Frank Benford was a physicist in General Electric’s Research Laboratory almost a century ago. In that era, data sets were typed or written out by hand. One day, as he was looking through pages and pages filled with numbers, he noticed a fascinating pattern that was consistent across all his voluminous ledgers of work.
First, some background. The leading digit of any number is the first digit on the left other than zero. For instance, in the number 8675309, the leading digit is 8. In the number 42, the leading digit is 4. There are nine possible leading digits: the numbers 1 through 9 (remember, 0 is excluded). Thus people reasonably assume that if you have a page filled with numbers, all of the nine possible leading digits should occur equally, each one showing up about 11% of the time. However, Benford noticed that in every large list of numbers, the number 1 is by far the most common leading digit you’ll see. What Benford discovered, and has been confirmed to be correct, is that about 30% of all the numbers in any large dataset will have 1 as its leading digit. The number 2 will be the leading digit about 17% of the time, number 3 about 12% of the time, and so forth, with each successive number being less common until you get to the number 9. The number 9 is by far the least common leading digit you’ll encounter, appearing less than 5% of the time.
In 1938, Benford published the “Law of Anomalous Numbers.” We now call this “Benford’s Law.” It’s a distribution pattern of leading digits that you expect to see in every large data set of numbers that hasn’t been manipulated by a human hand. That’s why Benford’s Law is such an exceptional tool in rooting out fraud.
Today, forensic accountants scan in in the tax returns, financial statements, and other transactional data of a business – basically pages with lots of numbers on them – then a computer checks to see whether the leading digits of all those numbers are consistent with the pattern of Benford’s Law. If these “naturally occurring” numbers haven’t been manipulated or fabricated, they will normally fit the pattern. If they don’t, then it’s reasonable to suspect that something fishy may be going on and thus a deeper investigation is warranted.
In their recent paper, “Abiding by the Law? Using Benford’s Law to Examine the Accuracy of Nonprofit Financial Reports,” academic researchers Heng Qu, Richard Steinberg, and Ronelle Burger published their findings of the first application of Benford’s Law to the tax returns and financial statements of an enormous sampling of charities to see if any trends are apparent.
The good news is that the financial statements of the non-profit field as a whole conform with Benford’s Law. In other words, as a group, the numbers of the whole universe of charities do not raise any suspicion. The bad news is that as you look at specific subsets of the data, your eyebrow begins to raise. “We find close conformity with Benford’s Law for the whole sample, but at the individual organization level, 34% of organizations do not conform,” write the researchers.
What immediately jumps out at you when looking at the research is that charitable work benefits from the involvement of paid professionals. Charities with a paid, professional staff have financial statements that are far more likely to conform with Benford’s Law than those who operate only with volunteers. “Organizations with paid directors/officers are significantly more conformant by all tests,” conclude the researchers. Further, volunteer-run organizations that pay professional accountants to audit their statements are also far more likely to conform with Benford’s Law. For charities that deal with significant amounts of money, it behooves them to hire a professional staff person, or pay an outside accountant, to ensure that funds are being properly handled and protected.
The other significant conclusion that can be drawn is that charities need to be held accountable by an entity that knows how to evaluate their work. The researchers write, “Organizations that receive government grants and those receiving indirect support [such as grants from a community foundation] are significantly more conformant by all tests than those that do not receive these funds.” Everyone performs better when we are accountable to someone for our performance. Charities that receive support from government agencies and grant-making foundations, and are thus held accountable by them, are far less likely to have non-conforming financial statements that might raise suspicion.
This column by Bret Bicoy originally appeared in the Peninsula Pulse on March 5, 2021.
Bicoy Philanthropic Advisors 