Earnings Manipulation and Expected Returns

Abstract

An accounting-based earnings manipulation detection model has strong out-of-sample power to predict cross-sectional returns. Companies with a higher probability of manipulation (M-score) earn lower returns on every decile portfolio sorted by size, book-to-market, momentum, accruals, and short interest. The predictive power of M-score stems from its ability to forecast changes in accruals and is most pronounced among low-accrual (ostensibly “high-earnings-quality”) stocks. These findings support the investment value of careful fundamental and forensic analyses of public companies.

Keywords: Equity Investments, Fundamental Analysis (Sector, Industry, Company), Valuation of Individual Equity Securities, Company Analysis, Financial Statement Analysis, Financial Reporting Quality, Aggressive Financial Reporting Techniques