# Detection of fraudulent financial statements using the hybrid data mining approach

- Suduan Chen
^{1}Email author

**Received: **31 August 2015

**Accepted: **12 January 2016

**Published: **27 January 2016

## Abstract

The purpose of this study is to construct a valid and rigorous fraudulent financial statement detection model. The research objects are companies which experienced both fraudulent and non-fraudulent financial statements between the years 2002 and 2013. In the first stage, two decision tree algorithms, including the classification and regression trees (CART) and the Chi squared automatic interaction detector (CHAID) are applied in the selection of major variables. The second stage combines CART, CHAID, Bayesian belief network, support vector machine and artificial neural network in order to construct fraudulent financial statement detection models. According to the results, the detection performance of the CHAID–CART model is the most effective, with an overall accuracy of 87.97 % (the FFS detection accuracy is 92.69 %).

### Keywords

Fraudulent financial statements Decision tree CART Decision tree CHAID Bayesian belief network Support vector machine Artificial neural network## Background

Financial statements are a company’s basic documents that reflect its financial status (Beaver 1966; Ravisankar et al. 2011). The financial statement is the main basis for decision -making on the part of a vast number of investors, creditors and other persons in need of accounting information, as well as a concrete expression of business performance, financial status and the social responsibility of listed companies and OTC companies. However, in recent years, cases of fraudulent financial statements have become increasingly serious (Wells 1997; Spathis et al. 2002; Kirkos et al. 2007; Yeh et al. 2010; Humpherys et al. 2011; Kamarudin et al. 2012). Since the Asian Financial Crisis in 1997, there have been many cases of fraudulent financial statements in Taiwan and the United States. Examples include the Enron case in 2001, the WorldCom case in 2003 in the United States, and the ABIT Computer, Procomp, Infodisc and Summit Technology cases in 2004 in Taiwan. Given these incidents, it has become important to be able to detect fraudulent behavior prior to its occurrence.

Data mining is a key tool for dealing with complex data analysis and classification. It identifies valuable events that are hidden in large amounts of data for analysis, and summarizes the data in a structured model to provide a reference for decision-making. Data mining has many different functions, such as classification, association, clustering and forecasting (Seifert 2004). The classification function is used most frequently. The classification results can be used as the basis for decision-making and for prediction purposes.

Fraudulent financial statements can be viewed as a typical classification problem (Kirkos et al. 2007). The classification problem involves performing computation using the variable characteristics of some known classification data, in order to obtain classification-related classification rules. Subsequently, the unknown classification data are inputted into the rules in order to obtain the final classification results. Regarding the issue of fraudulent financial statements, much of the past research has proposed the use of the data mining method because of its superiority in terms of forecasting after inputting large amounts of data for machine learning, as well as its accuracy in terms of classification and forecasting, which is far higher than that of conventional regression analysis. For example, artificial neural network (ANN), decision tree (DT), Bayesian belief network (BBN), and support vector machine (SVM) methods have been applied in order to detect fraudulent financial statements.

It is therefore urgent that we establish an effective and accurate fraudulent financial statement detection model, because conventional statistical models experience great disadvantages in detecting fraudulent financial statements due to their relatively high error rate. Some scholars have proposed using data mining techniques in order to judge concerns about business operational continuity and thereby reduce judgment errors. However, prior studies are neither sufficient nor complete. For example, most use only 1–2 statistical methods, without model comparison, Furthermore, most use a one-stage statistical treatment in order to establish the detection model, which is not prudent. The main purpose of this study is to propose a better model to detect potentially fraudulent financial statements, so that the losses incurred by investors and caused by auditors can be reduced. Compared with previous literature, this study adopts: (1) a two-stage statistical treatment; (2) five data mining techniques to create the detection model for comparison of model accuracy; (3) tenfold cross validation which is thought to be prudent and is commonly used in the academic field. In short, this study is not only prudent, but is also innovative and makes significant contributions to the literature. This study selects the major variables by applying the DT techniques of the Chi squared automatic interaction detector (CHAID) and classification and regression trees (CART). Moreover, this study establishes classification models for comparison by combining CART, CHAID, BBN, SVM, and ANN data mining techniques.

