International Journal of Auditing

Int. J. Audit. 12: 181–203 (2008)

Internal Auditors’ Evaluation of

Fraud Factors in Planning an Audit:
The Importance of Audit Committee
Quality and Management Incentives
Stephen Kwaku Asare,1 Ronald A. Davidson2 and
Audrey A. Gramling3
1
University of Florida
2
No affiliation
3
Kennesaw State University

We examine internal auditors’ fraud risk decisions in response

to variations in audit committee quality and management
performance incentives. Using an experimental approach, we
find that internal auditors serving in a either a self-assessment
role or a due diligence role were sensitive to variations in
management performance incentives, linked these variations
to fraud risk assessments and altered their audit plans
accordingly. With respect to audit committee quality, internal
auditors in both roles were sensitive to variations in quality,
but the responses to quality variations depended on whether
they were in a due diligence or self-assessment role. With
respect to the former, they linked the variation in quality to
fraud risk, but did not alter the scope of their planned audit
effort. With respect to the latter, they neither linked the
variations in quality to fraud risk nor to planned scope.

Key words: Audit committees, audit planning, corporate

governance, fraud risk, internal auditors, management incentives

SUMMARY auditors are asked to assume one of two roles:

We examine internal auditors’ fraud risk decisions
in response to variations in audit committee quality
and management performance incentives by
conducting two experiments in which internal
Correspondence to: Stephen Kwaku Asare, University of Florida
– Fisher School of Accounting, Warrington College of Business,
PO Box 117166, Gainesville, FL 32611-7166, USA. Email:
kwaku@ufl.edu
either planning an audit of the company at which
the internal auditor is employed (self-assessment)
or planning an audit of a potential acquisition
target company (due diligence).
The results of the experiments indicate that
internal auditors in both roles were sensitive to
variations in management performance incentives,
linked these variations to fraud risk assessments
and altered their audit plans accordingly. With
respect to audit committee quality, internal auditors

