Applying Benfordds Law to Detect Accounting Data Manipulation in the Banking Industry

Abstract

Accounting standards and financial reporting systems are supposed to contribute to the transparency of the operation of the financial system by providing market participants, regulators, and supervisors with high-quality information on the financial condition of banking institutions. Bank managers and board members, however, have strong incentives to misrepresent the accounting and financial performance of their banks over time, covering losses and conveying a healthy and sound image of the financial condition of their firms to the public, investors and, especially, to regulatory and supervisory authorities. Any kind of manipulation in banking data is very likely to transmit noise in the operation of the banking sector, as it distorts the expectations of market participants about the future price levels and, hence, about future conditions in the sector. Poor data quality seems to have played a crucial role in the formation of a number of banking scandals that have contributed to the late 2000s financial crisis. In this paper, we rely on a mathematical law which was established by an American financial engineering and physicist called Frank Benford in 1938 to detect possible data tampering in bank accounting data in the years prior to the crisis. More specifically, we test whether and to what extent a set of fundamental balance sheet variables - which reflect the level of bank soundness - were manipulated in the years before the outbreak of the crisis. The idea of detecting manipulations in accounting (or market) data by tests of conformity to Benford's law is nowadays well established in the forensic accounting and auditing literature. However, no relevant studies exist in the current banking literature. This is to say, the present study contains the first application of Benford’s law in banking. Moreover, our work is the only one that makes an attempt to identify operational discrepancies and uncover fraudulent practices in the banking sector of the economy prior to the crisis, considering the regulatory and supervisory changes that took place in the U.S. corporate and banking markets with the enactment of the Sarbanes-Oxley Act in mid-2002.