Antecedents to Financial Statement Misreporting: The Influence of Organizational Business Strategy, Ethical Culture and Climate

Abstract

Using organizational theory, this research study examines whether a firm's business strategy influences the ethical culture and climate within the organization, and thus explains why a firm's business strategy may ultimately contribute toward an increased risk of financial misreporting. This study develops from recent research which finds that companies following an innovative, risk-oriented Prospector business strategy are significantly more likely to experience financial reporting irregularities, despite increased audit effort levels. To examine the research question, both survey and archival methods are employed.

Using a large-scale research survey, I find two subset groups of Prospector firms where a smaller (larger) group is significantly associated with a less (more) ethical culture and climate, which offer insights into why companies following a Prospector business strategy continue to experience irregularities despite auditors' efforts. Results suggest auditors may not be able to distinguish between the two sets of Prospectors and thus may direct higher audit efforts too generally at Prospector firms rather than at the smaller set of firms with less ethical cultures and climates?i.e., firms more prone to rationalizing less ethical behavior. I also find that firms pursing a second type of strategy, a transitory Reactor strategy, are consistently associated with a negative ethical culture and climate.

For a subset of public companies which can be linked to archival data, I find evidence to suggest that companies with less (more) ethical climates are associated with an increased (reduced) risk of financial misreporting while controlling for incentive and opportunity factors. I continue to find evidence that companies following a Prospector business strategy are associated with greater risks of misreporting, confirming prior research. Altogether, my findings suggest several antecedents for firms experiencing greater risk of financial statement misreporting and provide evidence regarding the third leg of the auditing fraud triangle (rationalization).