ISSN 1090-6738
© 2008 The Author(s)
Journal compilation © 2008 Blackwell Publishing Ltd, 9600 Garsington Rd, Oxford OX4 2DQ,
UK and Main St., Malden, MA 01248, USA.
182
in both roles were sensitive to variations in quality,
but the responses to quality variations depended
on whether they were in a due diligence or
self-assessment role. With respect to the former,
they linked the variation in quality to fraud risk, but
did not alter the scope of their planned audit effort.
With respect to the latter, they neither linked the
variations in quality to fraud risk nor to planned
scope. This study provides preliminary evidence
that, for at least one fraud factor (i.e., audit
committee quality), internal auditors’ fraud
assessments and related planning decisions may be
contingent on their positional role.
INTRODUCTION
This study examines internal auditors’ fraud risk
decisions in response to variations in the level of
management performance incentives and the
quality of the audit committee. We conduct two
experiments that varied the role of the internal
auditors to reflect the dual role that they play in
fraud risk management programs. In the first
experiment, internal auditors assume a due
diligence role, which involves planning an audit of
a potential acquisition target company, while in the
second experiment they assume a self-assessment
role, which entails planning an audit of the
employing company.
Our focus on internal auditors’ fraud risk
decisions is motivated by the central role of internal
auditors in corporate fraud risk management
programs (IIA, 2007) and their growing role in
enterprise risk management (see Beasley et al.,
2005; Gramling & Myers, 2006; Sarens & DeBeelde,
2006). For instance, to meet the anti-fraud
regulatory requirements of the Sarbanes-Oxley
Act in the United States, corporate executives
and audit committees are increasingly turning
to internal auditors for support (Frank, 2004).
Similarly, standard setters have emphasized the
importance of internal auditors’ fraud detective
and preventive responsibilities and have provided
guidance aimed at improving effectiveness
(IIA, 2007; see, e.g., Performance Standards 2201
and 2210, Implementation Standard 1220.A1, and
Practice Advisory 1210.A2-1). It is therefore
important to examine how, and how well, internal
auditors evaluate management incentives and audit
committee quality, both of which have been
associated with fraud and highlighted in the
business press, recent regulations, and the
academic literature.
© 2008 The Author(s)
Journal compilation © Blackwell Publishing Ltd. 2008
S. K. Asare et al.
Our focus on internal auditors’ fraud risk
decisions is also motivated by the apparent
conflict between their role in a fraud risk
management program and their role as part of the
corporate management team. A further potential
conflict arises because internal auditors should be
in a position to consider audit committee quality
when making fraud evaluations, but internal
auditors are evaluated by those audit committee
members. Effective fraud prevention and
detection require a skeptical evaluation of
management performance incentives and the
quality of financial reporting oversight provided
by the audit committee (IIA, 2007, also see SAS
No. 99 (AICPA, 2002) and ISA No. 240 (IAASB,
2007)). As part of self-assessment, internal auditors
should consider the impact of performance
incentives on their own management teams and
whether the audit committee can exercise proper
financial reporting oversight. There are a priori
reasons to believe that internal auditors might
not be effective in this role. First, there is
a natural tendency not to associate deceptive
tendencies with one’s own management team.
Second, because internal auditors report to the
audit committee, they might unquestionably
assume that the committee is effective, fail to take
the quality of the committee into account, or
otherwise discount the quality of the committee in
their fraud decisions. The potentially conflicting
roles of internal audit in a self-assessment setting
raise questions about the conditions under which
internal auditors can effectively fulfill their fraud
detective and preventive responsibilities (see also
Asare & McDaniel’s (1996) finding that familiarity
with a preparer leads to less probing in the
orientation phase).
Related to the above is the question of whether
the internal auditors’ role drives the conceptual
lens that they use in a task (see e.g., Ahlawat &
Lowe, 2004; Dilts & Pence, 2006). Ahlawat & Lowe
(2004) find that internal auditors tend to be
advocates for client management and that their
judgments regarding inventory obsolescence are
influenced by whether they had assumed the role
of the internal auditor for the buyer or seller of
a target acquisition. This finding motivates the
current study’s attention to the dual roles of
internal auditors. In a self-assessment setting, the
familiarity between the internal auditors and
management is likely to be quite pronounced; and
the internal auditors’ role with respect to the audit
committee is highlighted by the fact that the audit
Int. J. Audit. 12: 181–203 (2008)
Internal Auditors’ Evaluation of Fraud Factors in Planning an Audit
committee has oversight responsibility related to
the internal audit function. In this setting, internal
auditors may adopt an internal perspective which
makes it difficult for them to carry out their
responsibilities effectively. By contrast, in a due
diligence setting, where the internal auditors’
familiarity with management and the audit
committee is lacking and where the audit
committee has no oversight role, we would expect
internal auditors to adopt an external perspective
and to be able to more effectively carry out their
responsibilities. We contend that for internal
auditors to be most effective they should adopt
an external perspective, regardless of whether
they are in a self-assessment or due diligence
setting.
By examining internal auditors’ judgments in
a self-assessment and a due diligence role, we
provide alternative settings in which they can use
either an internal or external lens. This allows us
to address whether internal auditors’ fraud risk
decisions vary by their role, while holding constant
the levels of performance incentives and audit
committee quality. Role-related differences in
internal auditors’ fraud-related judgments provide
an important insight into how to train internal
auditors to be effective partners in a fraud risk
management program.
We hypothesize that internal auditors will
link variations in management’s performance
incentives and quality of audit committee to fraud
risk assessments and will adjust audit plans to
reflect these assessments. These hypotheses
assume that internal auditors use an external
lens, which is not affected by whether they are
engaged in self-assessment or performing due
diligence. Under a changing conceptual lens
assumption, our hypotheses should hold for the
due diligence task, but not the self-assessment
task.
In our first experiment, internal auditors were
randomly assigned to one of the four cells created
by a full factorial crossing of level of management
performance incentive or quality of audit
committee (i.e., participants’ perceived competence
and independence of the audit committee). After
making initial risk assessments and scoping
decisions (budgeted hours) based on background
information about a target company (i.e., a due
diligence task), they were asked to provide revised
assessments and scoping decisions based on the
experimental variables. Our second experiment
differed from the first in that the hypothetical
© 2008 The Author(s)
Journal compilation © Blackwell Publishing Ltd. 2008
183
company was described as the employing
company.
Our experimental results indicate that internal
auditors consistently assess variations in
management performance incentives, link these
variations to fraud risk, and adjust their audit plans
accordingly. These results generally hold whether
they are in a due diligence or self-assessment role.
This overall finding is consistent with an external
lens perspective and suggests that justifiable
confidence may be placed in internal auditors to
play a critical role in anti-fraud and risk
management programs.
In terms of variations in audit committee quality,
internal auditors were consistently sensitive to
variations in quality, but the implications that
they drew were less clear and appeared to depend
on their role. In the due diligence setting, the
participants linked the variations in audit
committee quality to the risk of fraud. However,
they did not link this variation to fraud risk when
they evaluated their own audit committee in a
self-assessment setting. This is suggestive of using
an internal lens perspective. Alternatively, it may
be that the participants have more experience
assessing the fraud risk implications of an audit
committee in a due diligence setting than as part of
a self-assessment.
Finally, even in the due diligence setting, where
they linked the variations in audit committee
quality to the fraud risk, we found that the internal
auditors did not alter the budgeted audit effort.
One interpretation of this finding is that internal
auditors perceive the presence of a strong audit
committee of a target company as a deterrent to
fraudulent financial reporting, but do not believe
this presence to be a basis for reducing the scope
of work. Alternatively, internal auditors may be
signaling that the quality of the audit committee is
not a key consideration for them in their decision
to test for fraud in a target company, possibly
an appropriate signal given the relative lack of
familiarity of an acquired company.
The remainder of the paper is organized into four
sections. The next section provides background
information on the role of internal audit in assuring
quality financial reporting, discusses literature
related to the internal auditors’ role in assessing
the implications of audit committee quality
and management incentives in their fraud risk
assessments and related audit effort decisions, and
presents the research hypotheses. The research
method and results follow in the subsequent two
Int. J. Audit. 12: 181–203 (2008)
184
sections. We conclude with a summary of the
findings and a discussion of the potential
implications of these findings.
BACKGROUND AND HYPOTHESES
The responsibilities of the internal audit
function in preventing and detecting
financial statement fraud
Internal auditors perform multiple tasks in
organizations. For instance, they engage in
operational and compliance audits and assure
the quality of financial reporting (Felix et al.,
1998; BRC, 1999). They are also involved in
risk management activities (Beasley et al., 2005;
Gramling & Myers, 2006; Sarens & DeBeelde,
2006). Further, they can perform many of these
tasks as part of self-assessment, where the focus is
on the employing entity, or due diligence, where
the focus is on a targeted outside company (see
Aldhizer & Cashell, 2000; Burke, 2000; Davison,
2001; Nygaard, 2001). In this study, we focus on the
internal auditors’ role in assuring the quality of
financial reporting as part of both self-assessment
and due diligence. Our specific focus is on internal
auditors’ evaluation of fraudulent financial
reporting because of the potential for fraudulent
financial reports to cause significant dislocations in
global capital markets (e.g., Parmalat in Italy and
Enron in the United States). Regulators have urged
corporations to strengthen and report on the
quality of internal controls over financial reporting,
with specific emphasis on anti-fraud programs
(e.g., Sarbanes-Oxley Act in the United States).
Some exchange listing requirements mandate that
corporations implement an internal audit function
(see IIA, 2003, p. 22 for an overview) and corporate
executives have turned to their internal audit teams
to help strengthen their anti-fraud programs
(Frank, 2004).
Coextensively, standard setters in internal
auditing have provided guidance to internal
auditors for evaluating fraudulent financial
reporting. Specifically, IIA Standards require
internal auditors, who are planning an
engagement, to identify and evaluate fraud factors
(IIA, 2007; specifically refer to Performance
Standards 2201 and 2210, Implementation Standard
1220.A1, and Practice Advisory 1210.A2-1). Once
fraud factors have been identified, internal
auditors’ fraud risk judgments and decisions (i.e.,
fraud risk assessment and budgeted hours) should
© 2008 The Author(s)
Journal compilation © Blackwell Publishing Ltd. 2008
S. K. Asare et al.
appropriately reflect their assessments of fraud
factors (IIA, 2007; specifically refer to Performance
Standard 2230 and Practice Advisory 2210.A1-1.).
Internal auditors need to ensure that, in light of
the specific facts and circumstances, they have
obtained sufficient and appropriate evidence to
justify their conclusions. Fraud factors to be
considered when considering the nature and extent
of necessary evidence include management
performance incentives, as well as the quality of the
audit committee (IIA, 2007; see Practice Advisory
1210.A2-1 for a discussion of the elements of fraud
prevention or deterrence). These factors are also
noted in external auditing standards (e.g., SAS 99,
ISA 240), and have been found to be associated
with the incidence of fraudulent financial reporting
(e.g., Beasley et al., 1999b; Thomas & Clements,
2002).
There is anecdotal evidence that internal auditors
can detect corporate fraud (an example is the
WorldCom case, where ‘internal auditors played
a major role in surfacing and helping disclose
the accounting “errors” instigated by certain key
management officials’ (Bishop, 2002)). However,
the extent to which internal auditors can effectively
evaluate these fraud factors is an important open
question. What constitutes a fraud indicator is
based on professional judgment and is not
invariant to one’s perspective, specifically whether
one is evaluating from an internal or external
perspective. For instance, while external evaluators
may consider management performance incentives
as essentially a truth-distorting incentive, internal
evaluators may see the same incentive as strictly
effort-enhancing. Indeed, in the classical agency
setting, shareholders award these incentives to
realign management’s interest with theirs.
Likewise, while a low quality audit committee may
be considered by an external evaluator as an
opportunity for fraud, internal evaluators may
understand it as a strictly cost-benefit calculus or a
condition that has no harmful effect. As discussed
by Ahlawat & Lowe (2004), the nature of the
employer–employee relationship provides an
environment in which internal auditors may find it
difficult to be objective (see also Morgan, 1988).
Further, some research indicates that management
may be able to bias the professional objectivity of
internal auditors (Harrell et al., 1989).
The importance of examining whether one’s
role will influence one’s judgments is further
emphasized in management judgment and
decision-making research which demonstrates that
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Internal Auditors’ Evaluation of Fraud Factors in Planning an Audit
one’s position in an organization influences the lens
through which one makes decisions, and thus
influences the actual judgments and decisions (e.g.,
Dilts & Pence, 2006). In an internal auditing context,
many internal auditors have received education
in external auditing and perhaps retain the
knowledge, attitudes and skills of external auditors.
Thus, it is a reasonable expectation that they can
bring an external perspective and objectivity to the
evaluation of their own organization. Nevertheless,
they are recognized as part of the day-to-day
management team and report to the audit
committee, whose members have oversight and
evaluation responsibilities related to the internal
audit function. This association could lead them to
adopt an internal perspective in a self-assessment
setting.
The linkage between management
performance incentives and fraudulent
financial reporting
The linkage between management performance
incentives and fraudulent financial reporting has
been emphasized in the business press (see Byrne,
2002, for additional discussion on the relation
between excessive management compensation and
fraudulent financial reporting), and has resulted in
increased disclosure of management compensation
factors in the United States (SEC, 2006). Prior
research suggests that one type of external
evaluator, the external auditor, perceives that
management performance incentives are an
important indicator of fraud risk (Heiman-
Hoffman et al., 1996; Apostolou et al., 2001).
Archival research supports this linkage by
indicating that management performance
incentives are associated with the occurrence of
fraudulent financial reporting (Albrecht & Romney,
1986; Loebbecke et al., 1989; Bell & Carcello, 2000).
The source credibility literature provides the
theoretical grounding for the linkage between
management performance incentives and
fraudulent financial reporting.1 Source credibility
is influenced by various characteristics of the
information source including integrity (e.g.,
Kaplan & Reckers, 1984; Peecher, 1996),
competence (e.g., Messier & Schneider, 1988),
motivation (e.g., Jaspars et al., 1983; Eagly &
Chaiken, 1993) and personal/professional
relationship with the source (e.g., Asare &
McDaniel, 1996). From the perspective of an
external evaluator, management’s performance
© 2008 The Author(s)
Journal compilation © Blackwell Publishing Ltd. 2008
185
incentives affect the motivation to fraudulently
misstate financial information, which, in turn,
affects the credibility of their reported financial
numbers. For example, when management has
high (low) performance incentives, an external
evaluator would expect a higher (lower) likelihood
of fraudulent financial reporting. Accordingly, the
credibility of management’s financial reporting
assertions will be high (low) when management
performance incentives are low (high).
However, very little is known about how internal
evaluators assess management performance
incentives and incorporate the assessments into
their audit plan. When internal auditors perform a
due diligence task, it is reasonable to expect them to
link performance incentives to fraudulent financial
reporting. This expectation hinges on internal
auditors being an external evaluator of the
performance incentives of an unfamiliar/unrelated
management. If internal auditors assessing fraud
risk consider the credibility of the source from this
external perspective (e.g., Hirst, 1994; Goodwin,
1999), we should expect an association between
management performance incentives and assessed
risk of fraudulent financial reporting.2
The expectation is less clear in a self-assessment
setting where the motives pertain to a familiar/
related management. An empirical tension arises
because internal auditors socialize within a
corporation and report to that corporation’s
management. By contrast, in a due diligence
setting, the socialization within the corporation
being audited is absent and the internal auditors
may take on more of an external evaluator role. In a
self-assessment setting, because of the ongoing
relation with management, internal auditors may
see the incentives as strictly inducing effort, since
the contrary view requires them to accept that they
are associated with management that may falsify
information in response to incentives (i.e., they
may be unwilling to attribute an ‘evil mind’ to their
management team). That is, internal auditors may
view the situation from an internal perspective.
Even if internal auditors take an external
perspective, a second issue is whether internal
auditors follow up with audit planning judgments
(fraud risk assessment), and audit effort decisions
(level of budgeted hours) that reflect differences in
management performance incentives. It is possible
that internal auditors who take an internal
perspective may allow the confidence in familiar
management to affect their scoping decisions,
leading to no differences in related audit effort (see,
Int. J. Audit. 12: 181–203 (2008)
186
e.g., Asare & McDaniel, 1996) across varying levels
of management performance incentives.
When management performance incentives are
high (low) and internal auditors link this to a
penchant to misrepresent financial results, the
auditors should plan to exert more (less) effort
ascertaining whether, and to what extent,
fraudulent financial reporting has occurred. In
contrast, when incentives are not so linked,
there will be no effort adjustments. Our first set
of hypotheses, which assumes the external
perspective, states that internal auditors recognize
differences in management performance
incentives, and reflect the implications of these
differences in their risk assessments and audit
plans.3 Failure to reject these hypotheses will lend
credence to the internal perspective.
H1a: Internal auditors’ assessments of
management incentive to misstate financial
results will be higher (lower) when management
operates in a higher (lower) performance
incentive regime.
H1b: Internal auditors’ fraud risk assessments
will increase more when management
performance incentives are high compared to
when their performance incentives are low.
H1c: Internal auditors’ budgeted audit hours will
increase more when management performance
incentives are high compared to when their
performance incentives are low.
The audit committee as a mechanism to
limit the opportunity for fraudulent
financial reporting
An opportunity for fraud exists when internal
control over financial reporting is poorly designed
(see IIA, 2007; specifically refer to Practice
Advisory 2210.A1-1). Globally, many internal
control frameworks recognize that an
organization’s audit committee is an important
component of internal control (e.g., see internal
control frameworks from COSO, 2002, 2006; King
Committee on Corporate Governance, 2002; ASX
Corporate Governance Council, 2003; Financial
Reporting Council, 2006). The quality of the audit
committee relates to circumstances of the company
that might allow for, or mitigate, opportunities
for material management fraud. Regardless of
management’s performance incentives and the
related motivation to intentionally misstate their
© 2008 The Author(s)
Journal compilation © Blackwell Publishing Ltd. 2008
S. K. Asare et al.
financial results, a high quality audit committee,
exercising oversight over the financial reporting
process, reduces the opportunities for fraudulent
financial reporting (Loebbecke et al., 1989; Turner,
1998; Beasley et al., 1999b, 2000; Chtourou et al.,
2001).
Archival evidence, as well as a number of recent
financial reporting frauds where the quality of the
audit committee was called into question (e.g.,
Enron, and to a lesser extent Tyco and others
(O’Keefe, 2003)), has resulted in a growing level of
importance being placed on audit committee
quality (i.e., financial expertise and independence).
Research has demonstrated that audit committee
quality is related to limiting the opportunities for
fraudulent reporting (see also Beasley 1996;
McMullen & Raghunandan 1996; Beasley et al.,
1999a, 1999b, 2000; BRC, 1999, Chtourou et al., 2001;
Heffes, 2002).
While archival evidence supports a positive
relation between audit committee quality and
quality of financial reporting, there is little
empirical evidence that internal (or external)
auditors’ risk assessments and related audit effort
decisions are influenced by variations in audit
committee quality.4 In an external auditing context,
Cohen et al. (2002) note that external auditors view
audit committees as typically ineffective and
lacking adequate power to be a strong governance
mechanism. However, Cohen et al. (2002) find that
external auditors’ discussions with the audit
committee did impact their risk assessments and
audit planning decisions. In contrast, Stewart &
Munro (2007) find that Australian external
auditors’ assessments of audit risk are affected by
the existence and activities of the audit committee;
however, their audit testing decisions are not
greatly influenced by these audit committee
factors.
In an internal auditing context, Gramling &
Myers (2003) find that internal auditors rank audit
committee factors as important when assessing
fraud risk, albeit much less important than many
other factors. Further, Zain et al. (2006) document
that internal auditors’ assessments of their
contributions to the financial statement audit
are associated with various audit committee
characteristics. However, neither of these two
studies provides insights into whether audit
committee quality differences would be reflected in
internal audit planning judgments. We contend
that such differences should be considered by
internal auditors in planning their audits. Internal
Int. J. Audit. 12: 181–203 (2008)
Internal Auditors’ Evaluation of Fraud Factors in Planning an Audit 187

