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Fraud Detection: Benford's Law vs Beneish Model

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 2013 IEEE Symposium on Humanities, Science and Engineering Research (SHUSER)
Fraud Detection: Benford’s Law vs Beneish Model
Nooraslinda Abdul Aris1, Rohana Othman2, Siti Maznah Mohd Arif3, Mohamad Affendi Abdul Malek4 and Normah
Omar5
125
Accounting Research Institute and Faculty of Accountancy, Universiti Teknologi MARA, Shah Alam, Malaysia
3
Faculty of Accountancy, Universiti Teknologi MARA, Shah Alam, Malaysia
4
Computer & Mathematical Sciences, Universiti Teknologi MARA, Pahang, Malaysia
Abstract—Fraud is not a new subject. Fraud basically
involves any crime committed by a perpetrator that uses
deception in order to gain something as the element of
opportunity, pressure and rationalization exist. Thus, it is
important to prevent and detect fraud before it causes the
business to collapse. Fraud detection is an evolving
discipline. Statistical methods and data mining are said to
be among the best techniques to detect fraud. Computer-
based fraud detection revolves the usage of Benford’s Law
while Beneish model which is based on ratio analysis can
also be utilised in discovering anomalies and detecting
fraud. This paper, therefore, aim to focus on analysing the
usage, process and application of Benford’s Law and
Beneish Model in detecting accounting fraud.
Comparisons were made to conclude that both techniques
appear to have its own benefit in the quest of detecting and
preventing fraud occurrence.
Keywords-Fraud, data mining, Benford’s Law, Beneish Model
I. INTRODUCTION
Accounting fraud took centre stage when Enron (2001),
WorldCom (2002) and Nortel (2003) reported losses
amounting more than USD20 billion. Given the current state
where no industry is immune to fraudulent situations and the
negative publicity that swirls around them, prevention and
detection of fraud and abuse has become a major concern of
many organizations.
Fraud detection is a continuously evolving discipline. The
majority of business transaction data is now formatted
electronically. The likelihood is high that most of the data to
be investigated can be accessed electronically. Studies have
shown that as much as 93% of a modern company’s data is
stored digitally. Paper trail investigative work or manual
investigation will be too physically tedious, time-consuming
and the investigator might overlook some relevant data [1].
Two main strategies for detecting accounting fraud are
auditing and statistics. Statistical fraud detection strategies
rely on analytical methods. Some studies pointed that finding
the source of fraud using statistical method is more efficient
than analysing individual claims [2, 3].
Statistics methods and data mining have been applied
successfully to detect activities such as money laundering, e-
commerce scams, credit card fraud, telecommunications fraud,
insurance fraud, and computer intrusion etc. Thus, it may be a
suitable tool to detect accounting fraud.
978-1-4799-0443-3/13/$31.00 ©2013 IEEE
Discussions on computer-based fraud detection techniques
in most accounting circles revolve around the use of Benford’s
Law to discover user input or other fraudulent amount in
corporate databases. Analysis of data against Benford’s
distribution is useful. However, it is one of many computer-
based fraud detection techniques used by professionals and
researched by academics [4]. Beneish model which is based
on ratio analysis seems to be used in earning manipulation but
rarely discussed and compared with Benford’s Law.
This paper aims to compare the application of Benford’s
Law and Beneish Model in detecting fraud. Definition, usage
and process of the two techniques are discuss to shed light of
reader and also to provide alternative among researcher and
practitioners in developing tools to detect accounting fraud in
organisations.
The paper is divided into five sections. Section two
discusses the evolution of fraud – definition, classification,
fraud triangle and statistical data. This is followed by detection
of accounting fraud commonly employed by organisation.
Section four highlights the application of Benford’s Law and
data mining as compared to Beneish model and ratio analysis.
Last section presents the conclusion.
II. EVOLUTION OF FRAUD
A. Fraud and Its Classsification
Fraud is “deception or misrepresentation that an individual
or entity makes that knowing the misrepresentation could result
in some unauthorized benefit to the individual or to the entity
or to some other party” [5].