## Fraudulent financial statements

### Reviews on fraud

Regarding the processing of financial statements, Enron applied the highly controversial Special Purpose Entities account in order to solve the problem of financing liabilities. However, the company did not have to list its increased financing liabilities in the balance sheet, which is known as off-balance sheet financing in accounting. The US Committee of Sponsoring Organizations of the Treadway Commission (COSO) (Beasley et al. 1999) and SAS No. 99, 2002 defined a fraudulent financial statement as either intentional or reckless conduct based on false information or omissions that results in significantly misleading financial reports. The cost of the prevention of fraudulent financial statements in the United States is estimated to be in the billions of dollars each year (Humpherys et al. 2011). The US Association of Certified Fraud Examiners (ACFE) classifies fraud into six types: (1) providing false financial information; (2) misuse or misappropriation of corporate assets; (3) improper support or loans; (4) improperly acquiring assets or income; (5) improper circumvention of costs or fees; and (6) improper manipulation of financing by executives or board members. The Taiwan Accounting Research and Development Foundation released the Auditing Standards No. 43 communiqué in 2006, in which fraud was defined as the management, control unit or one or more employees deliberately using deception and other methods to acquire improper or illegal benefits. Therefore, it could be concluded that the four elements of fraud are: (1) serious erroneous expressions of the nature of transactions, (2) knowingly violating rules, (3) the victim accepting a misstatement as fact; and (4) damage due to financial losses caused by the above three situations. Misstatement fraud relating to financial statement auditing includes financial report fraud and misappropriation of assets. Financial reporting fraud refers to untrue financial statements which aim to deceive users. The US Security and Exchange Commission (SEC) state that financial statements should “provide a comprehensive overview of the company’s business and financial condition and include audited financial statements”.

Fraudulent financial statements are intentional and illegal acts that result in misleading financial statements or misleading financial disclosure (Beasley 1996; Rezaee 2005; Ravisankar et al. 2011). Stakeholders are adversely affected by misleading financial reports (Elliot and Willingham 1980). Most prior studies use conventional statistical multivariate analysis, notably logistic regression analysis (Beasley 1996; Summers and Sweeney 1998; Bell and Carcello 2000; Spathis et al. 2002; Sharma 2004; Uzun et al. 2004; Chen et al. 2006; Humpherys et al. 2011). Conventional statistical methods require compliance with the limitations of specific hypotheses, for example, the avoidance of collinearity of independent variables and the distribution of data (Chiu et al. 2002). However, according to Chen (2005), regarding variables, empirical financial variables often cannot comply with relevant statistical conditions, such as normal distribution. Therefore, the machine learning method, which requires no statistical hypotheses of data combinations, has emerged and been used by scholars as a classifier. The empirical results suggest that the machine learning method has a positive classification effect.

### Application of data mining in detecting fraudulent financial statements

Most previous research has used the conventional statistical method to make decisions regarding operational continuity. However, this method causes a number of disadvantages in terms of judgment and its error rate is relatively high. In recent years, some studies have applied data mining techniques in order to detect fraudulent financial statements and thereby reduce judgment errors. Studies applying DT techniques to detect fraudulent financial statements include: Hansen et al. (1992), Koh (2004), Kotsiantis et al. (2006), Kirkos et al. (2007), and Salehi and Fard (2013). Studies applying BBN techniques to detect fraudulent financial statements include: Kirkos et al. (2007), and Nguyen et al. (2008). Studies that apply SVM techniques to detect fraudulent financial statements include: Zhou and Kapoor (2011), Shin et al. (2005), Chen et al. (2006), Yeh et al. (2010), Ravisankar et al. (2011), Pai et al. (2011). Studies applying ANN techniques to detect fraudulent financial statements include: Hansen et al. (1992), Coats and Fant (1993), Fanning and Cogger (1998), Koh (2004), Chen et al. (2006), Kirkos et al. (2007), Ravisankar et al. (2011), and Zhou and Kapoor (2011). The judgment accuracy rates of using data mining techniques to detect fraudulent financial statements vary, and the construction of the model is neither complete nor perfect. As stated above, most studies only use 1–2 data mining techniques, without offering model comparison; and most use one-stage statistical treatment to establish the detection model, which is not prudent.

