Analyst, economist and behavioural scientist James Montier is the architect of a three-pronged approach to shorting stocks that he called the 'Unholy Trinity'. But he's also behind a useful accounting test that he developed in the context of shorting called the C-Score (C apparently stands for cheating or cooking the books). It's similar in nature to the Beneish M-Score, in that it's focused on identifying tell-tale signs / quantitative red flags which accompany bad accounting practice.

Even if you don't fancy shorting individual stocks (given the scope for unlimited loss!), the C-Score approach is still a useful tool as a red flag that's worth knowing about - as with the Altman Z-Score

How does it work?

Montier's C-Score is made up of six red flags or warning signals. The idea is that, like the Piotroski F-Score for financial health, these elements are scored in a simple binary fashion, 1 for yes, 0 for no.

These scores are then summed across the  elements to give a final C-score ranging from 0 (no evidence of earnings manipulation) to 6 (all the flags are present - yikes!). The areas tested are:

  1. Is there a growing divergence between net income and operating cash-flow? We've talked elsewhere about the fact that management have less flexibility to alter cash flow, whereas earnings can be stuffed for all sorts of "funnies", so this is something to watch for.  
  2. Are Days Sales Outstanding (DSO) increasing? If so (i.e. accounts receivable are growing faster than sales), this may be a sign of channel stuffing. 
  3. Are days sales of inventory (DSI) increasing? If so, this may suggest slowing sales, not a good sign. 
  4. Are other current assets increasing vs revenues? As some CFOs know that DSO and/or DSI are usually closely watched, they may use this catch-all line item to help hide things they dont want investors to focus upon.
  5. Are there declines in depreciation relative to gross property plant and equipment? This guards against firms altering their estimate of useful asset life to beat earnings targets. 
  6. Is total asset growth high? Some firms are serial acquirers and use their acquisitions to distort their earnings. While this may be justified in some circumstance, generally it has been shown that high asset growth firms underperform. It's not clear what Montier defines as…

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