Beneish Model: A Tool for Auditors to Check Accounting Manipulation
CA. Manmeet Singh Mehta
The author is a member of the Institute. He can be reached at mehta.ca@gmail.com and eboard@icai.in.
In the current era where organisations are seeking global investments, the businesses are facing stiff competition and therefore, are under constant pressure to show good financial results through their financial reporting system. Accounting manipulation allows a company to present a better though false financial picture. The reasons can range from securing finance and investor interests to meeting high shareholder expectations.
Financial Statement misstatements are rare, but when they occurs, the consequences can be devastating. They can cause huge damage to a company’s reputation and drain the wealth of investors. Auditors with their in depth knowledge and skills can do a wonderful job in identifying the financial wrongdoings, that are otherwise difficult to unearth and thereby enhance well drawn credibility for the profession. Read on. . . .
According to Association of Certified Fraud Examiners (ACFE) Report to the Nations 2020, 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 954,000.
‘Fraudulent Financial Reporting: 1998-2007’, a study published in 2010 sponsored by COSO explains that the number of alleged cases of public company fraudulent financial reporting increased to 347 versus 294 cases reported in COSO Study published in 1999. Further, apart from an increase in fraud cases, the median fraud of $12.05 million in the present study was nearly three times larger than the median fraud of $4.1 million in the 1999 COSO study.
In India, the SEBI-DRG Report on Earning Management (Ajit, Malik, & Verma, 2013)1 states that “average earnings management in Indian non-financial corporate sector in India is 2.9 percent of the total assets of these firms which is comparable to the estimates in US, Europe and elsewhere in the world. The study reveals that small-sized companies in India indulge in relatively more earnings management (10.6 percent of the total assets) than medium and large-sized firms.”
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.”
Standard on Auditing (SA) 240(Revised) The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements expresses “Fraudulent financial reporting involves intentional misstatements including omissions of amounts or disclosures in financial statements to deceive financial statement users.”
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.
SA 240 (Revised) reveals that fraudulent financial reporting may be accomplished by the following:
- Manipulation, falsification (including forgery), or alteration of accounting records or supporting documentation from which the financial statements are prepared.
- Misrepresentation in or intentional omission from, the financial statements of events, transactions or other significant information.
- Intentional misapplication of accounting principles relating to amounts, classification, manner of presentation, or disclosure.
The financial statement manipulations are committed by individuals, organisations as well as private and public companies.
Potential investors use financial statements to carry out financial analysis, which is a key component of investment.
Potential investors use financial statements to carry out financial analysis, which is a key component of investment. Readers of financial documents seek to understand the key factors behind the company’s performance and disposition. Credit institutions will check the “financial health” of a person or organisation and use annual financial statements to decide whether or not to lend. Regulators also use financial statements for regulatory decisions and formulating economic policies. All the above could be affected by fraudulent financial statements leading to incorrect decisions.
In general, three conditions are present when fraud occurs:
- Pressure or reason to commit fraud.
- Opportunity, like lack of controls.
- Ability to rationalise the fraud.
The detection of accounting fraud can be difficult, but not impossible
The detection of accounting fraud can be difficult, but not impossible. As financial transactions are larger and more frequent, many creative accounting practices and complex financial vehicles are used. The ability of auditors and audit teams to monitor them closely and thoroughly also gets hampered since it often involves different parties, management, and organisations. Further, management has a unique ability to direct its employees to perpetrate the fraud by an override of controls and disguise the manipulations.
Under SA 315, relating to Identifying and Assessing the Risk of Material Misstatement, an auditor has to assess the risk of material misstatement. Under SA 240 The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements, there is a responsibility cast on the auditor to have reasonable assurance that the financial statements are free from material misstatement, caused by fraud or error. Moreover, the auditor may, at times, be required by the legislation or regulation to make a specific assertion in respect of frauds on/by the entity in his report.
Thus, it is also imperative for the auditor that though difficult to detect, he has to elevate professional scepticism and enhance audit procedures to mitigate this risk of misstatement.
Both Auditors and Forensic accountants use financial statement ratios, multivariate statistical models and data mining techniques to uncover financial statement misstatements. Among these several resources and tools available which look for aggressive accounting practices and detect the propensity for fraud, Beneish Model is one such quantitative model.
Auditors can use Beneish ratios to help carry out the SA 240 requirement to obtain reasonable assurance that financial statements are free from material misstatement. Forensic accountants brought in to investigate a suspected misstatement can use Beneish Model to help focus the investigation.
What is Beneish Model?
Both Auditors and Forensic accountants use financial statement ratios, multivariate statistical models and data mining techniques to uncover financial statement misstatements.
Beneish’s M - Score is a mathematical model created by Professor Messod D. Beneish, an accounting professor in the Kelley School of Business at Indiana University. It uses eight financial metrics to arrive at a calculated score which can determine whether or not a company has manipulated its profits.
Earnings Management (EM) is possible by manipulating accruals (more by altering discretionary accruals) or by manipulating actual activities (operational activities). Discretionary accruals are the portion of accruals over which management exercises discretion and this estimated portion of accruals is often used as a proxy of the earnings that are managed.
In his study, Beneish found that he could correctly identify 76% of the earnings manipulators and incorrectly identify 17.5% as non-manipulators. In other words, Beneish found that 17.5% of the companies whose financial statements he thought were free from earnings manipulation were in fact manipulators.
