{"id":10952,"date":"2021-02-10T18:40:42","date_gmt":"2021-02-10T18:40:42","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=10952"},"modified":"2026-01-22T08:35:56","modified_gmt":"2026-01-22T08:35:56","slug":"examination-quality-companys-financial-reports","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/examination-quality-companys-financial-reports\/","title":{"rendered":"Examination of the Quality of a Company\u2019s Financial Reports"},"content":{"rendered":"<script type=\"application\/ld+json\">\r\n{\r\n  \"@context\": \"https:\/\/schema.org\",\r\n  \"@type\": \"ImageObject\",\r\n  \"@id\": \"https:\/\/analystprep.com\/study-notes\/images\/quality-financial-reports-img1-3\",\r\n  \"contentUrl\": \"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/02\/Img_1-3-1536x702.jpg\",\r\n  \"url\": \"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/02\/Img_1-3-1536x702.jpg\",\r\n  \"caption\": \"Financial Report Quality Examination Example (Img_1-3)\",\r\n  \"width\": 1536,\r\n  \"height\": 702,\r\n  \"copyrightNotice\": \"\u00a9 2024 AnalystPrep\",\r\n  \"acquireLicensePage\": \"https:\/\/analystprep.com\/license-info\",\r\n  \"creditText\": \"AnalystPrep Design Team\",\r\n  \"creator\": {\r\n    \"@type\": \"Organization\",\r\n    \"name\": \"AnalystPrep\"\r\n  },\r\n  \"isPartOf\": {\r\n    \"@type\": \"WebPage\",\r\n    \"@id\": \"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/examination-quality-companys-financial-reports\/\"\r\n  }\r\n}\r\n<\/script>\r\n<script type=\"application\/ld+json\">\r\n{\r\n  \"@context\": \"https:\/\/schema.org\",\r\n  \"@type\": \"QAPage\",\r\n  \"mainEntity\": {\r\n    \"@type\": \"Question\",\r\n    \"name\": \"Which Beneish model variable change would most likely increase manipulation risk?\",\r\n    \"text\": \"An analyst collects the following information to use the Beneish model to assess XYZ\u2019s corporation (a hypothetical company) likelihood of misreporting.\\n\\nSelected Beneish Model Data for XYZ Corporation (Current year):\\n- Days\u2019 sales receivable index (DSR): 1.135\\n- Leverage index (LEVI): 0.8855\\n- Sales, general, and administrative expenses index (SGAI): 0.685\\n\\nAll else held constant, which variable in the Beneish model has a year-over-year change that would most likely increase XYZ\u2019s likelihood of manipulation?\\n\\nA. DSR\\nB. LEVI\\nC. SGAI\",\r\n    \"answerCount\": 3,\r\n    \"acceptedAnswer\": {\r\n      \"@type\": \"Answer\",\r\n      \"text\": \"A. DSR.\\n\\nIn the Beneish model, DSR is positively related to the M-score. A year-over-year increase in DSR increases the M-score and therefore increases the likelihood of manipulation. LEVI and SGAI are negatively related to the M-score in this setup, so increases in those indices would decrease (not increase) the estimated likelihood of manipulation.\"\r\n    }\r\n  }\r\n}\r\n<\/script>\r\n\r\n\r\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/dVSE9osby10\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\r\n\r\n<p>The M-score is the score indicating the probability of earnings manipulation. (Refer to the previous section for analysis of the model variables.) The M-score is a normally distributed random variable with a mean of 0 and a standard deviation of 1. Therefore, the probability of earnings manipulation can be calculated using the cumulative probabilities for a standard normal distribution or the NORMSDIST function in Excel. For example, M-scores of \u20131.49 and \u20131.78 indicate that the probability of earnings manipulation is 6.8% and 3.8%, respectively. Higher M-scores, i.e., less negative numbers, indicate an increased probability of earnings manipulation.<\/p>\r\n<p>Additionally, the use of the M-score for classifying companies as potential manipulators depend on the relative cost of Type I errors and Type II errors. Type I errors occur due to incorrectly classifying a manipulator company as a non-manipulator. On the other hand, Type II errors are as a result of incorrectly classifying a non-manipulator as a manipulator. Beneish assessed that the likely relevant cutoff for investors is a probability of earnings manipulation of 3.8% (an M-score exceeding \u20131.78).