Application of Fuzzy Logic to Fraud Detection

Application of Fuzzy Logic to Fraud Detection

Mary Jane Lenard (University of North Carolina, USA) and Pervaiz Alam (Kent State University, USA)
DOI: 10.4018/978-1-60566-026-4.ch031
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Abstract

In light of recent reporting of the failures of some of the major publicly-held companies in the U.S. (e.g., Enron & WorldCom), it has become increasingly important that management, auditors, analysts, and regulators be able to assess and identify fraudulent financial reporting. The Enron and WorldCom failures illustrate that financial reporting fraud could have disastrous consequences both for stockholders and employees. These recent failures have not only adversely affected the U.S. accounting profession but have also raised serious questions about the credibility of financial statements. KPMG (2003) reports seven broad categories of fraud experienced by U.S. businesses and governments: employee fraud (60%), consumer fraud (32%), third-party fraud (25%), computer crime (18%), misconduct (15%), medical/insurance fraud (12%), and financial reporting fraud (7%). Even though it occurred with least frequency, the average cost of financial reporting fraud was the highest, at $257 million, followed by the cost of medical/insurance fraud (average cost of $33.7 million). Statistical methods, expert reasoning, and data mining may be used to achieve the objective of identifying financial reporting fraud. One way that a company can justify its fi- nancial health is by developing a database of financial and non-financial variables to evaluate the risk of fraud. These variables may help determine if the company has reached a stress level susceptible to fraud, or the variables may identify fraud indicators. There are a number of methods of analysis that may be used in fraud determination. Fuzzy logic is one method of analyzing financial and non-financial statement data. When applied to fraud detection, a fuzzy logic program clusters the information into various fraud risk categories. The clusters identify variables that are used as input in a statistical model. Expert reasoning is then applied to interpret the responses to questions about financial and non-financial conditions that may indicate fraud. The responses provide information for variables that can be developed continuously over the life of the company. This article summarizes the specifics of fraud detection modeling and presents the features and critical issues of fuzzy logic when applied for that purpose.
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Introduction

In light of recent reporting of the failures of some of the major publicly-held companies in the U.S. (e.g., Enron & WorldCom), it has become increasingly important that management, auditors, analysts, and regulators be able to assess and identify fraudulent financial reporting. The Enron and WorldCom failures illustrate that financial reporting fraud could have disastrous consequences both for stockholders and employees. These recent failures have not only adversely affected the U.S. accounting profession but have also raised serious questions about the credibility of financial statements. KPMG (2003) reports seven broad categories of fraud experienced by U.S. businesses and governments: employee fraud (60%), consumer fraud (32%), third-party fraud (25%), computer crime (18%), misconduct (15%), medical/insurance fraud (12%), and financial reporting fraud (7%). Even though it occurred with least frequency, the average cost of financial reporting fraud was the highest, at $257 million, followed by the cost of medical/insurance fraud (average cost of $33.7 million).

Statistical methods, expert reasoning, and data mining may be used to achieve the objective of identifying financial reporting fraud. One way that a company can justify its financial health is by developing a database of financial and non-financial variables to evaluate the risk of fraud. These variables may help determine if the company has reached a stress level susceptible to fraud, or the variables may identify fraud indicators. There are a number of methods of analysis that may be used in fraud determination. Fuzzy logic is one method of analyzing financial and non-financial statement data. When applied to fraud detection, a fuzzy logic program clusters the information into various fraud risk categories. The clusters identify variables that are used as input in a statistical model. Expert reasoning is then applied to interpret the responses to questions about financial and non-financial conditions that may indicate fraud. The responses provide information for variables that can be developed continuously over the life of the company. This article summarizes the specifics of fraud detection modeling and presents the features and critical issues of fuzzy logic when applied for that purpose.

Key Terms in this Chapter

Cluster Analysis: Defining groups based on the “degree” to which an item belongs in a category. The degree may be determined by indicating a percentage amount.

Fuzzy Logic: A mathematical technique that classifies subjective reasoning and assigns data to a particular group, or cluster, based on the degree of possibility the data has of being in that group.

This work was previously published in Encyclopedia of Information Science and Technology: edited by M. Khosrow-Pour, pp. 135-139, copyright 2005 by Information Science Reference, formerly known as Idea Group Reference (an imprint of IGI Global)

Data Mining: Using powerful data collection methods to analyze a company’s database or data stores and select information that supports a specific objective.

Internal Controls: Procedures applied by a business organization that ensure information is safeguarded, that it is accurate and reliable, and that it is processed efficiently and in accordance with management’s prescribed policies.

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