in Table 1 collectively lost over $180 billion dollars when these accounting irregularities were announced.26 Perhaps even more important than the investor wealth losses are the large welfare costs imposed by fraudulent financial reporting when resources are misdirected from their most productive use. These accounting misrepresentations

26

Beneish (1999a) and Karpoff et al. (2008) provide evidence of large market value losses to public revelations of accounting manipulation.

24

increase transactions costs by eroding investor confidence in the integrity of the capital market. In recent years, we have seen how accounting misrepresentations triggered action by regulators, who impose (often costly) regulation on firms and markets. In short, when it comes to reporting frauds, many must pay for the transgressions of a relative few.

Efforts to combat accounting fraud involve both public and private initiatives. On the one hand, accounting and security market regulators can help curb the practice through legislation and enforcement actions. On the other, private parties, such as more sophisticated investors, play a role by identifying firms that are likely to have manipulated earnings, and holding these firms accountable through market-based disciplining mechanisms.

In this study, we have explored the implications of an earnings manipulation detection model for equity investors. Using the Beneish (1999) model, which was estimated using data from the period 1982-1988 and its holdout sample performance assessed in the period 1989-1992, we show forensic accounting has significant out-of-sample ability to not only detect fraud, but also predict stock returns. Moreover, we provide evidence that the efficacy of the model derives substantially from its ability to predict in advance, the likely persistence (or reversal) of the accrual component of current year earnings.

A key feature of the Beneish model is its focus, not only on the results of aggressive accounting, but also on managerial predisposition to undertake such action in the first place. As Schrand and Zechman (2011) observed in their detailed analysis of 49 fraud cases, sometimes a firms initial misstatement reflects not so much a deliberate intent to deceive as simply an optimistic managerial bias. Our evidence is consistent with this observation, in that much of the incremental predictive power of the model derives from variables that indicate deteriorating fundamentals in fast-growing firms, rather than aggressive accounting, per se. These findings point to new directions for future research on earnings quality. Our hope and expectation is that these results will spur further work in the area of forensic accounting.

We end with a cautionary note to readers who may be interested in exploiting the return prediction patterns documented in this study. Looking ahead, it appears likely to us that as the
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methods for fraud detection become more sophisticated, so will the techniques of the perpetrators. For example, the evidence in Kama and Melumad (2011) shows that in recent (post Sarbanes-Oxley) years, U.S. firms seem to have adopted new methods such as the factoring of receivables to mask the effect of their earnings manipulations. In the case of the Beneish model, the factoring of receivables will directly affect the usefulness of the DSR variable. Over time, one should reasonably expect evolving adaptations of this nature to diminish the overall efficacy of the model for returns prediction.

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Ou, J. A. and S. H. Penman. 1989. Financial statement analysis and the prediction of stock returns. Journal of Accounting & Economics 11 (4): 29-46. Piotroski, J. 2000. Value investing: The use of historical financial statement information to separate winners from losers. Journal of Accounting Research 38: 1-41. Richardson, S. A., R. G. Sloan, M. T. Soliman, and I. Tuna. 2005. Accrual reliability, earnings persistence and stock prices. Journal of Accounting & Economics 39 (3): 437-485. Schilit, H. 2010. Financial Shenanigans: How to detect accounting gimmicks and fraud in financial reports. 3rd Edition, New York: McGraw-Hill. Siegel, J. G. 1991. How to Analyze Businesses, Financial Statements, and the Quality of Earnings. 2nd Edition, New Jersey: Prentice Hall. Sloan, R.G. 1996. Do stock prices fully reflect information in accruals and cash flows about future earnings? The Accounting Review 71 (July): 289-315. Stickney, C., P. Brown, and J. Wahlen. 2003. Financial Reporting, Financial Statement Analysis, and Valuation, 5th Edition. Thomson-Southwestern. Wells, J. T. 2001. Irrational ratios. Journal of Accountancy. New York: Aug : 80-83. Zachs, L., Editor. 2011. The Handbook of Equity Market Anomalies: Translating Market Inefficiencies into Effective Investment Strategies. New York: Wiley.

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Appendix --The Probability of Manipulation 1. Estimating MSCORE The sample in Beneish (1999) consisted of 74 firms that manipulated earnings and 2,332 nonmanipulators matched by industry over the period 1982-1992. On average, manipulators were smaller, less profitable, more levered and experienced faster growth than industry controls. We estimate the probability of manipulation to overstate earnings (which we denote MSCORE for ease of exposition) using the following (unweighted) PROBIT model, as published in Beneish (1999): MSCORE= -4.84 + .920*DSR + .528*GMI + .404*AQI + .892*SGI + .115*DEPI-.172*SGAI +4.679*ACCRUALS - .327*LEVI27 Where:
Variable Name DSR Description (Receivablest[2]/Salest[12])/(Receivablest-1/Salest-1) [Numbers in squared brackets are COMPUSTAT codes] Gross Margint-1/ Gross Margint, where Gross Margin is 1 minus Costs of Goods Sold [#8]/ Sales [1-(PPEt+CAt)/TAt] /[1-(PPEt-1+CAt-1)/TAt-1], where PPE is net [#8], CA are Current Assets [#4]and TA are Total Assets [#6] Salest[12]/Salest-1 Rationale Captures distortions in receivables that can result from revenue inflation Deteriorating margins predispose firms to manipulate earnings Captures distortions in other assets that can result from excessive expenditure capitalization Managing the perception of continuing growth and capital needs predispose growth firms to manipulate sales and earnings. Captures declining depreciation rates as a form of earnings manipulation. Decreasing administrative and marketing efficiency ( larger fixed SGA expenses) predisposes firms to manipulate earnings Increasing leverage tightens debt constraints and predisposes firms to manipulate earnings Capture where accounting profits are not supported by cash profits.

