Detecting Earnings Manipulation:

Application of Beniesh Model

Interpretation of Probability
Assessment Provided by Beneish
Model:
Estimated Probability:
>11.72%

Very significant danger of earnings

manipulation; extreme caution
recommended in all further analysis.

Between 5.99% and 11.72%

Serious risk of earnings manipulation;

further analysis necessary to confirm or
dispel negative signal

Between 2.94% and 5.99%

Grey zone; analysis does not sufficiently

argue for or against acceptance

Less than 2.94%

No evidence of manipulation

Variables in Beneish Model and Correlation

with Manipulation of Earnings
Assessment of Distortions in financial
statement data:
1.
2.
3.
4.
5.
6.

Days sales in Receivables Index

Gross Margin Index
Asset Quality Index
Depreciation Index
SG&A Index
Total Accruals to Total Assets

+
+
+
+
+
+

Variables in Beneish Model

Assessment of firms incentives/ability to
violate GAAP:
1.
2.
3.
4.
5.
6.

Capital Structure
Prior Market Performance
Time Listed
Sales Growth
Prior Positive Accruals Decisions
Declining Cash Sales

+
+
+
+

Beneish Index and Probability of CII

1. Days Sales

1.543

2. Gross Margin Index

0.865

3. Asset Quality Index

0.132

4. Depreciation Index

0.752

5. SG&A Index

1.005

6. Total Accruals to Total Assets

0.142

7. Sales Growth Index

1.656

8. Abnormal Return

0.511

9. Time Listed

19

10. Leverage

1.569

11. Positive Accruals Dummy

0.000

12. Declining Cash Sales Dummy

0.000

Manipulation Index

-1.273

Probability of Manipulation

0.101 or 10.1%

Interpretation of 10.1%
Between 5.99% and 11.72%
Serious risk of earnings manipulation; further
analysis necessary to confirm or dispel
negative signal.

Beneish Manipulation Index and

Probability of Manipulation in case of CII
CII

GAAP Violator

Control
Firms

1. Days Sales

1.543

1.269

1.199

2. Gross Margin Index

0.865

1.042

1.004

3. Asset Quality Index

0.132

0.937

0.807

4. Depreciation Index

0.752

0.981

1.021

5. SG&A Index

1.005

0.997

0.981

6. Total Accruals to Total Assets

0.142

0.204

0.144

7. Sales Growth Index

1.656

1.431

1.379

8. Abnormal Return

0.511

-0.325

0.011

9. Time Listed

19

29

31

10. Leverage

1.569

0.564

0.500

11. Positive Accruals Dummy

0.000

12. Declining Cash Sales Dummy

0.000

Manipulation Index

-1.273

Probability of Manipulation

0.101 or 10.1%

Additional Analysis: Simple Analytical

Procedure Vertical Analysis of Assets
80%

70%
61%
60%

Cash

59%

A/R

52%
50%
44%

Inventories

40%
35%

33% 32%

Prepaid Expenses

30%
25% 25%

Total CA

23%
20%

20%

Machinery and Equipment

15%

NET PPE

10%

0%
1988

1989

1990

Simple Analytical Procedure Horizontal

Analysis of Assets
376%
439%
1990

129%
NET PPE

266%
277%

Machinery and Equipment

Buildings

1989

Total CA
Prepaid Expenses

51%

Inventories
A/R

100%
100%
1988

100%
0%

50%

100%

150%

200%

250%

300%

350%

400%

450%

500%

Additional Analysis: Simple Analytical

Procedure Vertical Analysis of Liabilities
70%

60%

50%

Notes Payables
Current Maturities of LTL
40%

40%

A/P
Accrued Expenses
Accrued Income Tax

30%

Total CL
23%

LTD
Paid up Capital

20%
15%

Retained Earnings

10%

0%
1988

1989

1990

Additional Analysis: Simple Analytical Procedure

Horizontal Analysis of Liabilities
582%
1990

Retained Earnings
Paid up Capital
LTD

180%

Total CL

1989

Accrued Income Tax

Accrued Expenses
A/P
Current Maturities of LTL
Notes Payables

100%
1988

0%

100%

200%

300%

400%

500%

600%

700%

800%

Additional Analysis: Simple Analytical Procedure

Vertical Analysis of Income Statement
120%

100%
87%

85%

84%

80%
Sales
COGS

60%

GP
M, G and Admin Exp
NI

40%

20%

15%

16%

13%
7%

5%

3%

5%

3%

0%
1988

1989

1990

4%

Additional Analysis: Simple Analytical Procedure

Horizontal Analysis of Income Statement

297%
195%
1990

253%
238%
240%

144%
117%
132%
147%
145%

1989

NI
M, G and Admin Exp
GP
COGS
Sales

100%
100%
100%
100%
100%

1988

0%

50%

100%

150%

200%

250%

300%

350%

Three Variables of Greatest Concern

Days sales in Receivables Index and Growth in
Sales
Leverage
PP&E

Additional Analysis of A/R and Sales

Growth
Sales Pattern:
The sales in Q4 1989 were 22% of total sales and it went
up to 36% in Q4 1990. This % was 25% in case of peer
competitors in industry in both the years.

Major Customers and Concentration of Credit Risk:

Only a few customers and 5 customers occupy
80%(approximately) of total sales.
Customer C discontinued
Customer I there were no sales but A/R from that
customer
Significant decrease in provision for bad debts

Additional Analysis of Leverage

Significant increase in borrowings $ 4 million
to $ 24 million. The LTD of peer competitors
ranges between $0.5 million to $16 million.
This leverage of CII is risky because:
Most of sales revenue is based on a few
customers
Accounts Receivables collection risk.

Depreciation and PP&E

Additional Machines Purchased Vs Additional
Depreciation (4 Years).
Even though depreciation expense relative to
gross PP&E increased in 1990, the recorded
amount of 4.537 Million Dollars is clearly on
the low end of this range.

Qualitative Risk Factors Analysis

Industry Conditions, Operating Characteristics
and Financial Stability:
Industry was very competitive and characterized by
rapid changes.
Unable to generate positive cash flows from Operative
Activities.
Too much borrowings

Management Characteristics:
Most of the Independent Directors are Insiders
Audit committee met only once during 1990.

Facts
Real name of Circuit Industries Inc. is
Comptronix Inc.
Fraud Scheme:
Overstated Sales: Fake Credit Sales
Inflated PP&E
Others: inflated inventory, undercharged revenue
expenses

Pros and Cons of the Beneish Model

Merits:
Based on publicly available data.
Cost effective
It conveniently aggregates different pieces of
information into one summary number.

Demerits:
It failed to integrate inventory in its model
It does not consider the qualitative factors

Steps to Analyze
1. See Beneish M-Score Model / Composite
Index
2. a. Comment on distorting variables
b. Comment on Motivating variables
3. Compute Composite Index for this company
based on Beneish-M score
4. Compare and comment based on Beneish M
score index score

Steps to Analyze
5. Compare with GAAP violators / Control firms
- find most important four
6. Analytical procedure
i. Sales
ii. Depreciation
iii. Leverage
7. Qualitative Risk Factors
8. Merits & Demerits of Beneish
9. FACTS