Bankruptcy and Fraud Analysis: Shorting and Selling Stocks

5118 Words21 Pages
Journal of Forensic & Investigative Accounting Vol. 2, Issue 2

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
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Similar to the quality of earnings ratio, the red flag benchmark is a ratio of less than 1.0 (Schilit 2003). For example, Enron’s quality of revenues went down from 0.98 to 0.92 in its last year of operation. Since manipulation of revenue recognition is a common method for covering up poor results, this simple metric can help uncover schemes used to inflate revenues without the corresponding cash collection. Common methods include extending

increased credit terms to spur revenues but with slow collections, shifting future revenues into the current period, or booking asset sales or swaps as revenue. 3. Sloan Accrual Measure The Sloan accrual measure (1996 and updated as discussed by Robinson 2007) is based on the analysis of accrual components of earnings. It is calculated as follows: net income less free cash flows (operating cash flow minus capital expenditures) divided by average total assets. The red flag benchmark is a ratio of more than 0.10. For example, Sloan calculated that JetBlue had a ratio of 0.50 and his employer, Barclays Global Investors, shorted the stock and made over 12% in less than one year. This ratio is used to help determine the quality of a company’s earnings based on the amount of accruals included in income. If a large portion of a company’s earnings are based more on accruals, rather than operating and free cash flows, then, it is likely to have a negative impact on future stock price since the income is not coming from the company’s

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