The ‘Number One Method’ of Finding Audit Targets :CRA SOTW
Alan Baggett
Thinking about tricking the tax man? Beware the long arm of Benford’s
Law
Revenue agency uses first-digit rule to track cheaters
By Glen McGregor, The Ottawa CitizenApril 30, 2009
Ottawa • Canadians tempted to get creative with their income-tax
returns might want to familiarize themselves with the work of Frank
Benford before the Thursday night tax-filing deadline.
The Canada Revenue Agency is using a little-known statistical
phenomenon named after by the late American physicist to help identify
which tax returns to examine more closely.
Benford’s Law holds that in a series of naturally occurring numbers,
the number one will appear as the first digit more often than other
numbers. Whether the figures are street addresses, expense reports or
tax deductions, the “loneliest number” leads off about 30 per cent of
the time.
The number two occurs as the leading digit substantially less often,
in about 18 per cent of real-life numbers. Figures starting with a
nine account for only five per cent of a typical data set.
A bank statement, for example, should contain far more entries for
numbers like $1.70, $10.55 or $1,082 than those beginning with larger
numbers, such as $6.50, $800 or $98.60.
The pattern may seem counter-intuitive, but that’s what makes it a
powerful tool for spotting expense-account fudgers and tax cheats.
Someone who fabricates numbers tends to distribute them randomly, with
an equal share of leading digits from one to nine.
When these kinds of numbers are crunched by a computer, sets that
don’t conform to the leading-digit pattern can be easily spotted and
singled-out for closer examination.
Benford, who worked as engineer for General Electric, first tripped
over this phenomenon in 1938, reportedly when he noticed certain
logarithm tables in a textbook were more worn than others.
But only in recent years has the value of the pattern as an auditing
tool been recognized by forensic accountants, in part because faster
and cheaper computers allow first-digit analysis to be performed
easily on large amounts of data.
The CRA says it is now using the first-digit rule in certain
circumstances to combat what it politely calls “non-compliance” in tax
returns.
“Benford’s Law is a useful initial risk-assessment tool, however, it
is never used in reassessments or in support of reassessments, which
are done based on facts and tax law,” said spokesman Philippe Brideau.
While the CRA won’t say exactly how it employs Benford’s Law, the
agency has shown interest in using it to analyse corporate tax
returns, says Mark Nigrini, a College of New Jersey professor and the
leading expert on Benford-based tax auditing.
Two years ago, Nigrini spoke to the CRA’s research division about his
research and encouraged them to put the simple but effective technique
to use in the field. “They need to use all the new tools at their
disposal,” he says. “It should be one of your tests, of many.”
Benford’s Law is most effective at determining what sort of tax
information is more prone to errors or fraud and how to deploy
auditors.
Nigrini says analysis of U.S. tax returns shows deductions for
mortgage payments tend to follow Benford’s Law closely, but claims for
charitable contributions tend to be “very messy” when sorted by their
leading digits.
“When people invent fraudulent numbers, they tend to avoid numbers
that two of the same digit following each other — for example 155 or
773,” says Nigrini, who helps Ottawa-based CaseWare IDEA develops
statistics software based in part on Benford’s Law.
“Data-driven forensic methods are the second-best strategy,” he says,
next to preventing tax evasion by thorough reporting of tax
information by third parties, such as employers and banks.
Benford’s Law could be particularly useful as more Canadians file
their tax returns electronically, without having to submit paper
receipts to back up claims for child-care expenses, political
donations and charitable contributions, among others.
While Benford’s Law can’t prove fraud in any one tax return, it can
help choose which to examine more closely.
Nigrini says that auditors with the U.S. Internal Revenue Service aim
to recover $1,000 in unpaid taxes for every hour spent auditing. That
means they must identify returns that are the most likely to contain
fraud or errors and also yield large recoveries. Most large tax
collection services use special algorithms to identify which returns
to target, based on past patterns.
However, adding Benford to the mix would improve the efficiency of the
process, Nigrini says.
© Copyright (c) The Ottawa Citizen
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