A signal detection theory approach to analyzing the efficiency and effectiveness of auditing to detect management fraud

TLDR

This paper applies signal detection theory to the problem of detecting management fraud. The authors use SDT to analyze audit technology, fraud base rates, error costs, procedure extensions, and risk assessments before and during audits. SDT shows that auditors must tolerate high false‑alarm rates to maintain effectiveness, especially when Type II error costs exceed Type I costs, and offers policy implications for practice and standard‑setting.

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 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 and during the audit. The analysis suggests 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 also provides policy implications for auditor practice and standard‐setters.