New research has raised doubts about the ability of auditors to ferret out earnings management.

Benjamin Luippold

The research, which won the Best Paper Award at the 2010 annual meeting 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 may do this by warning about the risk of errors in some other area.

The experiment revealed that diversion is almost 100 percent successful if the area to which the auditor is nudged is error-free. Only about 7 percent 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,” said 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.”

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

Auditors who are warned about errors in areas that turn out to be clean seem to 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.