The term fraud has been described and elaborated in many
different ways by scholars and laymen alike, the most
simplistic being that fraud is any crime for gain that uses
deception [6]. Although scholars have approached this term in
a variety of ways, it has been generally agreed upon that fraud
can be defined ultimately as “the intentional act of misleading
or committing harm to others with the aim of securing an
unfair or unlawful advantage” [7-12]. Kranacher [11] has
further simplified the term as “theft by deception”.
As scholars have agreed, fraud involves elements such as
deception [13] and dishonesty [12] normally involved the
senior management [9], along with other attributes such as
purposeful intent, intensity of desire, risk of apprehension, the
violation of trust, rationalization, etc [14]. Moreover, unlike an
error or mistake, fraud is deliberate, intentional, and more often
than not, involves the purposeful concealment of facts [15].
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 2013 IEEE Symposium on Humanities, Science and Engineering Research (SHUSER)

This is interesting to point out because fraud does not
necessarily have to be a wilful act, but can take the form of an
omission [16]. This is supported by Ramamoorti [17] who
classifies fraud as comprising of two types of
misrepresentation: the suggestion of falsehood or the
suppression of truth.
Most scholars have agreed that the main aim of fraud is the
advantage or benefit the perpetrator would gain in the end.
KPMG [18], on the other hand asserted that the perpetrator
need not necessarily benefit from his/her deceit. Nevertheless,
what all scholars have shown to agree upon however, is that
fraud includes trickery, cunning and unfair means by which the
victim is cheated [7], and can also be committed through a
variety of different ways, such as through mail, wire, phone,
and the internet [19].
Scholars have classified accounting fraud in many different
ways. Albrecht [7], for example, offers two types of
classification; fraud committed against an organization
(occupational fraud), and fraud committed on behalf of an
organization (fraudulent financial statement). Whereas Viton
[20] categorizes fraud into three: management fraud,
occupational or transactional fraud, and corruption.
Nonetheless, most scholars agree that there are fundamentally
three types of fraud: corruption, asset misappropriation, and
fraudulent financial reporting [5, 10-12, 21-23].
perceived pressure or incentive, perceived opportunity, and
rationalization [10, 28, 30].
These model assists individuals and organizations in not
only detecting fraud, but in preventing it as well. For example,
in a study conducted by the ACFE [5, 25], it was shown that
the most common red flags by perpetrators were: living beyond
their means (43%), experiencing financial difficulties (36%),
excessive control issues in relation to their job (23%), and an
unusually close association with their vendors or customers
(22%). With this knowledge, people are more aware of these
tell-tale signs of fraud, and thus may help in preventing a loss
from occurring.
C. Fraud Statistics
Fraud can threaten the stability of a business by resulting in
some significant financial losses. ACFE [25] reported that the
typical business will lose on average 5% of revenue to fraud
each year. This figure translates to a potential projected annual
fraud loss of more than USD3.5 trillion using the 2011 Gross
World Product. As mentioned earlier, there are three types of
fraud. The statistics below showed that the most alarming
fraud in terms of frequency is asset misappropriation.
However, the median losses are highly contributed by the
fraudulent financial reporting [25].
Table 1: Frequency and Median Loss of Fraud by Types

Fraudulent financial reporting involves the intentional Asset Corruption Fraudulent

Misappropriation Financial Reporting
misstatement or omission of material information from the
organisation’s financial report [24]. It covers both financial and Frequ Median Frequ Median Frequ Median
non-financial aspects. According to ACFE report 2012 [25], ency Loss ency Loss ency Loss
(%) (USD ’M) (%) (USD ’M) (%) (USD ’M)
financial statement fraud schemes made up 8% of the total
fraud loses, but caused the greatest median loss of USD1 2006 91.5 0.15 30.8 0.58 10.6 2.0
million. Thus, understanding the causes, impact to business and 2008 88.7 0.12 26.9 0.25 10.3 2.0
also ways to detect and curb the financial statement fraud is
2010 86.3 0.135 32.8 0.25 4.8 4.1
very crucial.
