Financial Statement Irregularities: Evidence from the Distributional Properties of Financial Statement Numbers

Financial Statement Irregularities: Evidence from the Distributional Properties of Financial Statement Numbers

Dan Amiram 

Columbia Business School – Accounting, Business Law & Taxation

Zahn Bozanic 

Ohio State University (OSU) – Department of Accounting & Management Information Systems

Ethan Rouen 

Columbia Business School
January 2, 2014
Columbia Business School Research Paper No. 14-9

Abstract: 
Anecdotal evidence suggests that a significant portion of financial statement irregularities are ignored or missed by reporting firms, their auditors, and the SEC. Motivated by a method used by forensic investigators and auditors to detect irregularities in a variety of settings, we create a composite, red flag financial statement measure to estimate the degree of financial reporting irregularities for a given firm-year. The measure, which has several significant conceptual and statistical advantages over available alternatives, assesses the extent to which features of the distribution of a firm’s financial statement numbers diverge from a theoretical distribution posited by Benford’s Law, or the law of first digits. We find that whether in aggregate, by year, or by industry, the empirical distribution of the numbers in firms’ financial reports generally conform to the theoretical distribution specified by Benford’s Law. In a battery of construct validity tests, we show that i) manipulating revenue for a typical conforming firm will induce an increase in the deviation from the theoretical distribution 87% of the time, ii) the divergence measure is positively correlated with commonly used earnings management proxies, iii) the restated financial reports of misstating firms exhibit greater conformity, and iv) divergence decreases in the years following restatements. Turning to the informational implications of Benford’s Law, we provide evidence that as divergence increases, information asymmetry increases and earnings persistence decreases in the year following the disclosure of the financial report. Finally, we show that our measure predicts SEC Accounting and Auditing Enforcement Releases. Compared to firms that were not caught committing fraud by the SEC, firms that were caught have a higher deviation from Benford’s Law three years prior to fraud detection. However, while firms that were not caught are able to maintain a constant level of deviation, firms that were caught appear to have a significant decline in their deviation from Benford’s Law in the years before they were caught. The results are consistent with the explanation that fraudulent firms are able to hide their activities using techniques that violate Benford’s Law, but only get caught if those techniques become unsustainable.