Auditing Bank Financial Statements in Emerging Market Countries: The Use of the Benford Distribution

Abstract

The analysis considers the use of Benford’s Law as a forensic tool to audit the quality of accounting information reported by banks in emerging market countries. History suggests that lack of financial standards and reporting transparency can ultimately lead to bank failures in these nations. We use the Benford Distribution to analyze the first digits of bank financial statement entries and show the value of accounting standards in producing information of high quality. Benford’s Law maintains that the first digits of an unconstrained, large array of numbers might follow a lognormal pattern. It can be applied, for example, to financial statements issued by banks to infer their data integrity. To illustrate the importance of accounting standards and reporting transparency, the analysis utilizes Russian bank statement data from 2001 to 2011. The main finding is that accounting standards matter. After the Russian Central Bank required all banks to adopt International Financial Reporting Standards in 2004, the financial statement data largely conformed to Benford’s Law. While the Benford distribution can be used to infer the overall quality of bank financial statement data in emerging market countries, it is less effective in spotting troubled banks that commit reporting fraud. One possible reason is that the Benford distribution is scale invariant, and violation of Benford’s Law is a sufficient but not necessary condition for accounting irregularities.

Citation

Davydov, D. and Swidler, S. (2016), "Auditing Bank Financial Statements in Emerging Market Countries: The Use of the Benford Distribution", Boubaker, S., Buchanan, B. and Nguyen, D.K. (Ed.) Risk Management in Emerging Markets, Emerald Group Publishing Limited, Leeds, pp. 187-200. https://doi.org/10.1108/978-1-78635-452-520161018