[The 1987 Treadway Report recommended several ways the profession might enhance auditors' ability to detect fraud. The Auditing Standards Board implemented many of the recommendations in 1988 with nine new "expectation gap" pronouncements issued as SAS Nos. 53 through 61. These new standards clarify and extend an auditor's responsibility for (1) detecting and reporting errors, irregularities (including fraud), and illegal acts (SAS Nos. 53 and 54) and (2) assessing the internal control structure (SAS No. 55). The effect of recent and possible future increases in auditors' responsibility to deter and detect fraud warrants study. To provide insight into the strategic interaction between a manager and auditor, we develop a theoretical foundation through game-theoretic analysis and economic experimentation. The game involves one decision by the manager and two by the auditor. The manager moves first, choosing a probability of committing fraud. The auditor, without observing the manager's choice, decides whether to perform tests of controls and then decides the level of detailed tests of balances. This second stage of testing allows the auditor to detect fraud with a probability that increases with the level of testing (up to a probability of less than 1). We solve for Bayesian Nash equilibria in this setting. This study investigates the effects of four independent variables: (1) auditor's penalty, which reflects either a monetary loss (through lawsuits) or a loss of reputation from failure to detect fraud, (2) auditing standard requirements, which reflect the ability of auditing standard setters to increase auditors' responsibility for detecting fraud or other irregularities, (3) the quality of the internal control structure, which is represented by a distribution of unintentional clerical errors that the auditor must investigate to detect an irregularity, and (4) audit fee, which reflects increased competition in the market for auditing services. We examine the effect of these variables on: (1) tests of transactions and detailed tests of balances, (2) fraud detection, and (3) incidence of fraud. The results of the economic experiment indicate that increasing the auditor's penalty decreased fraud, increased detailed tests of balances, decreased tests of transactions, and increased fraud detection. Increasing testing requirements increased audit costs, decreased discretionary testing, increased fraud detection, and decreased fraud commission. With strong internal control, auditors increased tests of transactions and detected fraud more frequently; managers committed fraud less frequently. Increasing the audit fee resulted in less fraud. The empirical results support a direct relationship between testing, fraud detection, and fraud prevention. Two caveats are worth noting. Given our motivation for studying the interaction between manager and auditor, we frame the issue as fraud. However, the model actually encompasses all irregularities. Irregularities come in two varieties: fraud (misrepresentation of fact) and defalcations (misappropriation of assets). The situation modeled is sufficiently general to fit both types of irregularities, yet not so specific as to exclude either one. Management fraud possesses many unique features that are only implicit in the model (e.g., reporting). Hence, any generalizations should pertain to the detection of irregularities rather than to specific aspects of management fraud. A second caveat is that we focus solely on the economic implications of fraud in this study, and its ethical dimension is not explored.]

Investigates the effects of the auditor's penalty, auditing standard requirements, quality of the internal control structure and audit fee on tests of transactions and detailed tests of balances, fraud detection and incidence. Experimental economics; Game theory; Theory development.