Is conditional conservatism a source of deviations of financial statements from Benford’s Law?

Purpose – In this paper, we examine the association between conditional conservatism and deviations of the first digits of financial statement items from what are expected by Benford’s Law.
Design/methodology/approach – This research uses data of companies listed on the London Stock Exchange. We measure deviations of first digits from Benford’s Law following Amiram et al. (2015) and firm-year conditional conservatism following previous studies (Basu, 1997; Khan and Watts, 2009; García Lara et al., 2016). We use multiple regressions to provide evidence for our hypothesis.
Findings - The results show that conditional conservatism is positively associated with deviations from Benford’s Law. The findings are robust across different measures of deviations and conditional conservatism. Also, we find that the relationship between deviations from Benford’s Law and conditional conservatism is more pronounced for firms with debt issuance, and for leveraged firms facing financial distress. Next, our analyses confirm previous evidence by showing that the first digits of financial statement items of UK listed companies conform to Benford’s Law at the firm-specific level and the market level, and deviations of income statements are larger than those of balance sheets and cash flow statements.
Research limitations/implications – The research makes significant contributions to the literature. First, this is the first study that provides empirical evidence suggesting conditional conservatism may be a source of deviations from Benford Law. Second, we provide evidence confirming previous US findings (e.g., Amiram et al., 2015) showing that the distributions of first digits of financial statement items of UK listed companies also conform to Benford’s Law.
Practical implications – Our findings have implications for auditors. Auditors should be aware of “false positive” for material misstatements when using Benford’s Law as a risk assessment procedure. While both conditional conservatism and earnings management are related to deviations from Benford’s Law, conservatism-related biases could indicate less audit risks.
Originality/value – We provide new and original evidence suggesting that conditional conservatism is related to deviations from Benford’s Law.

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