Beneish M-score

The Beneish model is a statistical model that uses financial ratios calculated with accounting data of a specific company in order to check if it is likely (high probability) that the reported earnings of the company have been manipulated.

How to calculate

The Beneish M-score is calculated using 8 variables (financial ratios):
* Days Sales in Receivables Index
(DSRI)
DSRI = (Net Receivables_t / Sales_t) / (Net Receivables_t-1 / Sales_t-1)
* Gross Margin Index (GMI)
GMI = Sales_t-1 - COGS_t-1) / Sales_t-1/ Sales_t - COGS_t) / Sales_t* Asset Quality Index (AQI)
AQI = - (Current Assets_t + PP&E_t + Securities_t) / Total Assets_t/ - ((Current Assets_t-1 + PP&E_t-1 + Securities_t-1) / Total Assets_t-1)* Sales Growth Index (SGI)
SGI = Sales_t / Sales_t-1
* Depreciation Index (DEPI)
DEPI = (Depreciation_t-1/ (PP&E_t-1 + Depreciation_t-1)) / (Depreciation_t / (PP&E_t + Depreciation_t))
* Sales General and Administrative Expenses Index (SGAI)
SGAI = (SG&A Expense_t / Sales_t) / (SG&A Expense_t-1 / Sales_t-1)
* Leverage Index (LVGI)
LVGI = Current Liabilities_t + Total Long Term Debt_t) / Total Assets_t/ Current Liabilities_t-1 + Total Long Term Debt_t-1) / Total Assets_t-1* Total Accruals to Total Assets (TATA)
TATA = (Income from Continuing Operations_t - Cash Flows from Operations_t) / Total Assets_t

The formula to calculate the M-score is:
:M-score = −4.84 + 0.92 × DSRI + 0.528 × GMI + 0.404 × AQI + 0.892 × SGI + 0.115 × DEPI −0.172 × SGAI + 4.679 × TATA − 0.327 × LVGI

How to interpret

The threshold value is -1.78 for the model whose coefficients are reported above. (see Beneish 1999, Beneish, Lee, and Nichols 2013, and Beneish and Vorst 2020).
* If M-score is less than -1.78, the company is unlikely to be a manipulator. For example, an M-score value of -2.50 suggests a low likelihood of manipulation.
* If M-score is greater than −1.78, the company is likely to be a manipulator. For example, an M-score value of -1.50 suggests a high likelihood of manipulation.

Important notices

* Beneish M-score is a probabilistic model, so it cannot detect companies that manipulate their earnings with 100% accuracy.
* Financial institutions were excluded from the sample in Beneish paper when calculating M-score. It means that the M-score for fraud detection cannot be applied among financial firms (banks, insurance).

Example of successful application

Enron Corporation was correctly identified 1998 as an earnings manipulator by students from Cornell University using M-score. Noticeably, Wall Street financial analysts were still recommending to buy Enron shares at that point in time.

Further reading on financial statement manipulation

* A sequence of articles on Alpha Architect blog.
* An article on Investopedia about different types of financial statement manipulation ("smoke and mirrors", "elder abuse", "fleeing town", and others).

See also

* Data analysis techniques for fraud detection
* Benford's law

References

{{Reflist

Corporate finance
Financial ratios
Financial risk management
Valuation (finance)