auditors need to form a judgment about the control set of hypotheses, we present the following
environment, which includes the audit committee, hypotheses, which assume an external perspective.
and its potential effect on the likelihood of fraud.
H2a: Internal auditors’ assessments of audit
This evaluation is relevant whether internal
committee quality (i.e., financial competence,
auditors are undertaking a risk assessment of their
independence) will be higher (lower) when the
own company or evaluating another company, for
audit committee is described as having all (no)
instance in the context of a potential acquisition.
independent members, and having all (no)
The evaluation thus has the potential to affect the
members with financial and/or audit experience.
scope of the internal audit in a manner similar to
the way in which the external auditors’ assessment H2b: Internal auditors’ fraud risk assessments
of the audit committee affects their judgments of will increase more when the quality (i.e.,
perceived level of risk. The evaluation of the audit financial competence, independence) of the audit
committee performed by the internal auditor is part committee is low compared to when the quality
of the internal auditor’s attempt to understand the is high.
control environment of the organization, and how
H2c: Internal auditors’ budgeted audit hours will
that environment might affect the risk of fraud, and
increase more when the quality (i.e., financial
the planned scope of the audit. In fact, we allege
competence, independence) of the audit
that it would be inappropriate for the internal
committee is low compared to when the quality
auditor to not consider relevant control
is high.
environment factors (e.g., audit committee) when
planning an audit.
From a source credibility perspective, internal RESEARCH METHOD
auditors, taking an external perspective, should
first recognize differences in the quality of the Overview of experiments
source (i.e., the audit committee) and then
Internal auditors made financial audit planning
recognize that these quality differences may affect
decisions in two experiments. In Experiment 1,
the likelihood of fraudulent financial reporting
participants were asked to assume that they had
(e.g., Beasley et al., 1999a,b; Anon., 1999) when
been assigned to the internal audit team that will
assessing fraudulent financial reporting.
perform the audit of an acquisition target of their
The due diligence task provides a setting for
current employer.5 In Experiment 2, participants
internal auditors to take an external perspective.
were asked to assume that they had been assigned
However, in the self-assessment setting, internal
to the internal audit team that will perform the
auditors may have difficulty assessing an audit
audit of the employing company. In both
committee as weak (i.e., they are more likely to take
experiments, participants were told that their
an internal perspective). For example, they may
focus will be on the reliability and integrity of
perceive the existence of an audit committee as
the financial information. All participants were
prima facie evidence of management’s commitment
provided with background information and
to strong governance. This internal perspective is
comparative financial statements, after which they
magnified, given that internal auditors typically
made an initial assessment of the likelihood of
report to the audit committee, which is responsible
intentional misstatement of receivables and related
for providing oversight and evaluation of the
accounts and a preliminary budget for the audit
internal audit function.
of receivables. Subsequently the participants
If internal auditors adopt an external
were provided information on management
perspective, regardless of setting, we expect
performance incentives and the quality of audit
internal auditors to recognize differences in audit
committee and revised their assessments and
committee quality, and then reflect audit committee
budgeted hours.
quality in their fraud risk assessments and audit
plans (i.e., budgeted hours). On the other hand, if
internal auditors adopt an internal perspective in Overview of task and dependent variables
the self-assessment setting, we expect weaker
linkages between audit committee quality and The internal audit tasks and requested judgments
planning judgments (i.e., fraud risk assessments, were the same for both experiments. Specifically,
budgeted audit hours). Consistent with our first participants in both experiments were told that the

