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SIKS Master Class on Smart Auditing
         March 21, 2012, Vught




     Top Cycle Mining


Philip Elsas, ComputationalAuditing.com
    Hans Blokdijk, Limperg Institute
  Robert Nehmer, Oakland University
                                          1
Introduction
• Process mining is a technique that takes
  business event logs as input and generates
  a smart flow chart as output

• The business case for process mining:
  – Automatically generated flow chart
  – Flow chart is not documentation-only

                                               2
Process Mining
• References
  – Aalst, W. van der (2011). Process Mining:
    Discovery, Conformance and Enhancement of
    Business Processes. Springer Verlag, Berlin
    (ISBN 978-3-642-19344-6).
  – Jans, M., van der Werf, J.M., Lybaert, N.,
    Vanhoof, K. (2011) A business process mining
    application for internal transaction fraud
    mitigation, Expert Systems with Applications,
    38 (10), 13351-13359
  – http://www.processmining.org/
                                                    3
Our Approach
• Our approach is to strategically position
  process mining for the cash-to-cash top cycle
  by assessing and assuring completeness of
  loggings

• The cash-to-cash cycle is central in the
  integrated owner-ordered and
  management-ordered audit approach
   – To Be modality ('Soll')
   – As Is modality ('Ist')
                                              4
• Owner-ordered auditing addresses understatement of profits:
  whether revenues are understated and expenses are overstated
  As an owner you want assurance that management, who you
  entrusted your money, is not making profits while keeping
  parts of it unstated, since profits are the basis of your
  dividends and stock quotation
• Management-ordered auditing addresses
  overstatement of profits
  As management you want to attract investment capital by
  increasing your credibility that the profits you state are all
  real, not overstated, and so you hire the independent auditor to
  provide this assurance
• Management's illegitimate interest (overstating or
  understating profits) determines the direction of the audit
  from a market-driven value-adding perspective                  5
Owner-ordered audit: to check management

  to increase credibility that
  profits aren't understated


                                                  Owners
Money-inflow for
management

maximize equity


                                 Management
                                                                Money-inflow
                                                                for owners

                                                                long-term ROI
   Potential
    Owners                                    Management-ordered audit:
                                              to attract new investors
                                              to increase credibility that
                                              profits aren't overstated
                                                                                6
• In the owner-ordered audit tradition the auditor
  determines completeness of profits using the
  cash-to-cash top cycle
• Quantitative:
  enterprise-level spanning reconciliation checks
  (also known as: comprehensive coherence tests):
  central norm connecting:
  - ‘buy side’ and ‘sell side’ transaction volumes
  - generated ‘gross profit’ margins
• Qualitative: enterprise-level segregation of duties:
  non-identical and preferably opposite interests in
  top cycle logging locations                      7
Cash-to-cash top cycle


                         8
Top cycle represented as a smart flow chart:
transaction, or flow, as a box with adjacent arrows (active),
state or stock as a circle (passive)
                                                                9
Top cycle represented as matrices with
quantitative aspects (prices & volumes) and
qualitative aspects (authorizations by
                               agents/departments: S,B,F,D,C,W)
                                                             10
Top cycle represented as a set of equations with the primary
audit direction per equation parameter in an owner-ordered audit:
overstatement (overlining in dark orange color) or
understatement (underlining in light orange color)             11
$0           +    $30 * (900+100)   -     $0      => $27,000+$3,000
               $0           +    $30 * (900+100)   -     $0      => $27,000+$3,000


               0    +   900+100       -   0   =>       900+100
               0    +   900+100       -   0   =>       900+100


               $0       +       $18,000+$2,000 -        $0       => $20 * (900+100)
               $0       +       $18,000+$2,000 -        $0       => $20 * (900+100)


               $0 + $27,000+$3,000 - $9,000+$1,000 => $18,000+$2,000
               $0 + $27,000+$3,000 - $9,000+$1,000 => $18,000+$2,000

                                               recording + omitted recording
                                               reality + omitted reality

                                                                                      12
unstated revenues, spanning reconciliation checks & detectability
Economic substance of the business
can be represented by a

‘Web of equations’

which inevitably includes:
   ‘stocks’ and ‘flows’ outside of
   the basic cash-to-cash top cycle,
   such as transactions regarding:
   - fixed assets;
   - financing;
   - general expenses.
                                       13
The complete ‘web of equations’ is indispensable
to compose an ‘audit plan’,
for all the ‘stocks’ and ‘ flows’.