<\/p>\r\n<p><i><img loading=\"lazy\" decoding=\"async\" class=\"aligncenter size-full wp-image-22912\" src=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/02\/Img_1-3.jpg\" alt=\"M-Score\" width=\"1590\" height=\"727\" srcset=\"https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/02\/Img_1-3.jpg 1590w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/02\/Img_1-3-300x137.jpg 300w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/02\/Img_1-3-1024x468.jpg 1024w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/02\/Img_1-3-768x351.jpg 768w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/02\/Img_1-3-1536x702.jpg 1536w, https:\/\/analystprep.com\/study-notes\/wp-content\/uploads\/2021\/02\/Img_1-3-400x183.jpg 400w\" sizes=\"auto, (max-width: 1590px) 100vw, 1590px\" \/>Note: <strong>Exam tip:<\/strong> <\/i>Do not memorize the Beneish model or coefficients \u2013 instead, be in a position to interpret the model. We illustrate an example in the section that follows:<\/p>\r\n<h4>Example: Illustration of the Beneish Model<\/h4>\r\n<p>Beneish\u2019s M-score analysis for ABC Corporation (a hypothetical company) is shown below:<\/p>\r\n<p>$$ \\textbf{ABC Corporation M-score} $$<\/p>\r\n<p>$$\\small{\\begin{array}{l|r|r|r} \\textbf{Variable} &amp; \\textbf{Value of Variable} &amp; {\\textbf{Coefficient from}\\\\ \\textbf{Beneish Model}} &amp; \\textbf{Calculations}\\\\ \\hline\\text{DSRI} &amp; 1.200 &amp; 0.947 &amp; 1.136\\\\ \\hline\\text{GMI} &amp; 1.000 &amp; 0.471 &amp; 0.471\\\\ \\hline\\text{AQI} &amp; 0.600 &amp; 0.438 &amp; 0.263\\\\ \\hline\\text{SGI} &amp; 1.000 &amp; 1.041 &amp; 1.041\\\\ \\hline\\text{DEPI} &amp; 1.000 &amp; 0.067 &amp; 0.067\\\\ \\hline\\text{SGAI} &amp; 0.400 &amp; -0.408 &amp; -0.163\\\\ \\hline\\text{Accruals} &amp; 0.130 &amp; 4.938 &amp; 0.642\\\\ \\hline\\text{LEVI} &amp; 0.400 &amp; -0.640 &amp; -0.256\\\\ \\hline\\text{Intercept} &amp; {}&amp; {}&amp; -4.740\\\\ \\hline\\text{M-score} &amp;{} &amp;{} &amp; -1.071\\\\ \\hline\\text{Probability of manipulation} &amp;{} &amp;{} &amp; 7.93\\%\\\\ \\end{array}}$$<\/p>\r\n<p><strong><em>Question 1:<\/em> <\/strong>Assume that an analyst uses a cut-off value of -1.78 for the M-score. Would the results of the Beneish model call for the analyst to identify ABC as a probable manipulator?<\/p>\r\n<h4>Solution<\/h4>\r\n<p>The M-score for ABC is -1.071, which is higher than the cut-off of -1.78. This indicates a higher than the acceptable probability of manipulation. Therefore, the model is expected to lead an analyst to identify ABC as a probable manipulator. For ABC Corporation, the Beneish model estimates the probability of manipulation as 7.93%. Although the classification of companies as manipulators depends on the relative cost of Type I errors and Type II errors, the value of 7.93% greatly exceeds the cut-off of 3.8% that Beneish identified as the relevant cut-off.<\/p>\r\n<p><em><strong>Question 2:<\/strong> <\/em>From the exhibit, the values of DSRI, GMI, SGI, and DEPI are exceeding one. In the Beneish model, what does this indicate for each variable?<\/p>\r\n<h4>Solution<\/h4>\r\n<p>Days Sales Receivable Index (DSRI) is the ratio of days\u2019 sales receivables in year <em>t<\/em> relative to year <em>t \u2013 1<\/em>. The value higher than one for DSR indicates that receivables as a percentage of sales have increased. This variation may be reflective of improper revenue recognition leading to revenue inflation.<\/p>\r\n<p>Gross Margin Index (GMI) is the ratio of gross margin in year <em>t \u2013 1<\/em> to that in year <em>t<\/em>. When this ratio is greater than 1, the gross margin has declined.