2012 86.7 0.15 33.4 0.375 7.6 1.0
B. Fraud Triangle
In studying fraud, it is important to take into account the
key elements that make it up, such as the supply of motivated III. FRAUD DETECTION
offenders, the availability of suitable targets, and the absence of Accounting frauds typically encompass political and
capable guardians [26]. It is not unreasonable to assert that the business scandals stemming from a lack of disclosure from the
act of fraud is clandestine, violates the employee’s fiduciary management. Such scandals represent the ‘tip of the iceberg’,
duties to the organization, is committed for the purpose of akin to visible failure, which may be legal or quasi legal. Such
financial gain to the employee, and is at the expense of the scandal or, proverbially creative accounting, is normally
employing organization [27]. investigated by appointed government agencies, external
According to the Salehi and Azary [28], there are three auditors and fraud examiners. With more cases being
basic elements of fraud as stated earlier by Albrecht [29]. The unearthed, there is a need for a tool to identify the warning
elements are theft act - stealing or taking cash, inventory, signal of fraud.
information or assets that belong to the company; concealment Accounting anomalies often signal the presence of fraud.
- action taken by the perpetrator to hide the fraud; and Examples of accounting anomalies include irregularities in
conversion – actions that convert the stolen asset into cash and source documents, faulty journal entries, and inaccuracies in
spend it. ledgers. In order to get to the bottom of a complex fraud and
With the intention of improving fraud detection and thoroughly investigate all possible scenarios, it is important to
prevention, scholars have offered up a model referred to as the understand the way around an accounting system. Thus
“fraud triangle”, which gives individuals and organizations a knowing and understanding the strategies that may be
better idea of how and why fraud might take place, and thus employed by an entity in detecting fraud is essential.
helps in curbing the likelihood of fraud occurring to themselves
and to their businesses. The majority of scholars have agreed
upon three specific elements that constitute the fraud triangle:

727
 2013 IEEE Symposium on Humanities, Science and Engineering Research (SHUSER)
A. Audit
Audit involves an examination to assess whether the
financial statements and accompanying notes present fairly a
company’s financial position, results of operations, and cash
flows in accordance with generally accepted accounting
principles (GAAP). Once this examination is made, the
auditor is required to render an opinion. The auditor has a
responsibility to plan and perform the audit to obtain
reasonable assurance about whether the financial statements
are free of material misstatement, whether caused by error or
fraud.
The fraud risks assessment process normally covers a
cycle of gathering information, identifying and assessing the
risk associated with the organisation and responding to the risk
assessed [31]. However, the problems arise when public
misunderstanding on auditor’s roles and responsibilities to
detect financial assets misstatement or fraudulent activities
through the financial statement [32].
Therefore, the increased awareness of both fraud and the
importance of transparent financial reporting have spurred the
concern of regulatory bodies, as well as the accounting
profession. Fraud continues to be a prominent issue
commanding the attention of regulators as well as of the
accounting profession. The auditor’s concern is that the
financial statements of a company be stated fairly in all
material respects. Since auditors cannot evaluate every
transaction of a company, they have to make judgments and
decisions dictated by a risk assessment and cost-benefit
analysis. Both regulators and stakeholders are strengthening
the role of auditors in the deterrence and detection of fraud.
B. Data Mining
Data mining is emerging as one of the key features of
many security initiatives. Often used as a means for detecting
fraud, assessing risk, and product retailing, data mining
involves the use of data analysis tools to discover previously
unknown, valid patterns and relationships in large data sets
[33]. Data mining represents a difference of kind rather than
degree as compared to other data analysis applications. Data
mining utilizes a discovery approach, in which algorithms can
be used to examine several multidimensional data
relationships simultaneously, identifying those that are unique
or frequently represented.
