Detecting creative accounting in a company's financial numbers

When their operational parameters worsen, and the stress starts showing in the financial numbers, a lot of businesses get a tad creative with their accounts so that investors don't take to their heels.

Can this creativity be detected through analysing the financial results that are released? Not with certainty, but as a probability, yes. What we have here is a probabilistic score that measures a company's resemblance to other companies where the accounting has been creative.

We have developed the Modified C-score which indicates the probability of financial manipulations based on a quantitative method. We did that by modifying James Montier's C-score using his 6 basic checks and further improving it by adding our own 3 points. You will find the score on our stock pages, under the Essential checks tab.

We give a score to a company based on these nine points by giving them zero or one for each point based on qualification. The higher a C-score, the higher the probability of financial manipulation.

James Montier's C-score
Montier's C-Score is made up of six red signals. These are scored in a simple way, with a 1 for yes and a 0 for no.

These are then totalled to give a final C-score ranging from 0 (no evidence of earnings manipulation) to 6.

The individual tests are:

1. Is there a growing divergence between net income and operating cash-flow? This is based on the simple observation that earnings can be inflated, but cash flows are hard to manipulate.
2. Are Days Sales Outstanding (DSO) increasing? When a company stuffs the dealer pipeline, this number increases.
3. Are days sales of inventory (DSI) increasing? This is a sign of slowing sales.
4. Are other current assets increasing vs revenues? Since managements know that DSO and/or DSI can be closely watched, they may use this to hide something.
5. Are there declines in depreciation relative to gross property plant and equipment? Companies may alter their estimate of useful asset life to enhance reported earnings.
6. Is total asset growth high? It has often been observed that high asset growth firms underperform.
   
   Our additional checks:
7. Are debtors as per cent to revenue increasing? This means that the company is selling more on credit and not realising cash.
8. Is asset quality improving or declining? Asset quality is measured as the ratio of non-current assets other than plant, property and equipment to total assets. Which means the company may have high non-productive assets.
9. Is accrual ratio high or low? Total accrual is calculated as the change in working capital accounts other than cash less depreciation. Accrual ratio gives the difference between the accrual accounting and cash actually made out of it. A high ratio means that there is a high difference between the cash realised and earnings reported.