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188
audit team’s focus is on the reliability and integrity
of the financial information for the year just ended.
They had been assigned to plan an audit for the
area of accounts receivable and related accounts
(i.e., bad debts, allowance for uncollectable
accounts, cash discounts, and sales returns).6
Participants were told that their planning activities
would culminate in several risk assessments and
audit effort (i.e., budgeted hours) decisions.
Participants were reminded to make these
judgments as if they were on an actual audit where,
for instance, their judgments would be subject to
supervisory review.7
The first part of the case materials provided the
participants with information about the company
including comparative financial statements, key
personnel, and key accounting and internal control
policies. After reading this introductory material,
participants were then asked to indicate the
likelihood of an intentional material misstatement
existing in the net accounts receivable account.8
They made this assessment on a scale whose
endpoints were labeled ‘minimum likelihood’ = 0
and ‘maximum likelihood’ = 100. Participants were
also asked to budget audit hours to confirm
receivable balances, as well as to perform other
A/R work. They indicated total budgeted hours,
and provided an allocation of the total hours
among staff, seniors, managers, and director.
After providing these initial assessments,
participants were informed that their internal audit
director had additional information that she
believed they should consider. The director
provided information about revenue goals, and
related compensation incentives, and the
composition and activities of the audit committee
and board of directors.9 This additional information
served as the manipulations of management
performance incentives and audit committee
quality (see below). Subsequent to these
manipulations, participants were asked to provide
a revised risk assessment and update audit effort
decisions, as they deemed appropriate.
The case concluded with various follow-up and
demographic questions. In Experiment 1, on
average (s), the participants spent 28 (12.4) minutes
completing the case materials. These participants
reported a mean (s) of 7.43 (2.07) on a scale
of 0 = not at all understandable to 10 = very
understandable, when asked to indicate the
understandability of the instructions and case
materials. These measures were similar to those in
Experiment 2. Specifically, the time spent on the
© 2008 The Author(s)
Journal compilation © Blackwell Publishing Ltd. 2008
S. K. Asare et al.
case (28 vs. 28.05 minutes) and the perceived
understandability of the case (7.43 vs. 8.33) did not
differ between the two experiments.
The change in risk assessment and the
percentage change in budgeted audit hours after
seeing the manipulations serve as our dependent
variables (i.e., for H1b, H2b, H1c, H2c). This
pre-test/post-test approach serves at least two
objectives. First, it reduces noise that would result if
we were not able to obtain the participants’ initial
fraud risk assessments and budgeted hours (i.e.,
even if we were to have provided anchors for these
measures we have concerns as to whether our
participants would have actually used these
anchors). Second, this approach helps to ensure
that the relevant information was salient to the
participants. As discussed by Libby et al. (2002), this
approach increases power by allowing us to
analyze the changes in risk assessments and audit
effort decisions caused by our treatment. Since we
want to ensure that participants attend carefully
to the treatment information, and our analyses
are based on comparisons between treatment
conditions (which hold treatment salience
constant), we are not concerned about drawing
extra attention to the treatment.10 Further, our
approach is reflective of what internal auditors
might encounter on an engagement. That is, a
supervising auditor who is aware of information
will share that information with auditors working
on the relevant engagement. Alternatively, the
supervisor, in reviewing work papers, might have
occasion to remind the work paper preparer about
the need to consider other explicit information.
Participants
The participants in Experiment 1 were 60 internal
auditors who were recruited through either their
local Institute of Internal Auditors (IIA) chapter or
through personal recruitment from one of the
co-authors. The majority of the participants (54.1%)
were internal audit seniors or managers. On
average (s), our participants had 75.2 (66.12)
months experience as an internal auditor. Over the
last two years the participants had spent, on
average (s), 17.4 (21.3) percent of their time
conducting audits related to the integrity and
reliability of financial information. In terms of other
auditing experience, 14 participants reported
having external audit experience, with an average
experience of 39.7 months as an external auditor.
Int. J. Audit. 12: 181–203 (2008)
Internal Auditors’ Evaluation of Fraud Factors in Planning an Audit
A group of 43 internal auditors participated in
Experiment 2.11 The experience levels of the
participants in Experiment 2 were similar to those
in Experiment 1. Specifically, approximately 42%
of the participants were either audit seniors or
managers; and over the past two years participants
had spent approximately 27% of their time
conducting audits related to the integrity and
reliability of financial information. On average
(s), our participants had 100.23 (86.42) months
experience as an internal auditor. In terms of other
auditing experience, 26 (60.5%) participants
reported having external audit experience, with an
average experience of 22.7 (36.6) months as an
external auditor.
Research design and independent variables
In both experiments, we use a 2 ¥ 2
between-subjects research design. We manipulate
two factors, the level of management performance
incentives and the quality of the audit committee,
at two levels each.
The management performance incentive
conditions specifically focus on revenue-related
performance incentives. The performance
incentive was designed to encourage management
to engage in inappropriate revenue recognition
practices. In designing the high performance
incentive condition, we combined three of the top
ten fraud warning signs reported in prior research
(Heiman-Hoffman et al., 1996: 77; Eining et al.,
1997): management places undue emphasis on
meeting earnings projections or other quantitative
targets; a substantial portion of management
compensation depends on meeting quantified
targets; and management operating and financial
decision are dominated by a single person or a few
persons acting in concert.
Those in the high management performance
incentive condition were told:
Following last year’s net loss, the CEO
established some very aggressive revenue goals
for 2000. The sales force has faced a great deal
of pressure for sales growth from senior
management. In fact, achieving sales targets has
become a company-wide obsession. Much of this
pressure stems from management’s commitment
to analysts to achieve their goals. A significant
portion of senior management’s compensation
derives from a performance based bonus plan
tied to accounting earnings. The remainder
comes from a fixed salary.
© 2008 The Author(s)
Journal compilation © Blackwell Publishing Ltd. 2008
189
Those in the low management performance
incentive condition were told:
Following last year’s net loss, the CEO set
moderate revenue goals for the company for
2000. While these goals have provided motivation
to the sales force, these goals have not caused the
sales force inordinate pressure from senior
management for sales growth. While analysts
have used these goals in setting their forecasts,
management has not committed to the analysts
that they will achieve these goals. Senior
management’s compensation is derived
primarily from a fixed salary with only a small
percentage derived from performance bonuses
tied to accounting earnings.
Audit committee quality was manipulated
by varying the independence and financial
expertise of the audit committee.12 Specifically,
in the high quality condition, participants were
told:
The audit committee is comprised of three
members, who are all independent directors (i.e.,
no disclosed relationship between the director
and the company or its officers). Two of the audit
committee members are CPAs, while the third is
a CIA. All three have work experience in the
same industry as Valley Manufacturing. All three
have past experience in accounting and finance
positions; in fact, one of the audit committee
members is currently employed as a senior
officer with significant financial oversight
responsibilities.
In contrast, the participants in the low quality
condition were told:
The audit committee is comprised of three
members, of whom one is an officer of the
company, and one is a former employee of the
company, who recently retired. The third audit
committee member is an outside director (i.e.,
has no disclosed relationship between the
director and the company or its officers). None
of the three audit committee members are
professionally certified in accounting, as their
work experience has been exclusively in areas
outside accounting and finance. All three have
work experience in the same industry as Valley
Manufacturing.
Finally, the setting between Experiments 1 and 2
differed in the introductory statements as follows:
Int. J. Audit. 12: 181–203 (2008)
190
Due diligence (Experiment 1):
Mountain Manufacturing is currently
considering the acquisition of Valley
Manufacturing, a publicly held company whose
stock is traded on NASDAQ. Valley
Manufacturing manufactures and produces a
variety of products used primarily for industrial
application. It sells to industries that are
currently exhibiting a moderate amount of
growth and success. Its customers constitute a
diverse pool of industrial firms of which no
customer’s sales exceed 5% of total revenues.
Valley Manufacturing competes with five other
major manufacturers and has approximately
20–25% of the market share over the past five
years. The Company has a sales force of
individuals who contact clients and potential
customers on a regular basis.
As part of the acquisition negotiations, you
have been assigned to the internal audit team that
will perform an audit of Valley Manufacturing,
focusing on the reliability and integrity of the
financial information for the year (2000) that has
just ended. As part of this audit, you have been
assigned to plan the audit engagement for the
area of accounts receivable and related accounts
(i.e., bad debts, allowance for uncollectable
accounts, cash discounts, and sales returns).
Self-assessment (Experiment 2):
Assume that you are an internal auditor at Valley
Manufacturing, a publicly held company whose
stock is traded on NASDAQ. You have been
employed as an internal auditor at Valley
Manufacturing for several years. Valley
Manufacturing manufactures and produces a
variety of products used primarily for industrial
application. It sells to industries that are
currently exhibiting a moderate amount of
growth and success. Its customers constitute a
diverse pool of industrial firms of which no
customer’s sales exceed 5% of total revenues.
Valley Manufacturing competes with five other
major manufacturers and has approximately
20–25% of the market share over the past five
years. The Company has a sales force of
individuals who contact clients and potential
customers on a regular basis.
You have been assigned to the internal audit
team that will perform an audit of Valley
Manufacturing, focusing on the reliability and
integrity of the financial information for the year
© 2008 The Author(s)
Journal compilation © Blackwell Publishing Ltd. 2008
S. K. Asare et al.
(2000) that has just ended. As part of this audit,
you have been assigned to plan the audit
engagement for the area of accounts receivable
and related accounts (i.e., bad debts, allowance
for uncollectable accounts, cash discounts, and
sales returns).
RESULTS
Descriptive statistics
We present descriptive statistics on initial and final
fraud risk assessments and budgeted hours in
Table 1. We present these descriptives to provide
context for our dependent variables, which are the
changes in fraud risk assessments and budgeted
hours after viewing the manipulations (i.e., change
from initial to final).
Experiment 1: Due diligence
Panel A provides data about the due diligence
setting, where the overall mean (s) initial fraud risk
assessment is 38.25 (19.24) compared to the overall
mean (s) final risk assessment of 44.08 (22.75).
Participants in the high management performance
incentive condition provided a mean (s) initial
risk assessment of 39.68 (19.91), compared to a
mean (s) risk assessment of 36.72 (18.72) for those
in the low management performance incentive
condition. Participants in the high quality audit
committee condition provided a mean (s) initial
risk assessment of 37.58 (20.12), compared to a
mean (s) risk assessment of 38.97 (18.58) for those
in the low quality condition. In an ANOVA, using
the initial risk assessment as the dependent
variable, neither the management incentive
condition (F = 0.341, p = 0.562) nor the audit
committee quality condition (F = 0.072, p = 0.790)
is significant.
Comparative statistics for the overall initial and
final budgeted hours are a mean (s) of 125.22
(146.17), and 129.98 (146.86), respectively.
Participants in the high management performance
incentive condition provided a mean (s) budgeted
hours of 118.83 (124.26), compared to a mean (s) of
131.37 (166.75) for those in the low management
performance incentive condition. Participants in
the high quality audit committee condition
provided a mean (s) budgeted hours of 128.18
(166.47), compared to a mean (s) of 121.90 (122.86)
for those in the low quality condition. With respect
to the initial budgeted hours, neither the
Int. J. Audit. 12: 181–203 (2008)
Internal Auditors’ Evaluation of Fraud Factors in Planning an Audit 191

