Detecting Tax and Accounting Fraud thru Benford's Law

On a recent tax blog carnival, I found this interesting post about how the IRS can flag "creative" numbers for audit by using Benford's law.

Benford's Law turns out to be interesting. It has to do with the distribution of the leading digit in any set of numbers (i.e. stock prices, population counts, tax returns, etc).

You would think that this would be evenly distributed - i.e. 10% of the numbers would start with a 1, 10% with a 2, etc.

Instead, it turns out that the numbers are evenly distributed by their logrithms. So, for example 30% of the numbers should start with a 1, and the distribution drops until a 9 should only be the leading digit 4.6% of the time.

The IRS and forensic accountants make use of this mathematical rule.

If you want to read a little bit more on it, and see the actual formula, I also created an entry on my math blog.