Saturday, 3 August 2013

Detetecting Earnings Manipulation and Fraud: A Light Tutorial on Probit Analysis

By Dennis McLeavey, CFA

Lies, damned lies, and earnings management. If 20% of firms misrepresent economic reality through earnings management, analysts and portfolio managers must protect themselves by knowing how, why, and when individuals lie. Quantitative methods (e.g., probit analysis) with forensic formulas, such as the Beneish model (developed by Messod D. Beneish), offer part of the necessary skills to distinguish earnings manipulation from earnings management.

Before we move on, a word about probit. Because so much of finance involves binary variables (even the buy/sell decision is binary), it is surprising that probit is not more widely explored. Knowledge of the basics of probit analysis and Beneish’s choices and assumptions can help analysts and portfolio managers get value from his model. Cookbook use of what is termed the Beneish “M-model” misses changes in the world and can be misleading.

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