Data mining techniques includes round dollar payment,
duplicate payment, blank or "plugged" information, matching
vendor address to the employee address, vendor with payment
larger than the average payment, horizontal analysis, vertical
analysis, trend analysis, stratification and aging [1]. Data
mining is said to act like a giant magnet that pulls the needles
out of the haystack so that the fraud examiner or investigator
can sort, find and reduce the overall waste and abuse.
Data mining should be viewed as a process combining all
the hard and soft resources. This implies a structured and on-
going approach to an evolving optimization problem i.e. fraud.
Data mining as a process must be planned and implement in a
procedural way to ensure it success. Upon proper
implementation, productive results should be expected early
and continually improved [34].
728
Data mining process typically involves five main steps
namely preparation, data exploration, building model,
deployment and review. The most commonly used techniques
in data mining are artificial neural networks, decision trees,
genetic algorithms, the nearest neighbour method, and rule
indication. Using these techniques, four types of relationships
are generally sought namely classes - find data in
predetermined groups e.g. customer habits and preferences;
clusters – data are group according to logical relationships in
order to help identify market segments; associations – to
identify for example what does men tend to bought together;
and sequential patterns - anticipate behaviour patterns and
trends [35].
The five stages in driving successful data mining strategy
and implementation is training of both the expertise and
company personnel, assessment by the working committee,
proper strategy in place, implementation of the agreed strategy
and iteration i.e. providing a balance check and control to
ensure the data mining is working well in detecting fraud.
IV. BENFORD’S LAW AND BENEISH MODEL IN FRAUD
DETECTION
A. Benford’s Law
Benford’s Law is an advanced digital analysis technique
that involves examining the actual frequency of the digits in
the data. It is a mathematical tool that proposed a probability
distribution for first, second and other digits of numbers in
data sets. It describes the sizes of similar phenomena as long
as the sizes span multiple orders of magnitude [36]. The law
calculates that numbers in sets of data with low first digits,
such as 1, occur with more frequency than numbers with high
first digits, like 8 or 9. Valid, unaltered data, without
exceptional transactions, will follow the projected frequencies.
Benford’s Law was introduced to the auditing and accounting
literature and researchers have since used these digit patterns
to detect data anomalies.
Benford's law principle has been found to apply to many
sets of financial data, including corporate disbursements.
Benford’s Law is commonly being used in identifying fraud in
insurance claims, corporate income tax, employee expense
reports, vendor invoices, accounts receivable, accounts
payable and also fixed asset records.
Audit software can employ digital analyses using
Benford's law to identify fraud and other irregularities in
accounts payable, income tax forms, claims payments and
other disbursements. Data that meets the principles criteria,
but fails to follow the expected frequencies, may include
fraudulent items. It is very difficult for people to make up
credible numbers, as invented numbers are unlikely to follow
the law. Thus, this principle can be tested by the audit staff to
spot irregularities, including possible error, fraud detection, or
other anomalies.
Using Benford’s Law, one must start with measuring
deviation. The deviation of the distribution of digits between
what is observed and what is expected in many ways. One
method is the “Chi Square” test, a standard statistical test for
measuring the degree of similarity between elements in a
table. Based upon this statistic, and the number of “degrees of
 2013 IEEE Symposium on Humanities, Science and Engineering Research (SHUSER)
freedom”, it is possible to assign a probability that any
variation between actual and observed is due to chance alone.
The higher the Chi Square, the less likely that any difference
can be explained by chance alone.
Output from the processing will include measures of
Benford’s compliance using D-statistic. D-Statistics is a test
that relies on the fact that the value of the sample cumulative
density function is asymptotically normally distributed. For D-
statistics test, values in excess of 0.10 indicate that the
observed distribution differs significantly from the expected
and do not follow Benford’s Law.
Authors [37, 38, 39, 40, 41] have identified several steps in
Benford’s Law to detect fraud in accounting data. We have
simplified the process into five steps as illustrate in fig. 1.
