Beneish's M-Score – Tool to identify the fraud in Financial Statement

Beneish's M-Score – Tool to identify the fraud in Financial Statement

Before Starting, the first question comes to our mind that how can we detect fraud in Financial Statements using this Score?

For this, we need to understand what is Beneish’s M-Score?

 It is a mathematical Model created by Professor M. Beneish, who published a paper named “The Detection of Earnings Manipulation” in June 1999, in which he uses eight Financial Ratios to ascertain the possibility of manipulation in Financial Statements.

Now the question comes as what are Eight Financial Ratios?

Eight Financial Ratios are:

1. Days Sales in Receivables Index

(Net Receivablest / Salest) / (Net Receivablest-1 / Salest-1)

2. Gross Margin Index (GMI)

[(Salest-1 - COGSt-1) / Salest-1] / [(Salest - COGSt) / Salest]

3. Asset Quality Index (AQI)

[1 - (Current Assetst + PP&Et + Securitiest) / Total Assetst] / [1 - ((Current Assetst-1 + PP&Et-1 + Securitiest-1) / Total Assetst-1)]

4. Sales Growth Index (SGI)

Salest / Salest-1

5. Depreciation Index (DEPI)

(Depreciationt-1/ (PP&Et-1 + Depreciationt-1)) / (Depreciationt / (PP&Et + Depreciationt))

6. Sales General and Administrative Expenses Index (SGAI)

(SG&A Expenset / Salest) / (SG&A Expenset-1 / Salest-1)

7. Leverage Index (LVGI)

[(Current Liabilitiest + Total Long Term Debtt) / Total Assetst] / [(Current Liabilitiest-1 + Total Long Term Debtt-1) / Total Assetst-1]

8. Total Accruals to Total Assets (TATA)

 (Income from Continuing Operationst - Cash Flows from Operationst) / Total Assetst

After knowing all the eight financial ratios, we have to calculate The Beneish M-score as

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

Again the question raise if we calculate the M- Score, how do we predict the fraud using the ascertained score? It will be determined by the threshold value of -1.78.

• If the M-Score < -1.78 then, it predicts low possibility of manipulation.

• If the M-Score > -1.78 then, it predicts high possibility of Manipulation.

But sometimes it is not 100% accurate because of its probabilistic nature and also it cannot be applied to Financial Institutions like Banks, Insurance Companies, etc. because these Institutions were excluded from the sample in Beneish paper during the calculation of the M-score.

In the end, it is suggested that these are just a tool to predict the degree of manipulation but before giving an appropriate decision based on this model we should also identify and check all the aspects of the audit.

Source: The above article is based upon the information available in the Wikipedia and paper “The Detection of Earnings Manipulation”.

Article by

Abhishek Kumar

ERO0188631

CA Intermediate Student

Durgapur/Asansol, West Bengal

9547961025