Beneish M-Score: Identifying Financial Statement Manipulations
According to the ACFE’s “Report to the Nation 2016” financial statement fraud occurred in less than 10% of the cases reported by the respondents. But it caused the highest median loss of $975,000. Asset misappropriation schemes was reported in more than 83% of the cases with median loss of $125,000. And Corruption cases fell in the middle with 35.4% of cases with median loss of $200,000. Several cases included schemes in more than one category.
Messod Beneish in his paper “The Detection of Earnings Manipulation” described a formula, called the M-Score. The M-Score helps in identifying whether the company has indulged in earnings manipulations. It is an equation of eight different variables, each measuring the change in a ratio from one year to the next. The Formula is based on an evaluation of the financial statements of a sample of companies that had engaged in earnings manipulation.
The eight variables in the M-Score are as follows:
- DSRI – Days’ Sales in Receivables Index
This ratio measures the current year days’ sales in receivables to that of the previous year. It is an indicator of revenue inflation.DSRI = (CY Receivables / CY Sales) / (PY Receivables / PY Sales) - GMI – Gross Margin Index
This ratio measures the previous year gross margin to current year. An index of less than 1 means that margins have declined. Gross margin deterioration is a negative signal about the firms’ prospects. A firm with poorer prospects is more likely to engage in earnings manipulation.GMI = [(PY Sales – PY COGS) / PY Sales] / [(CY Sales – CY COGS) / CY Sales] - AQI – Asset Quality Index
This is the ratio of non-current assets other than fixed assets to total assets.AQI = [(CY Total Assets – CY Current Assets – CY PP&E) / CY Total Asset] / [(PY Total Assets – PY Current Assets – PY PP&E) /PY Total Asset] - SGI – Sales Growth Index
This is the ratio of the current year sales to that of the previous year. Growth does not imply manipulation, but growth firms are viewed by professionals as more likely to commit financial statement fraud because their financial position and capital needs put pressure on managers to achieve earnings targets.SGI = CY Sales / PY Sales - DEPI – Depreciation Index
It is the rate of depreciation expense for the previous year to that of the current year. A slower rate of depreciation (DEPI > 1) may indicate that the company is revising useful life of assets upwards or adopting a new method that is income friendly.DEPI = [PY Depreciation / (PY Depreciation + PY PP&E)] / [CY Depreciation / (CY Depreciation + CY PP&E)] - SGAI – Sales, General and Administrative expenses Index
This is the ratio of current year’s sales, general, and administrative expenses to that of the previous year.SGAI = (CY SG&A Expenses / CY Sales) / (PY SG&A Expenses / PY Sales) - LVGI- Leverage Index
This the ratio of total debt to total assets for the current year to the same ratio of the prior year. This ratio is intended to capture debt covenants incentives for earnings manipulation.LVGI = [(CY Long term debts + CY Current liabilities) / CY Total Assets] / [(PY Long term debts + PY Current liabilities) / PY Total Assets] - TATA – Total Accruals to Total Assets
Total accruals are calculated as the change in working capital account other than cash less depreciation. This ratio is used to assess the extent to which managers make discretionary accounting choices to alter earnings.TATA = (Income from continuing operations – Cash flow from operations) / CY Total Assets
The eight factor M-Score is calculated as follows:
M = -4.84 + 0.920*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI + 0.115*DEPI – 0.172*SGAI + 4.679*TATA – 0.327*LVGI
An M-Score of greater than -2.22 (i.e., a less negative score, such as -1.50) indicates a strong likelihood of financial statement fraud.
There is also a five-factor version of the M-Score. This version, developed after further research, excludes SGAI, TATA, and LVGI based on the conclusion that these three indexes are less significant than the other five. The five-factor M-Score is calculated as follows:
M = -6.065 + 0.823*DSRI + 0.906*GMI + 0.593*AQI + 0.717*SGI + 0.107*DEPI
Maria L. Roxas in her paper, “Financial Statement Fraud Detection Using Ratio and Digital Analysis”, tested the five-factor and eight-factor versions of the Beneish Model. And concluded that the five-factor version of the M-Score (with a benchmark of greater than -2.76) is a more reliable indicator of financial statement fraud than the eight-factor version (with a benchmark of greater than -2.22).
I have also created an excel template to calculate M-Score in excel. The template also includes financial ratios from my earlier post Financial Ratios in Fraud Analytics.
You can download the excel template here.