GMI AQI

SGI

DEPI

SGAI

Depreciation Ratet-1/ Depreciation Ratet, where depreciation rate equals Depreciation [#14-#65]/(Depreciation+PPE [#8]) (SGAt[189]/Salest[12])/(SGAt-1/Salest-1)

LEVI

Leveraget /Leveraget-1 where Leverage is calculated as debt to assets [(#5+#9)/#6] (Income Before Extraordinary Items [18]- Cash from Operations[308])/ Total Assetst[6]

Accruals to Total Assets28

27

Five of the eight variables in the multivariate estimation are statistically significant (DSR, GMI, AQI, SGI, and ACCRUALS); the remaining three (DEPI, SGAI, LEVI) are not (see Beneish 1999, Table 3). To gain additional insight on the relative importance of the individual inputs, Beneish (1999) re-estimated this model 100 times using 100 random estimation samples. At the 5% level, DSR and SGI were significant in all 100 estimations, Accruals in 95 of the 100 estimations, GMI and AQI in 84 of the 100 estimations. In contrast, DEPI, SGAI and LEVI were only significant in 18, 12, and two estimations respectively (see Beneish 1999, Table 4). 28 Beneish (1999) uses a total accruals variable that is computed slightly differently but yields similar results. This is because before the current presentation of the statement of cash flows became effective (pre-1987) few firms

31

2. Intuition behind the Eight Variables Broadly speaking, the profile of a typical earnings manipulator as defined by Beneish (1999) is a firm that: (1) is growing extremely quickly; (2) is experiencing deteriorating fundamentals (as evidenced by a decline in asset quality, eroding profit margins, and increasing leverage); and (3) is adopting aggressive accounting practices (receivables growing much faster than sales; large income-inflating accruals; decreasing depreciation expenses). More specifically, the model consists of eight financial ratios that can capture either financial statement distortions that result from earnings manipulation (DSR, AQI, DEPI and Accruals) or indicate a predisposition to engage in earnings manipulation due to certain economic conditions (GMI, SGI, SGAI, LEVI).29 Descriptive statistics for these ratios appear in Table A.1 below. Each is constructed so that a higher number increases the likelihood of manipulation. The following is a summary of the intuition behind these variables. Not all eight are individually important, but collectively they create a composite sketch, or profile, of a potential earnings manipulator. (1) Rapid Sales Growth A striking characteristic of the manipulator population is its rapid revenue growth. Table A.1 shows that the mean sales growth rate for the sample of manipulators (SGI) is 1.581, indicating that these firms on average increased year-over-year sales by 58%, compared to a 13.3% rate for an industry control group. Sales growth per se, is not a negative, but in this context, a firms high past growth trajectory may increase its predisposition to engage in manipulative behavior. (2) Deteriorating Fundamentals Several variables are designed to capture deteriorating economic conditions. Specifically, manipulators are hypothesized to have deteriorating gross margins (GMI) and increasing SG&A expenses (SGAI). Their debt-to-asset ratio is increasing (LEVI), and a greater proportion of their total assets reflect non-current and non-PPE investments i.e. they have increased their proportion of soft assets (AQI). (3) Aggressive Accounting The year-over-year ratio of the manipulators receivables-to-sales (DSR) shows their receivables are growing rapidly as a percentage of sales (1.412 for manipulators versus 1.03 for the control group). This indicates an unusual buildup in receivables despite the rapidly increasing sales (a sign of potential revenue inflation). DEPI indicates manipulators tend to have slowed down their depreciation expense as a percentage of their gross PP&E. Finally, Accruals indicates that the reported accounting profits of the manipulators are less supported by cash profits that those of non-manipulators.

reported cash flow from operations. Our current implementation follows the evolution of this variable in the accruals literature. 29 Some variables, such as DSR and AQI could be indicative of either deteriorating economic conditions or aggressive accounting (i.e. may play a dual role).

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Table A.1 Potential Predictive Variables: Descriptive Statistics for the Sample of 74 Manipulators and 2332 Industry-Matched Non-Manipulators in the Period 1982-1992 Manipulators Mean Median 1.412 1.219 1.159 1.028 1.228 1.000 1.581 1.341 1.072 0.977 1.107 1.028 1.124 1.035 0.049 0.026 Controls Wilcoxon-Z Mean Median P-Valuea 1.030 0.995 0.001 1.017 1.001 0.019 1.031 1.000 0.035 1.133 1.095 0.001 1.007 0.972 0.346 1.085 0.990 0.714 1.033 1.000 0.107 0.015 0.012 0.001 Median P-Valuea 0.001 0.078 0.824 0.001 0.638 0.098 0.039 0.018

Characteristic Days in Receivables Gross Margin Index Asset Quality Index Sales Growth Index Depreciation Index SGA Index Leverage Index Accruals to total assets

a. The Wilcoxon Rank-Sum test and the Median test compare the distribution of sample firms' characteristics to the corresponding distribution for non-manipulators. The reported p-values are two tailed and indicate the smallest probability of incorrectly rejecting the null hypothesis of no difference.

33

3. Incidence of Manipulation The distribution of sample manipulators over the sample period suggests an increasing frequency of SEC Accounting and Auditing Enforcement Actions time is as follows: Years Number of Firms 1981-1985 8 1986-1989 35 1990-1993 31 Total 74

The distribution of manipulators by two-digit SIC suggest the highest concentration is in Business Services (10 firms, 13.5%), followed by Industrial Products (7 firms, 9.5%), and both Electronic Manufacturing and Wholesales-trade tied at (5 firms, 6.8%).

