Data Mining Techniques: A Key forDetection of Financial Statement Fraud
Rajan Gupta
Research Scholar, Dept. of Computer Sc. &Applications, Maharshi Dayanand University,Rohtak (Haryana) – India. Email:raajangupta@gmail.com
Nasib Singh Gill
Head, Dept. of Computer Sc. & Applications,Maharshi Dayanand University, Rohtak (Haryana),India. Email:nasibsgill@gmail.com
Abstract
In recent times, most of the news from business worldis dominated by financial statement fraud. A financialstatement becomes fraudulent if it has some falseinformation incorporated by the managementintentionally. This paper implements data miningtechniques such as CART, Naïve Bayesian classifier,Genetic Programming to identify companies thoseissue fraudulent financial statements. Each of thesetechniques is applied on a dataset from 114companies. CART outperforms all other techniquesin detection of fraud.
1.
Introduction
Financial statement fraud is a serious social andeconomic problem worldwide and more severe ingrowing countries. A company listed with anystock exchange is required to publish its financialstatements such as balance sheet, income statement,statements of retained earnings and cash flowstatements yearly and quarterly. Financialstatements of a company reflects its actual financialhealth by analysing which, stockholders can form awise decision about investing in the company. Anintentional distortion of information in the financialstatement is termed as financial statement fraud.Conventionally, auditors are responsible foridentification and detection of fraudulent financialstatement. Although, auditors are supposed toprovide information weather the statement isaccording to GAAP or not. With an increase innumber of high profile fraud cases, auditors areoverburdened with an additional duty of detectionof fraud. Hence, various techniques of data miningare being used to ease out this extra pressure fromthe mind of the auditors.Some of the world’s major fraud cases includeEnron, WorldCom, Satyam and many more. Anumber of Chinese companies listed on US stock exchanges have faced accusations of accountingfraud, and in June 2011, the U.S. Securities andExchange Commission warned investors againstinvesting with Chinese firms listing via reversemergers. While over 20 US listed Chinesecompanies have been de-listed or halted in 2011, anumber of others have been hit by the resignationof their auditors. Warnings of fraud in US listedChinese companies have grown in recent months.In January 2011, the shares of China ForestryHoldings were suspended after the auditor KPMGinformed the board of directors of possibleirregularities in its accounting books. On 11 April,2011 the SEC suspended trading in RINOInternational due to questions surrounding theaccuracy and completeness of informationcontained in RINO’s public filings, and thecompany’s failure to report the resignation of itschairman, directors of the board and an outsidelawyer and forensic accountants brought in toinvestigate allegations of fraud. The finger waspointed at Sino-Forest Corporation, a Toronto-listed forestry firm, on 2 June, 2011, after a short-seller accused the firm of inflating its assets. Morerecently, the unravelling of Longtop FinancialTechnologies Ltd highlighted the scale of theproblem. The company regularly reported incomethat was slightly higher than executives’predictions [1].
1
The "cash balance" on Longtop'sbalance sheet was fake--a fiction created by thecompany's managers with bank complicity [2].
2
Data Mining is an iterative process within whichprogress is defined by discovery of knowledge.Data Mining is most useful in an exploratoryanalysis scenario in which there are nopredetermined notions about what will constitute an“interesting” outcome [3].
3
The application of DataMining techniques for detection and identificationof financial statement fraud is a fertile researcharea. Several law enforcement agencies and specialinvestigative units have used data miningtechniques successfully for detection of financialfraudsIn this study, we analyse the financial statements of various organisations for detection of financialstatement fraud by using data mining techniques.This research aims at identifying the financialratios / items from financial statements in order tohelp auditors in assessing the probability of financial fraud. In this study, data miningtechniques namely CART, Naive BayesianClassifier and Genetic Programming are tested fortheir applicability in detection of fraudulent
(IJCSIS) International Journal of Computer Science and Information Security,Vol. 10, No. 3, March 201249http://sites.google.com/site/ijcsis/ISSN 1947-5500
financial statements and differentiating betweenfraud and non fraud reporting. The dataset consistsof financial ratios obtained from publicly availablefinancial statements.The paper is organised as follows: Section 2discusses the relevant prior research followed bysection 3 which describes the various tricksadopted by management for falsifying financialstatements. Section 4 reveals the key variables andfinancial ratios related to detection of financialstatement fraud. Section 5 provides an insight in tothe data mining techniques used in this study.Section 6 analyses the results followed byconcluding remarks (Section 7).
