Monday 29 September 2014

Beneish M-Score


Beneish M-Score is a mathematical model that uses financial ratios and eight variables to identify whether a company has manipulated its earnings.

It was created by Professor Messod Beneish. In many ways it is similar to the Altman Z score, but optimized to detect earnings manipulation rather than bankruptcy.

It is based on a combination of the following eight different indices:
  1. DSRI = Days’ Sales in Receivables Index
    • DSR = Receivable /Sale
    • DSR t / DSR t-1
    • large increase in DSR could be indicative of revenue inflation. 
  2. GMI = Gross Margin Index
    • Gross Margin = (Sales - COGS)/Sales
    • Gross Margin t-1/ Gross Margin t
    • Gross margin has deteriorated when this index is above 1.
    • A firm with poorer prospects is more likely to manipulate earnings. 
  3. AQI = Asset Quality Index
    • Asset Quality = Non Current Asset other than PPE / Total Asset
    • AQI = AQI t / AQI t-1
    • Note: Biological assets is part of PPE for a plantation company. Likewise for land held for development, property development costs, investment property for property companies.
  4.  SGI = Sales Growth Index
    •  Sales t / Sales t-1
    • Sales growth itself is not a measure of manipulation.
    • A growth companies are likely to find themsleves under pressure to manipulate in order to keep up appearances
  5. DEPI = Depreciation Index
    • Rate of Deprecition = Depreciation / (PPE + Depreciation)
    • Rate of Deprecition  t-1/ rate of Depreciation t
    • > 1 indicates that assets are being depreciated at a slower rate - the firm might be 
      • revising useful asset life assumptions upwards
      • adopting a new method that is income friendly.
  6. SGAI = Sales, General and Administrative expenses Index 
    • SGA =  SGA Expenses / Sales
    • SGA t / SGA t-1
  7. LVGI = Leverage Index 
    • Legerage = Total Debt / Total Asset
    • Leverage t / Leverage t-1
    • > 1 = increase in leverage
  8. TATA - Total Accruals to Total Assets 
    • Total Accruals = Change in Working Capital Account
 
The Beneish M Score 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
The interpretation...
  • M Score > -1.78 - a strong likelihood of a firm being a manipulator. 
Beneish found that he could correctly identify 76% of manipulators, whilst only incorrectly identifying 17.5% of non-manipulators.
The 5 Variable Version of the Beneish Model
  • It  excludes SGAI, DEPI and LEVI which were not significant in the original Beneish model.
  • M  = -6.065 + 0.823*DSRI + 0.906*GMI + 0.593*AQI + 0.717*SGI + 0.107*DEPI 

References:-

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