Dechow F-Score: an earnings-manipulation risk signal
The Dechow F-Score builds on the 'Predicting Material Accounting Misstatements' model (Dechow et al., 2011). It scores how closely a company's financial statements resemble those of firms whose accounting was later found to be misstated. The result is a multiple of the average firm's misstatement probability. It is a signal about whether earnings quality deserves a closer look, not evidence that earnings were manipulated.
Formula
The model is a logit.
Predicted value = -7.893 + 0.79·RSST + 2.518·ΔAR + 1.191·ΔInv + 1.979·soft assets -0.932·ΔROA + 1.029·financing
Probability = 1 ÷ (1 + e−predicted value), F-Score = probability ÷ 0.0037 (0.0037 is the unconditional misstatement rate in the sample)
An F-Score of 1 means the same level as the average firm; 2 means twice as high. Zones: above 2.45 high risk, above 1.85 substantial risk, above 1 above-normal risk, otherwise below-normal.
Components
- RSST accruals: the change in net operating assets (equity + borrowings − cash) divided by average total assets. It catches accumulating earnings that cash does not back.
- Change in receivables and inventory: rapid growth raises doubts about whether revenue and profit will be realised.
- Soft-assets share: assets that are neither cash nor tangible fixed assets, i.e. how much rests on estimates.
- Change in ROA: a sudden jump in profitability (the coefficient is negative, so a rise lowers the score).
- New financing: pressure to raise funds. Caveat approximates it by whether borrowings increased.
Worked example
The result for the fictional company used throughout these guides, current and prior year. The figures come from Caveat's calculation engine.
| Term | Value | Weight |
|---|---|---|
| RSST accruals (change in net operating assets ÷ average total assets) | 0.0353 | 0.79 |
| Change in receivables ÷ average total assets | 0.0235 | 2.518 |
| Change in inventory ÷ average total assets | 0.0118 | 1.191 |
| Soft-assets share | 0.5278 | 1.979 |
| Change in ROA (current − prior) | 0.0333 | -0.932 |
| New financing (borrowings increased = 1) | 0 | 1.029 |
The F-Score is 0.31, which is below-normal risk: 0.31 times the level of an average firm.
How to read it
- High does not mean manipulation: fast-growing companies can score high on ordinary growth, since receivables, inventory and financing rise together. A high score is a reason to check.
- Which term drives it: find the term pushing the score up and examine that account (for example, receivables).
- Low is not reassurance: the model looks only for signs of some types of misstatement.
Both sides: a high score can be explained by expansion, while a low score still calls for checks if cash flow and profit move in different directions. Read it together with other earnings-quality measures such as operating cash flow relative to net income.
Limitations
- The original model was estimated on enforcement cases at US listed companies. Its fit for Korean private SMEs has not been validated.
- Caveat takes only two years. The original's change-in-cash-sales term needs a third year, so it is set to zero; it is the term with the smallest weight of the seven.
- New financing is approximated by whether borrowings rose, not by actual issuance, so an equity-only raise is missed.
- This is reference analysis and does not replace credit, investment or tax decisions.
FAQ
- Does a high Dechow F-Score mean fraud?
- No. It is a statistical signal that the financial profile resembles firms with past misstatements, and ordinary growth can raise it. The starting point is to find which term raised the score.
- What does an F-Score of 1.0 mean?
- The same level as the average misstatement probability in the sample. 2.0 is twice that.
- Is it the same as the Piotroski F-Score?
- Only the name is similar. The Piotroski F-Score grades financial strength on nine criteria, while the Dechow F-Score is a model of the probability of accounting misstatement.
- Which financial statement items are needed?
- Current and prior-year total assets, equity, borrowings, cash, receivables, inventory, net PP&E and net income. Both years are required.