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

The Beneish M score 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.

This is the link to the original M score for earnings manipulation paper.

 

The Beneish M Score Variables

The M score is based on a combination of the following eight different indices:

DSRI = Days’ Sales in Receivables Index

  • Measured as the ratio of days’ sales in receivables in year t to year t-1. A large increase in DSR could be indicative of revenue inflation.

GMI = Gross Margin Index

  • Measured as the ratio of gross margin in year t-1 to gross margin in year t.
  • Gross margin has deteriorated when this index is above 1. A firm with poorer prospects is more likely to manipulate earnings.

AQI = Asset Quality Index

  • Asset quality is measured as the ratio of non-current assets other than plant, property and equipment to total assets.
  • AQI is the ratio of asset quality in year t to year t-1.

SGI = Sales Growth Index

  • The ratio of sales in year t to sales in year t-1.
  • Sales growth is not itself a measure of manipulation. However, growth companies are likely to find themselves under pressure to manipulate in order to keep up appearances.

DEPI = Depreciation Index

  • Measured as the ratio of the rate of depreciation in year t-1 to the corresponding rate in year t.
  • DEPI greater than 1 indicates that assets are being depreciated at a slower rate. This suggests that the firm might be revising useful asset life assumptions upwards, or adopting a new method that is income friendly.

SGAI = Sales, General and Administrative expenses Index

  • The ratio of SGA expenses in year t relative to year t -1.

LVGI = Leverage Index

  • The ratio of total debt to total assets in year t relative to yeat t-1.
  • An LVGI >1 indicates an increase in leverage

TATA – Total Accruals to Total Assets

  • Total accruals calculated as the change in working capital accounts other than cash less depreciation.

 

The original Beneish M Score Formula

The eight variables are then weighted together according to the following:

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

A score greater than -1.78 indicates a strong likelihood of a firm being a manipulator. In his out of sample tests, 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

The five variable versions 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

A score greater than -1.78 indicates a strong likelihood of a firm being a manipulator.

 

Using the Beneish Score to Select Stocks

In 2008, Beneish goes into more detail in another paper that he published titled “Identifying Overvalued Equity” which seeks to use the M score to select stocks.

Beneish examines portfolio deciles based around his M score over the period 1993-2003 with annual rebalancing done four months after the financial year end.

The results produce 14% for the 8 variable model and 14.8% for the 5 variable M score version where the top M score stocks were held long while the lowest M score stocks were shorted.

 

Here is an example of how the Beneish M Score is presented in your analyzer: