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Fraud Detection—the Benford Analysis
Contributed by Aaron Blackmor, BP&S audit staff member.

This one simple tool leverages technology to uncover hidden areas of concern...

In our March newsletter, we told you about the epidemic of recent fraud cases.  In this article, we take a look at one technique available to companies that want to proactively defend themselves.  This tool, called a Benford analysis, allows users to deduce potential areas of concern amidst seemingly chaotic and disaggregated data. 

Benford’s law states that “in lists of numbers from many real-life sources of data, the leading digit is 1 almost one third of the time, and larger numbers occur as the leading digit with less and less frequency as they grow in magnitude, to the point that 9 is the first digit less than one time in twenty”(from Wikipedia).

In layman’s terms, one would expect to see most numbers with the leading digit of one—i.e. $160, $12,387, $194,030, etc.—then fewer numbers beginning with two, even fewer beginning with three, and so forth.  (For reference purposes, the following formula calculates the specific probability for any particular leading digit’s (d) occurrence: P(d) = Log₁₀(1+1/d)).

While this may just seem like a funny theoretical quirk with little applicability to the real world, this couldn’t be further from the truth.  Most accounting data sets have been shown to conform to this law, including accounts payable, accounts receivable, sales, expenses, and cash receipts and disbursements.  This widespread functionality bodes well for auditors and managers trying to find specific areas within a company’s records meriting fraud investigation.

Let’s look at an example of how your company might employ this tool.  First, you could start at the “big picture” level and perform a Benford analysis on your entire general ledger.  With a large data set like this, you would expect the frequency of 1’s, 2’s, etc. to conform very closely to the Benford model.  But let’s say that you see an unusually high number of transactions beginning with 4.  You focus your review on these transactions and find that a lot of these transactions are for $4,000—your monthly rent payment.  However, you also find that a lot of transactions are for $499—just below the $500 level of expenses requiring approval by the owner.  This could merely be a revealed bias or there could be more to the story, especially if you are able to determine whether the expense submissions are stemming from a select few employees or from everyone in the company.

A Benford analysis could also be applied to select categories of expenses, 401(k) contributions, check registers, inventory, specific bank accounts, wire transfers, and many other populations of transactions where there could be potential for loss or manipulation.  This analytical technique can be especially useful in conjunction with benchmark analysis of a company’s previous fiscal years, to see if anomalies identified are unique to the period in question, or if they have historical consistency.

As one piece of the package of forensic accounting tools that BPS employs, a Benford analysis can assist auditors and managers to focus their energies in areas of the business or on specific transactions.  If you have any questions or would like to discuss this and other techniques like it, feel free to contact us.

Non-Resident Withholding Tax

South Carolina Code Section 12-8-580 requires any person who purchases real property from a nonresident seller to withhold South Carolina income taxes from the seller.  In general, this rule applies to sale of any interest in real estate, including the sale of condominiums, time shares, minerals in place and any tangible personal property sold as part of a real estate transaction.

Special rules apply to like-kind exchanges involving real property.

South Carolina Revenue Advisory Bulletin No. 02-6 provides guidance on how to apply this law.

If you have questions, please give us a call.

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