Using Benford’s Law

To Detect Fraud

World Headquarters • the gregor building

716 West Ave • Austin, TX 78701-2727 • USA
 USING BENFORD’S LAW TO DETECT FRAUD

TABLE OF CONTENTS

I. FIRST OBSERVATIONS OF A MATHEMATICAL PHENOMENON

Simon Newcomb ......................................................................................................................................................1
Newcomb’s Observation .........................................................................................................................................1
Newcomb’s Analysis ................................................................................................................................................2
Summary.....................................................................................................................................................................2
Review Questions .....................................................................................................................................................3

II. BENFORD’S ANALYSIS

Frank Benford ...........................................................................................................................................................5
Benford’s Observations ...........................................................................................................................................5
Benford’s Law ...........................................................................................................................................................6
Conformity Example 1 ........................................................................................................................................ 8
Conformity Example 2 ......................................................................................................................................12
Benford’s Conclusion ............................................................................................................................................ 13
Summary.................................................................................................................................................................. 13
Review Questions .................................................................................................................................................. 15

III. BENFORD’S LAW AND FRAUD

Auditors’ and Investigators’ Responsibilities ..................................................................................................... 19
Benford’s Law and Accounting ........................................................................................................................... 20
Nigrini’s Observations .......................................................................................................................................... 22
Summary.................................................................................................................................................................. 23
Review Questions .................................................................................................................................................. 24

IV. A CLOSER LOOK AT BENFORD’S LAW

Scale Invariance ...................................................................................................................................................... 27
Which Data Sets Should Conform to Benford’s Law? .................................................................................... 28
Summary.................................................................................................................................................................. 30
Review Questions .................................................................................................................................................. 31

V. AUDIT SAMPLING
Types and Benefits of Sampling .......................................................................................................................... 33
Sampling Shortfalls ................................................................................................................................................ 34
Sample Size and Benford’s Law ........................................................................................................................... 35
Summary.................................................................................................................................................................. 35
Review Questions .................................................................................................................................................. 37

VI. ASSESSING CONFORMITY TO BENFORD’S LAW

Z-Statistic Analysis................................................................................................................................................. 39
Applying the Z-Statistic to a Benford Curve ..................................................................................................... 40
Summary.................................................................................................................................................................. 42
Review Questions .................................................................................................................................................. 44

VII. THE DIGIT TESTS

First Digit Test ....................................................................................................................................................... 45
Second Digit Test .................................................................................................................................................. 46

Using Benford’s Law i

 USING BENFORD’S LAW TO DETECT FRAUD

VII. THE DIGIT TESTS (CONT.)

First Two Digits Test ............................................................................................................................................ 47
First Three Digits Test .......................................................................................................................................... 48
Last Two Digits Test ............................................................................................................................................. 49
Applying the Z-Statistic to the Digit Tests ........................................................................................................ 49
Summary.................................................................................................................................................................. 51
Review Questions .................................................................................................................................................. 53

VIII. CONCLUSION ........................................................................................................................................ 55

IX. PRACTICAL PROBLEMS ....................................................................................................................... 57

X. SOLUTIONS TO REVIEW QUESTIONS

I. First Observations of a Mathematical Phenomenon .................................................................................... 91
II. Benford’s Analysis ............................................................................................................................................ 93
III. Benford’s Law and Fraud .............................................................................................................................. 96
IV. A Closer Look at Benford’s Law .................................................................................................................. 99
V. Audit Sampling ................................................................................................................................................ 103
VI. Assessing Conformity to Benford’s Law ................................................................................................... 106
VII. The Digit Tests ............................................................................................................................................ 108

XI. SOLUTIONS TO PRACTICAL PROBLEMS ................................................................................. 111

XII. FINAL EXAMINATION ..................................................................................................................... E-1

ii Using Benford’s Law