Corporate fraud: Every good boy deserves fudged profits

JIALAN WANG has a fascinating post up (via Kevin Drum, via Tyler Cowen) on apparent telltale mathematical evidence that corporate accounting fraud is a gradual upward trend over the past 30 years. The great thing is, she seems to have compiled this evidence in a few hours, by accessing Compustat, plugging all the financial data from 20,000 corporations into her model, and analysing the results. I am in awe of people who can do things like this, in something like the way I am in awe of people who can slam-dunk a basketball. Her analysis relies on Benford's Law, which establishes probabilistic relationships between the frequency with which the nine natural numbers occur as the first digit in measurements of natural phenomena. (The number 1 occurs most frequently, the number 9 least frequently.)

Benford's law has been used in legal cases to detect corporate fraud, because deviations from the law can indicate that a company's books have been manipulated. Naturally, I was keen to see whether it applies to the large public firms that we commonly study in finance...

So according to Benford's law, accounting statements are getting less and less representative of what's really going on inside of companies. The major reform that was passed after Enron and other major accounting standards barely made a dent.

Next, I looked at Benford's law for three industries: finance, information technology, and manufacturing. The finance industry showed a huge surge in the deviation from Benford's from 1981-82, coincident with two major deregulatory acts that sparked the beginnings of that other big mortgage debacle, the Savings and Loan Crisis. The deviation from Benford's in the finance industry reached a peak in 1988 and then decreased starting in 1993 at the tail end of the S&L fraud wave, not matching its 1988 level until...2008.

So that's nice to know. Now, here's what I'm interested in: when I was living in Vietnam, everybody knew that major companies, especially public ones, kept at least two sets of books, a secret one full of real numbers so the people who ran the company would know what was going on, and a public one full of pleasant fantasies for the foreign chumps who wanted to buy the stock. (It's the next China! Get in now!) My question is, do American companies do this too? Do they generally have a separate set of numbers somewhere that shows their own executives what's really going on? Is there a Benford's Law-conformant ledger of raw accurate information somewhere deep inside their servers that can generate top-secret reports for company officers, so they can be conscious of the company's actual mediocre performance? Or do they force their own executives to use the same, possibly deluded, investor-friendly numbers they present in the quarterly filings? Are the executives drinking the Compustat Kool-Aid? It wouldn't surprise me if, in America, with our superior commitment to openness and transparency, people had generally learned that the only way to lie successfully is to actually convince yourself of the falsehoods you're peddling. But I wonder. Anybody have any insight on this?

Update: Free exchange had it before we did.

Source: http://www.economist.com/blogs/democracyinamerica/2011/10/corporate-fraud?fsrc=scn/tw/te/bl/everygoodboydeserves