The Beneish model is a mathematical model that uses financial ratios and eight variables to identify whether a company has manipulated its earnings. It is used as a tool to uncover financial fraud.
The variables are constructed from the data in the company’s financial statements to create an M-Score that serves to describe how much the earnings have been manipulated.
A primary application of the Beneish model is as a tool to uncover financial fraud.
Professor M. Daniel Beneish of the Kelley School of Business at Indiana University created the model, which he published in a paper in 1999.
Famously, a group of Cornell University business students used the Beneish model to predict that Enron Corporation was manipulating their earnings.
Professor M. Daniel Beneish of the Kelley School of Business at Indiana University created the model. While he had been working on the model for years, Beneish’s paper, “The Detection of Earnings Manipulation” was published in 1999.
Professor Beneish has written a number of follow-up studies and extensions since first publishing the model. Beneish’s webpage at the business school has an M-Score calculator.
The basic theory that Beneish bases the ratio upon is that companies may be more likely to manipulate their profits if they show deteriorating gross margins, operating expenses and leverage both rising, along with significant sales growth. These factors may cause profit manipulation through various means.
The Beneish model’s eight variables are:
1. DSRI: Days’ sales in a receivable index
2. GMI: Gross margin index
3. AQI: Asset quality index
4. SGI: Sales growth index
5. DEPI: Depreciation index
6. SGAI: Sales and general and administrative expenses index
7. LVGI: Leverage index
8. TATA: Total accruals to total assets
Once these eight variables are calculated, they are then combined to achieve an M-Score for the company. An M-Score of less than -1.78 suggests that the company will not be a manipulator. An M-Score of greater than -1.78 signals that the company is likely to be a manipulator.
In 1998, a group of Cornell University business students used the Beneish model to predict that Enron Corporation was manipulating their earnings.
At the time, Enron stock was trading at only about half ($48 per share) of the price to which it eventually climbed ($90) before its dramatic fall into ruin and bankruptcy a few years later in 2001. At the time the Cornell students sounded the alarm, no one on Wall Street heeded their advice.
Many professional investment firms and investors use the model as part of the assessment process for the companies they track, and factor in a company’s Beneish M-Score when deciding which companies in which they will invest.