Bankruptcy and Fraud Analysis: Shorting and Selling Stocks
Hugh Grove Tom Cook Eric Streeper Greg Throckmorton*
To auditors, investors, fund managers, short sellers, and other external users, fraud and bankruptcy models may serve as important tools in analyzing the financial information presented by companies. Along with the earnings management ratios, quality of earnings and quality of revenue (Schilit 2003), more elaborate models and metrics (Altman 1968 and 2005, Dechow, Sloan and Sweeney 1996, Sloan 1996, Beneish 1999, and Dechow, Ge, Larson, and Sloan 2007, and Robinson 2007) may serve as a veritable arsenal of techniques for detecting financial problems within companies. When used together as a group, these models may also act as good leading indicators or predictors of future stock price performance. Furthermore, Security and Exchange Commission (SEC) letters to companies questioning their financial reporting may serve as a good screening tool for applying these models since such letters may alert auditors, investors, and other external users to potential financial reporting problems within a company. When companies file their annual 10-K reports, SEC personnel evaluate the financial data and try to determine if there are any potential improprieties or unusual methods being used. If there are, they will send a comment letter to the company outlining the dispute. As of May 12th, 2005, the SEC began publicly releasing comment letters which were issued after August 1st, 2004. They are now available through the SEC’s Edgar Database. The comment letters are sent by individual SEC staff members as part of a review and do not constitute a position taken by the SEC. These letters are only meant to outline reporting concerns, in contrast to Accounting and The authors are, respectively, Professor of Accounting, Professor of Finance, and alumni of the University of Denver. *
Auditing Enforcement Releases (AAERs), which occur when the SEC actually takes action against a company for financial reporting problems. This article is divided into the following three sections: red flag models, data analysis and results, and conclusions and future research. Red Flag Models Six different emerging models and ratios were used in this study to develop a more comprehensive red flag approach in screening for and identifying financial reporting problems in publicly held companies than just using traditional ratios. All six models are available from the authors in an Excel file. 1. Quality of Earnings The quality of earnings ratio is a quick and simple way to judge the quality of a company’s reported net income. The ratio is operating cash flow for the period divided by net income for the period. The red flag benchmark is a ratio of less than 1.0 (Schilit 2003). Also, large fluctuations in this ratio over time may be indicative of financial reporting problems, i.e., Enron’s quality of earnings ratios were 4.9, 1.4, and 2.3 over its last three years of operation. In its last year of operation, Enron forced its electricity customers to prepay in order to receive any electricity which dramatically increased its operating cash flows and quality of earnings ratio. Quality of earnings is also meant to measure whether a company is artificially inflating earnings, possibly to cover up operating problems. This ratio may indicate that a company has earnings which are not actually being converted into operating cash. Methods for inflating earnings (but not operating cash flows) include early booking of revenue, recognizing phony revenues, or booking one-time gains on sales of assets. 2. Quality of Revenues The quality of revenues ratio is similar to the quality of earnings, except that the 277
emphasis is on cash relative to sales rather than cash relative to net income. It is the ratio of cash...