Using Benford's Law for Fraud Detection and AuditingDon Sparks, CIA, CISA, CRMA, ARMAudimation Services Inc.
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Session Objectives
• How to apply Benford’s law analysis to find outliers in processes suchas payroll, cash disbursement and p-cards, county records, quarterlyfinancials, Insurance claims, etc.
• The types of data that do and do not conform to Benford’s Law• A practical guide to apply Benford’s tests using IDEA software (1st
digit, 2nd digit testing, advanced analytics – fuzzy logic, etc.)
In this session, you will learn the theory behind the law and how it can be used to find potential fraud and errors to help turn your internal audit or fraud investigation into a revenue generating center. Also, there will be a discussion on:
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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About Don Sparks, CIA, CISA, CRMA, ARM • Vice President Industry Relations - Audimation
Services, Inc.• CAE Property/casualty insurance internal audit• Risk Services firms: PwC & RSM• The IIA – eLearning: GAIN, Flash Surveys, &
Monthly web tv broadcasts on Audit & SOX• NAIC IT Working Papers Committee• Co-Author of GTAG 13 & GTAG 16• Creator & Programmer Auditchannel.tv
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Exhibit Benford’s Law with Population Data
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Auditors Share the Same Life CycleTasks must be Standardizedto move forward and buildKnowledge
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Data Miners Share the Same CRISP-DM Cycle
CRoss-Industry Standard Process for Data Mining
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Fraud Auditors Share The Same Anti-Fraud Process
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Auditors Share the Same Standards (The IIA IPPF)
• Achievement of the organization’s strategic objectives; • Reliability and integrity of financial and operational information; • Effectiveness and efficiency of operations and programs; • Safeguarding of assets; and • Compliance with laws, regulations, policies, procedures, and contracts.
2120.A1 – The IA activity must evaluate risk exposures relating to the organization’s governance, operations, and information systems regarding the following:
2120.A2 – The IA activity must evaluate the potential for the occurrence of fraud and how the organization manages fraud risk.
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Auditors Share the Same Risk FactorsAccording to the IIA practice advisory: Linking the Audit Plan to Risk and Exposures, suggests the following risk factors, among others, should be considered:
• Dollar materiality• Asset liquidity• Quality of internal controls• Degree of change or stability• Complexity• Managements competence
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Do Patterns in Data Mean Anything?
Statistics students are asked to perform a simple task. Create a matrix of heads and tails by recording the results of 200 coin flips. The professor reviews the results and easily identifies the students that just made up the results without flipping a coin. How did he know?
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Inventors and Innovators• Simon Newcomb – 1881• Frank Benford – 1938• Roger Pinkham – 1961• Mark Nigrini – 1992
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Why Benford’s Law?Most naturally occurring data sets follow a strange rule called Benford'sLaw. This rule allows you to predict how often each number 1 through 9 will appear as the first non-zero digit in the data set.
Benford's Law can be used to analyze large financial data sets and identify red flags. If the data doesn't look anything like the distribution predicted by Benford's Law, it may mean the numbers have been manipulated.
Places to use Benford’s Law are plentiful in organizations such as currency amounts, time durations, scientific and survey results, PIN numbers, surface areas, and numerical quantities.
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Benford’s Law DefinedOn the right, you can see the number 1 occurs as the leading digit 30.1% of the time, while larger numbers occur in the first digit less frequently.
For example, the number 3879• 3 - first digit• 8 - second digit• 7 - third digit• 9 – fourth digit
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Expected Frequencies Based on Benford’s Law Digit 1
stPlace 2
ndPlace 3
rdPlace 4
thPlace
0 0.11968 0.10178 0.10018
1 0.30103 0.11389 0.10138 0.10014
2 0.17609 0.19882 0.10097 0.1001
3 0.12494 0.10433 0.10057 0.10006
4 0.09691 0.10031 0.10018 0.10002
5 0.07918 0.09668 0.09979 0.09998
6 0.06695 0.09337 0.0994 0.09994
7 0.05799 0.0935 0.09902 0.0999
8 0.05115 0.08757 0.09864 0.09986
9 0.04576 0.085 0.09827 0.09982
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Scientific Methods vs. Data AnalyticsScientific Testing•Benford’s Law •Trend Analysis •Time Series Analysis •Correlation •Z-Score •Relative Size Factor •Same-Same-Same •Same-Same-Different •GEL
Operational Analytics•Extract•Statistics•Sort•Gaps•Duplicates•Aging Samples•Summarize•Stratify• Join (Match)• Compare
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Good Places to Use Benford’s Law
• When used correctly, it can be a powerful tool for identifying suspect accounts or amounts for further analysis.
