Competing in a world marketplace with continued trends of globalization requires firms to organize and strategize across conventional organizational boundaries in sustaining economic performance. The boundaries of the firms are very indistinct. They are complicated by the expectations of those who have power within and around the organizations. Large claims against auditors also seem to continue in the 21st century as evidenced from legal cases such as Price Waterhouse–BCCI and Andersen–Enron. The earnings performance of the major firms grows with sophistication in strategic management and audit risk reduction. The quality of the firms’ strategic decision-makings is often reflected in financial statements. The impacts of business environment, allocation of resource capabilities, corporate governance and the nature of management control are all now more significant for, and translated more quickly into, the statements. Unrealistic expectations from the users of the financial statements are frequent. Thus, the needs to examine a firm’s underlying organizational conditions that support continuous stream of rents generation and to bring the strategic management into the audit process domain for more reliable earnings reporting are compelling.

The auditing profession has traditionally been a discipline with determined objectives and established methodologies. It is an established engine of regulation. Nonetheless, the patterns of organizational fraudulent incidences change over time and business environment is essentially dynamic. The issues of predicting and preventing frauds are multidimensional exercises. The acts of delinquency and defaulting of financial statements appear in forms sometimes not easily recognizable by both auditors and clients. Consequently, frauds can go undetected until a major organizational crisis surfaces that awakes sleeping managers. That said, the conventional audit risk model and audit processes shall look beyond identifying collusive agents, aggregating material effects of group transactions and investigating the credibility of risks as stand-alone solutions. They must transcend traditional systems-oriented boundaries so as to gain a more complete picture about the quality and sustainability of a firm’s corporate earnings. And, the capabilities to estimate and bring down organizational business risks are undoubtedly becoming the bread and butter of major business enterprises.

Some major strategy literatures suggest that to create and sustain the above average returns or superior earnings management, a firm must align its internal structures with external environments (De Toni & Tonchia, 2003; Hitt, Ireland, & Hoskisson, 2001; Hofer & Schendel, 1978; Peteraf & Bergen, 2003). The components within the audit risk model are of little value unless there are strategic organizational conditions within the firm to organize them into structure, routines and systems that facilitate the practices of strategy and the financial reporting. These conditions must also meet the expectations of stakeholders and external auditors. Therefore, we argue that the variations in the firm’s earnings performance and audit risk reduction can be explained from the firm itself as a factor of production. The audit risk means the external auditors might give a wrong opinion on their clients’ financial statements.

Conventional explanations of strategy literature on achieving the above average returns have been dominated by economics related paradigms, the industrial organization (IO) and the resource-based view (RBV). Earnings management has also been a concern in the accounting profession for a long time as the practice can have impacts on earnings quality and financial reporting. Accounting scholars have proposed several techniques of managing earnings to improve a firm’s earnings performance. Schipper (1989) suggests the use of accounting accruals in arriving at a summary measure of firm performance. Ayres (1994), on the other hand, states three methods for managing earnings—accrual management, the timing for the adoption of mandatory accounting policies, and voluntary accounting changes. Managing earnings is also the choice by a firm of accounting policies so as to achieve some specific managerial objectives (Scott, 1997). The earnings manipulations are usually done to manage the investors’ impression of the firm (Degeorge, Patel, & Zeckhauser, 1999). Nonetheless, there has been a dramatic increase in attention to business ethics, corporate social responsibility, honesty in accounting and conflicts of interest avoidance at international level. The happenings of high profile corporate failure and regional economic crisis have led to restructuring of many firms. Empirical work shows that accounting profession employed in organizations with high ethical standards viewed earnings management activities as more unethical. There were early warning signals in the profession regarding ethical values and earnings management (Elias, 2004). Debate on the roles of the external auditors and managers of a firm in ensuring that the financial statements do not contain material errors is far from conclusive. Scholarly works that attempt to bring the strategy paradigms to the auditing domain to refine existing viewpoints on the earnings management are still relatively unexplored. This paper fills this gap. To be meaningful, the external auditors’ audit processes ought to be integrated with the unique organizational conditions of their clients’ entities in order to maintain earnings quality and reduce audit risk.

This paper has the following objectives and organization. Firstly, we establish the intersection points between the external audit processes and a firm’s strategic management agendas. We then review related literatures and develop a theoretical framework that embeds the characteristics of firms’ organizational conditions and two major theories of the firm. The potential implications of the framework on different stakeholders and existing literatures are discussed before we draw the conclusions and highlight future research directions.

2. Auditing and strategy convergence points

This section looks into the major components of an audit process. It divides the contents of the components into the organizational internal and external dimensions of clients’ entities that the external auditors are interested in the audit process when performing a statutory audit. This categorization is in line with the propositions presented above and the two major theories of the firm discussed below which argue that a good fit between a firm’s internal characteristics and external forces is crucial to the effectiveness of a strategy. The categorization seeks to establish some critical linkages between the strategy and auditing discipline.

2.1. Audit process

Auditors gather audit evidences in a back and forth manner from various sources concerning financial statement assertions through the audit processes. These sources, rarely perfectly reliable, update the auditors’ beliefs about the accuracy of the assertions. The auditors only provide a reasonable assurance in a statutory audit that their clients’ financial statements are free from material mis-statements. However, poorly managed audit processes increase the possibility of giving incorrect audit opinions, and thus, audit risks (Schultz & Hooks, 1998). Cullinan and Sutton, 2002 C.P. Cullinan and S.G. Sutton, Defrauding the public interest: A critical examination of reengineered audit processes and the likelihood of detecting fraud, Critical Perspectives on Accounting 13 (2002) (3), pp. 297–310. Abstract | PDF (99 K) | View Record in Scopus | Cited By in Scopus (12)Cullinan and Sutton (2002) find that some major international public accounting firms have re-engineered their audit processes that would de-emphasize direct testing of the underlying transactions and account balances but rely more on analytical procedures as the main sources for substantive evidences. While such exercises would improve the cost effectiveness of completing an audit and focus on value-added services for their clients, the audit processes might still be less effective in detecting most material frauds originate at the top levels of the clients’ entities.