Predicting a recession

Article courtesy of MU News Bureau

In the United States, publicly traded companies are required to report their recent financial performance, whether good or bad, to the public. The accuracy of these reports is critical for investors, analysts and regulators. A new study, conducted at the University of Missouri and Indiana University, suggests that when businesses submit misleading financial statements, it can be an early warning sign of a looming recession.

Matthew Glendening and Ken Shaw, MU professors of accounting, worked together with co-authors Daniel Beneish and David Farber, professors of accounting at Indiana University, to determine how misrepresentation in financial statements affects the economy. They developed a new model to predict U.S. recessions and slowdowns in GDP and found that recessions and economic slowdowns are more probable when there is a higher likelihood that financial statements have been manipulated.

“Accounting matters, and manipulated accounting information can negatively impact the economy,” Glendening said. When financial reporting is not adequately monitored and companies manipulate financial information, it can have potentially damaging consequences. Not only do investors use this information, but other firms do so as well. In many cases, firms make employment and investment decisions based on this information, which can be way too optimistic.”

The study found that high levels of potential manipulation in financial statements can improve recession prediction 5 to 8 quarters away, and can also predict downturns in GDP growth at a similar forecast horizon.

To assess the prevalence of financial statement manipulation in the economy, the researchers used a measure widely known as the M-Score, which was created by Professor Beneish in the late 1990s. The M-Score measures the likelihood that a company has manipulated its financial statements, and is based on eight variables, including how fast a company’s sales are growing compared to its accounts receivable. The M-Score is considered to be one of the most economically viable measures for investors to use to determine the likelihood that businesses have manipulated their financial statements. Famously, the M-Score provided one of the earliest warnings about the Enron accounting scandal.

“When companies misreport information, it can take years before they are caught, if they’re caught at all — and many are not,” Glendening said. “Our model shows that the likelihood of financial statement manipulation helps predict the outlook of the economy.”

Shaw said previous research used measures of financial misreporting at the individual firm level, but no one has previously aggregated the data to come up with an economy-wide measure of financial misreporting.

“The M-Score has been around for a long time, but it took us four co-authors working together to show it has predictive value for the status of the economy, which is something everybody has a stake in,” Glendening said.

Shaw said the authors’ ultimate goal is to provide research that is not only informative but can be used by regulators and managers.

“We want to answer questions of interest to real people in the real world,” Shaw said. “We try to do something of value in our research and see if there’s a way that we can help people.”

“Aggregate Financial Misreporting and the Predictability of U.S. Recessions and GDP Growth” was recently accepted for publication in The Accounting Review, the premier scholarly journal of the American Accounting Association.