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Beneish Model: A bane for Financial Statement fraudsters

Beneish Model provides a quick and easy way to track down companies that may have manipulated their Financial Statements

Beneish Model: A bane for Financial Statement fraudsters

Saturday March 21, 2020,

4 min Read

Beneish Model: A bane for Financial Statement fraudsters

Satyam did nothing but falsified accounts, and as a result many investors burnt their hard-earned money.

Financial Statement Fraud is rare, but when it occurs, the consequences can be devastating. It can cause a huge damage to a company’s reputation.

According to Association of Certified Fraud Examiners (ACFE) Report to the Nations 2018, financial statement fraud is least common and most costly. It has occurred in 10% of the cases and caused a median loss of a hefty USD 800,000. 

In the words of ACFE, financial statement fraud is “a scheme in which an employee intentionally causes a misstatement or omission of material information in the organization’s financial reports.”

 Accounting manipulation allows a company to present a better though false financial picture.

The Financial Statement manipulations are committed by individuals, private, and public companies. 

The reasons can range from securing finance and investor interests to meeting high shareholder expectations.

While the income recognition system is well known, the other way to manipulate a company’s financial position and profitability is through the overvaluation of complex financial instruments, overstated assets, understated liabilities, inflated revenue and misreporting.

The detection of accounting fraud can be difficult, if not impossible. It often involves collusion between different parties, management and organisations. 

Further, management has a unique ability to direct its employees to perpetrate the fraud by override of controls and disguise the manipulations.

In general, three conditions are present when a fraud occurs:

·        Pressure or reason to commit fraud

·        Opportunity like lack of controls

·        Ability to rationalise the fraud like we are doing it for the investors

Potential investors and regulators use financial statements to carry out financial analysis, which is a key component of investment and regulatory decisions. Cooked Financial Statements could lead to incorrect decisions.

Today, several resources and tools are available which looks for aggressive accounting practices and detect the propensity for fraud. Beneish Model is one such quantitative model.

What is Beneish Model?

Beneish’s M - Score is a mathematical model created by Professor Messod Beneish. It uses eight financial metrics to arrive at a calculated score which can determine whether a company has manipulated its profits or not. 

There is an incentive for companies to use creative accounting when there is a decrease in gross margins, an increase in operating costs, and increase in leverage.

Each of the eight metrics focuses on above aspects and measures the change in a ratio from one year to the next.

  • Current year DSR (Days’ Sales in Receivables) to that of the previous year, an increase in DSR could show revenue inflation and creating fictitious receivables. 

  • GMI (Gross Margin Index) is a ratio of a prior years’ Gross Margin Rate to that of the current year, a lower GMI would provide a pressure or temptation to manipulate when things are not going well. 

  • The AQI (Asset Quality Index) of over 1 shows an increase in cost deferrals.

  • A high SGI (Sales Growth Index) can mean manipulation in sales.

  • DEPI (Depreciation Index) uncovers an inappropriate increase in useful life of fixed assets.

  • SGAI (Sales General and Administrative Expense Index) indicates disproportionate increase in sales relative to SGA Expenses.

  • Similarly, TATA (Total accruals to Total Asset) and LVGI (Leverage Index) shows change in Goodwill and amortisations and Leverage respectively.

How does the model work?

All the above metrics are woven into a calculated score called M-score.

M-score greater than the value of -2.22 implies that the financial statements have been manipulated.

The convenience of this model is that the data to calculate the metrics can easily be obtained from the income statement, balance sheet and cash flows of the company and the model can easily be programmed even as a simple excel sheet.

Thus, Beneish Model provides a quick and easy way to track down companies that may have manipulated their Financial Statements.

Satyam’s M-Score indicated cooking of books in years prior to declaration of fraud. Beneish Model applied at the right time could have saved the investors from burning more money.

Similarly, there are other tools like Altman Z-score as well as Montier C-score and Ohlson O-score that detect financial fiascos. Just a word of caution that these are just tools and not a magic bullet to kill the demon of Financial Statement Fraud.