1 The Role of Key Audit Matters In Identifying Audit Risks And Improving The Financial Audit Quality Andreea Claudia Crucean West University of Timisoara
Streszczenie
Badanie opiera się na raportowaniu kluczowych spraw związanych z audytem sprawozdania finansowego (KAM) oraz wpływie pandemii COVID-19 na jakość sprawozdawczości finansowej i odpowiedzialność biegłego rewidenta. Celem artykułu jest zbadanie zidentyfikowanych przez audytorów tematów KAM oraz tego, w jaki sposób wpływ COVID-19 na sprawozdania finansowe spółek został uznany przez audytorów za ryzyko oraz uwzględnienie tego wpływu w KAM. Badanie ma charakter jakościowy i podsumowuje tematykę KAM zidentyfikowaną przez audytorów ujętą w raportach za lata 2016-2021. Dokonano analizy tematu KAM, branży firmy, kraju, rodzaju audytora oraz opinii audytowej. W celu określenia wpływu COVID-19 na sprawozdania finansowe oddzielnie przeanalizowano również okres 2020-2021. Próba składa się ze spółek notowanych na rynku pierwotnym na europejskich giełdach w latach 2016-2021. Wyniki sugerują, że w analizowanym okresie audytorzy deklarowali różne problematyki w KAM. Największy udział miały kwestie dotyczące przychodów i innych dochodów (11,27%). W odniesieniu do okresu COVID-19 temat kontynuacji działalności, zidentyfikowany w wydanych raportach, odnosił się w całości do wpływu COVID-19, stanowiącego jedną czwartą liczby KAM. Chociaż pandemia dotknęła wiele branż, niektórzy biegli rewidenci zwrócili szczególną uwagę na ocenę ryzyka i niepewności, aby wydać opinię z badania, która jest jak najbardziej przejrzysta i dokładnie ocenia roczne sprawozdania finansowe. Badanie wnosi wkład w literaturę naukową poprzez analizę skutków zidentyfikowanych przez audytorów przed pandemią COVID-19 i po niej, wyrażonych przez KAM w sprawozdaniach z audytów.
Słowa kluczowe: kluczowe sprawy związane z badaniem audytorskim sprawozdania finansowego (KAM), ryzyko, jakość badania sprawozdania finansowego, raport biegłego rewidenta, COVID-19, zasada kontynuacji działalności
Abstract
The research is based on the key audit matters (KAMs) reporting and the impact of the COVID-19 pandemic on the quality of financial reporting and auditor responsibility. The paper aims to investigate the KAMs topics identified by auditors and how the impact of COVID-19 on companies' financial statements was considered a risk by auditors that required attention, respectively, by including this impact in KAMs. The research is qualitative and summarizes the KAMs topics identified by auditors included in reports for the period 2016-2021. The analysis was made on the KAMs topic, company industry, country, auditor type and audit opinion. In order to identify the impact of COVID-19 on the financial statements, the period 2020-2021 was also analyzed separately. The sample consists of companies listed on the primary market on European stock exchanges for 2016-2021. The results suggest that during the analyzed period, the auditors declared different topics of KAMs. The revenue and other income topics had the largest share (11.27%). For the COVID-19 period, the going concern topic identified in the issued reports referred entirely to the impact of COVID-19, representing a quarter of the number of KAMs. Although the pandemic has affected many industries, some auditors have paid particular attention to risk and uncertainty assessments to issue an audit opinion that is as transparent as possible and accurately assess the annual financial statements. The research contributes to the academic literature by analyzing the effects identified by auditors before and after the COVID-19 pandemic, expressed by KAMs in the audit reports.
Keywords: key audit matters, risk, audit quality, auditor report, COVID-19, going concern
1. Introduction
The reporting of the key audit matters in the audit report contributes to the increase of the financial reporting quality of the audit report value, and the implicit interest for it. Also, the reporting of KAMs positively influences the differences between the auditor's expectations and users of the financial reporting.
In an attempt to reduce the information gap desired by users and those presented in the audit report and increase the quality of financial audit services, the IAASB adopted ISA 701, which came into force for audits completed on or after December 15, 2016. The aforementioned standard defines the KAMs as "those aspects that, according to the professional reasoning of the auditor, had the greatest importance in the audit of the financial statements of the current period."
