| This dissertation uses economic game theory to examine whether the quality of a company's internal control system provides auditors and investors information about the risk of management fraud. Results indicate that a manager with strong incentives to commit fraud may have incentives to choose a weak control system. This result holds even though it is assumed that internal controls do not prevent or detect management fraud. Although managers who commit fraud may prefer a weak control system, the auditor may be less likely, conditional on the audit evidence, to investigate for fraud when controls are weak than when controls are strong. This result can occur because routine audit procedures may not distinguish between errors and fraud. Thus, a weak control system can "hide" fraud. Additionally, the auditor may not fully compensate for the increased risk of fraud, so that the audit failure rate with respect to management fraud may be higher when controls are weak. These and other findings have implications for auditors' risk assessment, auditor compliance with due diligence standards, and auditor-client disagreements over auditors' internal control recommendations. The conclusions of the dissertation also provide support for legislative and regulatory efforts to require auditors to report on the adequacy of clients' internal controls. |
