An Analysis of Trust, Employee Trustworthiness, Fraud, and Internal Controls

We analyze important strategic relationships among trust, employee trustworthiness, fraud, and internal controls. A game is modeled between a manager and an employee, two rational decision makers. The manager makes control decisions based on the strength of controls and on employee trustworthiness, which are modeled as functions of monetary and psychic costs and benefits of committing and not committing fraud. We propose a rich definition of trustworthiness that incorporates an employee’s propensity to commit fraud and sensitivity to controls. Equilibrium strategies are identified that could be used to determine the best strategy and the optimum strength of controls to use by identifying trustworthy, untrustworthy, and opportunistically trustworthy employees. A relationship of trustworthiness with a probabilistic choice of controls by the manager is established. As the strength of controls increases, the trustworthiness of the employees also increases, but a minimum critical level of trustworthiness is required to make controls effective. A high level of control may be needed to deter fraud. Also, this increase in trustworthiness does not translate to a proportional reduction of controls by the manager. We caution against excessive investments in internal controls. A low strength control with high probability of controls may be a cost effective way to deter fraud. We also explore the interaction of controls strength with the losses to the manager when fraud is committed. We find that control is not always a viable strategy. Optimal payoffs indicate that, unlike simultaneous decision making, under sequential decision making, the manager’s best strategy is to choose controls and auditing an employee. Policy implications and managerial insights of these findings are discussed.