Main question:

Should a particular ‘stock’ or ‘flow’ be tested
- for:  overstatement,
- or:   understatement?

Requires different auditing techniques.

                                                  14
The analysis in owner-ordered auditing starts with:
testing sales for understatement

Equation:
Inv[B] + Pur – Inv[E] → Sales

But then, testing Sales for understatement means:
testing Inv[E] for overstatement!


                                               15
The analysis should be pursued for all equations,
and there is no need to audit any item, in either
B/S or P&L, for both under- and overstatement.

The general result is:
test all debits for overstatements (assets in
the B/S and expenditures in the P&L),
and
test all credits for understatements (liabilities in
the B/S and revenues in the P&L).
                                                   16
The International Standards on Auditing (ISA’s)
do not specify audit plans.

However, they require that all items in the accounts
are tested both for over- and understatements.

But this does not generally require two different
tests on an item:
if a debit is tested for overstatement, the
corresponding credit is implicitly tested for
overstatement as well!
Double-entry bookkeeping.                       17
One specific challenge in every audit:

Equation: Inv[B] + Pur – Inv[E] → Sales

is right in terms of quantities (of goods or services),
not in terms of money, like all the other equations!

The difference: ‘Gross Profit’,
which is to be audited for understatement.

Main challenge to be solved in every audit.
                                                  18
Mapping out the cash-to-cash top cycle enables
the auditor to perform:
‘comprehensive coherence testing’ (CCT)

extensively described in

‘Reflections on Auditing Theory’, chapter 3

(Kluwer Bedrijfswetenschappen,
Limperg Instituut, 1995).


                                                 19
But: CCT does not discover ‘shop in the shop’:
Entire cycle of purchases, sales, payments and
receipts fraudulently omitted from the accounting
records.

To be prevented by segregation of duties.

Mapping out the top cycle enables the evaluation
of internal controls.



                                              20
System Logging in Our
             Approach
• Information System (IS) server software is
  developed with built in logging capabilities
  and default log levels
• Log levels specify the amount of details
  logged
• The IS function uses logs to help control
  day-to-day operations and maintenance
• Auditors can mine existing logs for audit
  evidence in our approach
                                             21
Benefits of the approach
• Uses existing logs as a baseline
• Allows a critique of existing controls when
  combined with the top cycle approach
• IS personnel are already familiar with
  logging and require little or no additional
  training


                                                22
Example: Database server logging
• Access logging
  – Logs data about connections to a data base server:
    time stamp, duration, user ID, table accessed, etc.
    This data can be used to test separation of duties
    and appropriate access from the audit perspective.
• Write-ahead logging
  – Logs transaction details for transactions still in
    volatile areas of the system. Used to recover data in
    case of system failure but can be mined for
    transaction details. This data can include purchase
    cost, direct labor, and overhead details.

                                                          23
Full Coverage of Loggings
       Access log
      Write-ahead log




                            24
Logs Mapped to Matrix




                        25
Assessment with Top Cycle:
     Partial Coverage




                             26
Partial Coverage
Mapped to Matrix




                   27
Assessment Part 1
Absent logged measures can be corrected in one
of two ways:
    1) Increase logging levels and have the
          built in logging capture the measures
    2) Write a custom system to capture the
          measures
• In either case, costs are determinable and
  comparable with the value of the missing
  measures
                                             28
Assessment Part 2
• Problems in qualitative design of the system
  of segregation of duties would be discovered
  by setting expectation for access to the
  database and that necessary transactions are
  occurring.
• The logs can be checked to make sure these
  access points exist and are being routinely
  used.
                                             29
http://www.promtools.org/prom5/