Table 1: Descriptive statistics on fraud risk assessments and budgeted hours initial and final judgments (pre
and post-manipulations)
Panel A: Experiment 1: Due diligence
Initial fraud risk Final fraud risk Initial budgeted Final budgeted
assessment assessment hours hours
1 40.67 60.67 154.63 178.5
(21.20) (18.31) (163.65) (167.58)
n = 15 n = 15 n = 12 n = 12
2 38.75 45.63 88.14 108.54
(19.28) (23.37) (69.52) (101.99)
n = 16 n = 16 n = 14 n = 14
3 37.14 38.57 91.70 94.92
(15.89) (19.16) (59.83) (62.97)
n = 14 n = 14 n = 13 n = 13
4 36.33 31.00 168.21 139.00
21.59 (20.20) (221.97) (210.04)
n = 15 n = 15 n = 14 n = 14
Total 38.25 44.08 125.22 129.98
(19.24) (22.75) (146.17) (146.86)
n = 60 n = 60 n = 50 n = 50
Panel B: Experiment 2: Self-assessment
Initial fraud risk Final fraud risk Initial budgeted Final budgeted
assessment assessment hours hours
1 40.91 64.55 246.27 321.95
(22.56) (20.67) (374.98) (524.00)
n = 11 n = 11 n = 11 n = 11
2 28.33 55.00 149.25 180.92
(16.42) (24.31) (158.07) (175.88)
n = 12 n = 12 n = 12 n = 12
3 33.33 35.56 89.44 91.56
(16.58) (15.89) (64.95) (65.03)
n=9 n=9 n=9 n=9
4 42.73 34.55 83.41 81.59
(17.94) (22.07) (60.58) (60.33)
n = 11 n = 11 n = 11 n = 11
Total 36.28 48.14 144.71 172.88
(18.90) (24.22) (214.58) (290.84)
n = 43 n = 43 n = 43 n = 43
Notes:
1 = High performance incentive/Low audit committee quality.
2 = High Performance Incentive/High audit committee quality.
3 = Low Performance incentive/Low audit committee quality.
4 = Low performance incentive/High audit committee quality.

management incentive condition (F = 0.046, Experiment 2: Self-assessment

p = 0.832) nor the audit committee quality
condition (F = 0.016, p = 0.901) is significant. There
is an unexpected marginal interaction (F = 3.176,
p = 0.081). We control for any potential differences
in the initial assessments by using percentage
change in budgeted hours as our dependent
variable.
In Panel B, we report comparative statistics for the
self-assessment setting. The overall mean (s) initial
fraud risk assessment is 36.28 (18.90) compared to the
overall mean (s) final risk assessment of 48.14
(24.22). Participants in the high management
performance incentive condition provided a mean

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192
(s) initial risk assessment of 34.35 (20.19),
compared to a mean (s) risk assessment of 38.50
(17.55) for those in the low management
performance incentive condition. Participants in
the high quality audit committee condition
provided a mean (s) initial risk assessment of 35.22
(18.30), compared to a mean (s) risk assessment of
37.50 (19.97) for those in the low quality condition.
Neither the management incentive condition
(F = 0.358, p = 0.553) nor the audit committee
quality condition (F = 0.078, p = 0.782) is significant.
However, there is an unexpected marginal
interaction (F = 3.713, p = 0.061). Potential
differences are controlled for hypotheses testing
purposes by using the change in assessment, rather
than the final risk assessment.
The comparative statistics for the initial and final
budgeted hours are a mean (s) response of 144.71
(214.58), and 172.88 (290.84), respectively.
Participants in the high management performance
incentive condition provided a mean (s) budgeted
hours of 195.65 (280.83), compared to a mean (s) of
86.12 (60.97) for those in the low management
performance incentive condition. Participants in
the high quality audit committee condition
provided a mean (s) budgeted hours of 117.76
(123.66), compared to a mean (s) of 175.70 (286.69)
for those in the low quality condition. With respect
to the initial budgeted hours, neither the
management incentive condition (F = 2.934,
p = 0.095) nor the audit committee quality
condition (F = 0.629, p = 0.433) is significant.
Analysis of management performance
incentives and audit committee quality
Experiment 1: Due diligence
To test Hypothesis 1a, participants were asked to
characterize management’s incentive to misstate
the financial statements on an 11-point scale (see
first question in the Appendix). Participants in
the high performance incentive condition rated
management’s incentives to misstate the financials
at a mean (s) of 5.97 (2.15), compared to a mean
of 3.24 (1.68) reported by those in the low
performance incentive condition (t = 5.44,
p = 0.0001). These results suggest that internal
auditors link performance incentives to an
incentive to misstate the financial statements in the
due diligence setting.
To test H2a, participants were asked to assess
the financial competence and independence (i.e.,
© 2008 The Author(s)
Journal compilation © Blackwell Publishing Ltd. 2008
S. K. Asare et al.
characteristics of quality examined in this study) of
the audit committee (see second and third
questions in the Appendix). In the high quality
audit committee condition, participants rated the
financial competence of the audit committee at a
mean (s) of 7.77 (1.96), compared to a mean of 3.45
(1.80) for those in the low quality audit committee
condition (t = 8.87, p = 0.0001). Further, participants
in the high quality audit committee condition rated
the independence of the audit committee at a mean
(s) of 7.52 (1.96), compared to a mean of 3.21 (2.04)
reported by those in the low quality audit
committee condition (t = 8.33, p = 0.0001). Thus in
the due diligence setting, these results suggest
that internal auditors use information about the
financial competence and independence of the
audit committee members to evaluate the quality
of the audit committee, providing support for
H2a.13
Experiment 2: Self-assessment
In the self-assessment setting (Experiment 2),
participants in the high performance incentive
condition rated management’s incentives to
misstate the financial statements at a mean (s) of
6.74 (1.96), compared to a mean of 3.15 (1.27)
reported by those in the low performance incentive
condition (t = 7.01, p = 0.0001). In the high quality
audit committee condition, participants rated the
financial competence of the audit committee at a
mean (s) of 8.55 (1.18), compared to a mean of 3.68
(1.96) for those in the low quality audit committee
condition (t = 9.843, p = 0.0001). Further,
participants in the high quality audit committee
condition rated the independence of the audit
committee at a mean (s) of 7.91 (1.89), compared
to a mean of 4.79 (2.51) reported by those in the
low quality audit committee condition (t = 4.460,
p = 0.001).
These results, obtained in the context of a
self-assessment setting, provide more robust
support that internal auditors adopt an external
perspective, and that this perspective is adopted
even when evaluating their own organization.
Analysis of changes in assessed fraud risk14
Experiment 1: Due diligence
Hypothesis H1b indicates that internal auditors
will increase their fraud risk assessment more
when management performance incentives are
Int. J. Audit. 12: 181–203 (2008)
Internal Auditors’ Evaluation of Fraud Factors in Planning an Audit 193

Table 2: Experiment 1: Due diligence – Changes in fraud risk assessments

Panel A: Mean change in fraud risk assessment (standard deviations) by experimental condition
Low quality High quality Total
audit committee audit committee
High performance incentives 20.00 6.87 13.23
(15.58) (12.50) (15.36)
n = 15 n = 16 n = 31
Low performance incentives 1.42 -5.33 -2.06
(10.99) (9.90) (10.81)
n = 14 n = 15 n = 29
Total 11.03 0.97
(16.33) (12.74)
n = 29 n = 31
Panel B: Test of null hypothesis of no difference in change in fraud risk assessments
Mean square df F-value p-value
Incentives 3,544 1 22.85 0.0001
Audit committee 1,480 1 9.54 0.0031
Incentives ¥ Audit committee 151 1 0.98 0.3273
Notes:
Independent variables (see text for additional discussion):
Performance incentives: Management incentives to have good financial performance, at a high or low level.
Audit committee: Quality (independence and financial expertise) of the audit committee; at a high or low level.
Dependent variable (see text for additional discussion):
Revision in assessed risk of intentional material misstatement subsequent to viewing manipulations.