Table A.2 Manipulators by Two-Digit Industry SIC 1 10 13 15 20 22 23 24 27 28 30 34 35 36 37 38 45 47 48 49 50 51 52 54 56

Industry Description Agricultural Production Metal Mining Oil and Gas Extraction General Building Contractors Food and Kindred Products Textile Mill Products Apparel and Other Textile Products Lumber and Wood Products Printing and Publishing Chemicals and Allied Products Rubber and Misc. Plastics Products Fabricated Metal Products Industrial and Related Products Electronic & Other Electric Equipment Transportation Equipment Instruments and Related Products Transportation by Air Transportation Services Communications Electric, Gas, and Sanitary Services Wholesale Trade-Durable Goods Wholesale Trade-Nondurable Goods Building Materials & Garden Supplies Food Stores Apparel and Accessory Stores
34

N 1 1 1 1 1 3 1 1 2 4 1 1 7 5 2 2 1 1 1 3 5 1 1 1 1

% 1.4% 1.4% 1.4% 1.4% 1.4% 4.1% 1.4% 1.4% 2.7% 5.4% 1.4% 1.4% 9.5% 6.8% 2.7% 2.7% 1.4% 1.4% 1.4% 4.1% 6.8% 1.4% 1.4% 1.4% 1.4%

57 58 59 70 73 75 78 80 82

Furniture and Home furnishings Stores Eating and Drinking Places Miscellaneous Retail Hotels and Other Lodging Places Business Services Auto Repair, Services, and Parking Motion Pictures Health Services Educational Services

3 1 2 1 10 2 3 1 2 74

4.1% 1.4% 2.7% 1.4% 13.5% 2.7% 4.1% 1.4% 2.7% 100.0%

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Table1.PerformanceofModelforHighProfileFraudCasesduring19982002
Thistablereportsthe20companiesidentifiedbyauditintegrity.comasthehighestprofilefraudcasesuncovered duringthe1998to2002timeperiod.*Weexaminetheprobabilityofmanipulationscore(MSCORE)foreachfirm basedonfinancialstatementinformationreportedbythefirmduringtheperiodofallegedmanipulationbutprior topublicdiscovery.FirmsareflaggedasmanipulatorsifMSCOREexceeds1.78atanytimeduringtheperiodof alleged(oradmitted)violation.WecomputeMSCORE=4.84+.920*DSR+.528*GMI+.404*AQI+.892*SGI+ .115*DEPI.172*SGAI+4.679*ACCRUALS.327*LEVI.DSRdenotestheratioofreceivablestosalesinyeart dividedbythesameratioinyeart1.GMIdenotestheratioofgrossmargintosalesinperiodt1tothesameratio inperiodt.SGAdenotestheratioofselling,general,andadministrativeexpensetosalesinperiodtdividedbythe sameratioinperiodt1.SGIequalssalesintdividedbysalesint1.DEPIdenotestheratioofdepreciationto depreciablebaseint1dividedbythesameratioint.AQIequalsallnoncurrentassetsotherthanPPEasapercent oftotalassetsintdividedbythesameratioint1.ACCequalsincomebeforeextraordinaryitemsminusoperating cashflowsdividedbyaveragetotalassets.LEVIequalstheratiooflongtermdebt+currentliabilitiestototalassets intdividedbythesameratioint1.YearflaggedreferstothefirstyearthefirmisflaggedbytheMSCOREmodel asamanipulator.Yeardiscoveredreferstotheyearinwhichthefraudwasfirstpubliclyrevealedinthebusiness press.Marketcaplostdenotesthechangeinmarketcapitalizationduringthethreemonthssurroundingthe monththefraudwasannounced(i.e.,months1,0,+1).Marketcaplost(%)denotesthemarketcapitalizationlost inthethreemonthssurroundingthefraudannouncementmonth,asapercentageofmarketcapitalizationatthe beginningofmonth1. Year Flaggedas Year MarketCap MarketCap CompanyName manipulator? Flagged Discovered Lost($B) Lost(%) AdelphiaCommunications Yes 1999 2002 4.82 96.8% AmericanInternationalGroup,Inc. N/AFinancial AOLTimeWarner,Inc. Yes 2001 2002 25.77 32.2% CendantCorporation Yes 1996 1998 11.32 38.1% Citigroup N/AFinancial ComputerAssociatesInternational,Inc. Yes 2000 2002 7.23 36.4% EnronBroadbandServices,Inc. Yes 1998 2001 26.04 99.3% GlobalCrossing,Ltd Yes 1999 2002 (Delistedduetobankruptcy) HealthSouthCorporation No 2002 2.31 57.3% JDSUniphaseCorporation Yes 1999 2001 32.49 61.0% LucentTechnologies,Inc Yes 1999 2001 11.15 24.7% Motorola N/AOnlyabettedAdelphia QwestCommunicationsInternational Yes 2000 2002 9.84 41.8% RiteAidCorporation Yes 1997 1999 2.83 59.1% SunbeamCorporation Yes 1997 1998 1.28 58.8% TycoInternational No 2002 37.55 58.2% VivendiUniversal No 2002 1.28 27.9% WasteManagementInc Yes 1998 1999 20.82 63.6% WorldComInc.MCIGroup No 2002 1.03 69.8% XeroxCorporation No 2000 7.73 43.8% Mean 10.89 51.94% Median 8.79 57.75% *Thisfiveyearperiodwasmarkedbyalargenumberofcorporateaccountingscandals.Italsorepresentsanout ofsampletestfortheBeneish(1999)model,whichwasestimatedusingdatafrom19821988andtestedona holdoutsamplefrom19891992.WehavenoaffiliationwithAuditIntegrity.com.

