As evidenced in the LETS GOWEX SA (OTCMKTS:LGWXY) (BME:GOW) situation, a significant portion of financial statement irregularities are ignored or missed by reporting firms, their auditors, and the SEC. Now researchers say that they have discovered a statistical method to detect financial irregularity reporting.

In a paper titled “Financial Statement Irregularities: Evidence from the Distributional Properties of Financial Statement Numbers,” researchers create a composite, red-flag financial statement measure to estimate financial reporting irregularities.

The report is authored by Dan Amiram, Columbia Business School – Accounting, Business Law & Taxation; Zahn Bozanic, Ohio State University – Department of Accounting & Management Information Systems and Ethan Rouen at Columbia Business School.

Financial irregularities: Frequency distribution theory

The measuring methodology 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. The basis of this frequency distribution theory is used by quantitative analysts to assess stock prices for quantitative trading, population trends, death rates used for insurance probability tables. It is based off power laws, common in nature, and tends to be most accurate when values are distributed across multiple orders of magnitude.

The study says that in aggregate, by year, or by industry, the empirical distribution of the numbers in firms’ financial reports generally conforms to the theoretical distribution specified by Benford’s Law.

Financial irregularities: Key points

In a battery of tests, the study makes four key points.  It shows that 1) manipulating revenue for a typical conforming firm will induce an increase in the deviation from the theoretical distribution 87% of the time; 2) the divergence measure is positively associated with commonly used accruals-based earnings management proxies, yet is not associated with real activities earnings management proxies; 3) the restated financial reports of misstating firms exhibit greater conformity, and 4) divergence decreases in the years following restatements.

The study authors claim their method of analysis has advantages over available alternatives.  Turning to the informational implications of Benford’s Law as a benchmark, researchers show evidence that as divergence increases, information asymmetry increases and earnings persistence decreases after the disclosure of the financial statements. Finally, the study shows that their method of analysis predicts material misstatements as identified by SEC Accounting and Auditing Enforcement Releases (AAERs) and can be used as a leading indicator to identify misstatements.