Fig. 1: Five steps to detect fraud using Benford’s Law
Benford’s Law is likely useful when applied under several
conditions. For instances, set of numbers that result from
mathematical combination of numbers whereby the result
come from two distributions e.g. account receivable (number
sold x price); transaction-level data where sample is not
needed e.g. disbursement, sales, expenses; on large database
set, full year’s transactions will provide more accurate result;
and for account that appear to conform which the mean of a
set of number is greater than the median and the skewness is
positive e.g. most set of accounting numbers.
B. Beneish Model
Financial fraud creates huge losses to the companies. The
Beneish model, or Beneish M-Score, is a mathematical model
created by Professor Messod Daniel Beneish who has
formulated several analysis ratios and eight variables to
identify occurrence of financial fraud or tendency to engage in
earning manipulation [42, 43, 44]. The variables are
constructed from the data in the organization’s financial
statements and once computed, create an M-Score to show the
degree in which the earnings have been manipulated [45].
Beneish and Nichols [46] explain further to determine the
probability of financial statement fraud using two alternative
fraud detection model that involve five variables and eight
variables of Beneish [47] model. Table 2 provides the eight
variables use to calculate the ratio of the company’s financial
data. These eight variables are then calculated together using
the following formula:
729
M = -4.84 + 0.92*DSRI + 0.528*GMI + 0.404*AQI + 0.892*SGI +
0.115*DEPI – 0.172*SGAI + 4.679*TATA – 0.327*LVGI
Table 2: Eight ratio analyses used as the Beneish variables
Ratio Formula
Sales Growth Index Sales current year
(SGI) Sales prior year
Gross Margin Index (Sales prior year – Cost of goods sold prior year) /
(GMI) Sales prior year
(Sales current year – Cost of goods sold current
year) / Sales current year
Asset Quality Index Current assets + Property, plant and equipment
(AQI) Total assets
Days’ Sales in Receivables current year / sales current year
Receivable Index Receivables prior year / sales prior year
(DSRI)
Sales, General and Sales, general and administrative expenses current
Administrative year/ sales current year
Expenses Index Sales, general and administrative expenses prior
(SGAI) year/ sales prior year
Depreciation Index Depreciation current year/ Depreciation + PPE
(DEPI) current year
Depreciation prior year/ Depreciation + PPE prior
year
Leverage Index Long term debt + Current liabilities current year /
(LVGI) Total assets current year
Long term debt + Current liabilities prior year /
Total assets prior year
Total accrual to total ( Current Asset - Current Liabilities - Short-
assets (TATA)
term Debt –Depreciation & Amortisation - Deferred
tax on Earnings - Equity in Earnings)
Total assets
An M-Score of less than -2.22 suggests the company will
not be a manipulator. An M-Score of greater than -2.22 signals
that the company is likely to be a manipulator. It is interesting
to note that in testing out his model, Beneish used all the
companies in the Compustat database between the years 1982-
1992. Beneish [48] also developed a probit model that can be
used to provide evidence of a systematic relationship between
the likelihood of manipulation and selected financial statement
data. This model is a cost-effective tool. The result showed
that Beneish’s weighted and unweighted probabilities of
earning manipulation are significantly associated with the
existence of fraud. Beneish found that he could correctly
identify 76% manipulators, whilst only incorrectly identify
17.5% of non-manipulator [42].
The analysis of the financial statement required at least two
period of financial reporting to detect unusual event. However,
to identify the trend of the company’s financial statement
reporting, it is suggested to analyse the data for five reporting
period. Moreover it will show the details by doing vertical and
horizontal analysis.
Other than that, Beneish, Lee and Nichols [48] in their
study using the Beneish [47] model, which was estimated
using data from the period 1982-1988 and its holdout sample
performance assessed in the period 1989-1992 to show
forensic accounting has significant out-of-sample ability to
both detect fraud and predict stock returns. Moreover, they
provide evidence that the efficacy of the model derives
substantially from its ability to predict in advance, the likely
persistence (or reversal) of the accrual component of current
year earnings.