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Table2.YearbyyearSizeAdjustedReturnstoFlaggedFirms
ThetablereportstheyearbyyearsizeadjustedreturnsforfirmsflaggedbytheBeneish(1999)model andthosethatwerenot.BHSARdenotesannualbuyandholdreturnstoanequalweightedportfolio formedatthestartofthefirstdayofthefifthmonthfollowingtheendofthefiscalyear,lessthereturns toaportfoliooffirmsfromthesameNYSE/AMEX/NASDAQsizedecile(sizedecilemembership determinedatthebeginningofreturnwindow).Forfirmsthatdelist,anyproceedsupondelistingare reinvestedinthesizeportfoliotowhichthecompanybelongs.Flaggeddenotesfirmsthatfittheprofile ofanearningsmanipulatorbasedontheMSCOREmodelinBeneish(1999)andacutoffof1.78.***, **,*denotesignificanceatthe1%,5%,and10%levels,respectively. NotFlagged Flagged Year N Percent BHSAR Percent BHSAR Spread 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 FullSample 2304 2474 2786 2972 3139 2798 2789 2616 2480 2278 2550 2571 2534 2480 2348 1997 428 41544 82.4% 79.0% 79.8% 77.1% 76.6% 78.1% 77.2% 72.8% 86.6% 89.6% 88.1% 84.7% 87.3% 86.3% 86.8% 88.6% 91.1% 82.3% 3.5%*** 1.4% 1.2% 0.7% 0.4% 9.1%*** 6.6% 4.1%*** 1.5%* 5.7%*** 0.8% 2.2%** 1.1% 5.3%*** 0.7% 3.1% 6.5% 3.2%***
** ** ***

17.6% 21.0% 20.2% 22.9% 23.4% 21.9% 22.8% 27.2% 13.4% 10.4% 11.9% 15.3% 12.7% 13.7% 13.2% 11.4% 8.9% 17.7%

5.1%** 2.7% 15.4% 8.7%*** 9.4%*** 5.9% 21.6% 28.1%*** 17.5%*** 11.0%** 5.5% 5.2% 3.3% 1.5% 3.5% 6.5% 10.3% 7.5%***
** *** ***

8.6%*** 1.3% 16.5%*** 8.0%*** 9.9%*** 3.2% 28.2%*** 32.2%*** 16.0%*** 5.3% 6.3%** 3.0% 4.4%** 3.8%* 2.9% 3.3% 16.8%* 10.7%***

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Table3.Correlationmatrix
ThistablereportsPearson(abovediagonal)andSpearman(belowdiagonal)correlationsforsample variables.MSCOREdenotestheprobabilityofearningsmanipulationbasedontheBeneish(1999) model.SeethenotestoTable1foradescriptionoftheMSCOREmodel.Accrualsdenotesearnings beforeextraordinaryitemslesscashflowsfromoperationsscaledbyaverageassets.Momentum denotessizeadjustedreturnsforthesixmonthspriortotheBHSARreturnwindow.Marketvalueof equity(MVE)ismeasuredasofendofthefiscalyear.Booktomarket(BTM)denotesmarketvalueof equitydividedbycommonequity.Shortinterestratio(SIRatio)denotesthenumberofsharessoldshort asapercentageofthenumberofsharesoutstanding.BHSARdenotesannualreturnsstartingthefirst dayofthefifthmonthfollowingtheendofthefiscalyear,lessthereturnstoaportfoliooffirmswith comparablesize.Forfirmsthatdelist,anyproceedsupondelistingarereinvestedinthesizeportfolioto whichthecompanybelongs.***,**,*denotesignificanceatthe1%,5%,and10%levels,respectively. MSCORE Accruals Momentum Ln(MVE) BTM SIRatio BHSAR MSCORE Accruals Momentum Ln(MVE) BTM SIRatio BHSAR N=41,544 0.640*** 0.066*** 0.046*** 0.115*** 0.021*** 0.090*** 0.037*** 0.048*** 0.002 0.041*** 0.029*** 0.116*** 0.281*** 0.048*** 0.061*** 0.283*** 0.390*** 0.064*** 0.158*** 0.056*** 0.029*** 0.444*** 0.039*** 0.035*** 0.041*** 0.017*** 0.036*** 0.021*** 0.020*** 0.118*** 0.159*** 0.038*** 0.009* 0.030*** 0.126*** 0.036*** 0.063*** 0.033*** 0.025*** 0.012** 0.028*** 0.023***

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Table4.MultivariateCrossSectionalRegressions
Thistablereportsthetimeseriesmeanfrom15annualcrosssectional(FamaMacBeth)regressions. Thedependentvariableisthefirmspecificoneyearaheadbuyandholdsizeadjustedreturn.The independentvariablesareMSCORE(seethenotestoTable1foradescription),Accruals(earnings beforeextraordinaryitemslesscashflowsfromoperations,allscaledbyaverageassets),Momentum (sizeadjustedreturnsforthesixmonthspriortotheBHSARwindow),MVE(marketvalueofequity), SIRatio(shortinterestratio,thenumberofsharessoldshortasapercentageofthenumberofshares outstanding)andBTM(booktomarket).Observationsareassignedtotenportfoliosbasedonprioryear cutoffvalues.Portfolioassignmentsarethenscaledtorangefrom0to1.Tstatisticsarebasedonthe timeseriesdistributionoftheparameterestimates.

Intercept 1993 0.074** 1994 0.127** 1995 0.002 1996 0.017 1997 0.008 1998 0.256** 1999 0.060 2000 0.138*** 2001 0.045 2002 0.099 2003 0.235*** 2004 0.099** 2005 0.059** 2006 0.013 2007 0.007 2008 0.078 2009 0.032 Average 0.001 tstatistic 0.05 MSCORE Accruals 0.127*** 0.002 0.171*** 0.020 0.145*** 0.039 0.015 0.077** *** 0.162 0.015 0.016 0.319*** 0.348*** 0.151*** 0.370*** 0.120*** 0.158*** 0.106*** 0.143** 0.256*** 0.107*** 0.052 0.063 0.012 0.014 0.004 0.060* 0.081*** 0.032 0.070*** 0.074 0.086 ** 0.269 0.176* 0.093** 0.003 2.62*** 0.11 MVE 0.028 0.136*** 0.038 0.011 0.010 0.311*** 0.117** 0.046 0.109*** 0.121** 0.086*** 0.045 0.079*** 0.013 0.018 0.010 0.175** 0.020 0.72 BTM Momentum 0.033 0.071*** 0.213*** 0.238*** 0.141*** 0.046* 0.096*** 0.006 0.017 0.166*** 0.283*** 0.302*** 0.277*** 0.081* 0.219*** 0.340*** 0.005 0.116*** 0.183*** 0.053 *** 0.246 0.179*** 0.057* 0.106*** *** 0.153 0.022 0.003 0.080*** 0.034* 0.007 *** 0.238 0.264*** 0.148 0.157** 0.075** 0.091** 2.00** 2.63*** SIRatio Adj.Rsq 0.034 1.5% 0.063 3.0% *** 0.135 2.7% 0.040 0.5% 0.009 1.9% 0.373*** 3.4% ** 0.105 3.2% *** 0.158 12.7% *** 0.176 4.4% 0.008 2.0% ** 0.055 4.5% ** 0.069 0.4% *** 0.068 2.2% 0.031 0.6% 0.022 0.3% 0.005 3.8% 0.011 3.8% 0.021 3.0% 0.70

