The Effect of Tone at the Top on Internal Auditors’ Assessments of the Likelihood of Financial Misstatements

• In Event: Internal Control, Tone at the Top, Corporate Governance and Financial Reporting Quality

Abstract

The purpose of this study is to examine the effects of tone at the top and coordination with external auditors on fraud risk assessments made by internal auditors. Prior empirical evidence suggests that employees’ judgments could be influenced by the power of top management through the tone at the top. Given the important role of internal auditors in ensuring quality corporate governance, this study investigates whether internal auditors’ fraud risk assessments are biased in favor of management’ when the tone at the top is bad and whether the existence of coordination with external auditors can mitigate this bias. Results of an experiment involving 64 internal auditors indicate that internal auditors report a higher risk of intentional misstatements when the tone at the top is bad. This finding runs counter to the anticipated bias in internal auditors’ fraud risk assessments, suggesting that internal auditors are more skeptical when the tone at the top is bad, and a bad tone at the top is considered as a red flag to financial misstatements. The results on the coordination between internal and external auditors suggest that the existence of the coordination can be used as an effective mechanism to mitigate the influence of a bad tone on internal auditors’ fraud risk assessments.

Authors

• Zhe Wang, Australian National University

• Neil L Fargher, Australian National University