Two accounting professors at the Indiana University Kelley School of Business have developed what they call a more accurate model to predict recessions and economic slowdowns. Professors David Farber and Messod Beneish say their economic tool puts more emphasis on the likelihood that financial statements have been manipulated.
“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.
Existing recession prediction models rely on information from credit markets, monetary policy and inflation. The Beneish-Farber model uses not only those factors, but it also factors the aggregate probability of financial misreporting in the economy.
“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.
IU says while this new model 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.
“Firms that misreport often overinvest to hide the fact that they are facing economic headwinds,” said Beneish. “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.”
The Kelley professors found that recessions and economic slowdowns are more probable when there is a higher likelihood that financial statements have been manipulated.
Their model also improves the timeline in which economic downturns can be predicted.
“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,” said Farber.
For 2023, their model predicts no recession, but it does predict a slowdown. Click here to access their study.