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Table5.Timeseriesassetpricingregressions ToconstructthistablefirmsaresortedintodecileseachmonthbasedonthemostrecentMSCOREfor thefirmandprioryearMSCOREdecilecutoffs.SeethenotestoTable1foradescriptionoftheMSCORE model.Valueweightedreturnsarecalculatedeachmonthbasedonmarketvalueofequityatthe beginningofthemonth.Valueweightedportfolioreturnsarethenregressedontheexcessmarket return(MKT),thesizefactor(SMB),thebooktomarketfactor(HML),andthemomentumfactor (WML).Thetablealsoreportsreturnsforahedgeportfolio,calculatedasthereturnfortheLow MSCOREportfoliominusthereturnfortheHighMSCOREportfolio.Eachportfolioincludesatimeseries of210monthlyobservationsfromJuly1993throughDecember2010.***,**,*denotesignificanceat the1%,5%,and10%levels,respectively. PanelA.Threefactormodel Intercept(%) MKT SMB HML Adj.Rsq. *** *** Low 0.159 1.130 0.005 0.239 71.3% *** * 2 0.239 1.002 0.094 0.039 77.4% * *** *** 3 0.210 0.854 0.220 0.007 83.8% 4 0.162 0.944*** 0.010 0.067 80.8% 5 0.081 0.874*** 0.116*** 0.098** 82.0% * *** * 6 0.243 0.838 0.071 0.058 81.4% *** *** 7 0.099 0.950 0.168 0.055 79.8% 8 0.294 1.021*** 0.136** 0.121** 76.5% ** *** *** *** 9 0.402 1.254 0.347 0.284 85.1% *** *** *** *** High 0.786 1.334 0.692 0.354 85.6% *** *** *** Hedge 0.945 0.204 0.697 0.115 29.1% N=210monthsforeachportfolio PanelB.Fourfactormodel Intercept(%) MKT SMB HML WML Adj.Rsq. *** *** Low 0.189 1.113 0.007 0.244 0.039 71.3% *** * 2 0.215 1.015 0.104 0.034 0.031 77.4% 3 0.208* 0.856*** 0.221*** 0.006 0.004 83.7% *** 4 0.168 0.940 0.007 0.066 0.008 80.7% *** *** ** 5 0.099 0.864 0.123 0.095 0.022 82.0% * *** 6 0.224 0.848 0.063 0.061 0.024 81.4% 7 0.125 0.965*** 0.157*** 0.060 0.034 79.8% *** ** ** 8 0.285 1.015 0.140 0.123 0.012 76.4% * *** *** *** *** 9 0.329 1.214 0.378 0.298 0.095 85.5% *** *** *** *** High 0.747 1.313 0.708 0.361 0.051 85.6% Hedge 0.936*** 0.199*** 0.701*** 0.117 0.012 28.8% N=210monthsforeachportfolio

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Table6.SizeadjustedreturnstodecileportfoliosconditionalonMSCORE

Toconstructthistable,firmsarefirstsortedintodecileportfoliosbyMarketvalueofequity,Bookto Market,Momentum,andAccrualeachyearbasedonprioryearcutoffvalues,thengroupedbyMSCORE. Flagged(NotFlagged)denotesfirmsthatfit(donotfit)theprofileofanearningsmanipulatorbasedon theMSCOREmodelfromBeneish(1999)andacutoffof1.78.Momentumdenotessizeadjustedreturns forthesixmonthspriortotheBHSARreturnwindow.Shortinterestratiodenotesthenumberofshares soldshortasapercentageofthenumberofsharesoutstanding,andismeasuredinthemonthbefore portfolioformation.Accrualsdenotesearningsbeforeextraordinaryitemslesscashflowsfrom operationsscaledbyaverageassets.BHSARdenotesannualsizeadjustedreturnsstartingthefirstdayof thefifthmonthfollowingtheendofthefiscalyear.Forfirmsthatdelist,anyproceedsupondelistingare reinvestedinthesizeportfoliotowhichthecompanybelongs.***,**,*denotesignificanceatthe1%, 5%,and10%levels,respectively. PanelA.MVE(MarketValueofEquity)Portfolios FullSample NotFlagged Flagged NotFlagged Portfolio N BHSAR N BHSAR N BHSAR LessFlagged * *** 1 4009 2.6% 3236 4.6% 773 5.7% 10.3%*** 2 4127 2.5%* 3251 6.2%*** 876 11.5%*** 17.7%*** 3 4119 3.8%*** 3225 5.4%*** 894 2.0% 7.4%** 4 4151 0.8% 3243 3.6%*** 908 9.1%*** 12.7%*** *** *** 5 4119 1.3% 3291 3.5% 828 7.6% 11.1%*** 6 4180 0.6% 3439 3.0%*** 741 10.4%*** 13.3%*** 7 4206 0.9% 3500 2.9%*** 706 8.8%*** 11.7%*** 8 4217 0.0% 3624 1.3%* 593 7.5%** 8.8%*** * 9 4074 0.5% 3557 1.2% 517 4.2% 5.4%** 10 4342 0.1% 3976 0.8% 366 10.6%*** 11.5%*** Spread 2.7%* 3.8%** 5.0% PanelB.BooktoMarketPortfolios FullSample NotFlagged Flagged NotFlagged Portfolio N BHSAR N BHSAR N BHSAR LessFlagged 1 2936 5.0%*** 2085 3.0%** 851 10.0%*** 7.0%** 2 4260 2.3%** 3274 0.4% 986 11.3%*** 11.7%*** 3 4159 0.2% 3311 2.5%** 848 9.0%*** 11.5%*** ** ** 4 4197 0.9% 3415 2.5% 782 6.1% 8.6%*** 5 4305 1.7%* 3586 2.7%*** 719 3.2% 5.8%** 6 4124 2.8%*** 3482 4.4%*** 642 5.9%** 10.3%*** 7 4178 1.1% 3582 2.1%** 596 5.2%** 7.3%*** *** *** 8 4205 3.9% 3658 4.9% 547 2.7% 7.6%*** 9 4359 3.1%*** 3782 4.9%*** 577 8.6%*** 13.5%*** 10 4821 4.2%*** 4167 6.7%*** 654 11.6%*** 18.3%*** Spread 9.2%*** 9.7%*** 1.6%

