Who Created the Model?

Professor M. Daniel Beneish of the Kelley School of Business at Indiana University created the model.
Beneish's paper, "The Detection of Earnings Manipulation" was published in 1999, and several follow-
up studies and extensions have been written by him. Professor Beneish's webpage at the business school
has an M-Score calculator.

What is the Beneish Model

The Beneish model is a mathematical model that uses financial ratios and eight variables to identify
whether a company has manipulated its earnings. The variables are constructed from the data in the
company's financial statements and, once calculated, create an M-Score to describe the degree to which
the earnings have been manipulated. In many ways it is like the Altman Z-Score, but it is focused on
detecting earnings manipulation rather than bankruptcy.

According to a study conducted by the Association of Certified Fraud Examiners (ACFE), fraudulent
financial statements accounts for approximately 10% of incidents concerning white collar crime. Asset
misappropriation and corruption attend to occur at much greater frequency, yet the financial impact of
these latter crimes is much less severe. ACFE defines fraud as “the deliberately misrepresentation of
financial condition of an enterprise, by intentionally misstating or omitting amounts disclosures in the
financial statements so as to deceive their users”. Fraud’s effect on an organization’s bottom line is just
the tip of the iceberg.

The eight variables are:

1. DSRI - Days' sales in receivable index
2. GMI - Gross margin index
3. AQI - Asset quality index
4. SGI - Sales growth index
5. DEPI - Depreciation index
6. SGAI - Sales and general and administrative expenses index
7. LVGI - Leverage index
8. TATA - Total accruals to total assets

Once calculated, the eight variables are combined to achieve an M-Score for the company;
  An M-Score of less than -2.22 suggests that the company will not be a manipulator.
 An M-Score of greater than -2.22 signals that the company is likely to be a manipulator.

How to calculate

The Beneish M-Score is calculated using 8 financial ratios.

1. Days Sales in Receivables Index

(DSRI) DSRI = (Net Receivables t / Sales t) / (Net Receivables t-1 / Salest-1)

2. Gross Margin Index (GMI)

GMI = [(Salest-1 - COGS t-1) / Sales t-1] / [(Sales t – COGS t) / Sales t]

3. Asset Quality Index (AQI)

AQI = [1 - (Current Assets t + PP&E t + Securities t) / Total Assets t] / [1 - ((Current Assets t-1 +
PP&E t-1 + Securities t-1) / Total Assets t-1)]

4. Sales Growth Index (SGI)

SGI = Sales t / Sales t-1

5. Depreciation Index (DEPI)

DEPI = (Depreciation t-1/ (PP&E t-1 + Depreciation t-1)) / (Depreciation t / (PP&E t + Dep. t))

6. Sales General and Administrative Expenses Index (SGAI)

SGAI = (SG&A Expense t / Sales t) / (SG&A Expense t-1 / Sales t-1)

7. 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]

8. Total Accruals to Total Assets (TATA)

TATA = (Income from Continuing Operations t - Cash Flows from Operations t) / Total Assets

Formula interpretation
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

There is also a five variable version which excludes SGAI, DEPI and LEVI (as these were not significant in
the original Beneish model).

M-Score = -6.065 + 0.823*DSRI + 0.906*GMI + 0.593*AQI + 0.717*SGI + 0.107*DEP

A score greater than -2.22 (i.e. less negative than this) indicates a strong likelihood of a firm being a
manipulator.

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 as an earnings manipulator by students from Cornell
University using M-Score. Noticeably, Wall Street financial analysts were still recommending buying
Enron shares at that point in time.

By using this approach, total M-Score calculated with the figure of bigger than-2.22suggests that the
company had manipulated their earnings. According to the ratio calculated from MMHB’s (MEGAN
MEDIA HOLDINGS BERHAD) financial statement, the input variables are stated below;

Year 2006 2005

Net Sales 1,034,797 904,696
Cost of Goods 885,525 781,284
Net Receivables 81,760 62,705
Current Assets 671,534 370,991
Property, Plant and Equipment 660,983 712,071
Depreciation 121,465 116,492
Total Assets 1,389,094 1,145,265
SGA Expense 100,334 530,031
 Net Income 86,792 68,634
Cash Flow from Operations 109,063 129,729
Current Liabilities 330,236 443,275
Long-term Debt 597,153 701,990

Variable results by using figures from above table (formulas as mention above)

DSRI 1.140
GMI 0.946
AQI 0.750
SGI 1.144
DEPI 0.906
SGAI 0.165
LVGI 0.668
TATA -0.016

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

M-Score = −4.84 + 0.92 × 1.140 + 0.528 × 0.946+ 0.404 × 0.750+ 0.892 × 1.144+ 0.115 × 0.906−0.172 ×
0.165 + 4.679 × (−0.016) − 0.327 × 0.668

M-Score = -2.48

Based on the formula from the mathematical model, the study managed to clarify that the M-Score for
MMHB is larger than -2.22, thus gave an indication of MMHB had manipulated its earnings.

****************