The Beneish M score was created by Professor Messod Beneish to detect earnings manipulation.
It is an extremely useful quality check when screening for attractive stock investments.
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.
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.
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.
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.
Measured as the ratio of the rate of depreciation in year t-1 to the corresponding rate in year t. A 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.
The ratio of SGA expenses in year t relative to year t -1.
The ratio of total debt to total assets in year t relative to yeat t-1. An LVGI >1 indicates an increase in leverage.
Total accruals calculated as the change in working capital accounts other than cash less depreciation."
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 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
A score greater than -1.78 indicates a strong likelihood of a firm being a manipulator.