Using Benford's Law to Determine if Selected Company Characteristics are Red Flags for Earnings Management

Johnson, Gary C.
September 2009
Journal of Forensic Studies in Accounting & Business;Sep2009, Vol. 1 Issue 2, p39
Academic Journal
Exploratory research was conducted using Benford's Law to determine if selected company characteristics are associated with a risk of earnings management. Research has shown that companies engaged in managing earnings are at greater risk of failure than companies not manipulating their results. Net income and earnings per share quarterly data were collected from the EDGAR data base of the Securities and Exchange Commission (SEC) for twenty-four randomly selected publicly traded companies for fiscal years 1999 through 2004. Companies were classified and analyzed by size (capitalization), age (period of time publicly traded), level of reported insider trading, and beta values. Findings show that companies categorized as low capitalization (below 45 billion), higher levels of inside trading (3% and higher), and newer to being traded on the public markets (less than 25 years) represent a potential risk of earnings management. Mean Absolute Deviations (MAD) and correlations were also calculated and their results support the Benford digit analysis. This early warnings model may be used by investors and auditors as a preliminary evaluation of a subject company's risk of biased financial reporting.


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