How a Cue Can Help Veteran Auditors Better Detect Fraudby
Let’s say you’re an auditor with at least a couple of decades in the field under your belt, and you’re listening to the CEO of a public company answer questions during an earnings conference call. Would you be able to detect deception in his answers?
Chances are you won’t and for reasons you may not want to acknowledge. Unless, that is, you’re told to listen for what’s called a “negative affect” (i.e., cognitive dissonance – an uneasiness and discomfort in the CEO’s voice when lying).
That’s the basic premise of a new study, Improving Experienced Auditors’ Detection of Deception in CEO Narratives, by a team of researchers from the University of Illinois and Duke University.
The researchers found evidence that experienced auditors’ judgments about deception are less accurate for companies later linked to fraud, regulator investigation, or class-action lawsuits unless they are first instructed to look for signs of guilt in the CEO’s voice.
“Deception detection is very difficult. Most people have trouble figuring out when someone is deceiving them,” said study co-author Mark Peecher, the Deloitte Professor of Accountancy and associate dean of faculty at the College of Business at the University of Illinois. “The good news here is that very experienced auditors, who are hired because they’re supposed to be watchdogs for society, actually have the capacity to discern when upper management is being deceptive. The bad news is that they don’t fully tap into that ability and overlook fraud cues right before them, unless we make that task easier by prompting them with this cue.”
But the issue isn’t just about a lying CEO. Auditors must know what they’re listening for, have the spine to speak up about it, and call out the CEO who very likely is their client.
Easier said than done.
Citing a slew of research from 1993 to 2016, the authors posit that auditors face “disincentives” to detect fraud, use “motivated reasoning” to favor aggressive accounting methods, collect less evidence to avoid nasty interactions with managers, and are less skeptical as they gain experience.
“Collectively, these studies suggest experienced auditors are more attuned to the benefits of minimizing false positives as compared to false negatives, implying they will be more accurate at identifying nonfraud companies than fraud companies,” the study states.
But if experienced auditors are told to listen for deception (the “negative affect”) in what CEOs say, “it helps neutralize experienced auditors’ tendency to overlook or discount fraud cues, enabling them to apply audit-related knowledge that they have acquired over many years to better avoid false negatives,” the study states.
The researchers gathered 124 decisions from 31 auditors, mostly CPAs, at large public accounting firms. The test group averaged 24 years of experience in audit, assurance, or forensic services. Each participant got four companies to judge. The four were randomly drawn from five fraud and five nonfraud public companies. Excerpts were judged as fraudulent if the company’s quarterly financial statements discussed during the conference call were later restated and linked to fraud, there was an investigation by regulators, or class-action litigation resulted.
After reviewing the four excerpts, auditors decided if the CEOs’ answers were fraudulent. Researchers found that only the auditors who were instructed to look for fraud did the best. To better understand that, researchers then had the auditors indicate specific red flags in the CEOs’ comments. They found that auditors, when told to, described the red flags more extensively in companies with fraud.
“The ability to pinpoint worrisome portions of CEO narratives holds promise for auditors’ ability to tailor audit procedures to test specific accounts and transactions in need of investigation,” the study states.
Maybe, maybe not. Veteran auditors, who have the experience warranted to presumably catch more fraud, may not do so because they become “reluctant skeptics,” the study states. While auditors can face penalties for failing to detect fraud, they aren’t rewarded for doing so. And auditors who report clients to regulators can lose the client and are excluded from monetary awards for whistleblowing under the Dodd-Frank Act, the study states.
Peecher’s co-authors for the study included Jessen Hobson, assistant professor of accounting and PwC LLP Faculty Fellow, at the University of Illinois; Bill Mayew, associate accounting professor at Duke University; and Mohan Venkatachalam, accounting professor and senior associate dean of executive programs at Duke University.
Terry Sheridan is an award-winning journalist who has covered real estate, mortgage finance, health care, insurance, personal finance, and accounting and taxation issues for newspapers, magazines, and websites. A Chicago native and former South Florida resident, she now lives in New England.