Academic journal article Auditing: A Journal of Practice & Theory

Factors Affecting Internal Auditors' Consideration of Fraudulent Financial Reporting during Analytical Procedures

Academic journal article Auditing: A Journal of Practice & Theory

Factors Affecting Internal Auditors' Consideration of Fraudulent Financial Reporting during Analytical Procedures

Article excerpt

Internal auditors serve a vital function in corporate financial reporting. One area where internal auditors play an important role is in the prevention and detection of fraudulent financial reporting. The Standards for the Professional Practice of Internal Auditing states that internal auditors should be alert to the possibility of intentional wrongdoing and should have sufficient knowledge to recognize potential fraud indicators. This research examines whether internal auditors are sensitive to these risk factors.

We provided 127 internal auditors with an unexpected fluctuation in operating income and asked them to list explanations for the fluctuation and to assess the likelihood of fraud. We found that internal auditors were more likely to list fraud explanations when (1) income was greater than expected, and (2) debt covenants were restrictive in a situation where income was greater than expected. We also found that internal auditors assigned a higher likelihood of fraud when (1) income was greater than expected, and (2) when an earnings-based bonus plan was used and debt covenants were restrictive. The practical implication of our findings is that internal auditors did recognize and adjust their consideration of fraudulent financial reporting in the presence of specific fraud indicators. Therefore, internal auditors may serve to deter fraud, and CPAs may want to consult with internal auditors in evaluating and assessing fraud risks.

An examination of factors that affect internal auditors' consideration of fraudulent financial reporting provides important insights into their role in the financial-reporting process. Relatively little academic research has examined the distinct role of internal auditors in this process. Yet, the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (1999) recognizes that internal auditors serve a vital function in corporate accounting and financial reporting. Moreover, external auditors rely on the work of internal auditors in the performance of annual audits, which is a critical aspect of financial reporting (e.g., Schneider 1985; Messier and Schneider 1988). Hence, many groups involved in corporate governance and disclosure (e.g., top management, audit committees, external auditors, government regulators) benefit by a better understanding of internal auditors' judgments, particularly their consideration of fraudulent financial reporting.

According to the Standards for the Professional Practice of Internal Auditing, internal auditors should be alert to the possibility of intentional wrongdoing, including fraudulent financial reporting (IIA 1998, Section 280.01). They are expected to have sufficient knowledge to identify potential fraud indicators (IIA 1998, Section 280.02.2). Internal auditing standards go on to suggest that analytical procedures may be useful in uncovering instances of fraudulent financial reporting and that internal auditors are expected to use such procedures in examining and evaluating information (IIA 1998, Section 420.01).

We investigate internal auditors' consideration of fraudulent financial reporting in an analytical procedures task. Prior research (Church and Schneider 1995; Church et al. 1998) has examined internal auditor behavior in tasks involving analytical procedures. The findings suggest that fraud explanations may be generated to account for unexpected fluctuations in financial data. But in general, empirical evidence on internal auditors' consideration of fraud in accordance with professional standards is scant.

In the experiment reported in this study, internal auditors are provided with an unexpected fluctuation in operating income and asked to list explanations to account for the fluctuation and assess the likelihood of the occurrence of fraud. We find that internal auditors are more likely to list fraud explanations when (1) income is greater than expected, and (2) debt covenants are restrictive, conditioned on income being greater than expected. …

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