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

Abstract

This study investigates internal auditors' consideration of fraudulent financial reporting as an explanation for an unexpected difference in operating income. We examine whether such consideration is affected by the direction of the difference, the use of earnings-based bonus plans, and the restrictiveness of debt covenants. We conduct an experiment in which 127 internal auditors list potential explanations for the unexpected difference. We find that these factors affect internal auditors' consideration of fraudulent financial reporting. Internal auditors list a larger proportion of explanations involving fraud (1) when income is greater than expected, and (2) when debt covenants are restrictive, conditioned on income being greater than expected. We also find that internal auditors assign a higher likelihood of fraud when (1) income is greater than expected, and (2) when an earnings-based bonus plan is used and debt covenants are restrictive. The practical implication is that specific factors can affect internal auditors' consideration of fraudulent financial reporting and potentially may impact audit plans.