Detection Of Earnings Manipulation: Beneish M-Score by Sui Chuan Yeo, ValueEdge
Fraud and earnings manipulation are difficult to detect for most investors. To make things simpler, we introduce to readers a mathematical model that uses eight variables as an indicator for earnings manipulation.
What is the Beneish M-Score?
The Beneish M-Score was created by Professor Messod Beneish in 1999 to detect earnings manipulation. His subsequent paper in 2007 found that using the M-Score as a stock selection strategy yielded a hedged return of 13.9% per annum. Ignoring its supposed effectiveness, the M-Score’s main appeal lies in its convenience. It is created from eight variables which are easily obtained from the company’s financial statements.
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Calculation of the Beneish M-Score
- Days’ Sales in Receivables Index (DSRI)
- Gross Margin Index (GMI)
- Asset Quality Index (AQI)
- Sales Growth Index (SGI)
- Depreciation Index (DEPI)
- SGA Index (SGAI)
- Leverage Index (LVGI)
- Accruals to Total Assets (TATA)
Interpretation and Caveat
The M-Score is calculated by adding the variables based on this formula:
M = -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
If the M-Score is more than -1.78, there is a strong likelihood of a firm being a manipulator. Users of the M-Score have to be familiar with its limitations however, lest too much emphasis is placed on it. The score correctly identifies 76% of manipulators, while incorrectly identifying 17.5% of non-manipulators. In other words, it is not a certainty. In addition, the test and coefficients were run based on U.S data. It is quite possible that different markets will have different figures. Lastly, as with all back tests, there is no guarantee that the figures are accurate today even though they may have been accurate in the past.
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