Business Strategy, Financial Reporting Irregularities, and Audit Effort

TLDR

The study examines whether clients’ business strategies influence financial reporting irregularities and audit effort, and introduces a replicable strategy measure that identifies organizational strategy as an ex‑ante determinant of these outcomes. Using Miles and Snow’s organizational strategy theory, the authors develop a comprehensive, publicly available measure of business strategy. Prospector strategy is linked to higher financial reporting irregularities and audit effort, the strategy measure captures client risk and adds explanatory power beyond traditional models, and the findings point to audit improvements for Prospector clients.

Abstract

This study examines whether clients' business strategies are a factor in determining the occurrence of financial reporting irregularities and the level of audit effort. We use the organizational strategy theory of Miles and Snow to develop a comprehensive measure of business strategy using publicly available data. We find that Miles and Snow's Prospector strategy is more likely to be involved in financial reporting irregularities and generally requires greater audit effort. The business strategy measure also appears to capture client business risk and provides incremental explanatory power beyond the individual measures of client complexity or risk used in traditional audit fee models. We contribute to the literature by constructing a replicable business strategy measure and identifying organizational business strategy as an important ex ante determinant of financial reporting irregularities and levels of audit effort. Our results suggest that investigating how audits can be improved to reduce financial reporting irregularities among Prospector clients is an important area for audit practice and future research.