Top Forensic Algorithms Check Whistleblowers' Allegations Against Infosys

Summary

• Two whistleblowers filed complaints with the board of Infosys alleging two different unethical practices.
• News of the complaints was released this past Monday and the stock price suffered an initial drop of more than 16%.
• In this article, I examined the scores from four top forensic algorithms that check for earnings manipulation, financial irregularities, and bankruptcy risks.
• In the period examined from 2013 to 2019 there were no strong initial indicators of any earnings manipulation or material financial irregularities in any of the tests.
• The forensic tables of Altman, Beneish, Ohlson, and Montier are displayed below along with value/growth algorithm of Piotroski.
• This idea was discussed in more depth with members of my private investing community, Value & Momentum Breakouts. Get started today »

Do Forensic Algorithms Detect Any Infosys Financial Fraud?

In an ongoing look at some major whistleblower accusations recently, I took a look to see if the claims against Infosys (NYSE:INFY) showed any irregularities in the top forensic algorithms commonly used by certified fraud examiners. As part of my regular stock analysis and selections, I routinely publish screens of the most positive and negative forensic stocks in the market. Most recently, I examined whistleblower claims against Disney (DIS):

Top Forensic Algorithms Check Whistleblower's $6B Claims Against Disney

I also took a look at Harry Markopolos' accusations that "General Electric (GE) has engaged in fraud larger than Enron or Worldcom" in my article:

Running Top Forensic Algorithms On 2012-2019 GE Financials

In another series of articles, I look at certain combinations of these forensic and value scores to predict stock price performance like Tesla's (TSLA) recent 40% decline:

The 3 Largest Stocks for October Scoring Worse Than Tesla Before Its 40% Decline

These models are designed to flag certain elements where examiners could look deeper to assess conditions of a company.

The Infosys Stock Chart from 2011 to 2019

Two Whistleblower Complaints Against Infosys

A member of Infosys' board received the complaints on September 30, chairman Nandan Nilekani said in a statement. The first complaint contains allegations of "disturbing unethical practices" while the second "largely deals with allegations relating to the CEO's international travel," he said. The company first disclosed the complaints on Monday. (Source)

The magnitude of the allegations are not known publicly nor are the time periods directly impacted by these claims.

The complaints accuse the company's CEO of under-reporting costs in order to inflate profits and hiding "critical information" from auditors and the board, according to multiple Indian newspapers, which said they had obtained copies of the alleged complaints. (Source)

Significant claims of earnings manipulation in a multi-billion corporation should become evident in at least one of the top forensic algorithms assessing more than 22 different ratios across different quarterly periods spanning seven years of data. There are ways to hide material breaches, but the application of multiple models reduces the chances for significant irregularities to go completely undetected.

Forensic Algorithms on Infosys from 2013 to 2019

It's unlikely the CEO's international travel will turn up as an issue on the forensic and valuation models as an irregularity as these type of expenses would typically remain within sustainable operational parameters. Of greater concern are the claims of inflated profits, hidden "critical information," and under-reporting costs which can be detected depending on the relative magnitude of these irregularities. On the first pass, not only are all the forensic and value algorithms not adverse at the top level, but they are in highly favorable conditions for low risk of manipulation, bankruptcy, and financial irregularities.

Analyzing these Infosys accusations over the time period from 2013 to 2019 using the Altman Z-score, Beneish M-score, Ohlson O-score probability and the Montier C-score reveal the following:

(UncleStock.com)

First, looking at the Beneish model that uses eight variables to assess whether any earnings manipulation has occurred we see that none of the scores over the past seven years are adverse. Second, applying the Altman Z-score for assessing bankruptcy risk along five financial ratios reveals steadily improving scores with very low risk of insolvency. Third the Ohlson probability score of bankruptcy risk over the next two years is at an extremely low percentage below 1% over the analyzed time period. Fourth, the Montier C-score using six criteria to assess the likelihood that a company is cooking their books currently shows the highest positive (lowest chance) score possible for this risk. The score has been improving steadily and may have had some risk in 2014 to examine more closely. Lastly, the Piotroski value score remains a steady positive value for good expected returns at current price levels. The time period evaluation of these forensic and value algorithms does not show significant or prolonged risks of financial irregularities that may relate to the whistleblowers' complaints.

