Scanning for Financial Shenanigans
Shawn is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In the late 1990’s, Indiana University professor Messod Beneish developed a model that gave investors the ability to target companies that are manipulating their earnings. His model, known as the Beneish M-Score, uses 8 key attributes (explained more in the Appendix below) that he believed were relevant in detecting fraudulent earnings. His research, linked here, can be a useful tool for investors.*
Creating a screen using the M-score model resulted in 600 companies. The table below shows a few that I found interesting.
600 is a big number. Considering there are a few blue chips on the list, one would have to wonder if all these companies are really manipulating their earnings. I would guess not. But using the model at face value is not the message for investors. This exercise is to direct investors to where further research is needed. Even Beneish noted this concept stating “...the screening results require further investigation to determine whether the distortions in financial statement numbers result from earnings manipulation or have another structural root.”
Let’s heed to Beneish’s comment and examine what is the root of the potential manipulation for a few companies on the list. The model gives a greater proportion of weight to the trends of 1) deteriorating asset quality, 2) greater rise in net receivables compared to revenue and 3) significant increase in revenues. I want to examine each case in further detail.
Deteriorating asset quality
Starting with the biggest offender on the list; Shutterfly (NASDAQ: SFLY) is the online provider of digital photo printing and sharing that has generated revenue of $473 million in fiscal 2011. The stock is up over 30% YTD as the company's initiatives in building strategic relationships with retailers and increasing product innovation is building momentum. The company, however, triggered the M-Score model because Goodwill increased significantly year over year reducing total asset quality, which is a measure of the percent of assets which future value is unknown as explained in the Appendix. The company spent $400 million to acquire Tiny Prints, a competitor that offers cards and stationery products. Upon closing of the acquisition, the company recorded over $325 million, or about 80% of the purchase amount as Goodwill. The rest acquired customers, distribution channels and equipment. This increased the company’s goodwill as a percentage of total assets from around 3% in FY 2010 to almost 50% in FY 2011.
Greater rise in net receivables compared to revenue
EBAY (NASDAQ: EBAY), the provider of online auctions and PayPal wouldn’t show up on the list if it wasn’t for disparity in the growth of receivables versus the growth in revenue. The company grew revenue over 27% in FY 2011, but saw their receivables grow by double at 50%. Receivables are complicated to analyze because the growth could be business related or circumstantial. Many of the 600 on this list failed in this category. EBAY probably failed because of collections timing due to the holiday season. Even though it is common to have this occurrence, more research is important as Beneish found a strong correlation between disproportionate rises in receivables and manipulation. His theory was that companies would often adjust their credit policy towards the end of the quarter to book higher revenue.
Significant increase in revenue
This variable might seem counter intuitive as the goal of every investor is to find a company that grows revenues. But the companies that fall under this category are those that show abnormal revenue growth. Beneish highlighted this variable as research demonstrates that internal controls tend to lag amidst periods of rapid growth. Couple that with increased pressure from managers to continually hit higher growth targets and you have a recipe for disaster. Green Mountain Coffee Roasters (NASDAQ: GMCR) , the maker of the ubiquitous Keurig coffee brewing machine, grew revenues by 95% year over year in 2011 but has seen its shares stumble 75% over the past fifty two weeks as analysts call into question the company’s accounting practices. Beneish stresses that high growth does not automatically equate to fraud. Rather, investors should be aware of the negative effects of growth on past firms and to make sure the company has adequate controls.
Investors should make it part of their routine to examine the M-Score of the stocks in their portfolio. Consider asking questions to management if the company failed in the attributes referenced; did they adjust their procedures? Is there something inherent to the business that is becoming more challenging? If analyzed correctly, the benefits of going underneath the surface could prove to be invaluable.
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* Students at Cornell University examined Enron using the M-Score as part of a research project. Their conclusion, before Enron was discovered for fraud, was the company is manipulating earnings (you can read more about the students in the New Yorker article written by Malcolm Gladwell.)
Appendix
1) How do you calculate the Beneish M-Score?
Collect the last two fiscal years of financial statements and use the following algorithm.
M = -4.84 + 0.92*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI + 0.115*DEPI – 0.172*SGAI - 0.327*LVGI + 4.679*TATA
Any output greater than -2.22 is to be considered a earnings manipulation risk.
2) Variables
DSRI - Days’ Sales in Receivables Index: Receivables/Total Sales
Ratio of sales to receivables versus prior year. A large increase could be due to a change in policy allowing for greater sales. Managers could use this tactic to increase sales at the end of an accounting period.
GMI - Gross Margin Index: Gross Profit/Total Sales
GMI greater than 1 indicates gross margins have deteriorated due to lower earnings potential. Deteriorating business prospects could lead to manipulation.
AQI - Asset Quality Index: (Non-Current Assets – PP&E) / Total Assets
AQI is a measure of the proportion of assets on a company’s balance sheet which future benefits are less certain (i.e. non-tangible assets like Goodwill).
SGI - Sales Growth Index: Total Sales
Best explained by Beneish’s words, “Growth does not imply manipulation, but growth firms are viewed by professionals as more likely to commit financial statement fraud because their financial position and capital needs put pressure on managers to achieve earnings targets. In addition, concerns about controls and reporting tend to lag behind operations in periods of high growth.”
DEPI - Depreciation Index: Depreciation / (Depreciation + Net PP&E)
DEPI greater than 1 indicates that assets are being depreciated at a lower rate than in past. Worst case scenario is that companies are extending the useful life of their assets improperly.
SGAI - SG&A Index: S&GA expenses/Total Sales
Rapid growth in this ratio could indicate an increase in payroll or other unsustainable actions
LVGI - Leverage Index - Total Liabilities/Total Assets
A LVGI ratio greater than 1 indicates an increase in leverage. Leverage is not necessarily a bad event but could be disastrous if handled improperly.
TATA - Total Assets to Total Accruals - (Working Capital - Cash) - Depreciation
Investors are taught to follow the cash which makes this ratio important as it calculates the amount of “accrued cash,” displacing earnings.
ShawnRobinson has no positions in the stocks mentioned above. The Motley Fool owns shares of eBay and has the following options: long DEC 2012 $16.00 puts on Green Mountain Coffee Roasters and short DEC 2012 $21.00 calls on Green Mountain Coffee Roasters. Motley Fool newsletter services recommend eBay and Green Mountain Coffee Roasters. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.
