Detecting Fraud in Bankrupt Municipalities Using Benford's Law

Acknowledgements I would like to thank Professor Flynn, one of my thesis readers, for assisting me in developing and completing this project. His guidance and unrelenting advice helped make this possible. I would like to express my appreciation and gratitude to Professor Massoud, also one of my thesis readers, for introducing me to the accounting field. Thank you for guiding and supporting me throughout all of my endeavors. Your passion inspires all of us. Abstract This thesis explores if fraud or mismanagement in municipal governments can be diagnosed or detected in advance of their bankruptcies by financial statement analysis using Benford's Law. Benford's Law essentially states that the distribution of first digits from real world observations would not be uniform, but instead follow a trend where numbers with lower first digits (1, 2…) occur more frequently than those with higher first digits (…8,9). If a data set does not follow Benford's distribution, it is likely that the data has been manipulated. This widespread phenomenon has been used as a tool to detect anomalies in data sets. The annual financial statements of Jefferson County, Vallejo City, and Orange County were analyzed. All the data sets showed overall nonconformity to Benford's Law and therefore indicated that there was the possibility of fraud occurring. I find that Benford's Law, had it been applied in real time to those financial statements, would have been able to detect that something was amiss. That would have been very useful because each of those jurisdictions subsequently went bankrupt. This paper demonstrates that Benford's Law may in some cases be useful as an early indicator to detect the possibility of fraud in municipal governments' financial data.