Researchers at the Indiana University Kelley School of Business and the University of Missouri have devised a more accurate model to predict recessions and economic slowdowns, based on the aggregate probability of financial misreporting in the economy.
Kelley School accounting professors Messod D. Beneish and David B. Farber found that recessions and economic slowdowns are more probable when there is a higher likelihood that financial statements have been manipulated.
For 2023, their model predicts no recession, but it does predict a slowdown. While their recession forecast differs from the consensus forecast of professionals on a recent Wall Street Journal survey, it is in line with forecasts from Goldman Sachs and Morgan Stanley.
Like existing recession prediction models that rely on information from credit markets, monetary policy and inflation, the new model uses an estimate of the spread between long and short treasury rates. Unlike existing models, the researchers’ model improves recession prediction by considering the aggregate probability of financial misreporting in the economy.
“The rationale for our finding is that the aggregate probability of financial misreporting measures the amount of misinformation in the economy, and this has real economic consequences, as firms base their investment, hiring and production decisions on both their financial information and on that of their competitors,” said Beneish, professor of accounting and the Alva L. Prickett Chair at Kelley.
“Firms that misreport often overinvest to hide the fact that they are facing economic headwinds,” Beneish added. “This results in their competitors recognizing with a delay that the level of economic activity is declining. When the misreporting is discovered, firms recognize that an economic downturn is occurring and curtail their investment and production activity.
“These curtailments can reduce levels of consumption by households owing to lower wages and employment. For these reasons, an increasing amount of misreporting in the economy can lower both investment and consumption, which would account for the economy going into recession.”
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 Beneish in the late 1990s. The M-Score, which measures the likelihood that a company has manipulated its financial statements, remains the most economically viable measure for investors out of seven misreporting measures compared in a study published in October 2022. Notably, the M-Score provided one of the earliest warnings about the Enron accounting scandal.
“Because our model improves recession prediction by about 25% over a simple model based on the spread between long and short Treasury yields, regulators should find it useful as they debate the likelihood of recessions,” said Farber, associate professor of accounting at Kelley. “Another benefit of our model is that it improves recession prediction five to eight quarters ahead of its likely occurrence, giving regulators and business leaders more lead time to prepare for a recession.”
The study, “Aggregate Financial Misreporting and the Predictability of U.S. Recessions and GDP Growth,” is forthcoming at The Accounting Review, the premier scholarly journal of the American Accounting Association.