high compared to when their performance
incentives are low. Hypothesis H2b indicates that
internal auditors will increase their fraud risk
assessments more when the audit committee
quality is low compared to when the quality is
high.
The revision in fraud risk assessment subsequent
to the manipulations is the dependent variable
used in testing H1b and H2b. Descriptive statistics
pertaining to the dependent variable are presented
in Panel A of Table 2. After reading the
manipulations, participants in the high
management performance incentive condition
increased their risk assessments by a mean (s) of
13.23 (15.36), compared to a mean (s) decrease of
2.06 (10.81) for those in the low management
performance incentive condition. Participants in
the high quality audit committee condition
increased their risk assessments by a mean (s) of
0.97 (12.74), compared to a mean (s) increase
of 11.03 (16.33) for those in the low quality
condition.
Panel B of Table 2 indicates that the incentive
variable (F = 22.85, p = 0.0001) and the audit
committee variable (F = 9.54, p = 0.0031) are both
significant. These results provide support for both
H1b and H2b, suggesting that internal auditors
take an external perspective in a due diligence
setting. The interaction is not significant (F = 0.98,
p = 0.3273).
Experiment 2: Self-assessment
Our next analysis assesses whether internal
auditors revised their initial fraud assessments
in the self-assessment setting consistent with an
external perspective. Descriptive statistics
pertaining to the revision in fraud risk assessment,
our dependent variable, are presented in Panel A
of Table 3. Participants in the high management
performance incentive condition increased their
risk assessments by a mean (s) of 25.22 (20.19),
compared to a mean (s) decrease of 3.50 (10.89) for
those in the low incentive condition. Participants
in the high quality audit committee condition
increased their risk assessments by a mean (s) of
10.00 (24.12), compared to a mean (s) increase of
14.00 (19.30) for those in the low quality condition.
Panel B of Table 3 indicates that the management
performance incentive variable (H1b) is significant

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194 S. K. Asare et al.

Table 3: Experiment 2: Self-assessment – Changes in fraud risk assessments

Panel A: Mean change in fraud risk assessment (standard deviations) by experimental condition
Low quality High quality Total
audit committee audit committee
High performance incentives 23.63 26.67 25.22
(21.57) (19.69) (20.20)
n = 11 n = 12 n = 23
Low performance incentives 2.22 -8.18 -3.50
(4.41) (12.50) (10.89)
n=9 n = 11 n = 20
Total 14.00 10.00
(19.30) (24.12)
n = 20 n = 23
Panel B: Test of null hypothesis of no difference in change in fraud risk assessments
Mean square df F-value p-value
Incentives 8,412 1 30.84 0.000
Audit committee 144 1 0.53 0.471
Incentives ¥ Audit committee 480 1 1.76 0.193
Notes: See Table 2.

(F = 30.84, p < 0.001) and the interaction of
management performance incentive and audit
committee quality is insignificant (F = 1.76,
p = 0.193). These two results are consistent with
Experiment 1, and suggest that, in a
self-assessment setting, internal auditors are able to
associate their own management’s performance
incentives with fraud risk. However, inconsistent
with the results from Experiment 1, we find that
audit committee quality (H2b) is not significant
(F = 0.53, p = 0.471), indicating a difference from
Experiment 1, which is consistent with the use of
an internal perspective in evaluating their own
audit committee. The difference in perspective
when evaluating management and the audit
committee in Experiment 2 (i.e., external
perspective when evaluating management and
internal perspective when evaluating the audit
committee) might reflect the internal auditors’
recognition that the audit committee, and not
management, has ultimate responsibility
(including evaluation responsibility) for the
internal audit function.
Analysis of percentage changes in audit
effort decisions
Experiment 1: Due diligence
Hypothesis H1c indicates that internal auditors’
budgeted hours will increase more when
management performance incentives are high,
compared to when their performance incentives
are low. Hypothesis H2c states that internal
auditors’ budgeted audit hours will increase more
when the quality of the audit committee is low,
compared to when the quality is high.
The dependent variable used to test H1c and
H2c is the percentage change in budgeted
hours subsequent to viewing manipulations. Our
descriptive statistics are presented in Panel A of
Table 4.15 Participants in the high management
performance incentive condition increased
budgeted hours by a mean (s) of 23.67 (31.13)
percent, compared to a mean (s) decrease of 3.69
(17.16) percent for those in the low management
performance incentive condition. Participants in
the high quality audit committee condition
increased budgeted hours by a mean (s) of 4.73
(12.23) percent, while those in the low quality
condition increased budgeted hours by a mean (s)
of 15.68 (31.67) percent.
Panel B of Table 4 indicates that the management
performance incentive variable is significant
(F = 15.73, p = 0.0003), providing support for H1c.
However, neither the audit committee variable
(F = 2.46, p = 0.1238), nor the interaction (F = 1.40,
p = 0.2428) is significant. These results provide
evidence that, in a due diligence setting, internal
auditors’ budgeted audit hours are sensitive to
levels of management performance incentives, but

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Internal Auditors’ Evaluation of Fraud Factors in Planning an Audit 195

Table 4: Experiment 1: Due diligence – Percentage changes in total budgeted hours

Panel A: Mean percentage change in total budgeted hours (standard deviations) by experimental condition
Low quality High quality Total
audit committee audit committee
High performance incentives 33.65% 14.45% 23.67%
(30.28%) (30.10%) (31.13)
n = 12 n = 13 n = 25
Low performance incentives -2.30% -4.98% -3.69%
(21.80%) (12.23%) (17.16%)
n = 12 n = 13 n = 25
Total 15.68% 4.73%
(31.67%) (24.59%)
n = 24 n = 26
Panel B: Test of null hypothesis of no difference in mean percentage change in total budgeted hours
Mean square df F-value p-value
Incentives 0.957 1 15.73 0.0003
Audit committee 0.149 1 2.46 0.1238
Incentives ¥ Audit committee 0.085 1 1.40 0.2428
Notes:
Independent variables (see text for additional discussion):
Performance incentives: Management incentives to have good financial performance, at a high or low level.
Audit committee: Quality (independence and financial expertise) of the audit committee; at a high or low level.
Dependent variable (see text for additional discussion):
Percentage change in total budgeted audit hours subsequent to viewing manipulations.

they do not reflect variations in audit committee
quality.16 Thus, internal auditors appear to take an
external perspective with respect to an external
management. Regarding the audit committee,
internal auditors appear to take an internal
perspective, or possibly, are signaling that they do
not place much emphasis on the characteristics of
an audit committee with which they are unfamiliar
for purposes of reducing audit scope.
Experiment 2: Self-assessment
We next examine H1c and H2c in a self-assessment
setting. Our descriptive statistics on the dependent
variable are provided in Panel A of Table 5.
Participants in the high management performance
incentive condition increased budgeted hours by a
mean (s) of 24.73 (40.84) percent, compared to a
mean (s) decrease of 0.18 (6.40) percent for those
in the low management performance incentive
condition. Internal auditors in the high quality
audit committee condition increased budgeted
hours by a mean (s) of 11.16 (24.45) percent, while
those in the low quality condition increased
budgeted hours by a mean (s) of 15.79 (37.77)
percent.
Panel B in Table 5 indicates that, consistent with
Experiment 1, the management performance
incentive variable is significant (F = 6.617,
p = 0.014), providing additional support for
H1b. That is, an external perspective is taken
when evaluating management – even one’s own
management. Further, also consistent with the
results from Experiment 1, neither the audit
committee variable (F = 0.176, p = 0.677), nor the
interaction (F = 0.002, p = 0.961) is significant. These
results provide evidence that, when auditing one’s
own organization, internal auditors’ budgeted
audit hours are sensitive to levels of management
performance incentives, but they do not reflect
variations in audit committee quality. There are
multiple interpretations for the finding regarding
the audit committee in a self-assessment setting. It
may be that internal auditors take an internal
perspective with their own audit committee,
which may be driven by their recognition that
the audit committee has oversight responsibility
for the internal audit function. This oversight

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196 S. K. Asare et al.