2.
Related Work
An overview of the academic literature concerningdetection of financial statement fraud is given here.Number of studies such as PwC [4]
4
, and ACFE[5]
5
tells the story about detection of fraud.Findings of these studies suggest that many anumber of times fraud has been detected by chancemeans or accident. For example reports of PwC [4]revels that 41% of the fraud cases were detected bymeans of tip – offs or by chance.Several groups of researchers have devoted asignificant amount of effort in studying the use of data mining techniques in detection of financialstatements fraud from different perspectives.Beasley [6]
6
used Logit regression to test theprediction that the inclusion of larger proportionsof outside members on the board of directorssignificantly reduces the likelihood of financialstatement fraud with a sample of 150 Americanfirms. They found that non-fraud firms have boardswith significantly higher percentages of outsidemembers than fraud firms. Green and Choi [7]
7
presented a neural network fraud classificationmodel employing endogenous financial data. Aclassification model created from the learnedbehavior pattern is then applied to a test sample.Fanning and Cogger
8
[8] also used an artificialneural network to predict management fraud. Usingpublicly available predictors of fraudulent financialstatements, they found a model of eight variableswith a high probability of detection. Kirkos
9
[9],carry out an in-depth examination of publiclyavailable data from the financial statements of various firms in order to detect FFS by using DataMining classification methods. In this study, threeData Mining techniques namely Decision Trees,Neural Networks and Bayesian Belief Networks aretested for their applicability in management frauddetection. Spathis et al
10
[10] compared multi-criteria decision aids with statistical techniquessuch as logit and discriminant analysis in detectingfraudulent financial statements. Cecchini et al [11]
11
developed a novel financial kernel using supportvector machines for detection of managementfraud. An innovative fraud detection mechanism isdeveloped by Huang et al.[12]
12
on the basis of Zipf’s Law. This technique reduces the burden of auditors in reviewing the overwhelming volumes of datasets and assists them in identification of anypotential fraud records. Hoogs et al[13]
13
presentsa genetic algorithm approach to detecting financialstatement fraud. Cerullo and Cerullo [14]
14
explained the nature of fraud and financialstatement fraud along with the characteristics of NN and their applications. They illustrated how NNpackages could be utilized by various firms topredict the occurrence of fraud. Koskivaara [15]
15
proposed NN based support systems as a possibletool for use in auditing. He demonstrated that themain application areas of NN were detection of material errors, and management fraud. Busta andWeinberg[16]
16
used NN to distinguish between‘normal’ and ‘manipulated’ financial data. Theyexamined the digit distribution of the numbers inthe underlying financial information. Koh andLow[17]
17
construct a decision tree to predict thehidden problems in financial statements byexamining the following six variables: quick assetsto current liabilities, market value of equity to totalassets, total liabilities to total assets, interestpayments to earnings before interest and tax, netincome to total assets, and retained earnings to totalassets. Belinna et al [18]
18
examine theeffectiveness of CART on identification anddetection of financial statement fraud. Theyconcluded by saying that CART is a very effectivetechnique in distinguishing fraudulent financialstatement from non fraudulent. Further, Deshmukhand Talluru [19]
19
demonstrated the construction of a rule-based fuzzy reasoning system to assess therisk of management fraud and proposed an earlywarning system by finding out 15 rules related tothe probability of management fraud. Zhou &Kapoor [20]
20
examine the effectiveness andlimitations of data mining techniques such asregression, decision trees, neural network andBayesian networks. They explore a self – adaptiveframework based on a response surface model withdomain knowledge to detect financial statementfraud. Recently, Ravisankar et al [20]
21
uses datamining techniques such as Multilayer FeedForward Neural Network (MLFF), Support VectorMachines (SVM), Genetic Programming (GP),Group Method of Data Handling (GMDH),Logistic Regression (LR), and Probabilistic NeuralNetwork (PNN) to identify companies that resort tofinancial statement fraud. They found that PNNoutperformed all the techniques without featureselection, and GP and PNN outperformed otherswith feature selection and with marginally equalaccuracies.If we summarize the existing academic research,we arrive at a conclusion that detection of financialstatement fraud is an instance of classification and
(IJCSIS) International Journal of Computer Science and Information Security,Vol. 10, No. 3, March 201250http://sites.google.com/site/ijcsis/ISSN 1947-5500
decision problem. In present research, we apply thesame idea and implements data miningclassification methods for differentiation betweenfraudulent and non fraudulent observations.
