SUMMARY
This study examines whether a company's business strategy is an underlying determinant of the strength of its internal control over financial reporting (ICFR) and auditors' internal control reporting quality. Organizational theory suggests that companies following an innovative “prospector” strategy are likely to have weaker internal controls than companies following an efficient “defender” strategy. Consistent with theory, we find that firms with greater prospector-like characteristics are more likely to report and less likely to remediate material weaknesses, incremental to known determinants of material weaknesses. We also find that auditors' internal control reporting quality is lower among clients with greater prospector-like characteristics when measured using the timeliness of reported material weaknesses. Our findings indicate that business strategy is a useful summary indicator for evaluating companies' internal control strength and suggest that internal control reporting is an important area for audit quality improvement among prospector-like clients.
JEL Classifications: D21; 21; M41.
Data Availability: Data are obtained from public sources as indicated in the text.
According to auditing standards, explanatory language added at the auditor's discretion to unqualified audit reports should not indicate increased financial misstatement risk. However, an auditor is unlikely to add language that would strain the auditor-client relationship absent concerns about the client's financial statements. Using a sample of 30,825 financial statements issued with unqualified audit opinions during 2000–2009, we find that financial statements with audit reports containing explanatory language are significantly more likely to be subsequently restated than financial statements without such language. We find that this positive association is driven by language that references the division of responsibility for performance of the audit, adoption of new accounting principles, and previous restatements. In addition, we find that (1) “emphasis of matter” language that discusses mergers, related-party transactions, and management's use of estimates predicts restatements related to these matters, and that (2) the financial statement accounts noted in the explanatory language typically correspond to the accounts subsequently restated. In sum, our results suggest that present-day audit reports communicate some information about financial reporting quality.
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