Prior studies point out that using data mining techniques to detect fraudulent financial statements is superior to adopting a conventional regression analysis in terms of accuracy. This study proposes using a two-stage fraudulent financial statement detection model using the DT CART and CHAID algorithms in variable selection in order to identify influential variables. Next, this study applies CART, CHAID, BBN, SVM and ANN in order to construct the fraud detection model and conducts a pairwise comparison of the testing groups of each model in terms of classification accuracy, Type I errors, and Type II errors to identify the model with the optimal accuracy.

## Methods

This study utilizes several data mining techniques: DT, BBN, SVM, and ANN.

### Decision tree

Values (A) is the set of all possible values of attribute A, S_{v} is the subset of values v of attribute A in S. The first item of this equity is the entropy of the original set; and the second item is the expectancy value of S after classification with A. The expected entropy described in the second item is the weighted sum of each subset, and the weighted value is the proportion |S_{v}|/|S| of samples belonging to S_{v} in the original sample S.

The second part is the pruning criteria, which uses error based pruning (EBP) to carry out the appropriate pruning of the DT and thereby improve the classification accuracy rate. EBP is from pessimistic error pruning (PEP), both are proposed by Quinlan. The most important feature of EBP is its ability to make judgments according to the error rate. It computes the error rate of each node and determines the nodes that cause a rise in the error rate of the DT before engaging in appropriate pruning of these nodes to improve the accuracy rate of the DT.

### Bayesian belief network

BBN, first proposed by Pearl (1986), plays an important role in issues of uncertainty and inference, and has been extensively applied in many cases, such as natural resources (Newton et al. 2007), and medical diagnosis and software cost evaluation (Stamelos et al. 2003). Its inference depends on the acquisition of new information. According to the Bayes’ theorem, the probability values of the status of relevant nodes are adjusted. It is a good method for establishing the model and is able to reflect the uncertain factors of reality. The structure of the diagram presents causal relationships and infers final results by the computation of probability. When given new information, BBN is able to regulate probability (Tang et al. 2007). Namely, when the probability value is adjusted, all the relevant nodes on the network can be adjusted according to the conditional probabilities.

### Support vector machine

SVM is a set of artificial intelligent learning methods proposed by Vapnik (1995). It is a machine learning method based on statistical learning theory and SRM (structural risk minimization). It primarily depends on using input training data to find an optimal separating hyperplane that can distinguish two or more types (class) of data through the learning mechanism. It is a supervised learning, predication and classification method for data mining.

### Linear divisibility

*x*

_{ r },

*x*

_{ s }are any support vectors that each classification can meet \(\alpha_{r} ,\,\alpha_{s} > 0,\,y_{r} = - 1,\,y_{s} = 1.\) We acquire the clear hard classifier, as in Eq. (8):

### Linear non-divisibility

*α*,

*β*are Lagrange constants.

### Artificial neural network

In the evolutionary process of neural networks, it is necessary to have a parameter with a training model in order to train the required weight for the forecast variable at the outset, and such parameters are randomly generated. Given this, the parameters used in each training model differ. Finally, the weights of forecast variables generated by the neural network are also different, but the error will meet a minimal value, so the neural network is a deduction acquired through a trial-and-error method, and its purpose is to minimize errors in the model forecast results. For the same data, the weighs trained are not equal, and so the essence of a neural network is to emphasize the training model. Therefore, there will be no judgment formula for the result of the neural network model, rather only the judgment result is obtained.

