Professor Messod Beneish at Indiana University created a mathematical model that uses financial ratios and eight variables to identify whether a company has manipulated its earnings.. In many ways it is similar to the Altman Z score, but optimised to detect earnings manipulation rather than bankruptcy. Here is the orginal full paper and here is an excellent article on the model.
The eight variables are:
1. DSRI – Days’ sales in 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 calculated, the eight variables are combined together to achieve an M-Score for the company. An M-Score of less than -2.22 suggests that the company will not be a manipulator. An M-Score of greater than -2.22 signals that the company is likely to be a manipulator.
Jae at Old School value has created a spreadsheet to calculate the M score for a company. Check out his article to download the sheet.