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Michael G. Alles Alexander Kogan Miklos A. Vasarhelyi Jia Wu Rutgers University Nov, 2005

Continuity Equations: Analytical Monitoring of Business Processes and Anomaly Detection in Continuous Auditing. Michael G. Alles Alexander Kogan Miklos A. Vasarhelyi Jia Wu Rutgers University Nov, 2005. Data-oriented CA: Automation of Substantive Testing.

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Michael G. Alles Alexander Kogan Miklos A. Vasarhelyi Jia Wu Rutgers University Nov, 2005

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  1. Continuity Equations: Analytical Monitoring of Business Processes and Anomaly Detection in Continuous Auditing Michael G. Alles Alexander Kogan Miklos A. Vasarhelyi Jia Wu Rutgers University Nov, 2005

  2. Data-oriented CA: Automation of Substantive Testing • Formalization of BP rules as data integrity constraints. • Verification of data integrity  identification of exceptions. • Selection of critical BP metrics and development of stable business flow (continuity) equations. • Monitoring of continuity equation residuals  identification of anomalies.

  3. Establishing Data Integrity: A Procurement Example • Referential integrity along the business cycle and identification of completed cycles: P.O.  Shipment receipt  voucher payment. • Identification of data consistency issues and automatic alarms to resolve exceptions: • Changes in purchase order vendor numbers; • Discrepancies between the totals and the sums of line items; • Discrepancies between matched voucher amounts.

  4. Detection of Exceptions • Referential integrity violations • PO without matching requisition • Received item without matching PO • Payments without matching received items • Data integrity violations • PO has zero order quantity • Received item has negative quantity • Invalid payment check numbers (e.g. All 0s) • Gross payment amount is smaller than net payment amount

  5. Advanced Analytics in CA: BP Modeling Using Continuity Equations • Continuity equations: • Statistical models capturing relationships between various business processes. • Can be used as expectation models in the analytical procedures of continuous auditing. • Originated in physical sciences (various conservation laws: e.g. Mass, momentum). • Continuity equations are developed using the methodologies of: • Simultaneous equation modeling (SEM); • Multivariate time series modeling (MTSM).

  6. Basic Procurement Cycle t2-t1 P.O.(t1) Receive(t2) t3-t2 Voucher(t3)

  7. Continuity Equations of Basic Procurement Cycle Receive(t2)= P.O.(t1) Voucher(t3)= Receive(t2) • Aren’t partial deliveries allowed? • Are all orders delivered after exactly the same time lag? • Are there any feedback loops?

  8. Inferred Analytical Model of Procurement P.O.(t)= 0.24*P.O.(t-4) + 0.25*P.O.(t-14)+ 0.56*Receive(t-15) + εPO Receive(t)= 0.26*P.O.(t-4) + 0.21*P.O.(t-6)+ 0.60*Voucher(t-10) + εR Voucher(t)=0.73*Receive(t-1) - 0.25*P.O.(t-7) + 0.22*P.O.(t-17)t-17 + 0.24*Receive(t-17)+ εV

  9. Detection of Anomalies • Anomalies are detected if: • Observed P.O.(t) < Predicted P.O.(t) - Var or • Observed P.O.(t) > Predicted P.O.(t) + Var • Similarly for: • Receive(t) • Voucher(t) • Var = acceptable threshold of variance. • If there is anomaly  generate alarm!

  10. Steps of Analytical Modeling and Monitoring Using Continuity Equations • Choose essential business processes to model (purchasing, payments, etc.). • Define (physical, financial, etc.) metrics to represent each process: e.g.,$ Amount of purchase orders, quantity of items received, number of payment vouchers processed. • Choose the levels of aggregation of metrics: • By time (hourly, daily, weekly), by business unit, by customer or vendor, by type of products or services, etc.