### Sample and variable selection

#### Data sources

This study investigates Taiwan’s listed and OTC companies who released fraudulent financial statements during the period of 2002–2013. From companies listed in the Securities and Futures Investors Protection Center, and among the major securities criminal prosecution and judgment publications by the Securities and Futures Bureau, from those companies that violated the term of “misrepresented expression of financial statements”, Articles 155 and 157 of the Securities Transaction Act, and No. 43 Bulletin of Auditing Standards, this study selected 44 fraudulent companies. Those companies included one in the building and construction industry, two in the food processing industry, two in the textile and fiber industry, seven in the semiconductor industry, nine in the electronics industry, four in the photoelectric industry, one in the telecommunications industry, six in other electronics industries, two in the steel industry, one in the rubber industry, one in the shipping industry, three in the software services industry, two in the electric-mechanical industry, one in the electric appliance and cable industry, and two in other industries. The financial statements of the financial industry are not comparable to other industries and the financial ratio is different from that of general industries, and thus the financial industry was eliminated.

In order to control numerous external environmental factors such as time, industry, and company size, the matching method can be adopted. Hence, this study adopted the matching sample design concept proposed by Kotsiantis et al. (2006) in order to match one fraudulent company with three normal companies. This study selects normal companies with similar total assets in the same industry in the previous year of the fraudulent financial statements as the matching sample. A total of 176 companies are selected, including 44 fraudulent companies and 132 normal companies who have not engaged in fraudulent behavior.

#### Variable definition

Research variables and definitions

Variables | No. | Variable description | Definition/formula (the year before the year of fraud) |
---|---|---|---|

Financial variables | X 1 | Accounts receivable ratio | Accounts receivable ÷ total assets |

X 2 | Current assets ratio | Current assets ÷ total assets | |

X 3 | Fixed assets ratio | Fixed assets ÷ total assets | |

X 4 | Operating income to total assets | Operating income ÷ total assets | |

X 5 | Net income to total assets | Net income ÷ total assets | |

X 6 | Net income to fixed assets | Net income ÷ fixed assets | |

X 7 | The proportion of cash against total assets | Cash ÷ total assets | |

X 8 | Natural logarithm of total assets | ln total assets | |

X 9 | Natural logarithm of total liabilities | ln total liabilities | |

X 10 | Gross profit ratio | Gross profit ÷ net sales | |

X 11 | Operating expenses ratio | Operating expenses ÷ net sales | |

X 12 | Debt ratio | Total liabilities ÷ total assets | |

X 13 | Current ratio | Current assets ÷ current liabilities | |

X 14 | Quick ratio | Quick assets ÷ current liabilities | |

X 15 | Inventory turnover | Cost of goods sold ÷ average inventory | |

X 16 | Cash flow ratio | Operating cash flow ÷ current liabilities | |

X 17 | Pre-tax profit ratio | Pre-tax profit ÷ net sales | |

X 18 | Accounts receivable turnover | Net sales ÷ average accounts receivable | |

X 19 | Sales growth rate | (Current year’s sales − last year’s sales) ÷ last year’s sales | |

X 20 | Debt-to-equity ratio | Total liabilities ÷ total equity | |

X 21 | Returns on assets before tax, interest, and depreciation | Income before tax, interest and depreciation ÷ average total assets | |

X 22 | The ratio of current liabilities against total assets | Current liabilities ÷ total assets | |

X 23 | Total asset turnover | Net sales ÷ average total assets | |

Non-financial variables | X 24 | The major stockholders’ stockholding ratio | Number of stocks held by the major shareholders ÷ total number of common stocks outstanding |

X 25 | Duality of board director and CEO | If duality of board director and CEO existed, it is set as 1; otherwise, 0 | |

X 26 | Size of the board of directors | Number of directors | |

X 27 | The ratio of pledged stocks held by directors and supervisors | Number of pledged stocks held by directors and supervisors ÷ number of stocks held by directors and supervisors | |

X 28 | The ratio of stocks held by directors and supervisors | Number of stocks held by directors and supervisors ÷ total number of common stocks outstanding | |

X 29 | Audited by BIG4 (the big four CPA firms) | 1 for companies audited by BIG4, otherwise, it is 0 | |

X 30 | Number of outside supervisors | Number of outside supervisors |

#### Research design

## Results and discussion

This study selects 30 variables in order to determine the variables with the greatest impact on fraudulent financial statements. The selected variables are processed in the second stage using BBN, SVM and ANN modeling and classification performance tests.

