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AMERICAN ACCOUNTING ASSOCIATION
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CONTACT: Ben Haimowitz (212-233-6170)

Managers who manipulate company earnings can make detection
hard for auditors, but their tactics can easily backfire, study reveals

How common is it for companies to manage earnings by manipulating their financial statements? While no one knows for sure, there is plenty of evidence of such practices, whether done to smooth out earnings or meet targets or simply conceal poor performance. Manipulating financial results has become so widespread, in fact, that whole books have been written in recent years on earnings-management strategies, including one that devotes a chapter each to techniques with such colorful names as "cookie jar reserve," "big bath," "throw out," and "big bet on the future." Meanwhile, research has raised questions about the ability of auditors to ferret out earnings management.

Now, just in time for the earnings-report season, a new study probes accountants' ability in this regard. The research, prepared for a meeting this month of the Auditing Section of the American Accounting Association, tests how experienced auditors respond to a baiting tactic that evasive managers might well employ -- diverting an auditor from the site of financial manipulation to another part of a firm's financial statements. Managers could achieve this by warning about the risk of errors in this other area.

The experiment reveals that diversion works exceedingly well if the area to which the auditor is nudged is error-free: only about 7% of experienced auditors efficiently detected earnings manipulation in such cases.

But diverting the auditor can backfire too -- if managers seed the diversion site with errors.

"When auditors are diverted to areas that do not contain errors, they are not likely to uncover earnings- management errors elsewhere in the financial statements," explain the study's authors, Benjamin L. Luippold of Georgia State University and Thomas Kida, M. David Piercey, and James F. Smith of the University of Massachusetts at Amherst. "However, if management overtly leads auditors to an area containing errors, auditors perform better at discovering managed earnings elsewhere in the financial statements."

In short, "directing auditors to accounts containing errors may not only be ineffective, but may actually backfire on management." In such cases, the professors found, 44% of auditors efficiently detected earnings manipulation. In contrast, only 29% detected earnings manipulation when managers didn't divert auditors at all. And, of course, the 44% detection rate was far above the 7% rate that prevailed when a diversion site was error-free.

Why divert the auditors to an area that has been deliberately seeded with errors? The authors explain: "Given budget constraints, more time spent [by an auditor] in one area of the audit may result in less time spent in other areas. In addition, allowing auditors to find errors may contribute to the auditors feeling satisfied that they 'have done their job,' resulting in auditors feeling less compelled to discover other errors. Finally, management may feel that pointing out areas that lead to error discovery may increase the trust that auditors have in them, resulting in auditors performing less work in areas that management suggests are problem-free."

But such reasoning, the authors observe, fails to take account of auditors' habitual "skepticism and conservatism...an auditor's tendency to focus on negative information, especially with respect to the client reporting higher profits. As a result, if an auditor uncovers a distracting error, that discovery may raise red flags concerning the accuracy of the financial statements and actually increase the auditor's effort to uncover errors elsewhere."

In contrast, auditors who are warned about errors in areas that turn out to be clean evidently "conclude that if the client's accounts are accurate in areas of higher misstatement risk, they are likely to be error-free elsewhere in the financial statements." The authors cite the example of the ZZZZ Best Company, which eluded detection by diverting auditors to its legitimate carpet-cleaning business and away from its fraudulent restoration business.

The study's findings are based on an experiment involving 76 auditors with an average of four years' professional experience, two thirds of them employed by Big Four accounting firms. Working on computers, participants perused about 20 pages of financial statements and data about a fictional manufacturing company which, the auditors were informed, had consistently met analysts' earnings forecasts. The statements revealed that in the current period, the company had beat analysts' forecasted earnings per share by about $0.025. An error was embedded in the statements, however (spread among different accounts to make it difficult to uncover), which understated compensation expense and accruals by about $450,000, and which, if discovered, would cause the company to miss its earnings target.

The auditors were randomly assigned to four groups. Two of them (the diversion groups) were informed that the individual who had been responsible for maintaining non-current assets (such as property and plant and equipment) had left the company about six months ago and that her replacement had very little accounting experience. In the case of one of the diversion groups, two offsetting, easily uncovered errors were embedded among non-current assets, but the other group's non-current-assets section was error-free. As indicated above, the former group was over six times more likely than the latter one to detect earnings manipulation.

Neither of the remaining two groups of participants was given cause to pay special attention to any particular area of the statements; one group's non-current assets contained the same offsetting, easy-to-detect  errors that one of the diversion groups encountered, while the other group's non-current-assets section was error-free. As indicated earlier, the same percentage of auditors in both non-diversion groups were able to detect earnings manipulation.

The study also gauged the extent to which skepticism contributed to auditors' detection abilities. As the authors note, "While auditors are trained to practice professional skepticism, there appears to be differences in the degree of skepticism held by auditors. The question therefore arises: Are auditors who exhibit greater skepticism more likely to scrutinize the financial statements and perform better at detecting managed earnings?" To find out, the researcher asked auditors to agree or disagree with a series of statements bearing on managers' trustworthiness -- for example, "Managers try to manage earnings to meet earnings targets," and "Managers are likely to commit fraud if left unmonitored." The result: auditors with more than an average amount of skepticism were about twice as likely as others to detect earnings management, leading the authors to conclude that "even though professional skepticism is practiced widely by auditors...there is room for further growth through added practice and training."

The study, entitled "Managing Audits to Manage Earnings: The Impact of Baiting Tactics on an Auditor's Ability to Discover Earnings Management Errors," is one of some 70 research reports being presented at the annual meeting of the Auditing Section of the American Accounting Association (San Diego, Jan. 14-16). The AAA, with 8,000 members, is a worldwide organization devoted to excellence in accounting education, research, and practice.

 

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