 2013 IEEE Symposium on Humanities, Science and Engineering Research (SHUSER)

Fig. 2 illustrates five main steps that can be used to detect exercised when using
fraud or earning manipulation in the company’s financial data. Benford’s law as not all
“non-conforming” data
are necessarily
fraudulent.
• Certain types of fraud
cannot be found with
this analysis. • The earnings
• Some populations of
accounting-related data
do not conform to a
Benford’s distribution.
using financial
information for
publicly traded
companies, and as
such, cannot be reliably
used to study privately-
held firms.
manipulation in the
sample involves
earnings overstatement.
May not be reliable to
study firms operating
in circumstances
conducive to
decreasing earnings.

V. CONCLUSION

Fig. 2: Five step of Beneish Model in detecting fraud Accounting fraud is a serious threat to any firms, small or
big as no one is immune from it. The opportunity to engage in
Clearly, both techniques can be used to detect fraud in fraud increases as the firm’s control structure is week;
accounting data. It provides future researchers’ alternative ineffective corporate governance and quality of audit function
techniques for fraud detection thus assist in mitigating the deteriorate. As highlighted above, although fraudulent
financial losses. To summarize our finding, table 3 below financial reporting reported relatively low percentage of cases
conclude and compare Benford’s Law and Beneish Model. but the median losses are huge. The fact that fraud is costly
Table 3: Comparison between Benford’s Law and Beneish Model and the prevention may also be so, understanding how to
prevent and detect accounting fraud is a must.
Benford’s Law Beneish Model
Definition Advanced digital analysis A mathematical model that Audit and statistical techniques are said to provide the
technique that involves uses eight financial ratios to means of detecting fraud. These audit and statistical
examining the actual detect whether an entity has
frequency of the digits in the manipulated its earnings. techniques for fraud detection especially using accounting data
data. or financial statements are crucial for organisation. Audit
How Begin with measuring Create an M-Score which is involves an examination of fairness, and transparency
deviation - “Chi Square” test. based on a combination of presentation of financial statement to the stakeholders. It is
Then output is tested using eight different variables.
D-statistic. common to have internal auditor to review the organisation
Usage and Commonly used in Commonly used to detect books on a periodic basis in order to prevent fraud from
application identifying fraud in insurance earnings manipulation in occurring. On top of that, external auditor’s review is seen to
claims, corporate Income tax, various organisations as long be worth and beneficial for the business.
employee expense reports, two years financial data is
vendor invoices, accounts available. Statistical techniques had grown in term of acceptance
receivable, accounts payable
and also fixed asset records. among the users in identifying anomalies or red flags. Data
Advantages • Powerful analytical tool • Considers variables mining is one of the tools in detecting fraud with the
for testing irregularities related to both the application of Benford’s Law. Beneish Model on contrary
in data. detection and focus on the application of ratio analysis using at least two sets
• The tests are incentives for fraud.
of accounting records. Having these two techniques –
straightforward and • Allows user to assess
easily implemented on the different aspects of Benford’s Law and Beneish model will allow user of
spread sheets without a firm’s performance accounting data and assist auditor and investigator in finding
any additional software. simultaneously instead anomalies which can be translated into fraud occurrences. By
• Computers can easily be of in isolation. applying the right techniques, the accuracy of financial
programmed to include • Exploratory power for
a Benford’s law fraud. statement could be reinforces and upholds the organisation’s
component, to test for • Widespread acceptance reputation.
the quality of different and used in the
queries and corporate, academic ACKNOWLEDGMENT
enumerators. and institutional world.
• Most accounting-related Thus reasonable to The team would like to express their gratitude to
data can be expected to presume that the results Accounting Research Institute (ARI), Universiti Teknologi
conform to a Benford’s are accurate and up-to- MARA (UiTM) for providing the financial means and
distribution. date. facilities. This article would not have been possible without the
• Cost-effective as it
requires at least two support of the grant provider, family members, and friends.
years data.
Disadvanta • Can only be applied to • Study based on out-
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