Table 5: Experiment 2: Self-assessment – Percentage changes in total budgeted hours

Panel A: Mean percentage change in total budgeted hours (standard deviations) by experimental condition
Low quality High quality Total
audit committee audit committee
High performance incentives 26.56% 23.05% 24.73%
(48.94%) (33.93%) (40.84)
n = 11 n = 12 n = 23
Low performance incentives 2.63% -1.82% -0.18%
(6.30%) (6.03%) (6.40%)
n=9 n = 11 n = 20
Total 15.79% 11.16%
(37.77%) (27.45%)
n = 20 n = 23
Panel B: Test of null hypothesis of no difference in mean percentage change in total budgeted hours
Mean square df F-value p-value
Incentives 0.633 1 6.617 0.014
Audit committee 0.017 1 0.176 0.677
Incentives ¥ Audit committee 0.000 1 0.002 0.961
Notes: See Table 4.

responsibility often involves having the audit
committee review or approve internal audit’s work
plan and related budgets (e.g., Scarbrough et al.,
1998; Goodwin, 2003). It may be that internal
auditors would have difficulty justifying to the
audit committee the need for an increased audit
budget due to a low quality audit committee.
Alternatively, the respondents may be signaling
that they do not place much emphasis on the
characteristics of an audit committee when making
audit budgeting decisions.
SUMMARY OF RESULTS, RELATED
DISCUSSION AND LIMITATIONS
Summary of results and related discussion
We find that internal auditors are consistently
sensitive to variation in management’s performance
incentives, systematically link these variations to
fraud risk assessments, and methodically adjust
their audit plans to reflect these differential
assessments. These findings suggest that internal
auditors take an external perspective when
evaluating performance incentives whether they are
in a due diligence or self-assessment role.
While internal auditors were consistently
sensitive to variations in audit committee quality,
the implications arising from these variations were
dependent on their specific role. In a due
diligence setting, internal auditors linked the
variations in audit committee to the risk of
fraud. However, perhaps adopting an internal
perspective, they did not link this variation to
the likelihood of fraud in a self-assessment
setting. Such a perspective may be the result of
recognition that in a self-assessment setting the
audit committee has oversight responsibility,
including evaluation responsibility, for the internal
audit function.
Finally, while they linked variations in audit
committee quality to the risk of fraud in a due
diligence setting, the internal auditors were less
willing to vary the audit budget in response to
different levels of audit committee quality in either
a due diligence or self-assessment setting. While
the response in a due diligence setting may reflect a
disposition not to vary audit effort in response to an
unknown audit committee, we are less confident of
this conclusion because the lack of linkage of audit
committee quality and audit effort in the ‘own’
company setting makes it difficult to assess the
scope question in that regime. It may be that
internal auditors do not see audit committee
quality as an important factor in determining
budgeted audit hours.

© 2008 The Author(s) Int. J. Audit. 12: 181–203 (2008)