<\/p>\r\n<p>Sales Growth Index (SGI) is the ratio of sales in year <em>t<\/em> relative to year <em>t \u2013 1<\/em>. The value higher than one for SGI indicates positive sales growth relative to the previous year. Companies could be predisposed to manipulate earnings to manage perceptions of continuing growth and also to obtain the capital needed to support growth.<\/p>\r\n<p>Depreciation Index (DEPI) is the proportion of depreciation rate in year <em>t \u2013 1<\/em> to the corresponding rate in year <em>t<\/em>. A DEPI greater than 1 suggests a slower depreciation rate of ABC\u2019s assets to manipulate earnings.<\/p>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>An analyst collects the following information to use the Beneish model to assess XYZ\u2019s corporation (a hypothetical company) likelihood of misreporting.<\/p>\r\n<p>$$ \\textbf{Selected Beneish Model Data for XYZ Corporation} $$<\/p>\r\n<p style=\"text-align: left;\">$$\\small{\\begin{array}{l|r|r} {}&amp; \\textbf{Current year} &amp; \\textbf{Previous Year}\\\\ \\text{Days\u2019 sales receivable index (DSR)} &amp; 1.135 &amp; 0.835\\\\ \\hline\\text{Leverage index (LEVI)} &amp; 0.885 &amp; 0.685\\\\ \\hline\\text{Sales, general, and administrative expenses index (SGAI)} &amp; 0.685 &amp; 0.535\\\\ \\end{array}}$$<\/p>\r\n<p>All else held constant, which variable in the Beneish model has a year-over-year change that would <i>most likely<\/i> increase XYZ\u2019s likelihood of manipulation?<\/p>\r\n<p>\u00a0 \u00a0A. DSR<\/p>\r\n<p>\u00a0 \u00a0B. LEVI<\/p>\r\n<p>\u00a0 \u00a0C. SGAI<\/p>\r\n<h4 style=\"text-align: left;\">Solution<\/h4>\r\n<p style=\"text-align: left;\"><strong>The correct answer is A.<\/strong><\/p>\r\n<p>The Days Sales Receivable Index (DSR) variable in the Beneish model is positively related to the Beneish model M-score. Thus, a year-over-year increase in DSR from 0.835 to 1.135 would lead to an increase in the M-score, which implies an escalation in XYZ\u2019s probability of manipulation.<\/p>\r\n<p><strong>B is incorrect. <\/strong>The Leverage Index (LEVI) variable is negatively related to the Beneish model M-score. Hence, a year-over-year increase in LEVI from 0.685 to 0.8855 would lead to a decline in the M-score, which implies a decrease in XYZ\u2019s likelihood of manipulation.<\/p>\r\n<p><strong>C is incorrect. <\/strong>The Sales, General, and Administrative Expenses Index (SGAI) variable is negatively related to the Beneish model M-score. Therefore, a year-over-year increase in SGAI from 0.535 to 0.685 would lead to a decrease in the M-score, which implies a decrease (not increase) in XYZ\u2019s likelihood of manipulation<\/p>\r\n<\/blockquote>\r\n<p>Reading 15: Evaluating Quality of Financial Reports\u00a0<\/p>\r\n<p><em>LOS 15 (d) Evaluate the quality of a company\u2019s financial reports.<\/em><\/p>","protected":false},"excerpt":{"rendered":"<p>The M-score is the score indicating the probability of earnings manipulation. (Refer to the previous section for analysis of the model variables.) The M-score is a normally distributed random variable with a mean of 0 and a standard deviation of&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,312],"tags":[216,313,168],"class_list":["post-10952","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-financial-reporting-and-analysis-fra","tag-cfa-level-2","tag-financial-reporting-and-analysis-fra","tag-the-quality-of-a-companys-financial-reports","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Examination of the Quality of a Company\u2019s Financial Reports - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"Understand how to interpret the M-score generated by the model and its implications for identifying potential manipulators.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/examination-quality-companys-financial-reports\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Examination of the Quality of a Company\u2019s Financial Reports - 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