An Investigation of Internal Auditor Judgment on the Importance of Indicators of Potential Financial Fraud: An Analytic Hierarchy Process Approach.

Abstract

Financial fraud has become a serious problem to the business community. As a result, regulators and financial statement users have looked to the auditing profession for answers to the problem. The role of the internal auditor has received significant attention due to the unique position they fill. That is, they are positioned to observe and test financial and operational activities of the firm on a continuous basis. In addition, internal auditors are able to devote more time to the deterrence and detection of financial fraud than their external counterparts. The National Commission on Fraudulent Financial Reporting (Treadway Commission) issued its final report in October 1987 following a two-year investigation into the problem of financial fraud. An effective internal audit function was mentioned as a chief variable in the detection and deterrence of financial fraud. Both the Treadway Commission and the American Institute of Certified Public Accountants (Statement on Auditing Standards No. 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities, May 1988) published lists of indicators or red flags of financial fraud. This study focused on the internal auditor's ability to identify red flags and rank their importance to the overall assessment of the potential for financial fraud. The Analytic Hierarchy Process was used to model the judgment of each subject who participated in this study. In addition, measures of consensus were computed to evaluate the overall level of agreement between the subjects on the importance rankings of the red flags. In general, internal auditors ranked management red flags as most important to the overall evaluation of the potential for financial fraud, followed by firm then industry red flags. Conclusions as to the rankings within each of the three principal groupings of red flags were not so clear.