Journal compilation © Blackwell Publishing Ltd. 2008
Internal Auditors’ Evaluation of Fraud Factors in Planning an Audit
These findings suggest that further research
directed at addressing whether, and why,
familiarity with one’s own company seems to
breed fraud risk insensitivity to the audit
committee quality would be particularly useful,
especially given the increasing focus on the
importance of the audit committee. Further
investigation is needed to assess auditors’
perceptions of the ability of the audit committee to
mitigate fraudulent financial reporting. For
instance, why is the audit effort (i.e., budgeted
hours) not linked as directly with audit committee
quality as is management performance incentives?
Given the heightened focus on quality financial
reporting, and on the importance of management
performance incentives and audit committee
quality, continued examination of the importance
of these factors is warranted.
In terms of future research focused on the audit
committee, we recognize that a great many audit
committee characteristics (e.g., experience,
knowledge; see DeZoort & Salterio, 2001) will
affect the quality of the audit committee. Our
attention to audit committee quality is focused on
the participants’ perceived competence and
independence of the audit committee. Greater
analysis as to how other audit committee quality
characteristics are perceived by internal auditors to
affect audit committee quality, and therefore audit
assessments and plans, will provide useful insights
into important corporate governance issues.
Additionally, the BRC (1999: 6–7) recognizes that
the effectiveness of an audit committee is likely
contingent on the characteristics of the overall
board. That is, if the board is low quality (i.e.,
lacking in independence and/or competence),
the audit committee, even if high quality, will
likely find it difficult to fulfill its responsibilities
effectively. The Sarbanes-Oxley Act of 2002 has
mandated improvements in boards of directors,
and other calls for improvements have been made
repeatedly (e.g., see Borris & McNamee, 2003).
While our experimental approach involved holding
board characteristics constant (i.e. our design does
not incorporate variations in overall board
characteristics), research that assesses whether
internal auditors recognize the importance of the
quality of the overall board is yet another important
extension of research in the area of corporate
governance, and is especially relevant given recent
discussions regarding corporate governance.
Finally, we find no evidence of an interactive
effect of management performance incentives and
© 2008 The Author(s)
Journal compilation © Blackwell Publishing Ltd. 2008
197
audit committee quality on any of our dependent
measures. On the one hand, the ‘fraud triangle’
perspective often used to discuss fraud factors
(IIA, 2007; see Practice Advisory 1210.A2-1) might
suggest an interactive effect of fraud incentive
and fraud opportunity factors on audit planning
assessments. Yet, internal auditors may view the
presence of one risk factor as suggesting a
heightened level of fraud risk and that the absence
or presence of another factor has little additional
impact. We encourage future research to investigate
whether, under certain conditions, various types of
fraud factors do have an interactive effect on
relevant planning judgments.
Specifically, our findings imply that internal
auditors appear to respond in an effective and
efficient manner to the level of management
performance incentives, whether they are in a due
diligence or self-assessment role. Our results
further imply that internal auditors are generally
aware of the importance of a strong audit
committee to reducing the risk of fraudulent
financial reporting, but are nevertheless unwilling
to reduce the scope of their fraud-related audit
work as a result of the presence of a strong audit
committee.17 We encourage internal auditors to
adopt an external perspective and not change their
conceptual lens as their audit setting varies.
Further, internal auditors should appropriately
consider the facts and circumstances of their
unique settings and plan audits that allow them to
obtain the sufficient and appropriate evidence
necessary to justify their overall conclusions.
Future research which can determine helpful ways
to encourage these types of internal audit behaviors
is warranted.
Limitations
The experimental approach generally has a number
of limitations, which should be taken into account
in interpreting our results. For example, an
experimental approach does not allow for direct
engagement with internal auditors in their unique
operational settings, as would occur in a case study
approach (cf. Turley & Zaman, 2007). Also, internal
auditors’ experiences with its own management
and its own audit committee could substantially
affect the risk evaluation of a target company in a
due diligence setting. Further, prior research
demonstrates that the internal audit process is
affected by the nature of the interaction between
the audit committee, the internal auditors, and the
Int. J. Audit. 12: 181–203 (2008)
198
external auditors (Turley & Zaman, 2007). We were
not able to capture these important organizational
aspects in our experimental approach. To obtain
important insights about internal auditors’
activities and judgments, we encourage greater
use of case studies to understand internal
audit activities within the context of their own
organizations.
Our results are specific to the scenarios used in
our study and may not generalize to other settings.
In terms of specific experimental choices, first we
acknowledge that a relatively brief scenario was
used to describe the setting, and such an approach
does not necessarily fully capture the richness of
the entire information set generally available to
internal auditors. This experimental approach may
not fully replicate the conflicting motivations and
loyalties that such situations involve. However,
relying on prior research (e.g., Ahlawat and Lowe,
2004), we believe the experimental approach does
allow us to capture auditors’ tendencies in these
settings. Second, in Experiment 1, the internal
auditor participants were asked to assume they
were conducting an audit in the context of a due
diligence audit for a potential acquisition. While
internal auditors conduct this type of engagement,
we do not have specific experience measures for
our participants. Thus, a possible lack of familiarity
with a due diligence setting may have made it less
likely that the participant would have adopted an
external perspective in making their assessments
and planning judgments in Experiment 1. Third, in
the absence of a normative model, we cannot
unequivocally assess the accuracy of our
participants’ judgments and decisions. However,
the directions of the effects we find seem to be
consistent with expected responses. Fourth, our
design does not allow for a team approach that
would be typical for many internal audit
engagements. Fifth, we limited the focus in a
number of ways, including not allowing the
auditors to rely on evidence about controls as part
of the audit, and only having them focus on one
financial statement area (i.e., accounts receivable
and related accounts). We encourage research
which allows for this expanded setting in which to
examine internal auditors’ judgments.
This study was conducted prior to the
heightened focused on internal controls, including
the importance of the audit committee, and on
intense media attention on management
performance incentives. While our results suggest
that internal auditors were generally sensitive to
© 2008 The Author(s)
Journal compilation © Blackwell Publishing Ltd. 2008
S. K. Asare et al.
our manipulated factors, we do not know whether
their focus on these factors has increased over time.
While this limitation impacts the ability to
unequivocally assess the importance of these
factors in today’s environment, it does provide
a useful benchmark for future research.
Notwithstanding these limitations, our results
provide an enhanced understanding of internal
auditors’ judgments in alternative risk
management roles, and should prove useful to
various stakeholders concerned about quality
corporate governance and financial reporting.
ACKNOWLEDGEMENTS
The authors wish to gratefully acknowledge the
financial support of their respective institutions
and thank Mark Zimbelman for allowing us to
modify his case for our experiments. They
gratefully acknowledge comments received on
earlier versions of this paper from Bill Felix, Steve
Salterio, Joe Schultz, and workshop participants at
Georgia State University.
NOTES
1. The terms credibility and reliability are
interpreted as having the same meaning and
are used interchangeably (see Goodwin, 1999).
While we appeal to the source credibility
literature as a theoretical basis for our
hypotheses, other literatures in psychology
provide alternative, complementary theoretical
frameworks. For example, attribution theory
suggests that when an information source
has incentives to bias, evaluators of that
information should perceive that information
as less persuasive (e.g., Eagly & Chaiken, 1993).
2. While there has been limited research on
whether external auditors are sensitive to
variations in management performance
incentives, the question of whether internal
auditors make decisions similar to external
auditors appears to be of concern to a number
of parties, including the IIA, which argues that
they do not (Rittenberg & Covaleski, 2001).
Possible reasons why internal and external
auditors may make different decisions include
closer supervision used for external auditors,
differing consequences of external versus
internal audit judgment errors, greater range
of decision areas of internal auditors (Ratliff
et al., 1993), and provision of services only to
Int. J. Audit. 12: 181–203 (2008)
Internal Auditors’ Evaluation of Fraud Factors in Planning an Audit
the organization rather than to the public
(Greenspan et al., 1994). Arguments why
external and internal auditors may make
similar decisions include the fact that many
internal auditors have external audit experience
and both are professionals (Kalbers & Fogarty,
1995).
3. This hypothesis relates to our first experiment
where internal auditors evaluate a target’s
management incentives and audit committee,
and are expected to take an external
perspective. It is less clear whether an external
perspective would be adopted in our second
experiment, where internal auditors evaluate
their own organization.
4. Cohen & Hanno (2000) examine a somewhat
related issue and find that the extent of
substantive testing, measured by number of
locations to be tested, is affected by the quality
of corporate governance, but that the extent of
testing to be performed at an interim date is not
affected by corporate governance quality.
Cohen & Hanno’s (2000) definition of
corporate governance is quite different from
what we examine here. Their independent
variable of corporate governance included
characteristics of the board (e.g., level of board
independence, importance of board-developed
code of conduct) and activities and
characteristics of the audit committee (e.g.,
meetings with internal and external auditors).
Thus, their design, unlike the design presented
here, does not allow for unambiguous
interpretation regarding the importance of
audit committee quality.
5. The hypothetical firm is based on case
materials modified from Zimbelman (1997).
While we use the client description in
Zimbelman (1997) as a basis for our case
description, the number of judgments required
of our participants is significantly fewer than
those required of Zimbelman’s participants.
Accordingly, we do not anticipate that our
participants will need to devote as much time
to the task as those in Zimbelman (1997). Also,
in Experiment 1, we make a context
modification from Zimbelman (1977) in that we
use the context of performing due diligence
work on a potential acquisition (see Applegate,
2000; Burke, 2000).
6. On average (s), in Experiment 1, over the past
two years participants had worked on 11.2
(19.7) audits where they performed procedures
© 2008 The Author(s)
Journal compilation © Blackwell Publishing Ltd. 2008
199
related to the integrity of the accounts
receivable balance. This demographic data was
similar for participants in Experiment 2.
7. Prior to running the experiment, preliminary
versions of the cases were given to several
practicing internal auditors for their review
and completion. After making minor changes
to the preliminary case, all agreed that the
case was realistic and could be reasonably
completed by internal auditors.
8. Participants also provided an assessment of an
unintentional material misstatement (e.g.,
error). This assessment is not the focus of our
research and thus the corresponding results
are not presented in tabular form. While
performance incentives are expected to be
associated with fraud risk, there is no strong
reason to believe that these incentives would
be associated with the likelihood of
unintentional misstatements (i.e., errors). Since
our research focuses on fraud risk, we do
not formally present a hypothesis related
to unintentional misstatement. However,
supplemental ANOVA results indicate that
management performance incentives are only
marginally significant (p > 0.075) in explaining
internal auditors’ assessments of the risk of
unintentional misstatements (i.e., errors).
Further, we would expect the effect of audit
committee quality on risk of unintentional
misstatement to be similar to its effect on
intentional misstatement risk. ANOVA results
support this expectation and indicate that audit
committee quality is significant (p > 0.009) in
explaining assessments of unintentional
misstatements. We find similar results when
performing the same analysis with the data
obtained in Experiment 2.
9. Information about the board was not
manipulated. Accordingly, participants in all
experimental conditions received the same
information about the Board of Directors. That
information indicated: ‘The Board is comprised
of seven members. On average, the board
members have served on Valley
Manufacturing’s Board for five-and-a-half
years. The Board typically has seven meetings a
year. Less than half of the Board members are
company insiders (i.e., officers of Valley
Manufacturing). All of the other Board
members are senior executives at other
companies. Two of the Board members are
outside directors on other boards. The Board
Int. J. Audit. 12: 181–203 (2008)
200
has two committees – a Compensation
committee and an Audit committee.’
10. See Hirst et al. (1999) for an example
application of this approach.
11. These participants were selected in the same
manner as for the first experiment. That is, they
were recruited through either their local
Institute of Internal Auditors (IIA) chapter or
through personal recruitment from one of the
co-authors. No participant completed both
Experiment 1 and Experiment 2.
12. While there has been an increased focus on
improving the quality of audit committees, we
anticipate that variations in quality among
audit committees continue to exist. Our focus
on whether internal auditors recognize and
respond to variations in audit committee
quality remains an important issue and
provides evidence for the potential value of
mandated changes to audit committee
structure and membership. Our focus on audit
committee quality is limited to the participants’
perceived competence and independence of
the audit committee. We recognize that there
are other dimensions of audit committee
quality, and we discuss these in the final section
of the paper.
13. We collected various audit experience
measures and used those measures as
covariates in all of our analyses. We tested on an
individual basis (i.e., only one covariate was
considered at a time) whether the following
experience measures had an influence on any
of our dependent variables: (1) whether the
participant had a CPA, (2) whether the
participant had ever been employed as an
external auditor, (3) experience auditing the
integrity of the accounts receivable balance,
and (4) percentage of time spent in the last
two years conducting audits related to
the reliability and integrity of financial
information. For both experiments, we found
no evidence that these experience-related
variables influenced participants’ judgment,
and consequently, we do not include these
measures in the analyses reported below.
14. In addition to the covariate analysis described
above, we performed sensitivity analyses to
determine whether our results, presented in
this section, are sensitive to demographic or
case perception variables. ANOVAs indicate
that the means of the following variables are
not significantly different across the four cells:
© 2008 The Author(s)
Journal compilation © Blackwell Publishing Ltd. 2008
S. K. Asare et al.
self-reported effort in completing the case,
self-reported length of time to complete the
case, perception of similarity of case materials
to those used in practice, internal audit
experience with manufacturing clients, and
internal audit experience with public
companies.
15. The sample size difference between Tables 1
and 3 result from some subjects not providing
complete information necessary for testing
both hypotheses.
16. The analysis we present is based on a revision
in total budgeted hours. We recognize that
audit effort decisions might be reflected in
ways other than the total number of budgeted
hours. For example, more hours may be spent
in a particular audit area, while fewer hours
may be spent in another audit area. Our
results remain qualitatively unchanged (i.e.,
management performance incentive is
significant, audit committee quality and
interaction are not significant) if we use
revisions in hours for either of the two budget
categories (i.e., confirmation work, other
accounts receivable work) as the dependent
variable. Another alternative approach to
dealing with increased fraud risk would be to
assign more knowledgeable (experienced)
audit team members. However, subsequent
analysis looking at changes in audit hours by
experience levels did not suggest that this
approach was used by our participants.
17. This finding is consistent with that reported by
Cohen & Kida (1989) in an external audit
setting, as they found that most external
auditors were unwilling to reduce testing when
analytical review signaled no apparent
problems.
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AUTHOR PROFILES
Stephen Kwaku Asare is the KPMG Profesor
of Accounting at University of Florida where he
teaches financial reporting, corporate controls, and
attestation. He is a member of the Florida Bar and
a Certified Fraud Examiner. His research focuses
on understanding and improving audit decision
making. He is also interested in governance issues
in emerging democracies. His research has
appeared in accounting, psychology and law
journals.
Audrey A. Gramling, PhD, CIA, CPA, is an
Associate Professor of Accounting at Kennesaw
State University. She is a member of the Institute
of Internal Auditors, serves as a Research Fellow
of the ERM Initiative at North Carolina State
University, and is a member of COSO’s Task Force
for its project on monitoring controls. She currently
serves as the President of the Auditing Section
of the American Accounting Association. Her
research investigates both internal and external
auditing issues, with a focus on decision behavior
of auditors, external auditor independence, internal
control reporting, and other factors affecting the
market for audit and assurance services.

APPENDIX A: EXCERPTS FROM CASE MATERIALS – MANIPULATION CHECKS

Based on the case materials, how would you characterize Valley Manufacturing
management’s incentive to misstate the financial statements? (circle one number)
.___.___.___.___.___.___.___.___.___.___.
0 1 2 3 4 5 6 7 8 9 10
| | |
no moderate level high level
incentive of incentive of incentive

Based on the case materials, how would you characterize the financial competence of the
overall audit committee at Valley Manufacturing? (circle one number)
.___.___.___.___.___.___.___.___.___.___.
0 1 2 3 4 5 6 7 8 9 10
| | |
not at all somewhat very
competent competent competent

Based on the case materials, how would you characterize the independence of the audit
committee at Valley Manufacturing? (circle one number)
.___.___.___.___.___.___.___.___.___.___.
0 1 2 3 4 5 6 7 8 9 10
| | |
not at all somewhat very
independent independent independent

© 2008 The Author(s) Int. J. Audit. 12: 181–203 (2008)

Journal compilation © Blackwell Publishing Ltd. 2008