The Interaction between Internal Control Assessment and Substantive Testing in Audits for Fraud

Abstract

We examine, from the auditor's perspective, the interaction between internal control evaluations and substantive testing in a model of fraud detection. The purpose of our study is to examine a two-stage model of the auditor/manager interaction in which the auditor assesses the ?likelihood?; or possibility of fraud in the first stage and conducts substantive tests in a second stage. We compare this two-stage model to a model in which the auditor is restricted to substantive testing only, in order to assess the incremental costs and benefits of performing internal control evaluations. We find that the two models yield the same equilibrium probability of fraud detection, but that the two-stage model achieves this level of detection at a lower cost to the auditor.

JEL Classification: M49, C70