41

PanelC.MomentumPortfolios FullSample NotFlagged Portfolio N BHSAR N BHSAR 1 4326 3.2%** 2990 2.7% ** 2 4146 2.3% 3307 0.2% ** 3 4202 1.9% 3536 0.1% 4 4086 0.6% 3511 0.4% 5 4116 0.7% 3593 1.7%** 6 4092 2.4%*** 3604 3.3%*** 7 4169 2.2%*** 3633 3.6%*** *** 8 4148 3.1% 3533 4.6%*** 9 3945 5.2%*** 3315 6.6%*** 10 4314 7.4%*** 3320 8.7%*** Spread 10.7%*** 6.0%** PanelD.ShortInterestRatioPortfolios FullSample NotFlagged Portfolio N BHSAR N BHSAR ** 1 3751 2.2% 3189 4.0%*** 2 3889 4.5%*** 3275 4.8%*** ** 3 3877 1.8% 3322 3.3%*** 4 3920 3.5%*** 3333 5.7%*** 5 3918 2.9%** 3356 3.8%*** 6 4084 1.2% 3450 3.1%*** ** 7 4165 2.5% 3512 4.6%*** 8 4678 0.4% 3878 1.0% 9 4655 0.9% 3672 1.5% *** 10 4607 3.0% 3355 0.2% *** Spread 5.3% 3.7%**

Flagged N BHSAR 1336 16.6%*** 839 12.3%*** 666 11.8%*** 575 6.3%*** 523 6.1%** 488 4.8%** 536 7.1%** 615 5.7%*** 630 2.4% 994 3.1% 19.6%***

NotFlagged LessFlagged 19.3%*** 12.4%*** 11.7%*** 6.7%*** 7.9%*** 8.2%*** 10.7%*** 10.3%*** 9.0%*** 5.7%

Flagged N BHSAR 562 7.6%*** 614 2.5% 555 6.9%** 587 9.2%*** 562 2.7% 634 8.9%*** 653 8.9%*** 800 7.2%** 983 9.8%*** 1252 11.8%*** 4.3%

NotFlagged LessFlagged 11.6%*** 2.4% 10.2%*** 15.0%*** 6.4%* 12.0%*** 13.5%*** 8.2%*** 11.3%*** 12.1%***

42

PanelE.AccrualPortfolios FullSample Portfolio N BHSAR 1 4193 3.3%** 2 4121 3.2%*** 3 4136 2.5%** 4 4128 2.3%*** 5 3999 3.4%*** 6 4018 1.2% 7 4008 1.2% 8 4224 1.1% 9 4334 0.3% 10 4383 4.7%*** Spread 8.0%***

NotFlagged N BHSAR 3727 6.2%*** 3735 4.5%*** 3796 3.3%*** 3787 3.2%*** 3627 4.3%*** 3630 1.7%* 3530 2.4%** 3570 2.0%** 3270 1.8%* 1670 0.6% 5.7%**

Flagged N BHSAR 466 19.8%*** 386 9.7%** 340 6.9%** 341 7.0%* 372 4.6% 388 3.1% 478 7.5%*** 654 3.7% 1064 6.7%*** 2713 7.9%*** 11.9%***

NotFlagged LessFlagged 26.1%*** 14.2%*** 10.2%*** 10.1%*** 8.8%*** 4.8%* 9.8%*** 5.7%** 8.5%*** 8.5%***

43

Table7.SizeadjustedreturnstoaccrualandMSCOREquintileportfolios
ToconstructPanelA,firmsareindependentlysortedonaccrualsandMSCOREbasedonprioryearcutoff values.PanelsBandCreportnestedsorts.InPanelB(C)firmsaresortedonaccruals(MSCORE)first and,withineachaccrual(MSCORE)portfolio,furthersortedintoMSCORE(accrual)portfolios.Forthe firstpasssortsinPanelsBandC,firmsaresortedintoportfoliosbasedonprioryearcutoffvalues.The secondpasssortsinPanelsBandCarebasedoncurrentyearcutoffvalues.SeethenotestoTable1for adescriptionoftheMSCOREmodel.Accruals(orAcc)denotesearningsbeforeextraordinaryitemsless cashflowsfromoperationsscaledbyaverageassets.BHSARdenotesannualsizeadjustedreturns startingthefirstdayofthefifthmonthfollowingtheendofthefiscalyear.Forfirmsthatdelist,any proceedsupondelistingarereinvestedinthesizeportfoliotowhichthecompanybelongs.***,**,* denotesignificanceatthe1%,5%,and10%levels,respectively. PanelA.Independentsorts LowMSCORE 2 3 4 HighMSCORE Portfolio N BHSAR N BHSAR N BHSAR N BHSAR N BHSAR Spread LowAcc 5244 2 3 4 HighAcc 2248 672 6.4%*** 1113 4.5%*** 3128 0.2% 2599 981 199
**

