The Advisen Total Accrual Metric (ATACm): Back-Testing Underscores its Strength

Abstract of an Advisen Whitepaper

Utilizing the concepts of academic research on aggressive accrual accounting policies, Advisen introduced proprietary adjustments, and created a powerful tool Advisen Total Accrual metric (ATACm) which correlates growth in accruals with the likelihood of attracting securities class action lawsuits. Advisen has subjected its ATACm tool to extensive back-testing to both test its rigor and to provide further insights into the impact of the tool.

Accrual accounting is fundamental to GAAP accounting policies. But the inherent flexibility of accrual accounting leaves the opportunity for pushing estimates beyond prudent levels in order to inflate earnings, and other key items such as revenue, as well as to undervalue expenses. These inflated earnings usually prove unsustainable, and often ultimately lead to securities class action (SCA) lawsuits.

ATACm is a reliable indicator of companies with higher risks of attracting such lawsuits as a result of aggressive accrual accounting policies. The ATACm research findings are impressive, revealing a strong correlation between ATACm scores and attracting SCA lawsuits. Throughout the time period studied, from 1995 to 2007, companies with the top 5% of ATACm scores attracted 22% of SCA lawsuits between one and two years after their FYE date, and the top 15% represented 46% of lawsuits. Additionally, the top 40% of ATACm scores were associated with 79% of lawsuits filed.

Back-testing analysis performed on this metric supports these claims by proving that using ATACm on a portfolio of companies improves underwriting performance over the scenario without ATACm. To simulate a typical underwriter's portfolio, Advisen used a portfolio sampling approach. This approach is used to simulate a strategy that an underwriter might employ to benefit from ATACm's value. The back-testing results enable views of portfolios of companies in various risk scenarios, from the scenario that removes companies with the riskiest ATACm scores, to the scenario that removes all companies but those with the least risky of ATACm scores. In addition to providing insight into the risk avoided by eliminating companies with risky ATACm scores in portfolios, these results assist in pricing such companies that are retained in portfolios.