Â鶹ÒùÔº

Auditors can prevent fraud just by tipping their hand

If you've ever played poker, chances are you used strategic reasoning, a method of thinking that involves making informed decisions by understanding and anticipating the actions of others.

In other words, you try to spot your opponent's tell.

Strategic reasoning can be used in business, too. University of Alabama Assistant Professor of Accounting Chez Sealy is co-author of a research study published in that revealed auditors may be able to prevent financial fraud simply by signaling how they plan to conduct a strategic audit—without the need for extra costly procedures.

The research explored how different audit strategies influence managers' decisions to commit or conceal fraud.

Financial reporting fraud costs businesses millions of dollars every year. While auditors typically focus on detecting fraud after it happens, this study suggests they can also play a key role in preventing it in the first place.

The researchers investigated whether managers are less likely to commit fraud if they believe auditors will use advanced strategic reasoning to detect fraud. Put simply, auditors can play a significant role in preventing fraud by making it clear they are thinking strategically about how fraud might occur and how managers might try to evade detection.

The study suggests auditors can use different levels of strategic reasoning to deter fraud:

• Zero-order reasoning: Auditors follow standard procedures, focusing on their own incentives to complete an efficient audit.
• First-order reasoning: Auditors consider how managers may try to manipulate financial statements and adjust their approach accordingly.
• Second-order (or higher) reasoning: Auditors anticipate how managers might react to their auditing strategies and adjust their approach accordingly.

The research found that when managers were informed that auditors use first- or second-order reasoning, they were less likely to commit fraud. This is because they perceived a higher risk of being caught.

"If auditors signal this type of more strategic thinking, they can get the benefits of decreasing potential fraud without spending a lot more time, money, and resources on it simply because the signal works," Sealy said. "The signal shows managers that 'OK, I don't know exactly what they're going to do, but that's scary.' There's so much uncertainty, it's going to reduce that propensity to commit fraud."

While signaling a more strategic audit approach reduced fraud, it also made fraud more difficult to detect when it did occur. Managers who still chose to commit fraud put more effort into hiding it in response to the increased perceived risk.

From a business and regulatory perspective, the key takeaway is that auditors can prevent fraud more effectively with strategic reasoning rather than increasing audit costs. This benefits businesses by reducing fraud and improving financial transparency while maintaining efficiency in the auditing process.