Risk Management

‘Boomerang’ Auditors Make Better Fraud Detectives, Experiment Shows

Auditors who spend time as CFOs and then return to public accounting are likely to do a better job of catching earnings cheaters.
David KatzAugust 21, 2015

“Boomerang” auditors – auditors who spend time as CFOs or controllers and then return to public accounting – are better at sniffing out when and by how much their clients are cheating on their financial reports, a new study finds.

Marietta Peytcheva

Marietta Peytcheva

Further, auditors who are psychologically inclined to stand in another person’s shoes “are better able to judge managers’ reported earnings” than auditors less able to see things as others see them, according to the study, “Perspective taking in auditor-manager interactions: An experimental investigation of auditor behavior,” which appears in the August 2015 edition of Accounting, Organizations and Society.

One experiment the researchers performed shows that if you’re an auditor who at one time has assumed the role of a corporate financial manager, “you’re better able to take the perspective of the manager, and you’re better able, therefore, to understand when the manager is sort of lying to you, when the manager is overstating earnings,” says study co-author Marietta Peytcheva, an assistant professor of accounting at the Lehigh University’s College of Business and Economics.

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In a second experiment, they found that regardless of whether an auditor has done a stint as a CFO, auditors who have a naturally better “perspective-taking disposition” can do a better job of guessing the CFO’s or controller’s incentives and “can quantify that better,” she adds.

Peytcheva notes that the ability to understand the mindset of financial managers is very important for auditors, who never observe “true earnings” – what the company’s internally known experience is rather than what it reports. Lacking inside knowledge of a corporation’s financials, auditors with either learned or inborn perspective-taking skills know what aspects of company’s public reporting to probe, what questions to ask the financial manager, and what results to test.

Financial managers and auditors are involved in a “strategic game” when they decide what numbers should appear in corporate financial statements, according to Peytcheva. “CFOs make assertions to auditors, and the auditors don’t test everything. But they should know when to test and what to test,” she adds.

In light of other new research, perspective-taking ability on the part of auditors may be a lot more important than previously thought. News of the experiments follows publication of research by three University of South Carolina accounting professors that found that company managers have a bias toward hiring  accounting professionals who seem prone to earnings management.

The Big Four accounting firms have been recruiting financial managers, controllers, and CFOs on the grounds that they bring back stronger finance knowhow, more unique experience, and knowledge of a particular industry, according to Peytcheva.

“But what we’re saying is, [knowing] how a manager thinks … can be very valuable, because it can improve the interaction between the manager and the auditor,” she says. “And the auditor can improve financial reporting in future interactions with other CFOs if the auditor has been a CFO.”

For the first experiment — the one measuring the boomerang effect — the study’s authors recruited 58 mostly undergraduate public-university business majors with an average of age of 21. The students were randomly divided into one of two groups: one whose role would change from “manager” to “auditor” over the course of the experiment and one that would remain as “auditor” throughout.

The experiment proceeded through six rounds. In each of the first two rounds a manager received two numbers — for example, 50 and 20 — that added up to an accurate earnings total. Sitting in a separate room, the auditor only knew of the 50 part. At that point, the manager might select a total of 90 to send to the auditor – thus “overstating” the accurate earnings figure. The auditor was then told, “Your manager reported 90,” says Peytcheva. “First decide to accept this report or to reject it, and, second, estimate how much is the true earnings.”

In round 3, all the participants became auditors and remained so until the end of the experiment. They were provided with a number representing one of two parts of an accurate earnings total, plus a corresponding number reported by a manager. (The numbers were randomly selected from a prior experiment done by the researchers.) The students then each had to say whether the manager’s number was true or false, and if false, by how much.

The students with the first two rounds of “managerial” experience ended up scoring higher than those without it, according to the study.

In the second experiment, which employed 39 students, participants were asked similar questions but weren’t divided into two groups. Each was then given a psychological test to measure his or her ability to assume the perspective of another person. Those who scored higher on the test also ended up scoring high on their ability to detect earnings manipulation, the researchers found.