Therefore, the auditor is responsible for reporting and detailing all key high-risk issues in accordance with ISA 315 (Revised 2019), Identifying and Assessing the Risks of Material Misstatement. These issues may relate to accounting estimates, subsequent events, business continuity, and any uncertainties that may impact the audit.[1]
Each KAM must be described individually and sorted according to their priority, even if they appear sequentially as notes to the financial statements.[2]
The role of the audit profession in the implementation of audit standards aims to improve the quality of audit reports, and one of the improvements is the inclusion of key audit aspects (KAM) as a separate section in the auditor's report. Introducing KAMs aims to provide information about the highest-risk areas and the effect of the most significant events.[3] The COVID-19 pandemic also significantly impacted the accounting field, but especially the audit activity. Auditors were forced to adapt quickly and find solutions to ensure the applicability of audit standards.[4]
To facilitate the work of auditors, professional organizations have proposed solutions such as: applying additional audit procedures to highlight the impact of the COVID-19 pandemic on financial reporting and audit reports (ACCA, 2020), communicating the effects generated by COVID-19 to the audit committee, their reporting and identification of potential risks,[5] adaptation to a circular economy and a change in lobbying activities (Accountancy Europe, 2020), application of professional skepticism and adjustment of financial reporting according to the impact generated by COVID-19 (Australian Accounting Standard Board - AASB - and Auditing and Assurance Standard Board - AUASB, 2020).
Even the specialists from Big4 companies have conducted studies on this subject. In this sense, PwC Romania (2020) analyzed the importance of the principle of business continuity on a sample of 91 companies, of which 37% were forced to discontinue the activity after declaring a state of emergency, 20% restricted the area of activity, 19% opted for work in the home office regime, and 27% resorted to technological unemployment. Deloitte (2020) believes that in terms of financial reporting, entities face challenges for the future reporting period, and the audit should focus on adjusting balance sheet items so that the effect of the COVID-19 pandemic is reported correctly and clearly.
Non-Big4 auditors believe that all these factors, such as declining revenues, reduced financial liquidity, and the risk of business continuity, significantly affect a company's sustainability.[6]
Auditors' challenges during the COVID-19 pandemic may adversely affect the quality of financial audit activity, as insufficient audit evidence and difficulties may be obtained in assessing the risk of business continuity that may lead to changes in financial statements, and changes in financial statements may change audit report (Auditing Oversight Bodies - CEAOB, 2020).
In order to highlight these effects as clearly as possible, the auditor has the option of inserting in the audit report a paragraph dedicated to subsequent events, as specified in the International Standards on Auditing (ISA 560, Subsequent Events, and ISA 701, Disclosure of Key Audit Aspects in the Independent Auditor's Report). The first standard mentions the need to include an explanatory note detailing the effects of the COVID-19 pandemic on an entity's financial and economic condition. At the same time, ISA 701 regulates that the auditor's responsibility is to carefully consider the need for key audit aspects but also the audit risk assessment, and their inclusion in a specific paragraph.
All these measures are necessary to ensure transparent communication with the users of the accounting information, especially in the case of investors. Haţegan[7] et al. opined that communication with investors was affected in several ways during the pandemic, from physical distancing by organizing meetings in the online environment to the need for changing certain legislative aspects to inform investors about any change in activity.
Thus, the aim of the paper is to investigate the KAMs topics identified by auditors and how the impact of COVID-19 on companies' financial statements was considered a risk by auditors that required attention, respectively, by including this impact in KAMs.
The article is structured as follows: a part reserved for the literature review, followed by a part describing the research methodology, and the results obtained are finalized with conclusions and references used.
2. Literature Review
2.1. The Role of KAMs in Improving the Audit Quality
The purpose of KAM reporting is to increase the audit's quality and provide additional information to external users. They also reduce costs and provide valuable information to investors.[8]
Another influencing factor of KAMs is the perspective of the auditors. More precisely, the audit concerns the KAMs from two perspectives: quality and effectiveness.[9]
Matta and Feghali[10] investigated the impact of Key Audit Matters (KAMs) on the quality of financial information and its value to Lebanese auditors. The empirical part is done through a survey completed by 38 Lebanese external auditors who audit exclusively Lebanese banks. The data collected consisted of KAM-related statements, such as the quality of financial information, the investment decision, and the audit expectation gap measured on a Likert scale (1 to 5), followed by quantitative analysis. According to the authors, the value creation of KAMs is determined by the quality of its financial information, its ability to help during investment decisions, and its effect on the audit gap. In addition, the results highlighted that a KAM improves the auditee's understanding of the audited entity, builds confidence in the audited financial statements and helps reduce the gap in audit expectations.
Rousseau and Zehms[11] investigated the perceptions of UK auditors and concluded that Big4 audits tend to report more KAMs, especially when they are not in the first year of the client's audit.
Barghathi et al.[12] studied whether KAMs can increase the audit quality and reduce agency costs based on a sample of 6 Big4 and 4 non-Big4 auditors. The results support the fact that the reporting of KAMs increases the quality of the audit but also the managerial responsibility that minimizes the agency's costs.