### Variable selection

Since this study selects relatively more variables, DT is applied in order to identify the important and representative variables. In this study, SPSS Clementine is used as the software for DT variable selection, and CART and CHAID are used for variable selection.

### CART algorithm selection

The CART is a data mining algorithm developed by Breiman et al. (1984). It is a binary segmentation DT technique used for application with continuous or classified non-parameter data. Segmentation condition selection is determined by the data classes and their attributes. Segmentation conditions are determined by Gini rules. Segmentation divides the data into two subsets, and the conditions for the next segmentation are found in the subset.

Selection results of decision tree CART

Variables | Variable importance |
---|---|

X16 (cash flow ratio) | 0.496 |

X02 (current assets ratio) | 0.480 |

X19 (sales growth rate) | 0.016 |

X09 (natural logarithm of total liabilities) | 0.008 |

### CHAID algorithm selection

The CHAID is a method that applies the Chi square test in the computation of the P-values of the broken nodes of the branches and leaves of the DT in order to determine whether or not segmentation should be continued. CHAID can prevent the excessive use of data and allow the DT to stop segmentation. In other words, CHAID is able to complete pruning before the establishment of the model.

Selection results of decision tree CHAID

Variables | Variable importance |
---|---|

X12 (debt ratio) | 0.2347 |

X16 (cash flow ratio) | 0.2181 |

X14 (quick ratio) | 0.2119 |

X02 (current assets ratio) | 0.1337 |

X21 (returns on assets before tax, interest, and depreciation) | 0.1282 |

X11 (operating expenses ratio) | 0.0734 |

### Construction of the models and cross validation

This study applies SPSS Clementine for modeling purposes and uses CART, CHAID, BBN, SVM and ANN in order to construct models and evaluate the classification performance of the variables selected by the two algorithms’ DTs. After normalization of the selected variables, random sampling without repetition is conducted. The rigorous tenfold cross validation is also adopted in this study for testing classification accuracy.

### CART models

Detection accuracy of CART models—tenfold cross validation

Model | FFS (%) | Non-FFS (%) | Overall accuracy (%) |
---|---|---|---|

CART–CART | 88.59 | 77.78 | 83.19 |

CART–CHAID | 81.88 | 79.51 | 80.70 |

CART–BBN | 77.18 | 73.22 | 75.20 |

CART–SVM | 75.17 | 74.19 | 74.68 |

CART–ANN | 75.84 | 74.16 | 75.00 |

Type I error and Type II error of CART models

Model | Type I error rate (%) | Type II error rate (%) | Overall error rate (%) |
---|---|---|---|

CART–CART | 11.41 | 22.22 | 16.81 |

CART–CHAID | 18.12 | 20.49 | 19.30 |

CART–BBN | 22.82 | 26.78 | 24.80 |

CART–SVM | 24.83 | 25.81 | 25.32 |

CART–ANN | 24.16 | 25.84 | 25.00 |

### CHAID models

Detection accuracy of CHAID models—tenfold cross validation

Model | FFS (%) | Non-FFS (%) | Overall accuracy (%) |
---|---|---|---|

CHAID–CART | 92.69 | 83.24 | 87.97 |

CHAID–CHAID | 79.19 | 71.37 | 75.28 |

CHAID–BBN | 81.88 | 80.13 | 81.01 |

CHAID–SVM | 79.87 | 78.23 | 79.05 |

CHAID–ANN | 83.20 | 81.59 | 82.40 |

Type I error and Type II error of CHAID models

Model | Type I error rate (%) | Type II error rate (%) | Overall error rate (%) |
---|---|---|---|

