Determine if a company has manipulated earnings with the Beneish M-Score.

It’s simply a
mathematical formula which uses data from a company’s financial reports.

Companies facing financial distress sometimes manipulate earnings by altering depreciation rates,
delaying when expenses are recognized, registering sales early or other creating accounting tricks.
This may not necessarily be illegal, but can be used to disguise if a company is suffering financial
difficulty (often to maintain share price).

In 1999 Professor Messod Beneish published an empirical equation that employs eight financial
ratios to detect earnings manipulation. The equation is

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

where

 Days Sales in Receivables Index (DSRI). This measures the increase in receivables and revenues
between two reporting periods (the average for well-run companies is 1.031, while those companies
that have manipulated sales have an average value of 1.465%).
 Depreciation Index (DEPI)
 Sales Growth Index (SGI)
 Leverage Index (LVGI)
 Total Accruals to Total Assets (TATA)
 Gross Margin Index (GMI)
 Asset Quality Index (AQI)
 Sales, General and Administrative Expenses Index (SGAI)
These parameters are calculated from data in company financial reports issued in two consecutive
years. The following data is needed.
 Net Sales
 Cost of Goods
 Net Receivables
 Current Assets
 Property, Plant and Equipment
 Depreciation
 Total Assets
 Selling, General and Administrative Expenses,
 Net Income
 Cash Flow from Operations
 Current Liabilities
 Long-Term Debt
For example, DSRI is defined as
A latter modification to the M-Score equation eliminated some of the less significant parameters
(SGAI, DEPI and LVGI), giving this five-parameter equation

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

An M-Score greater than -2.22 indicates a high probability of earnings manipulation.

Professor Beneish backtested the equation against the financial reports released by companies
between 1982 to 1992 (some of which had manipulated earnings). The M-Score correctly identified
76% of those companies that had manipulated earnings. 17.5% of false-positives were returned.

Beniesh later determined the effectiveness of the M Score as a stock picking tool. A strategy based
on the M-Score gave a yearly hedged returned of 14% (see “The Predictable Cost of Earnings
Manipulation”, 2007).

This Excel spreadsheet implements both the 5-parameter and 8-parameter version of the M-Score.
Simply enter the appropriate data from two consecutive company financial reports.