Internal Controls for Preventing Fraud and Building Trustworthiness in Companies

• In Event: Auditing II

Abstract

The purpose of this paper is to analyze relationships among trust, employee trustworthiness, fraud, and internal controls in a game-theoretic framework. The modeled game is between the manager and employee. The manager trusts the employee (no controls) based on the employee trustworthiness, and the employee trustworthiness is modeled as a function of monetary and psychic costs/benefits of committing and not committing fraud. The analyses of the games indicates that as the employee’s trustworthiness and the strength of internal controls exceeds a critical value, the manager and employee increasingly choose trust (no controls) and no fraud as rational choices. Also, as the employee trustworthiness goes down, the strength of the internal controls has to increase exponentially to keep the employee from choosing fraud. Third, the analysis indicates that probability of fraud is inversely related to the efficiency of the controls in detecting fraud and also to the size of the loss from fraud to the manager. Fourth, the results of sequential game indicate the conditions under which manager is better off than simultaneous game equilibrium strategies. Finally, the results of the multi-period game strategies such as min max, tit for tat, and bluff strategies are evaluated. The policy implications of these findings for the managers are also discussed.

Author

• Jiangxia Liu, Gannon University