An inspection game of internal audit and the influence of whistle-blowing

Abstract

In this paper we analyse how whistle-blowing affects fraudulent behaviour of managers while the company instigates imperfect internal audit to detect the fraud. To do so, we employ in a first step a non-cooperative inspection game to analyse fraudulent behaviour of a manager controlled by an internal auditor. In a second step we introduce exogenous whistle-blowing of a manager’s employee to aid the auditor to reveal the fraud. In a third step, the two-person inspection game is extended to a three-person approach with endogenous whistle-blowing. Our novel results are that the intensity of internal audit is always lower with whistle-blowing than without and that whistle-blowing renders the manager to act less fraudulently than compared to the basic inspection game if and only if she is unaware of the whistle-blower’s expected pay-off and the efficacy of internal audit is sufficiently low.