Financial Statement Fraud & The Beneish’s M -score

Financial Statement Fraud and the Beneish’s M -score

Why is it important to detect and stop financial statement fraud?  

1. Investors
2. Market Analyst
3. Creditors

Companies that need to borrow money, list stocks on a stock exchange like the New York Stock Exchange, or are looking for partners,  need to have financial statements. Financial statements typically include a balance sheet, income statement, statement of changes in cash flow and retained earnings statement.

Wall Street Journal article

In order for people to rely on any statements they usually have a CPA firm audit the statements and verify that they are accurate and represent of the performance of the company for the past year.

However, our firm is constantly being retained for fraud involving financial statements that were improperly prepared and relied upon by investors, banks and other relevant entities.

The best way that we have for determining whether financial statements are fraudulent is by applying a statistical ratio analysis.

Ratios allow you to measure the relationship between components of the financial statement.

Ratios are extremely important because they allow us to compare a company’s results over many periods. This makes it easier to spot changes and then investigate what caused those changes. A companies ratios also can be compared to other companies' ratios or industry ratios

Ratio analysis is typically used for the following reasons.

1. Analysis of financial statements
2. Analysis of operational efficiency of the firm
3. Gives you insights into the profitability of the company
4. Identify business risk of the firm
5. Identify financial risk of the company
6. Compared the firm to other companies and/or industry ratios 

Some of the most common ratios are as follows:

1. The quick ratio
2. Debt to equity ratio
3. Working capital ratio
4. Price-to-earnings ratio
5. Earnings-per-share
6. Return on equity
7. Profit margin

We often first look at the profit margins to determine if there is fraud, we had many companies that showed large fluctuations in their profit margin. This is usually easy to spot once we prepare a ratio analysis over several periods.

If we are looking at it company in a specific industry typically has profit ratios of 40%. But the company were analyzing consistently has profits of close to 50%. We will then perform a detailed analysis to determine why and if there’s a legitimate reason for the higher profit margin.

When we suspect there may be financial statement fraud will usually use the  Beneish’s M -Score.

The Beneish’s M -Score is a mathematical model that uses eight financial ratios weighted by coefficients to identify whether the company has manipulated its profits. We have successfully used this in many of our investigations when we are retained to analyze financial statements.

This methodology is built on the assumption that companies that have high sales growth, deteriorating gross margins, rising operating expenses and rising leverage have incentives to manipulate the profits. They are likely to manipulate profits by accelerating sales recognition, increasing cost referrals, rising accruals and reducing depreciation. This method relies on eight ratios to explain and detect for these targeted manipulated items.

The components of Beneish’s M -Score analysis are as follows:

1. Day Sales and Receivable Index( DSRI)
2. Gross Margin Index (GMI)
3. Asset Quality Index (AQI)
4. Current Year Sales Divided By Prior Years Sales (SGI)
5. Depreciation (DEPI)
6. Sales, General And Administrative Expenses (SGAI)
7. Leveraged Index (LVGI)
8. Total Accruals to Total Assets (TATA)

Once we have the eight variables we then add  them together according to the following formula:

Beneish’s M -Score= -4.84 +0.92* DSRI +.528* GMI +.404*AQI+.892*SGI +115*DEPI -.172* SGAI +4.679* TATA -.327* LVGI

When we plug the numbers in and if the score is greater than -2.22 that means there is a probability of profit manipulation. For example, we just had a company score -1.6 and another one score 2.1. In those cases, we eventually did find and testify based on fraudulent financial statements.