A recent paper published in the scholarly journal The Accounting Review indicates that there are signals from reported corporate earnings that indicate a higher likelihood of the US economy slipping into a recession in the next five to eight quarters. The authors use a model that predicts the likelihood of earnings manipulation by publicly traded companies based on individual companies’ M-Scores. M-Scores are computed using eight fairly common financial statement ratios. The financial ratios used to compute the M-Score are
· Days Sales in Receivables Index
· Gross Margin Index
· Asset Quality Index
· Sales Growth Index
· Depreciation Index
· Sales, General, and Administrative Expenses Index
· Leverage Index
· Total Accruals as a percentage of total assets
The higher the M-Score, the greater the likelihood of financial statement manipulation. The logic behind the M-Score is that companies are more likely to manipulate their earnings to mask declining financial performance. Students at Cornell University used the M-Score to predict that Enron was manipulating its earnings in the late 1990s, years before its phenomenal collapse in 2001.
The authors aggregated the M-Scores for all publicly traded companies and used those aggregate M-Scores to predict recessions using data from the past 40+years. Higher aggregate M-Scores indicate a higher probability of recession in the next five to eight quarters. Results of the authors’ data analyses show that each of the major recessions in the past 40 years were preceded by increasing aggregate M-Scores in the five to eight quarters prior to the onset of recessions. The authors report that aggregate M-Scores for the quarter ended March 31, 2023, are at their highest levels in 40 years. They conclude that it is likely that the US economy will slip into a recession in the next five to eight quarters.
No economic or financial model can be 100% accurate at predicting the future, so the authors’ predictions must be viewed through that lens. The model predicts a higher likelihood of recession; it does not guarantee that one will occur.
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