  11. Steps of Analytical Modeling and Monitoring Using Continuity Equations - II • Identify and estimate stable statistical relationships between business process metrics – Continuity Equations (CEs). • Define acceptable thresholds of variance from the expected relationships. • If the variances (residuals) exceed the acceptable levels, alarm human auditors to investigate the anomaly (i.e., the relevant sub-population of transactions).

  12. How Do We Evaluate CE Models? • Linear Regression Model is the classical benchmark for comparison. • Models are compared on two aspects: • Prediction Accuracy. • Anomaly Detection Capability. • Mean Absolute Percentage Error (MAPE) is used to measure prediction accuracy. • MAPE = Abs (predicted value – actual value) / (actual value) * 100% • A good analytical model is expected to have high prediction accuracy, or low MAPE.

  13. Prediction Accuracy Comparison: Results Analysis • Prediction accuracy comparison results: • Linear regression (best). • Multivariate Time Series (middle). • Simultaneous Equations (worst). • Difference is small (<2%). • Noise in our data sets may pollute the results. • Prediction accuracy is relatively good for all three models: • MAPE is around 0.40 (Leitch and Chen 2003). • Other studies report over 100% MAPE.

  14. Simulating Error Stream: The Ultimate Test of CA Analytics • Seed errors of various magnitude into randomly chosen subset of the holdout sample. • Identify anomalies as those observations in the holdout sample for which the variance exceeds the acceptable threshold of variance. • Test whether anomalies are the observations with seeded errors, and count the number of false positives and false negatives. • Repeat this simulation several times by choosing different random subsets to seed errors into.

  15. Acceptable Threshold of Variance • What to use as acceptable threshold of variance? • Prediction Interval • Confidence interval for the predicted variable value. • Anomalies are detected if: • Value in the observation < lower confidence limit, or • Value in the observation > upper confidence limit.

  16. Error Seeding Procedure • To simulate an anomaly detection scenario, we seed errors into the hold-out data set (47 obs.): • Original anomalies are detected before error seeding. • Errors are seeded into 8 randomly-selected observations which do not have original anomalies. • 5 different error magnitudes are used for each round of error seeding respectively. (10%, 50%, 100%, 200% and 400% of actual value of the seeded observation). • The above procedure is repeated 10 times to reduce the variance of the results.

  17. Measuring Anomaly Detection • False positive error (false alarm, Type I error): A non-anomaly mistakenly detected by the model as an anomaly. Decreases efficiency. • False negative error (Type II error): An anomaly failed to be detected by the model. Decreases effectiveness. • Detection rate is used for clear presentation purpose: The rate of successful detection of seeded errors. Detection rate = 1 – False Negative Error Rate • A good analytical model is expected to have good anomaly detection capability: low false negative error rate (i.e. high detection rate) and low false positive error rate.

  18. Simulated Error Correction • CA makes it possible to investigate a detected anomaly in (nearly) real-time. • Anomaly investigation can likely correct a detected problem in (nearly) real-time. • Real-time problem correction results in utilizing the actual (not erroneous) values in analytical BP models for future predictions. • Real-time error correction is likely to benefit future anomaly detection, and the magnitude of this benefit can be evaluated using simulation.

  19. Benefit of Real-time Error Correction: MTSM

  20. Anomaly Detection Rate Comparison: Results

  21. False Positive Error Comparison

  22. Anomaly Detection Rate Comparison: Results Analysis • SEM and MTSM outperform the linear regression model when the error magnitudes are large, even though linear regression has slightly better detection rate when the error magnitudes are small. • It is more important to detect material errors than non-material errors.

  23. Concluding Remarks • New CA-enabled analytical audit methodology: simultaneous relationships between highly disaggregated BP metrics. • How to automate the inference and estimation of numerous CE models? • How to identify and remove outliers from the historical data to estimate statistically valid CEs (step-wise re-estimation of CEs)? • How to identify the need to re-estimate a CE model (trends in residuals)? • How to make it worthwhile (trade-off between effectiveness, efficiency and timeliness)? • Any patterns for detected errors?

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