3.3%*

537

7.6%* 1.0% 2.3%** 3.0% 2.7%

***

478 3.5% 796 1.0% 1365 2.7%* 2723 0.7% 3060 1.2% 2.4%

942 13.5%*** 19.9%*** 806 6.2%*** 10.8%*** 861 0.0%

* *** ***

4.0%*** 1286 3.6%*** 2520 4.2%

**

0.2% 3.1% 1.0%

237 0.8% 72 5.6%

2918 759

1373 3.8% 4627 4.7% 8.8%

8.3%

5.0% 4.8% Spread 12.1% PanelB.MSCOREsortedwithinAccrualsportfolios LowMSCORE 2 3 Portfolio N BHSAR N BHSAR N BHSAR LowAcc 1656 2 3 4 Spread 1646 1596 1641 5.7% 1667 8.7%
***

***

4 N BHSAR 1667 1.1% 1607 2.4% 1650 1.4%

HighMSCORE N BHSAR Spread 1660 4.7%** 10.4%*** 6.5%*** 2.4% 7.7%*** 8.1%*** 1602 1.4%
**

1664 1605 1647

5.5%

3.7%** 1656 3.9%*** 1607 3.4% 3.8%

**

5.8%*** 1656 1.9%* 2.0%

*

2.3%** 2.1%* 3.1%

**

1656 2.9%** 1650 2.8%* 1644 4.3% 1.5%

1650 1749

HighAcc 1736

1.9%

0.7% 8.0%***

1743 3.3%** 8.8%***

1749 5.5%*** 1740 6.2%*** 6.7%***

44

 PanelC.AccrualssortedwithinMSCOREportfolios LowAcc 2 3 4 HighAcc Portfolio N BHSAR N BHSAR N BHSAR N BHSAR N BHSAR Low MSCORE 1686 5.6% 1697 8.8%*** 1699 4.3%*** 1697 5.0%*** 1693 1.9% 2 3 4 High MSCORE Spread 1597 1598 1677 4.1% 3.5% 0.2%
** **

Spread 3.6% 0.1% 1.3% 4.3%**

1607 1606 1687

4.3% 2.8% 0.8%

*** ***

1608 1607 1689

3.5% 2.1% 1.2%

***

1607 3.6% 1687 2.5%

*** **

1599 1601

4.0% 2.2%

*** * ***

1606 3.0%

1679 4.0%

1715 6.7%*** 1725 12.2%***

4.9%*** 1724 2.6% 13.7%*** 7.0%***

1725 6.2%*** 1719 5.5%*** 1.2% 11.2%*** 7.4%***

45

 Table8.ComparingMSCOREcomponentsforhighandlowaccrualfirms ThistablecomparesthemeanforeachofthesevencomponentsoftheBeneishmodel(otherthanaccruals)invarioussubpopulationsofour sample.Toconstructthistable,weindependentlysortedfirmsintoquintilesaccordingtoAccrualsandMSCORE(sameasTable7PanelA).To focusonthesubpopulationoffirmswhereMSCOREexhibitedthestrongestincrementalpredictivepoweroverAccruals,weexaminefirmsinthe lowestAccrualquintilethatarealsoeitherinthehighestorthelowestMSCOREquintile.Wethencompareandcontrastthemeanforeachof thesevenvariablesinthemodelacrosshighandlowMSCOREfirms.Theresultsarereportedintheupperthreerowsofthistable.For comparison,wealsogroupfirmsinthethreehighestAccrualquintiles(quintiles3,4,and5)andfurtherseparatethemaccordingtotheir MSCOREscore.Onceagain,wecomputethemeanforthesamesevenvariables,andreporttheresultsinrowsfourthroughsix.Finally,inthe bottomrow,wereportdescriptivestatisticsandtheresultofasignificancetestforthedifferenceindifferenceacrossthesefirms. Eachcolumnofthetablepertainstooneofthesevenmodelvariables,where:DSRdenotestheratioofreceivablestosalesinyeartdividedby thesameratioinyeart1.GMIdenotestheratioofgrossmargintosalesinperiodt1tothesameratioinperiodt.SGAdenotestheratioof selling,general,andadministrativeexpensetosalesinperiodtdividedbythesameratioinperiodt1.SGIequalssalesintdividedbysalesint 1.DEPIdenotestheratioofdepreciationtodepreciablebaseint1dividedbythesameratioint.AQIequalsallnoncurrentassetsotherthan PPEasapercentoftotalassetsintdividedbythesameratioint1.LEVIequalstheratiooflongtermdebt+currentliabilitiestototalassetsint dividedbythesameratioint1.***,**,*denotesignificanceatthe1%,5%,and10%levels,respectively. Accrual MSCORE Quintile Quintile N DSR GMI AQI SGI SGAI DEPI LEVI Lowest Lowest 5244 0.867 1.030 0.948 1.084 1.075 0.966 1.167 Highest 942 1.404 1.167 5.272 2.381 0.929 1.071 1.064 HighLow 0.537 0.137 4.324 1.297 0.146 0.105 0.103 3,4and5 Lowest Highest HighLow 981 0.759 6861 1.331 0.572 0.035 0.908 1.071 0.163 0.025 0.857 2.330 1.473 2.851*** 0.980 1.570 0.590 0.707*** 1.110 0.949 0.161 0.015 1.011 1.108 0.097 0.008 1.216 0.991 0.225 0.122***