                                  30
Mining the top cycle business process

                                        31
Concluding remarks
• Based on existing logs in appropriate segregation of
  duties an organization may already be very close to
  boost audit power by process mining
• Additionally required logging detail or additional
  segregation of duties is systematically identified
  using the cash-to-cash top cycle from the proven
  owner-ordered audit tradition




                                                     32

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Top Cycle Mining

  • 1. SIKS Master Class on Smart Auditing March 21, 2012, Vught Top Cycle Mining Philip Elsas, ComputationalAuditing.com Hans Blokdijk, Limperg Institute Robert Nehmer, Oakland University 1
  • 2. Introduction • Process mining is a technique that takes business event logs as input and generates a smart flow chart as output • The business case for process mining: – Automatically generated flow chart – Flow chart is not documentation-only 2
  • 3. Process Mining • References – Aalst, W. van der (2011). Process Mining: Discovery, Conformance and Enhancement of Business Processes. Springer Verlag, Berlin (ISBN 978-3-642-19344-6). – Jans, M., van der Werf, J.M., Lybaert, N., Vanhoof, K. (2011) A business process mining application for internal transaction fraud mitigation, Expert Systems with Applications, 38 (10), 13351-13359 – http://www.processmining.org/ 3
  • 4. Our Approach • Our approach is to strategically position process mining for the cash-to-cash top cycle by assessing and assuring completeness of loggings • The cash-to-cash cycle is central in the integrated owner-ordered and management-ordered audit approach – To Be modality ('Soll') – As Is modality ('Ist') 4
  • 5. • Owner-ordered auditing addresses understatement of profits: whether revenues are understated and expenses are overstated As an owner you want assurance that management, who you entrusted your money, is not making profits while keeping parts of it unstated, since profits are the basis of your dividends and stock quotation • Management-ordered auditing addresses overstatement of profits As management you want to attract investment capital by increasing your credibility that the profits you state are all real, not overstated, and so you hire the independent auditor to provide this assurance • Management's illegitimate interest (overstating or understating profits) determines the direction of the audit from a market-driven value-adding perspective 5
  • 6. Owner-ordered audit: to check management to increase credibility that profits aren't understated Owners Money-inflow for management maximize equity Management Money-inflow for owners long-term ROI Potential Owners Management-ordered audit: to attract new investors to increase credibility that profits aren't overstated 6
  • 7. • In the owner-ordered audit tradition the auditor determines completeness of profits using the cash-to-cash top cycle • Quantitative: enterprise-level spanning reconciliation checks (also known as: comprehensive coherence tests): central norm connecting: - ‘buy side’ and ‘sell side’ transaction volumes - generated ‘gross profit’ margins • Qualitative: enterprise-level segregation of duties: non-identical and preferably opposite interests in top cycle logging locations 7
  • 9. Top cycle represented as a smart flow chart: transaction, or flow, as a box with adjacent arrows (active), state or stock as a circle (passive) 9
  • 10. Top cycle represented as matrices with quantitative aspects (prices & volumes) and qualitative aspects (authorizations by agents/departments: S,B,F,D,C,W) 10
  • 11. Top cycle represented as a set of equations with the primary audit direction per equation parameter in an owner-ordered audit: overstatement (overlining in dark orange color) or understatement (underlining in light orange color) 11
  • 12. $0 + $30 * (900+100) - $0 => $27,000+$3,000 $0 + $30 * (900+100) - $0 => $27,000+$3,000 0 + 900+100 - 0 => 900+100 0 + 900+100 - 0 => 900+100 $0 + $18,000+$2,000 - $0 => $20 * (900+100) $0 + $18,000+$2,000 - $0 => $20 * (900+100) $0 + $27,000+$3,000 - $9,000+$1,000 => $18,000+$2,000 $0 + $27,000+$3,000 - $9,000+$1,000 => $18,000+$2,000 recording + omitted recording reality + omitted reality 12 unstated revenues, spanning reconciliation checks & detectability
