The Wall Street Journal
Investors rely on auditors to serve as watchdogs against corporate fraud. But auditors have little to gain—and much to lose—from doing a lot of barking.
Although failing to detect fraud can be disastrous, auditors know that identifying genuine wrongdoing usually means considerable trouble and expense—and perhaps questions about why it wasn't spotted sooner. Conversely, a false alarm about fraud antagonizes clients, dismays supervisors and produces its own stresses. Auditors thus learn to be reluctant skeptics.
What might boost their confidence and accuracy? A new study shows that just a few timely words of encouragement radically improved the ability of auditors to detect fraud. The finding could help them to become more vigilant—and also help investors who might otherwise fall prey to dishonest enterprises.
To see if they could overcome veteran auditors' aversion to diagnosing fraud, accounting professors at the University of Illinois and Duke University randomly chose five public companies that had experienced or been accused of fraud, and five that were not. (All the companies were relatively obscure and lacked signs of fraud on their financial statements.) The subjects for the study were 31 seasoned auditors with an average of 24 years experience, all but three of whom were certified public accountants.
Each auditor was assigned four companies and given financial statements and the transcript of the first five minutes of an actual 2007 earnings conference call by the firm's CEO. A company was deemed fraudulent if its quarterly financial statements were later restated and linked to fraud, a regulatory investigation or a class-action lawsuit. CEOs were assumed to know about the fraud. Auditors were asked to read the transcript and say whether they thought a fraud was afoot.
Crucially, half the auditors were told to look out for "cognitive dissonance" in the CEOs remarks—"the negative, uncomfortable emotion a person feels when they are saying something that they know is not true." Such individuals, the auditors were told, would feel "uneasy" and "bothered."
That simple instruction had a big effect. Auditors who received it identified 70% of the fraudulent companies they encountered; those without the instruction nailed just 43%. The instruction also boosted the auditors' ability to detect unidentified "red flag" sentences in the transcripts of fraudulent companies. Research assistants had determined that these sentences were related to the particular fraud. Auditors without any special instructions spotted 21% of them; the "instructed" auditors spotted 32%, without any increase in false positives.
It is hard to say what cues these veteran auditors were picking up from this humdrum material. The transcripts, unlike those prepared commercially, included "uhs" and "ahs" and other signs of hesitation. But these weren't more prevalent in red-flag sentences, says Mark Peecher, one of the authors of a forthcoming academic article on the research. He attributes the auditors' mysterious powers of fraud detection to the prompt and "the know-how and business sense they've amassed over the years."
The results suggest that auditors could find more fraud if they were simply asked to watch for cognitive dissonance—basically, discomfort—in management's response to questions. It seems to shatter what the researchers call the "illusion of objectivity" that normally prompts watchdogs to rationalize suspicious clues.
"Improving Experienced Auditors' Detection of Deception in CEO Narratives," Jessen L. Hobson, William J. Mayew, Mark Peecher and Mohan Venkatachalam, Journal of Accounting Research (forthcoming) This article was licensed through Dow Jones Direct.
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