Digital analysis and the reduction of auditor litigation risk;

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Digital Analysis and the Reduction of Auditor Litigation Risk
Mark Nigrini
Saint Mary's University, Halifax
INTRODUCTION
Digital analysis is an audit technology that has recently been introduced to the auditing community. The tests are based on mathematical principles first published in 1881. However, it is only due to recent tax evasion and auditing research, and the decline in the cost of computing, that the techniques have become viable from a cost/benefit perspective. This paper discusses the potential of digital analysis to reduce the litigation risk of auditing.
The basis of digital analysis is that, in the absence of certain types of fraud and other irregularities, the digital frequencies of client financial data should conform to Benford's Law. Since Benford's Law is expected to govern the digital frequencies, the literature is reviewed so that users can assess the feasibility of this assertion. The chronological review concentrates on the factors relevant to an audit application. The objective is to demonstrate that the expected frequencies of Benford's Law do form a valid a priori distribution.
Extracts from the literature on auditor litigation are reviewed. Joint and several liability makes litigation potentially very expensive. A principal defense is non-negligent performance or, stated differently, that the audit was conducted in accordance with generally accepted auditing standards. The responsibility of the auditor to detect errors and irregularities is however still open to differing interpretations.
The conclusion discusses the viability of digital analysis as a litigation reduction risk tool. If used correctly, digital analysis has characteristics that would work favorably for auditors in a litigation situation. A major advantage is that it removes some subjectivity from the decision as to whether client data appears to be reasonable.
BENFORD'S LAW
Newcomb (1881) notes that the first pages of books of logarithm tables appear to be more worn than the later pages. Since people used these books like dictionaries, it seemed that the first pages were used more than the later pages. The first pages coincide with numbers with low first digits. Newcomb, an astronomer, suggested that the first few pages were worn because people had to look up the logarithms of numbers with low first digits more often than the logarithms of numbers with high first digits. The modern equivalent would be observing that the keys of the low digits on a computer or calculator were more worn than the keys of the higher digits. Without much explanation, Newcomb presented the probability of the occurrence of digits in lists of natural numbers. He stated that the usefulness of the discovery was that if someone were presented with a list of digit strings, they could conclude whether the list was the logarithms of numbers, or the numbers themselves.
Copyright, 1996, Mark J. Nigrini. All rights reserved. No part of this manuscript may be reproduced, in any form or by any means, without permission in writing from Mark J. Nigrini.
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