Beneish Model is the statistical method to calculate the trend in the organisation through various ratios. Through beneish model, one can find the various areas where chances of financial manipulation are higher.
The Beneish Model uses eight financial ratios to understand the financial position and areas for manipulation.
Formula (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
Professor M. Daniel Beneish who originated the above formula after rigorous research has added the coefficients based upon the calculation and comparison with manipulators and non- manipulators.
The eight ratios upon which this formula based on are:
1. Days Sales in Receivables Index
2. Gross Margin Index
3. Asset Quality Index
4. Sales Growth Index
5. Depreciation Index
6. SGA Index
7. Leverage Index
8. Accruals to total assets
Let’s discuss each one separately
DAYS SALES IN RECIEVABLES INDEX (DSRI)
DSRI is the days sales in credit or receivable in the year in which manipulation has uncovered (t) to the year before the manipulation (t-1)
This helps in recognizing whether there has been any manipulation in relation to revenue or trade debtors (receivable), whether fictitious revenue has been recorded or early booking of revenue, fake invoices has been used to manipulate.
There is a chance that this is all explainable but there is high probability of manipulation when the trend does not match between revenue and receivables.
DSRI = (Accounts Receivablest/Salest*Number of Days) /(Accounts Receivablest-1/Salest-1*Number of Days)
The coefficient of 0.92 indicates the positive increase in coefficient of index with consistency with disproportionate increase in receivable due to manipulated revenues
GROSS MARGIN INDEX (GMI)
If the GMI is higher than 1, then it is considered that gross margins are worse. This indicates negative about financial position of the organisation and when the situation of the organisation, they are more likely to manipulate.
GMI = [Salest-1 – COGSt-1)/Salest-1]/ [Salest – COGSt)/Salest]
ASSET QUALITY INDEX (AQI)
This ratio helps in finding the costs which are capitalized even though it does not classify to be capitalized to manipulate financials to benefit the organisation.
It means increasing the profits through capitalizing costs.
AQI = {1 – [(current assets(t) + net fixed assets(t))/total assets (t)]}/ {1 –[(current assets (t – 1) + net fixed assets(t – 1)) / total assets (t – 1)]},
SALES GROWTH INDEX (SGI)
The growth in sales does not reflect manipulation but when compiled and compared with other ratios it may reflect fake sales and overbooking of revenues.
SGI = [sales(t)] / [sales (t – 1)]
DEPRECIATION INDEX (DEPI)
Depreciation index lower than 1 indicates that either the organisation has reduced he rates or has increased the period of depreciation, in anyway suggesting lowering cost and increasing profit.
DEPI = [depreciation (t – 1) / (depreciation (t – 1) + net assets (t – 1))] /[depreciation (t) / (depreciation (t) + net assets (t))]
SALES GENERAL AND ADMINISTRATIVE EXPENSES INDEX (SGAI)
This ratio with sales ratio indicates whether increase in sales has also increased sales expenses thus showing and reflecting manipulation through sales.
SGAI = [(selling, general & administrative expense (t) + sales (t)) / sales (t)] / [(selling, general & administrative expense (t – 1) + sales (t – 1)) / sales (t – 1)].
LEVERAGE INDEX (LVGI)
LVGI represents debt ratio of the organisation in the manipulation year to the year before manipulation. Higher debt indicates red flags and opportunity to attempt for fraud.
LVGI= current liabilities (t) / total assets (t)] /[current liabilities (t – 1) / total assets (t – 1)].
Total Accruals to Total Assets (TATA)
Total Accruals are calculated through the change in working capital other than cash and cash equivalents deduction depreciation and income tax.
Higher the TATA, higher the chances of accounting manipulation.
TATA = (Δnet working capital– Δcash and equivalents– Δincome tax – depreciation)/total assets (t).
Manipulators or Not?
If the value calculated is greater than -1.78, then it is more likely to be a manipulator and where the value calculated is lower than -1.78 then the chances are lower.
But in any case, if any of the ratio seems imbalance, the reason behind should be found to ensure the financials.
Conclusion
The Beneish Model is a way to detect red flags and calculating higher possibilities of being a manipulator. The ratios in the formula perfectly almost every part of the balance sheet where manipulation can be done. If used effectively, can help various fraud investigators in finding the preparator.
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