Applying Digital Analysis Using Benford's Law to Detect Fraud: The Dangers of Type I Errors

At first glance the application of digital analysis using Benford's Law holds great promise as a fraud detection process. However, a closer look at the underlying statistical assumptions reveals that auditors seeking to use Benford's Law must be aware of the costs of the potential Type I errors that can occur during the analysis stage. For example, statistical considerations indicate that there is a far greater chance of making a Type I error if the Benford's Law analysis is completed on a “digit-by-digit” basis, as compared to the “test-by-test” basis typically employed by statisticians. In this paper, we explain the merits of each choice in terms of statistical concepts and practical audit process considerations.