Making Money the Old Fashioned Way, By Cooking the Books

Via Tyler Cowen, here’s a fascinating bit of research from Jialan Wang based on Benford’s Law. Benford’s Law tells us about the distribution of digits in many kinds of tabular data, including financial data. The digit 1 shows up 30.1% of the time, 2 shows up 17.6% of the time, all the way to 9, which shows up 4.6% of the time. If you examine some financial data, and the digits show up in the wrong proportions, it probably means the books have been cooked.

Well, guess what? Back in 1960 corporate reports followed Benford’s Law almost precisely. Today? Not so much. The chart below shows deviations over time for three different industries. Finance took a big leap in 1980, when the S&L scandal was taking off, and then leveled out. IT and manufacturing took smaller jumps in the early 80s, bigger jumps during the dotcom era, and then leveled out at about the same rate as finance. But all three industries, and the business community as a whole, have deviations at much higher levels today than they did in 1960.

What does this mean? Possibly nothing. Maybe there’s a plausible explanation. But what it probably means is that large corporations routinely fudge their figures far more than they used to. Wang puts it like this:

While these time series don’t prove anything decisively, deviations from Benford’s law are compellingly correlated with known financial crises, bubbles, and fraud waves. And overall, the picture looks grim. Accounting data seem to be less and less related to the natural data-generating process that governs everything from rivers to molecules to cities. Since these data form the basis of most of our research in finance, Benford’s law casts serious doubt on the reliability of our results. And it’s just one more reason for investors to beware.

I’m not surprised. But it would be interesting to do a similar study on European corporations to see if the same trend is evident. Is systematic book cooking mainly a Wall Street phenomenon, or has the entire world’s business community been getting less honest over time?

$500,000 MATCHING GIFT

In 2014, before Donald Trump announced his run for president, we knew we had to do something different to address the fundamental challenge facing journalism: how hard-hitting reporting that can hold the powerful accountable can survive as the bottom falls out of the news business.

Being a nonprofit, we started planning The Moment for Mother Jones: A special campaign to raise $25 million for key investments to make Mother Jones the strongest watchdog it can be. Five years later, readers have stepped up and contributed an astonishing $23 million in gifts and future pledges. This is an incredible statement from the Mother Jones community in the face of the huge threats—both economic and political—against the free press.

Read more about The Moment and see what we've been able to accomplish thanks to readers' incredible generosity so far, and please join them today. Your gift will be matched dollar for dollar, up to $500,000 total, during this critical moment for journalism.

We Recommend

Latest

Sign up for our newsletters

Subscribe and we'll send Mother Jones straight to your inbox.

Get our award-winning magazine

Save big on a full year of investigations, ideas, and insights.

Subscribe

Support our journalism

Help Mother Jones' reporters dig deep with a tax-deductible donation.

Donate

We have a new comment system! We are now using Coral, from Vox Media, for comments on all new articles. We'd love your feedback.