Factors affecting internal auditors' consideration of fraudulent financialreporting during analytical procedures

This study investigates internal auditors' consideration of fraudulent fina ncial reporting as an explanation for an unexpected difference in operating income. We examine whether such consideration is affected by the direction of the difference, the use of earnings-based bonus plans, and the restrict iveness of debt covenants. We conduct an experiment in which 127 internal a uditors list potential explanations for the unexpected difference. We find that these factors affect internal auditors' consideration of fraudulent fi nancial reporting. Internal auditors list a larger proportion of explanatio ns involving fraud (1) when income is greater than expected, and (2) when d ebt covenants are restrictive, conditioned on income being greater than exp ected. We also find that internal auditors assign a higher likelihood of fr aud when (1) income is greater than expected, and (2) when an earnings-base d bonus plan is used and debt covenants are restrictive. The practical impl ication is that specific factors can affect internal auditors' consideratio n of fraudulent financial reporting and potentially may impact audit plans.