• Easy to use and best of all not well known by fraudsters!• A tool to complement additional tests/tools. • Users have to gain expertise in interpreting results.
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Types of Data That ConformAccounts Payable (number sold * price)
Estimations in General Ledger Test of approval violations under $2,500
Accounts Receivable (number bought*price)
Inventories at many locations Purchase orders
Disbursements Computer System data file conversions
Loan data
Sales Processing inefficiencies due to high quantity
Customer balances
T&E Expenses New Combinations of selling prices
Stock prices
Most sets of Accounting Numbers with
Customer refunds Journal entries
Full year of transactions Credit card transactions
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Non-Conforming Data TypesSituation Examples
Data set comprised of assigned numbers Checks, invoices, zip codes, telephone, insurance policy YYMM####
Numbers influenced by human thought Prices set at psychological thresholds ($1.99, ATM withdrawals
Accounts with a large number of firm-specific numbers
An account specifically set up to record $100 refunds
Accounts with a built in minimum or maximum Assets must meet a threshold before recorded
Airline passenger counts per plane Data sets with 500 or fewer transactions
Where no transaction is recorded Theft, kickback, skimming, contract rigging
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Simple Facts
• The number 1 predominates most progressions. • Probabilities are scale invariant – works with numbers denominated as
dollars, yen, euros, pesos, rubels, etc.• Not all data sets are suitable for analysis.• Not good for sampling – results in large selection sizes.• Good low cost entry into using continuous auditing/monitoring.• You need to run Benford’s Law on the same data set at regular
intervals.
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Areas of Concern About Using Benford’s LawAnalysis tools like Benford’s Law enable auditors and other data analysts to focus on possible anomalies in large data sets. They do not prove that error or fraud exist, but identify items that deserve further study on statistical grounds. The analysis complements existing analytical tools and techniques, and should not be used in isolation from them.•Not necessarily fraud – many False positives•Certain types of fraud will not be detected•Useful tool, setting future auditing plans•Low Cost Entry into Digital continuous analysis
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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What’s in Your Audit Toolbox?
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Exhibit Benford’s Law Used in Financial Areas
• A video from the internet of Benford’s law applied to 10 Years of Apple Inc Financials
• Video with Equity Funding Fraud• Demo of data with Equity Funding Fraud• Demo of 500,000 records in a P- Card data set• $860,000 Accounts Payable Fraud
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Uses in Fraud Investigations• First and Second Digit Analysis *• First Two Digits Analysis*• First Three Digits Analysis**• Last Two Digits Analysis**• Summation Test**• Advanced Settings – Fuzzy Logic Setting #• Rounded By Analysis #• Duplication Analysis #* =Primary **=Advanced #=Associated
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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See Red Flags – Less Costly, Better and Faster
• Technology is getting better all the time• The need to find fraud faster to improve recovery• Risk based audit planning• Early warning sign past data patterns have changed• Fraud Deterrence – fraudsters may not understand the theory but
know audit is always looking • Identify Duplicates, Whole Numbers, Recurring Expenses, other
data pattern anomalies• Great analytic when coupled with high dollar and stratified random
sample techniques
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Where Can Benford’s Be Used –LIBOR Case?Feb. 26, 2013 – Discovery of banks’ efforts to manipulate the London Interbank Offered Rate (LIBOR) owes a lot to statistical techniques that provide first indications of wrongdoing.
If regulators (and auditors) want to uncover more misdeeds in the markets, they’ll have to use statistical screening tools more actively than they do today.
Extending the analysis over a 30 year period revealed Libor submissions followed Benford’s closely for about 20 years, but began to diverge sharply in the mid-2000’s.
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Where Can Benford’s Be Used - Lottery?
No. The outcome of the lottery is truly random. This means every lottery number has an equal chance of occurring.
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Tips for Successful Data Analytics Integration
•Start with a high-priority, high-return project•Focus on efficiency and effectiveness
•Communicate•Be brief; be thorough; be gone
•Exercise patience•Call the Integration Help Desk
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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Questions? Don Sparks832-327-1877
Using Benford's Law for Fraud Detection and Auditing Presented by Don Sparks, Audimation Services 02/09/2016
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