The Interaction between Internal Control Assessment and Substantive Testing in Audits for Fraud*

Abstract We examine the interaction between internal control assessments and substantive testing in a model of fraud detection. The purpose of our study is to examine a two‐stage model of the auditor‐manager interaction in which the auditor assesses the “likelihood” or possibility of fraud in the first stage and conducts substantive tests in the second stage. We examine the allocation of audit resources across these two distinct facets of the audit. We find that, regardless of the auditor's allocation, the probability of undetected fraud remains the same, but the allocation of some audit resources to internal control assessment may provide cost savings for the auditor.