  • 13. Economic substance of the business can be represented by a ‘Web of equations’ which inevitably includes: ‘stocks’ and ‘flows’ outside of the basic cash-to-cash top cycle, such as transactions regarding: - fixed assets; - financing; - general expenses. 13
  • 14. The complete ‘web of equations’ is indispensable to compose an ‘audit plan’, for all the ‘stocks’ and ‘ flows’. Main question: Should a particular ‘stock’ or ‘flow’ be tested - for: overstatement, - or: understatement? Requires different auditing techniques. 14
  • 15. The analysis in owner-ordered auditing starts with: testing sales for understatement Equation: Inv[B] + Pur – Inv[E] → Sales But then, testing Sales for understatement means: testing Inv[E] for overstatement! 15
  • 16. The analysis should be pursued for all equations, and there is no need to audit any item, in either B/S or P&L, for both under- and overstatement. The general result is: test all debits for overstatements (assets in the B/S and expenditures in the P&L), and test all credits for understatements (liabilities in the B/S and revenues in the P&L). 16
  • 17. The International Standards on Auditing (ISA’s) do not specify audit plans. However, they require that all items in the accounts are tested both for over- and understatements. But this does not generally require two different tests on an item: if a debit is tested for overstatement, the corresponding credit is implicitly tested for overstatement as well! Double-entry bookkeeping. 17
  • 18. One specific challenge in every audit: Equation: Inv[B] + Pur – Inv[E] → Sales is right in terms of quantities (of goods or services), not in terms of money, like all the other equations! The difference: ‘Gross Profit’, which is to be audited for understatement. Main challenge to be solved in every audit. 18
  • 19. Mapping out the cash-to-cash top cycle enables the auditor to perform: ‘comprehensive coherence testing’ (CCT) extensively described in ‘Reflections on Auditing Theory’, chapter 3 (Kluwer Bedrijfswetenschappen, Limperg Instituut, 1995). 19
  • 20. But: CCT does not discover ‘shop in the shop’: Entire cycle of purchases, sales, payments and receipts fraudulently omitted from the accounting records. To be prevented by segregation of duties. Mapping out the top cycle enables the evaluation of internal controls. 20
  • 21. System Logging in Our Approach • Information System (IS) server software is developed with built in logging capabilities and default log levels • Log levels specify the amount of details logged • The IS function uses logs to help control day-to-day operations and maintenance • Auditors can mine existing logs for audit evidence in our approach 21
  • 22. Benefits of the approach • Uses existing logs as a baseline • Allows a critique of existing controls when combined with the top cycle approach • IS personnel are already familiar with logging and require little or no additional training 22
  • 23. Example: Database server logging • Access logging – Logs data about connections to a data base server: time stamp, duration, user ID, table accessed, etc. This data can be used to test separation of duties and appropriate access from the audit perspective. • Write-ahead logging – Logs transaction details for transactions still in volatile areas of the system. Used to recover data in case of system failure but can be mined for transaction details. This data can include purchase cost, direct labor, and overhead details. 23
  • 24. Full Coverage of Loggings Access log Write-ahead log 24
  • 25. Logs Mapped to Matrix 25
  • 26. Assessment with Top Cycle: Partial Coverage 26
  • 28. Assessment Part 1 Absent logged measures can be corrected in one of two ways: 1) Increase logging levels and have the built in logging capture the measures 2) Write a custom system to capture the measures • In either case, costs are determinable and comparable with the value of the missing measures 28
  • 29. Assessment Part 2 • Problems in qualitative design of the system of segregation of duties would be discovered by setting expectation for access to the database and that necessary transactions are occurring. • The logs can be checked to make sure these access points exist and are being routinely used. 29
  • 31. Mining the top cycle business process 31
  • 32. Concluding remarks • Based on existing logs in appropriate segregation of duties an organization may already be very close to boost audit power by process mining • Additionally required logging detail or additional segregation of duties is systematically identified using the cash-to-cash top cycle from the proven owner-ordered audit tradition 32