Strategic Testing and an Employee's Span of Action

This paper examines the differences in an internal auditor’s (a firm’s ) equilibrium testing strategy when employees have different abilities to steal from line items. I constrast two models. In the strategic employee model there are two employees who can each steal from one item. In both models the firm cam use costly, imperfect testing to reduce its expected losses. Two effects drive the results. The supervisor has greater strategic flexibility than the employees since he can choose a portfolio of thefts. The firm’s detection technology improves in the supervisor model because one test may detect multiple thefts. Since both playe’s strategy spaces have expanded in the supervisor model, both the firm and supervisor can be better or worse off than in the employee model employee. However, the improvement in the detection technology may lead to greater testing in the supervisor model. Two extensions examine the increased testing result. The first shows that if the supervisor has more skill at covering up his thefts than employees, then the supervisor model can have more or less testing than the employee model. In the second extension employees can observe each other’s thefts and can inform on others when caught stealing. In this extension the maximum amount of testing is identical in both models.