An analysis of efficiency and effectiveness of auditing to detect management fraud: a signal detection theory approach

Abstract

The purpose of this paper is to apply Signal Detection Theory (SDT) to the problem of detecting management fraud. The use of SDT methodology significantly strengthens our understanding of the relationships among audit technology, base rates of management fraud, costs of Type I and Type II errors, extensions of audit procedures, and risk assessments prior to and during the audit. The analysis indicates that the auditor must accept disproportionate false alarm rates in order to maintain audit effectiveness in the presence of management fraud. This condition becomes even stronger as the costs of Type II errors increase compared to costs of Type I errors. The study provides policy implications for auditor practice and standard-setters.