“Are Cannabis Companies “Cooking Their Books”? Check the M-Score

The TDR Three Key Takeaways:

  1. The Beneish M-Score Role in Detecting Earnings Manipulation: Developed in the 1990s, the Beneish M-Score uses eight financial ratios to identify possible earnings manipulation in financial statements. Its effectiveness was highlighted during the Enron scandal. While it’s widely used in forensic accounting, it’s not a definitive indicator of fraud.
  2. Highlighting Financial Discrepancies: The M-Score is effective in spotting mismatches between cash flow and income statements, a common sign of financial irregularities. This capability is crucial for assessing the accuracy of reported earnings.
  3. Application to Cannabis Industry: Applied to 43 cannabis companies, the M-Score identified three with potential for non-transparent reporting: Ascend Wellness, Grown Rouge, and PharmaCielo. Being flagged indicates a need for more investigation, not necessarily guilt. This highlights the importance of ongoing financial scrutiny in this sector.

In the late 1990s, Professor Messod D. Beneish from Indiana University’s Kelley School of Business developed the Beneish M-Score, a mathematical model to detect earnings manipulation in company financial statements. Introduced in a 1999 paper, it employs eight financial ratios, weighted and combined into a single score, selected based on a study of firms with and without manipulated earnings.

Gaining prominence in forensic accounting and financial analysis, the M-Score was notably effective in the Enron scandal, indicating possible earnings manipulation before its public exposure. The model is used by auditors, analysts, and regulators to screen for financial irregularities, although it is not a definitive fraud indicator. The Beneish M-Score continues to be a relevant tool in financial manipulation detection.

The model primarily flags discrepancies between cash flow and income statements. For example, if a company records revenue for sales that are unlikely to be paid or are prone to returns, the revenue appears in the income statement, but the cash flow statement doesn’t reflect the actual cash inflow.

The M-Score is calculated from eight financial ratios; a score above -2.22 suggests potential earnings manipulation. This is vital for investors, analysts, and auditors to spot red flags in financial statements and evaluate the reliability of a company’s reported earnings, underscoring the importance of thorough financial due diligence.

We applied this calculation to the 43 cannabis companies we monitor. The results? Only four show potential for non-transparent financial reporting or, informally, “cooking the books.”

However, being one of these four companies merely signals a need for further investigation; it does not confirm misrepresentation. It’s a prompt for investors or analysts to conduct more in-depth due diligence. The three cannabis companies at risk, based on their latest financial results, are Ascend Wellness, Grown Rouge, and PharmaCielo. We will update our readers as new financial results are released, which may improve these companies’ standings and remove them from the watch list.

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