3.
Artifice used by top level executives forfraudulent financial reporting:
Financial statements are a company's basicdocuments to reflect its financial status [22].
22
Acomplete and thorough analysis of financialstatements could help investors in judging thefinancial status of a company. Any materialmisstatement in the financial statement has been amajor apprehension to the investors worldwide.The techniques associated with the production of fraudulent financial statement have been discussedin Schilit’s book “Financial Shenanigans” [23].
23
The book reported seven common tricks:(1) Recording revenue before it is earned;(2) Creating fictitious revenue;(3) Boosting profits with non-recurringtransactions;(4) Shifting current expenses to a later period;(5) Failing to record or disclose liabilities;(6) Shifting current income to a later period and(7) Shifting future expenses to an earlier period.The first five tricks aim at boosting current yearearnings, and the last two shift current-yearearnings to the future in order to create an illusionof steady income over years.A number of studies have been conducted forfinding indicators for Fraudulent Financialstatements. One such study conducted by C.Fei inchina found four types of companies which aremore prone to financial scandals [24].
24
(i) Companies with frequent capital operations andrelated-party transactions.(ii) Companies with high- and volatile-stock prices(iii) Initial Public Offering (IPO) companies and(iv) Companies in a declining or over-competitivebusiness environmentManagement of an organisation may falsify thefinancial statement to achieve the following:a.
Good amount of loan sanctioned from abank b.
Paying less dividends to shareholdersc.
Avoid payment of taxes andd.
Inflated stock pricesIn present time there is a steady increase in numberof companies which are falsifying their financialstatements in order to present a rosy picture aboutfinancial status to the stockholder and makingselfish gain. Hence, detection of such fraud is anadditional responsibility of auditors and is the needof the hour.
4.
Key financial items / ratios relevant tothe detection of fraud:
The values and numbers present in financialstatements can be easily interpreted with the help of different financial ratios. Financial ratio assistsinvestors / auditors in evaluating the actual positionof the company. On the basis of existing academicresearch and expert’s knowledge, we identify thefollowing financial variables / ratios (Table 1).
(a)
Z-score:
Financial distress may be amotivation for management fraud [8]. Tomeasure the financial distress Z-score isdeveloped by Altman [25]
25
. It is aformula for estimating the financial statusof a company and also helpful inbankruptcy prediction. The formula for Z-score for public companies is given by:Z-score= (Working capital / Total assets* 1.2) +(Retained earnings ÷Total assets* 1.4)+ (Earningsbefore income tax ÷Total assets* 3.3)+(Book valueof total / Liabilities * 0.6) + (Sales ÷Total assets*0.999)
(b)
A high debt structure
may be anindicator for fraudulent financialreporting, because it shifts the risk frommangers to debt owners. Hence we canstate that higher levels of debt mayincrease the likelihood of financialstatement fraud and one should carefullyconsider the financial ratios related to debtstructure.
(c)
Continues growth:
The need forcontinues growth may be anothermotivational factor for financial statementfraud [26].
26
So, sales to growth ratioshould be measured as a fraudulentfinancial statement indicator.Sales to growth =(Current Year's sales - LastYear's sales) / (Last Year's sales)
(d)
Other items:
A company may manipulateaccounts receivable, inventories and grossmargin. Accounts receivable may bemanipulated by recording sales beforethey are earned. Inventory is also prone tomanipulation. Mangers may manipulateinventory either by reporting inventory atlower cost or by obsolete inventory orboth. A company may use gross marginas a factor for falsifying financialstatement. The company may not match itssales with the corresponding cost of goodssold, thus increasing gross margin, netincome and strengthening the balancesheet [8].
(e)
Other qualitative variables: Qualitative
variables such as qualification or thecomposition of the administrative board of a company, previous auditors, highturnover of CEO and CFO, size and age of a company could prove helpful insearching for indicators of cooked books.
(IJCSIS) International Journal of Computer Science and Information Security,Vol. 10, No. 3, March 201251http://sites.google.com/site/ijcsis/ISSN 1947-5500
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Data Mining Techniques: A Key for detection of Financial Statement Fraud
In recent times, most of the news from business world is dominated by financial statement fraud. A financial statement becomes fraudulent if it has some false information incorporated by the management intentionally. This paper implements data…
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