LowAccrualsHighAccruals

46

Table9.Regressionoffutureearningsoncurrentperiodearningscomponents
Thistablereportstheresultsfromaseriesofpooled(crosssectionalandtimeseries)regressions.The dependentvariableisalwaysyeart+1earnings(definedasincomebeforeextraordinaryitemsexcluding depreciation,dividedbyaveragetotalassetsinyeart).Theindependentvariablesarevarious componentsofcurrentperiod(yeart)earnings,aScaledProbabilityofManipulation(SPM)measure, andinteractionterms.EARNdenotesincomebeforeextraordinaryitemsexcludingdepreciation;CFO denotescashfromoperations;ACCdenotesincomebeforeextraordinaryitemsexcludingdepreciation lessCFO;ACCPOSdenotesACCifpositive,0otherwise;ACCNEGdenotesACCifnegative,0otherwise. Allthesevariablesaredividedbyaveragetotalassetsinyeart.SPMdenotesMSCORErankedinto decilesandscaledtorangefrom0(lowestMSCORE)to+1(highestMSCORE).***,**,*denote significanceatthe1%,5%,and10%levels,respectively. Model1 Model2 Model3 Model4 Intercept EARN CFO ACC ACCPOS ACCNEG 43.84% 38,008 48.16% 48.85% 49.35% 0.025*** 0.796*** 0.938 0.493*** 0.769
*** ***

0.013***

0.003* 0.974
***

0.017*** 0.975*** 0.996*** 0.213*** 0.353** 0.555*** 0.032***

0.340***

ACCPOS*SPM ACCNEG*SPM SPM AdjRsq N

47

Table10.Earningsannouncementreturnsbyquarter

Thistablereportsthecumulativeabnormalreturns(CAR)aroundthenextfourearningsannouncementsforvariousMSCOREbasedportfolios. Firmsareaddedtoportfoliosonthefirstdayofthefifthmonthfollowingtheendofthefiscalyear.CARdenotesthecumulativerawreturnover days1,0,and+1relativetotheearningsannouncementdate,minusthecumulativereturntothebenchmarksizeportfoliotowhichthefirm belongs.ToconstructPanelAwesortfirmsintoFlaggedandNotFlaggedcategoriesbasedonMSCOREandacutoffof1.78.Toconstructthe nexttwopanels,wefirstsortfirmsintodecilesbasedontheircurrentMSCOREscoreanddecilecutoffsfromtheprioryearMSCOREdistribution. WethencalculateCARforeachdecileportfolio(PanelB),aswellasforalternativehedgeportfolios(PanelC).InPanelC,westartwiththemost extremeportfolios(deciles1and10)andprogressivelyaddlessextremeMSCOREfirmstothelongandshortpositions.Wereportshortwindow announcementperiodCARforeachofthenextfourquarters,aswellasthetotalCARforallfourquarterlyannouncements.***,**,*denote significanceatthe1%,5%,and10%levels,respectively. PanelA.Earningsannouncementreturnsbyquarterforflaggedandnotflaggedfirms

NotFlagged Flagged Difference

Quartert+1 N CAR 33658 0.35%*** 7263 0.44%*** 0.79%***

Quartert+2 N CAR 32939 0.11%** 7099 0.38%*** 0.49%***

Quartert+3 N CAR 32017 0.16%*** 6848 0.70%*** 0.85%***

Quartert+4 N CAR 28411 0.51%*** 5844 0.01% 0.52%***

TotalCAR For4Qtrs 1.03%*** 1.48%*** 2.51%***

PanelB.EarningsannouncementreturnsbyquarterandMSCOREdecile Quartert+1 Quartert+2 Quartert+3 Decile N CAR N CAR N CAR * 4062 0.01% 1 4297 0.23% 4200 0.31% * 2 4025 0.25% 3937 0.21% 3839 0.07% 3 3896 0.47%*** 3807 0.21% 3707 0.24% ** * 4 4006 0.29% 3914 0.23% 3824 0.41%*** 5 3791 0.46%*** 3703 0.17% 3597 0.45%*** *** 6 4104 0.34% 4026 0.08% 3920 0.27%* 7 4091 0.59%*** 3998 0.12% 3882 0.16% 8 4214 0.16% 4142 0.19% 4025 0.19% 4104 0.19% 3956 0.49%*** 9 4202 0.13% 10 4295 0.51%*** 4207 0.55%*** 4053 0.77%*** 48

Quartert+4 N CAR 3540 0.58%*** 3426 0.60%*** 3348 0.55%*** 3431 0.62%*** 3202 0.47%*** 3506 0.71%*** 3444 0.42%*** 3516 0.30%* 3421 0.06% 3421 0.08%

TotalCAR For4Qtrs 1.01%*** 1.03%*** 1.38%*** 1.44%*** 1.45%*** 1.13%*** 1.21%*** 0.05% 0.72%** 1.84%***


PanelC.EarningsannouncementsreturnstoalternativeMSCOREbasedhedgeportfolios Long Decile1 1to2 1to3 1to4 1to5 Short Decile10 9to10 8to10 7to10 6to10 Qtrt+1CAR 0.74%*** 0.56%*** 0.29%** 0.22%** 0.25%*** Qtrt+2CAR 0.86%*** 0.63%*** 0.45%*** 0.42%*** 0.41%*** Qtrt+3CAR 0.78%*** 0.67%*** 0.43%*** 0.39%*** 0.44%*** Qtrt+4CAR 0.66%** 0.59%*** 0.40%*** 0.30%*** 0.28%*** TotalCAR For4Qtrs 2.85%*** 2.31%*** 1.98%*** 1.55%*** 1.31%***

49

Figure1A:Marketvalueofequityportfolios

Figure1B:Booktomarketportfolios

50

Figure1C:Momentumportfolios

Figure1D:ShortInterestPortfolios

51

 Figure1E:Accrualportfolios

52