(Kaur, Sharma and Khanna 2014)2 in a study of a sample of 332 Indian Companies from 6 different sectors had one important verdict, which is all the sectors under study were engaged in earnings management. They used the Beneish model to discover that 32.14% of companies in the telecoms sector were engaged in earning management taking a sample of 28 telecom companies further out of a sample of 93 companies in the retail sectors 31.18% were involved in earnings management.
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.
Beneish Model is based on eight ratios that could indicate a propensity to engage in earning manipulations (GMI, SGI, SGAI, LEVI) whereas some ratios capture financial statement distortions that can result from manipulating this earning (DSRI, AQI, DEPI, and TATA).
Each of the eight metrics focuses on the above aspects and measures the change in a ratio from one year to the next.
1. Days’ Sales in Receivables Index (DSRI)
It is 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.
Account receivable and Sales generally show a correlation. This ratio detects a rise in days receivables to Sales, the change might result from revenue inflation by accelerated revenue recognition.
2. Gross Margin Index (GMI)
GMI (Gross Margin Index) is a ratio of a prior years’ Gross Margin Rate to that of the current year, a deteriorating gross margin would provide pressure or temptation to manipulate when things are not going well.
When the GMI is greater than 1, the company’s gross margins have decreased and management is motivated to show better numbers and inflate profit.
3. Asset Quality Index (AQI)
The AQI (Asset Quality Index) is the ratio of non-current assets (other than the plant, property and the equipment) to total assets of a year versus the prior year.
An increase in long term assets, other than property plant and equipment (for example, the cost deferrals, amortisations), relative to total assets indicates that a firm has possibly increased its cost deferral to inflate profits.
4. Sales Growth Index (SGI)
SGI (Sales Growth Index) is the ratio of Sales during the current year to the prior year.
Growth in sales as such does not indicate manipulation, however, companies with high growth rates find themselves highly motivated to commit deception when the trend reverses. Shareholders from inside and outside the company expect that growth to continue and those expectations pressure managers to produce which could lead those managers to indulge in manipulative practices. Whenever there is a slowdown the growth firms could face a decrease in its capitalisation providing incentives to manipulate earnings.
5. Depreciation Index (DEPI)
DEPI (Depreciation Index) ratio of the rate of depreciation of current year to the prior year.
A high DEPI indicates that the depreciation during the year has been slow which could be due to upward revision of estimated useful life of or adopted a new method that is income increasing, either way, the company is deferring cost and increasing income. DEPI of more than 1, therefore, uncovers an inappropriate increase in the useful life of fixed assets.
6. Sales, General, and Administrative expenses Index (SGAI)
SGAI (Sales General and Administrative Expense Index) is the ratio of SG&A expenses of the current year to the prior year.
SG&A Expenses should rise in tandem with sales, an increase in SGAI, therefore, indicates a disproportionate increase in SGA Expenses could suggest manipulative coverups.
7. Leverage Index (LVGI)
LVGI (Leverage Index) is the ratio of total debt to total assets of the current year to the prior year.
An increase in LEVI of greater than 1 shows either new Debt or increase in existing Debt which means some additional debt covenants. Thus, an increase in leverage creates an incentive to manipulate profits to meet debt covenants.
8. Total Accruals to Total Assets (TATA)
TATA (Total accruals to Total Asset) It is calculated as the change in the accounts of working capital other than the cash less depreciation to Total assets.
These accruals could mean that management had made discretionary accounting choices to inflate earnings. A high TATA, therefore, indicates that there is more possibility of profit manipulation.
The detailed description of the above-mentioned ratios would indicate that they are very valuable in providing an insight into the financial statements of an organisation by analysing different areas that may contain fraudulent transactions as well as earning manipulations.
Thus, the Beneish ratios focus on financial statement manipulations and capture an inappropriate increase in receivables (DSRI, indicates of revenue increase), abnormal capitalisation of expense and decrease in depreciation (AQI and DEPI, both indicative of expense decrease), and whether the income is supported by cash profits (Accruals). The four other ratios can indicate favourable conditions for manipulation of financials i.e. portray declining gross margins and rising administration costs (GMI and SGAI, both signals of deteriorating forecasts), inflated sales (SGI) since there is an incentive for young growth firms to prop up figures to obtain funding, and the last ratio indicates an increase in dependence on debt financing (LEVI), this increases the chance of manipulation to meet the debt financing covenants.
How does the model work?
All the above metrics are woven into a calculated score called M-score.
M = -4.84 + 0.92*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI + 0.115*DEPI – 0.172*4.679*TATA – 0.327*LVGI
M-score greater than the value of -2.22 (or less negative than this number, e.g., –2.00 would be greater) implies that the financial statements have been manipulated. Thus, the higher a company’s M-Score, the more likely it is that the company is manipulating its earnings. Thus, Beneish Model provides a quick and easy way to track down companies that may have manipulated their financial statements.
Some considerations when using Beneish model are:
- Beneish Model is designed with US disclosure in mind and many Indian companies do not distinguish between Cost of Goods and SGA in their disclosure so the relevant figures have to be reworked.
- Further, the Model is designed for non-financial companies so results might not be reliable for financial companies.
Conclusion:
The Beneish model presents a useful tool for the auditors to identify potential cases of financial manipulations that needs to be explored further. A careful and deeper analysis by the auditors can pinpoint cases of financial misstatements.
The convenience of this model is that the data to calculate the metrics can easily be obtained from the income statement, balance sheet, cash flows of the company and the model can easily be programmed even as a simple excel sheet. ■