CHAID–CART | 7.31 | 16.76 | 12.03 |

CHAID–CHAID | 20.81 | 28.63 | 24.72 |

CHAID–BBN | 18.12 | 19.87 | 18.99 |

CHAID–SVM | 20.13 | 21.77 | 20.95 |

CHAID–ANN | 16.80 | 18.41 | 17.60 |

### Statistical test

The t-test of the models

Model | CART | CHAID | df | P value |
---|---|---|---|---|

CART | 134.147*** | 155.612*** | 9 | 0.000 |

CHAID | 190.738*** | 115.696*** | 9 | 0.000 |

BBN | 117.247*** | 307.987*** | 9 | 0.000 |

SVM | 117.391*** | 193.874*** | 9 | 0.000 |

ANN | 169.994*** | 223.735*** | 9 | 0.000 |

The Wilcoxon rank-sum test of the models

Model | Mean rank | Z score | P value | |
---|---|---|---|---|

CART | CHAID | |||

CART | 7.1 | 13.9 | −2.5324 | 0.0057 |

CHAID | 15.1 | 5.9 | 3.4395 | 0.0003 |

BBN | 5.5 | 15.5 | −3.7418 | <0.0001 |

SVM | 5.5 | 15.5 | −3.7418 | <0.0001 |

ANN | 5.5 | 15.5 | −3.7418 | <0.0001 |

## Conclusions

A company’s financial statement is the key basis for all investor judgments, and is the last line of defense for investor interests. If management attempts to withhold information, even when independent CPAs, investment banking and securities analysts are involved, investors can experience significant losses. The most well-known scandal is the Enron bankruptcy case. Top management intentionally misled investors so as to profit by one billion USD. This caused bankruptcy for many investors and employees, and impacted the accounting and business community heavily.

The Enron case caused investors to lose confidence in financial statements and led to the establishment of the Sarbanes–Oxley Act (1992), which mandates that companies form auditing committees headed by independent directors. The Enron case resulted in the reform of accounting standards and the reconstruction of regulatory mechanisms.

In fact, unusual signs in financial statements often occur before the outbreak of a scandal. For example, signs of revenue situations, cash flow conditions and the ratio of liabilities and assets can all exist. Irrationalities can be found in financial statements from a few quarters to 1 year before the event. Fraudulent financial statements may look highly presentable, and many investors may be cheated. However, it is better to prevent fraud, protect investors from being cheated, and ensure that criminals are punished. Whether legal norms and supervision requirements are stringent enough and whether or not corporate governance can prevent intentional and deliberate acts of stealing company assets by manipulating financial statements are therefore issues that need to be addressed.

An increasing number of cases of fraudulent financial statements are able to damage companies and result in major losses for investors. People pay a heavy price to compensate for this damage. Therefore, establishing an effective fraudulent financial statement detection model is considerably important.

This study aims to provide a non-conventional analysis method by using multiple data mining techniques, including: the DT, BBN, SVM and ANN in order to construct a more accurate fraudulent financial statement detection model. In the first stage, this study applies the DTs of CART and CHAID to select the important variables. CART, CHAID, BBN, SVM and ANN are then combined in order to construct a classification model for comparison. According to the research results, the detection performance (overall accuracy) of the CHAID–CART model is the best at 87.97 % (the FFS detection accuracy is 92.69 %). It also has the lowest Type I error rate of 7.31 %. The sequences for overall accuracy are 83.19 % for the CART–CART model, 82.40 % for the CHAID–ANN model, 81.01 % for the CHAID–BNN model, 80.70 % for the CART–CHAID model, 79.05 % for the CHAID–SVM model, 75.28 % for the CHAID–CHAID model, 75.20 % for the CART–BNN model, 75.00 % for the CART–ANN model, and 74.68 % for the CART–SVM model.

Based on the empirical results of this study, the accuracy of the DT CHAID, combined with CART, in detecting fraudulent financial statements, is relatively high. It can therefore be used as a tool to help auditors in the detection of fraudulent financial statements. The research findings can provide a reference for investors, shareholders, company managers, credit rating institutions, auditors, CPAs (certified public accountants), securities analysts, financial regulatory authorities, and relevant academic institutions.

## Declarations

### Acknowledgements

The author thanks the editor-in-chief, editors, and the anonymous reviewers of SpringerPlus, for their insightful comments, which helped to improve the quality of this paper.

### Competing interests

The author declare that no competing interests.

**Open Access**This article is distributed under the terms of the Creative Commons Attribution 4.0 International License (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted use, distribution, and reproduction in any medium, provided you give appropriate credit to the original author(s) and the source, provide a link to the Creative Commons license, and indicate if changes were made.

## Authors’ Affiliations

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