Distraction and deception go hand in hand, whether in a magic act or at a dishonest company. Sam Antar, the ex-CFO of electronics retailer Crazy Eddie, kept auditors away from the company’s fraudulent practices in the 1980s in part by having his staff distract them with constant small talk and invitations to coffee and lunch. Around the same time, Barry Minkow, the founder of ZZZZ Best, kept auditors focused on the legitimate side of the business (carpet cleaning) and away from an “insurance restoration” unit, which was fake.
A 2009 study backs up that anecdotal evidence. Performed by researchers at the University of Massachusetts at Amherst, the study demonstrates that auditors are less likely to find manipulated earnings when management directs their attention away from areas of financial statements that contain errors. (The study was recently voted best research paper by the American Accounting Association’s auditing section.)
The researchers, headed by Benjamin Luippold, now an assistant professor at Georgia State University, conducted an experiment in which 76 auditors participated, most of them from Big Four accounting firms. The auditors’ average experience was four years. They were given 20 pages of financial statements for a fictitious manufacturer, which they could review at their leisure. The auditors were told that the publicly traded company, with about $100 million in assets, had repeatedly beaten analysts’ earnings forecasts, most recently by $0.025 per share. In addition, they knew that the audit had a materiality threshold of $100,000.
Each report contained an error that understated compensation expense and accruals by about $450,000, enabling the company to beat the earnings target. However, the error was divided between accounts to make it hard to find.
The likelihood of the auditors’ finding the error depended on what management told them about the audit beforehand. The auditors were divided into four groups. One group was told nothing; another was “baited” into looking at a section of the financial statements that contained no errors; and the other two groups were pointed in the direction of minor, “distracting” errors or diversions. (One such diversion was the risk alert that an employee with little accounting experience had recently been put in charge of noncurrent assets, suggesting that that was an area on which to focus.)
Only 7% of the auditors who were diverted to accounts that had no errors found the earnings-management mistake. On the other hand, 44% of auditors who were directed to areas containing minor errors also found the key earnings-management error. The researchers reason that distractions involving actual errors “could raise a red flag, resulting in greater overall audit effort and a greater likelihood that [the auditors] would find the earnings management error.” Would-be fraudsters, take note.