# How to Detect Earnings Manipulation Using the Beneish M Score

Written by

Jae Jun

What You Will Learn

• How to detect earnings manipulation using Beneish M Score
• How to use the 5 variables of Beneish M Score for flexible valuation

### Introducing the Beneish M Score

Calculate the Beneish M Score | Flickr: photosteve101

#### What is the Beneish M Score?

I was recently introduced to an article by a reader on the M Score and have found it quite interesting and wanted to share it with you as well. I’ve summarized and edited parts of the original article.

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.

Beneish used all the companies in the Compustat database between 1982-1992.

#### 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

• 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 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 version 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

#### 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.

You can download a spreadsheet that will automatically pull in the required financial data to calculate the Beneish score for the prior 2 years and TTM. Both the 5 variable and 8 variable version of the M score is included.

You will receive a list of all the other free spreadsheets, the excel add-in from the SMF group required to download data from the internet as well as all the installation help material.

And that is how you calculate the Beneish M Score.

Feel free to check out the free version and then when ready, go to the stock valuation software page and review what you will get with the premium.

The premium version includes several valuation models as well as fundamental analysis data, historical data, charts and competitor comparison features. Just by entering one ticker, you can immediately get all that information on your favorite stock which will save you hours in your analysis.

Go now and see for yourself why people rave about the spreadsheets.

• Charlie

Hey Jae
When you say a score greater then -2.22 you mean more negative right?

• Graham Jervis

i doubt it, i think he means more positive, MSFT has a score of -3.14 and -2.95, i doubt they are manipulating their numbers.

• http://www.oldschoolvalue.com Jae Jun

@ Charlie,

By greater than -2.22, a score of -2.21, -1.3 or 3.2 show that there is a high chance of earnings being manipulated.

• kubrick

i can’t get my M score sheet to work. i have the 10 yr and 5 yr spreadsheets which i paid for and the altman z and they all work excpet for this one. when i open the sheet it gives me the option to enable the content and i said yes but still doesnt work

• Ranajit

Good article Jae. You can try the Beneish model on Satyam Computers Limited(SAY)..now Mahindra Satyam..whose ex-CEO admitted to major accounting fraud in 2009. The M model seems to have raised a red flag every alternate year from 2002. Check it out.

Can you think of a few more examples of such companies so that we can try them out?

• Fraser

Hi,
In the post it says “The five variable version excludes SGAI, DEPI and LEVI which…”. However, the five variable formula includes DEPI but does not includes TATA.
I assume this is a typo? If so, is the typo in the comment or the formula?
Thanks.

• http://www.oldschoolvalue.com Jae Jun

@ Fraser,
Yes that is a typo. The 5 variable version excludes TATA.

• dodge1664

Hi Jae,

good effort with the spreadsheet, but I’m struggling to figure out how the total accruals inside TATA is calculated. Could you spell that out in more detail?

Roger

• http://www.oldschoolvalue.com Jae Jun

@ dodge1664,

Total Accruals/ Total Assets (TATA) is calculated as
(Net Income – CFO)/Total Assets

• Dodge1664

@Jae Jun

Thanks for the quick reply! That seems to be the formula Beneish used in his 2005 paper \The Relation between Accruals and the Probability of Earnings Manipulation\, however his 1999 paper \The Detection of Earnings Manipulation\ seems to use a different one involving current assets, current liabilities, income tax due and depreciation. Other authors on the web refer to your formula as \net operating accurals\ rather than \total accruals\, e.g.

http://www.investopedia.com/university/accounting-earnings-quality/earnings9.asp

I also found this formula for total accruals which also subtracts
Capex and dividends:
http://www.portfolio123.com/blog.jsp?postid=53&topic=idea

I’m pretty confused, but I guess I’ll go with your suggestion, thanks!

• http://www.oldschoolvalue.com Jae Jun

Thanks for those links. I’ll look at it and see how easy it is to calculate.
I don’t believe the number has to be so precise, but the original formula should suffice quite fine.

• BillyBobJoe

I got the download link, but dont see the Mfactor benoit spread sheet. Is it in one of the others somewhere. I am hoping to use it as another filter in my options trading methodology.

Thanks, BBJ

PS have followed Randy Harmelink’s stuff for years and also created my own versions

• BillyBobJoe