A deeper dive into the forensic factors for any irregularities

The tables below break down each of the factors and allow us to take a closer look for any financial criteria within each of the forensic and value models that may show some irregularity or distress.

Beneish M-Score factors

The Asset Quality Index factor shows three years of adverse scoring based on the ratios of market cap to revenue relative to prior year ratios in these earnings periods. The most recent three years show a return to high quality asset levels according to the models measures. There's no other pervasive multi-year irregularity or current financial factor that is outside of expected parameters.

Altman Z-score factors

The individual Altman Z-score bankruptcy risk factors show a very positive and healthy balance sheet with very low risk of solvency concerns.

Ohlson O-score factors

The individual Ohlson O-score distress factors also show very positive scores and low risk of bankruptcy. The only adverse scores over the past seven years are in the Income After Tax one-year relative difference criteria. These two recent year scores highlight a decline in the yearly differences in income after taxes that might actually be inconsistent with any fraud complaints alleging the inflating of profits. The risk here is again very minimal.

Montier C-score factors

Examining the Montier C-score factors for earnings and financial statement manipulations we find several areas highlighted for closer analysis. While the current year received the best overall possible score on the Montier model, some prior years had some red flags despite scoring in the low risk levels over the past seven years. In particular the total assets fluctuation of one-year growth levels is consistently high over this evaluated time period and could be an area for further evaluation to understand the significant variation. Related to this factor are the Depreciation rates and the Days Inventory Outstanding that have fluctuated significantly but consistent with the unusual asset growth measures. The Days Sales Outstanding one-year growth measure shows a very significant reduction in this metric for 2019 relative to all the prior years to 2013. The sudden improvement in 2019 across most of the manipulation factors to very high positive levels seemingly inconsistent with all the prior year trends may be an indicator of unusual positive enhancements or change in the business. It may be worthwhile as an investigator to look at why many of these factors moved so much higher positive year-to-date 2019 than in all the prior years' trends. It also would be critical to know the time period of the alleged unethical manipulations in the whistleblowers' complaints to see how this matches with any unusual factor changes above.

Piotroski F-score factors

Finally, looking at the value categories of the Piotroski F-score may give us some additional insight to what is considered a fairly positive valued stock at these price levels. Debt and buyback ratios are low and favorable, while return on assets and current ratios are not particularly strong. This does not validate any forensic concerns but may give a positive picture for the price value of this stock especially after the selloff reaction to the disclosure of the complaints.

Conclusion

According to all the forensic models applied, there's no indication of alleged rampant financial irregularities spanning from 2013 to today in the Infosys financials. The three-year period of adverse scoring in the Beneish M-score factor for asset quality does not appear to be consistent with what little we know about the whistleblower claims. Much more information from the claims is necessary to match the time periods and the financial categories materially affected. The significant change in 2019 Montier C-scores with substantial improvements over all prior years is another area to look at more closely.

These models are certainly not foolproof and were designed by academic researchers to improve the chance of detection of irregularities leading to bankruptcy, earnings manipulation, or flag the presence of financial distress.

At the same time, these models are among the best peer-reviewed forensic models in the financial literature and have some significant documented value.

The Beneish model for example has "correctly identified, in advance of public disclosure, a large majority (71%) of the most famous accounting fraud cases that surfaced after the model's estimation period." (Beneish, Lee, & Nichols, 2013, p. 57).

I trust the insight from these different forensic and value algorithms will give you added value to your investment goals and objectives in the days ahead.

JD Henning, PhD, MBA, CFE, CAMS

References

Altman, E. I. (1968). The Prediction of Corporate Bankruptcy: A Discriminant Analysis. The Journal of Finance, 23(1), 193-194. doi:10.1111/j.1540-6261.1968.tb03007.x.

Beneish, M. D. (1999). The Detection of Earnings Manipulation. Financial Analysts Journal, 55(5), 24-36. doi:10.2469/faj.v55.n5.2296.

Beneish, M. D., Lee, C. M. C., and Nichols, D. C. (2013). Earnings Manipulation and Expected Returns. Financial Analysts Journal, 69.2, 57-82.

Ohlson, J. A. (1980). Financial Ratios and the Probabilistic Prediction of Bankruptcy. Journal of Accounting Research, 18(1), 109. doi:10.2307/2490395.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.