March 23, 2010
Unfortunately, spotting and preventing individual cases of intentional quadrophobia could prove difficult for regulators, because companies engaging in quadrophobia will always have a strong statistical case to hide behind. Even if fours are evenly distributed, there is a 90 percent chance in any given quarter that the value in the first decimal place of reported EPS figures will not be four. And, even over four years, or 16 quarters, there is an 18.5 percent chance that honest companies will never report a four in the first decimal place.
Furthermore, it is uncertain whether increased attention from auditors would deter quadrophobia, anyway. Grundfest and Malenko found quadrophobia to be statistically significant in both audited and unaudited data prior to 2001, which means that auditors failed to deter the practice. From 2002, the year Sarbanes-Oxley passed, onwards, quadrophobia does decrease in audited annual data, in which the number of fours has approached 10 percent. Grundfest and Malenko caution, however, that these numbers may be skewed by loopholes included in Sarbanes-Oxley such as allowances for "unusual and nonrecurring transactions.” It is therefore impossible, they say, to tell whether the tighter auditing process had any effect on quadrophobia. Sarbanes-Oxley did not significantly change the auditing process for quarterly data, and has the prevalence of quadrophobia in quarterly data has stayed about the same.
To get an idea what it would be like for auditors looking for individual cases of quadrophobia, Advisor Perspectives examined COMPUSTAT's quarterly EPS data for Enron from 1999 through 2001 and for WorldCom from 1999 through 2002, the years of each company’s alleged accounting violations. Because official EPS reports show EPS figures rounded to the nearest cent, we calculated EPS values for each quarter using the raw data for income and common shares. In 11 quarters, a four appeared in the first decimal place of Enron's EPS figures once, in the second quarter of 2000, for a rate of 9 percent. In WorldCom's data, a four showed up in the first decimal place of EPS figures once in 13 quarters, in the first quarter of 1999, for a rate of 8 percent. While both rates are lower than 10 percent, neither is low enough to suggest any sort of wrongdoing.
Finally, even if increased attention from auditors could deter quadrophobia, it is uncertain whether increased investment in the auditing of quarterly data to spot the behavior pattern is warranted. Once again, the dollar amounts involved in quadrophobia tend to be very small. And deterring quadrophobia alone would leave other, more damaging accounting practices unaffected. Grufest and Malekno therefore urge us to view quadrophobia as simply one more forensic tool investigators can use to detect accounting fraud at individual firms.
Charlie Curnow is an assistant editor at Advisor Perspectives.
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