What works on auditors may work on lenders
A 2009 study performed by researchers at the University of Massachusetts at Amhurst demonstrated that auditors are less likely to find manipulated earnings when management directs their attention away from areas of financial statements that contain errors.
The auditors were split into four groups and here was their success at spotting a $450,000 error in an audit where $100,000 was the materiality threshold:
- 7% of the group that was ‘baited’ into looking at a section of the financial statements that contained no errors found the big one.
- 44% of the groups pointed in the direction of minor ‘distracting’ errors or diversions like a risk alert that an employee with little accounting
experience had recently been put in charge of noncurrent assets found the big one.
- The article in CFO magazine did not share the success rate of the group that was told nothing.
The take-away for lenders and underwriters?
You are more likely to look for bigger problems when you find smaller problems with the numbers, and I think that is a good thing.
And it is natural for a borrower to direct your focus to what is going well. That does not mean they are hiding something else.
But it doesn’t mean they aren’t! Be careful to do your due diligence on all material aspects of the business and don’t fall victim to the fraudsters diversion tactics.