Audit Strategies and Multiple Fraud Opportunities of Misreporting and Defalcation

38 Pages Posted: 21 Jul 2003  

Evelyn Patterson

Indiana University-Kelley School of Business

James Noel

First Principles Consulting, LLC

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Abstract

We examine how an auditor assesses the risk of fraud and formulates an audit plan when the auditee has the opportunity to commit various types of fraud. Unlike previous studies, the auditee can misappropriate assets (also called defalcation), misreport financial information (also called fraudulent financial reporting), or misreport financial information in combination with defalcation. Our results identify four possible equilibria whose characteristics depend on the auditee's relative rewards and penalties from the various types of fraud, the cost of audit effort and expectations about the auditee-firm's performance. When the cost of audit effort is sufficiently small, fraud risk assessment depends on the auditee's rewards and penalties associated with each type of fraud, but not on the auditor's beliefs about firm performance. The auditor develops an audit plan that focuses on the type of fraud the auditee is most motivated to commit, and in turn, the audit plan deters all other types of fraud.

Keywords: defalcation, misreporting, audit strategy, fraud

JEL Classification: C72, M41, M43, M49, G38

Suggested Citation

Patterson, Evelyn and Noel, James, Audit Strategies and Multiple Fraud Opportunities of Misreporting and Defalcation. Available at SSRN: https://ssrn.com/abstract=414920 or http://dx.doi.org/10.2139/ssrn.414920

Evelyn Patterson (Contact Author)

Indiana University-Kelley School of Business ( email )

801 West Michigan
Indianapolis, IN 46202
United States
317-278-7843 (Phone)

HOME PAGE: http://kelley.iupui.edu/faculty/FacultyProfile.cfm?netid=evpatter

James Noel

First Principles Consulting, LLC ( email )

1802 E. Desert Park Lane
Phoenix, AZ 85020
United States
602-674-3488 (Phone)

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