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Business Strategy, Financial Reporting Irregularities, and Audit Effort

Authors


  • Accepted by Steven Salterio. This study was the recipient of a 2010 PwC INQuires Grant. We thank Steven Salterio, two anonymous reviewers, Urton Anderson, Max Baker, Leonard Bierman, Elizabeth Carson, Demetris Christodoulou, Rajib Doogar, Neil Fargher, Peter Gillett, Shirley Gregor, Carl Hollingsworth, Andrew Jackson, Kerry Jacobs, Karim Jamal, Shane Johnson, Christine Jubb, Bill Kinney, Robert Knechel, Habib Mahama, Mary Lea McAnally, Stuart McLeay, Gary Monroe, Ed O'Donnell, Mark Peecher, Joshua Ronen, Greg Shailer, Marjorie Shelley, Ira Solomon, Ken Trotman, Senyo Tse, Dechun Wang, Mike Wilkins, Mark Wilson, and seminar participants at the 2011 AAA Auditing Section Midyear Conference, University of Illinois 19th Audit Symposium, Australian National University, Texas A&M University, University of New South Wales, and University of Sydney for helpful comments. We are grateful to PricewaterhouseCoopers, Texas A&M University, University of New South Wales, and the Ernst & Young Professorship for financial support.

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.

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