Page 373 - JoFA_2022

FRAUD / AUDITING

Benford's Law-based journal single over if it is followed by an under. For example,
the pattern under, under, over, under, under has three
entry or general ledger runs. Also, a series such as over, under, over, under,
under, over, over, under, under, under (exactly the
results from 10 to 19 in the figure “The First-Two
analytics testing is not Digits of the Population of Journal Entries”) has
six runs.
In data that conforms almost perfectly to Ben-
suggested for datasets with ford’s Law, we would expect 46 runs in the first-two
digits graph. However, in journal entry and accounts
fewer than 5,000 records. payable data there is a tendency to have overs
(spikes) at the multiples of 10 (10, 20, 30, …, 90)
because of our tendency to use round numbers for
pricing services and for estimates. In the figure
“The First-Two Digits of the Population of Journal
graph where the actual proportions are (mostly) Entries” there is an over at each of the multiples
above the Benford’s Law line. The fictitious entries of 10. This tendency slightly reduces the number
inflated the 20 to 49 proportions which together of runs in accounting data, making our practical
with the preexisting spike at 50 created a ridge expectation 43 (slightly fewer) runs. My experience
from 20 to 50. The addition of the first-two digit 20 with running these tests with internal auditors as
to 49 amounts also causes the other actual propor- a part of general ledger analytics indicated that
tions to decrease, creating corresponding valleys journal entry data with 35 or fewer runs might
from 10 to 19 and from 51 to 99. A valley is a include some combination of ridges and valleys.
range in the graph where the actual proportions are The graphs in the figure “Authentic Journal Entries
(mostly) below the Benford’s Law line. With Added Fictitious Amounts” have 19 and 11
This clustering of the unders and the overs runs, respectively, which is way below the suggested
(actual less than Benford’s Law, or actual more critical value of 35 runs. The original data shown in
than Benford’s Law) might not be noticeable to an the figure “The First-Two Digits of the Population
untrained eye. To identify this valley-ridge-valley of Journal Entries” had 37 runs, which is above the
pattern, auditors could use the Runs test. A run is critical value and which correctly signals that there
defined as a series of successive (in a row) overs or a are no noticeable ridges or valleys. As a side issue,
series of successive unders. A run could consist of a the conformity to Benford’s Law has deteriorated,

Where to target Benford’s Law

Not all types of journal entries are well suited to Benford’s Law- work-in-process. These entries generally do not conform to
based testing. Top-side journal entries are (usually) made in a Benford’s Law, not because of fraud or error, but because a
spreadsheet after the consolidation is completed but before the handful of transaction types might dominate the population.
financial statements are prepared. They do not appear as entries For instance, a courier service might have its most frequent
in the general ledger and are not subject to standard system “product” be overnight delivery at a $25.35 selling price. This
controls. They are never formally posted to the ledger accounts product would cause the system to record perhaps a million
of the subsidiaries. Top-side journal entries played a large role in journal entries for that amount each day, which would cause
the WorldCom fraud. They are significant audit risks and should an excess of first-two digits 25s when compared with the
be 100% tested. expectations of Benford’s Law.
System or automated journal entries are also not The manual entries are well suited to Benford’s Law-based
good candidates for Benford’s Law-based testing. These testing. These entries are used for adjustments, accruals and
journal entries flow from sales transactions, manufacturing prepayments, funds transfers, internal billings, cost allocations,
production, and purchase transactions. These recurring entries reversals (voids), closing entries, and rare activities such as
record day-to-day activities. For example, when a product acquisitions. The manual entries are under the control of top
is finished and moves off the factory floor, an automated management and are exactly what would be used for financial
system will increase finished goods inventory and decrease statement fraud.

16 | Journal of Accountancy September 2022