Benford's Law and its Application in Auditing - Coursework Example

Accounting Fraud Name Date Introduction In recent times various cases of corporate collapses have been reported, including big corporations, such as Worldcom, Enron and HIH. These collapses have mainly been attributed to accounting fraud, which may have been known by auditors or not known. This has brought auditors under sharp focus given that it is their work to certify the true and fair view of the financial statement. One of the main tools the auditors can use to detect accounting malpractices include the Benford's Law. In this paper, I review the Benford's Law and show how it can be applied to detect accounting fraud using the payables data. Besides, people commit accounting fraud due to various reasons that shall as well be discussed in the last section of the paper followed by a conclusion. Benford's Law and its Application in Auditing Frank Benford, a research physicist at General Electric founded the Benford’s Law in 1923. In the course of his career, Benford came to realize that the numbers beginning with the digit one were used more often (around 33 per cent of the time) than numbers beginning with digit two to nine. In general, the frequency kept declining as the numbers progressed from 1 through to 9, as indicated below; The Benford’s Law is also known as the first – digit law or the law of naturally occurring numbers. Brenford’s Law can be applied to detect abnormalities in large data sets in various fields. For instance, analysts such as Hal Varian and Mark Nigrini have used the Law to detect possible frauds in socio economic data, in-forensic accounting and auditing respectively. In auditing, the law of naturally occurring numbers can be used to detect accounting frauds in financial data. Lynch and Zhu (2008) states that a set of non–manipulated naturally occurring numbers would display the highest frequency for leading digit as 1 and lowest for 9. The minute this pattern is disturbed at any point of time, auditors can be able to track errors or fraud. This is grounded on the assumption that people who commit accounting fraud are disposed to make up figures that tend to distribute their digits quite evenly. Therefore, a simple comparison of first digits’ frequency distribution ought to detect the irregular entries. In the following part the payables data is used to show how the Benford’s Law can be used to detect accounting fraud. The excel ActiveData functionality tool is used for the analysis. The first step is to select ‘Digital Analysis’. Under the appearing window, we select ‘Invoice_amount’ and uncheck ‘Include Stratified Analysis’. Then make sure to check ‘First Digits Test’ and click ‘Finished’, as shown below; Excel will generate series of data and graph representation based on first-digit test for the analysis of invoice amount as shown below; From the figure above, it is clear that the digit counts of 4, 5 and 6 show a deviation between the payable’s data proportion and Benford proportion. Therefore, the payables data contains some erroneous entries, which could point to a possible fraud. Notice that the payables data proportion bars do not touch the Benford proportion curve. For further evidence, we go back to the table and click on digits 4, 5 and 6 to get the drill–down of their entries. The result indicates that there are duplicate invoices for each one of them. Below is the example of the entries for the 4th digit count; Reasons People Commit Accounting Fraud The fraud triangle is used to identify the various causes of accounting fraud. According to Romney and Steinbart (2008), the fraud triangle identifies three key broad reasons as to why people commit accounting fraud. The causes are (1) pressure to commit the fraud, (2) opportunity to commit the fraud, and (3) attitude/rationalization of the person committing the fraud. Pressure Accounting fraud mainly arises from financial pressure. However, fraud could also be committed due to emotional and lifestyle pressures. Opportunity Opportunity to commit fraud comes as a result of weak or lack of internal controls. This provides an opportunity for the manipulation of figures with some guarantee that they would not be detected easily. Rationalization Rationalization relates to an individual’s ethical conduct and mind-set that justifies the fraudulent actions. Conclusion Accounting fraud has come to be a more common phenomenon in today’s corporate world. However, there are many tools such as the Benford’s Law that can be used to detect anomalies that may point to possible fraud. Individuals find themselves committing accounting fraud due to a combination of three key factors: pressure to commit fraud, opportunity and rationalisation to do so. References Lynch, L., and Zhu, X. (2008). Putting Benford's Law to Work. Retrieved November 22, 2015, from The Institute of Internal Auditors: https://iaonline.theiia.org/putting-benfords-law-to-work Romney, M. B. and Steinbart, P. J. (2008). Accounting information systems (7 / Marshall B Romney, Paul John Steinbart, Barry E Cushing ed.). Reading, Mass.: Addison-Wesley. Nigrini, M. J. (n.d.). Data Analysis Technology for the Audit Community. Retrieved from http://www.nigrini.com/ Nisen, A. G. (2013). Why People Commit Fraud. Retrieved 23 November 2015 from http://www.businessinsider.com/why-people-commit-fraud-2013-5?op=1 Moroney, C.H. (2011). 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