Identifying the factors that influence the number of KAMs declared by auditors is important for the following reasons: the higher the number of KAMs, the less valuable the audit report is due to its increasing complexity.[13] The number of KAMs can reduce their effectiveness,[14] and users rely on KAMs in making an economic decision.[15] The description of the KAMs in the audit report should include information about the audit of the companies' audit financial statements[16] and describe an individual image of each balance sheet item that is affected.[17]
According to the theory of agency and stakeholders, the disclosure of KAMs also contributes to reducing information asymmetry and conflicts of interest between management and stakeholders, as well as to reducing the waiting gap.[18]
A study was also carried out on Spanish entities by Pérez,[19] who analyzed the audit reports for the first two years after the audit reform based on an econometric model on the basis on three hypotheses: What type of content was included in the comprehensive audit report in Spain in the first year of implementation? What factors determine the appearance of KAMs? What differences are presented in the new extended audit report in the second year of implementation? The conclusions showed that out of 373 KAMs, 12 referred to business continuity in 2017. KAM reporting was a helpful tool for users of financial statements.
The usefulness of KAMs in compiling audit reports was also validated by the authors Mińano et al.,[20] who studied the importance of KAMs based on a sample of 2,149 entities listed in the UK in 2013--2018. The dependent variable was the number of KAMs, and the independent ones were the type and rotation of the auditor, the size of the auditor, and the financial performance. The results showed a positive relationship between KAMs and the three independent variables.
The authors Grosu et al.[21] analyzed the audit reports from 2016 to 2018 of 46 companies listed on the Bucharest stock exchange to assess whether KAMs can represent the financial audit quality. The dependent variable was the number of KAMs in the audit reports, and the independent ones were the type of auditor and the audit opinion. The results emphasized that the reporting of KAMs leads the auditor to issue an unqualified opinion and, at the same time, reduces the audit risk. The Big4 also issues several unqualified opinions when reporting KAMs in audit reports.
Haţegan[22] analyzed the KAMs reported in 2016-2019 for a sample of 12 companies listed on the Bucharest stock exchange to highlight the most common problems reported in the financial industry. The variables analyzed were the number of KAMs, the auditor's size, the audit opinion, the rotation of the auditor, and the profitability. No strong correlations were identified between the variables, and in conclusion, the analyzed variables did not influence the reporting of KAMs.
Suttipun and Swatdikun[23] investigated the influence of KAMs on the financial performance of Thai companies, respectively, a sample of 180 companies listed in 2016-2018. The dependent variable was the number of KAMs, and the independent one was the financial performance expressed by the value of the assets. The study showed a negative relationship between KAMs and financial performance.
2.2. The Impact of COVID-19 on Audit
Auditors are responsible for ensuring the correctness of financial statements, taking into account the effects of the COVID-19 pandemic, of which stock valuation, asset depreciation, revenue recognition, payment of tax liabilities, and optimal revenue management were the most significant challenges in maintaining the accuracy of financial reporting.
Hegazy and Kamareldawla[24] investigated how external auditors comply with ISA 701 requirements, using a questionnaire sent to a sample of 5 audit firms, 2 of which were Big4. Research has suggested that the current explanations of ISA 701 may not adequately assist particular auditors in identifying appropriate KAMs.
The impact of the pandemic on financial audit activity has been intensely debated internationally, both qualitatively and quantitatively. Gold and Heilmann[25] analyzed 22 scientific papers that discussed the effects of KAMs detailed in audit reports. The qualitative analysis showed that the reporting of KAMs affects the behavior of investors, the responsibility of auditors, and the reaction of the market.
Other factors influencing the number of KAMs are shareholders and associations, managers, and external auditors.[26]
Albitar et al.[27] studied the impact of the pandemic on five indicators of audit quality, namely: audit fees, the principle of business continuity, audit procedures, remuneration, and human capital. The authors considered the fact that although the COVID-19 pandemic is not a financial crisis yet, its effects are the most serious challenge for auditors and customers; respectively, social distancing due to COVID-19 can significantly affect audit fees, activity concern, human capital audit, audit procedures, audit effort of the auditor's remuneration, which can ultimately have a significant impact on the quality of the audit.
Subsequent events during the COVID-19 pandemic and their importance on the continuity of activity and quality of financial audit were analyzed. The study by Crucean and Haţegan,[28] included audit reports and annual financial statements of 60 companies listed on the Bucharest stock exchange. The authors pointed out that the effects of the COVID-19 pandemic significantly affected several industries, in some cases necessitating the company's closure, limiting travel for business, technological unemployment or work at home, all of which hindered communication with stakeholders.
Badawy[29] analyzed the impact of the audit quality perception, measured by adding a KAM on the COVID-19 pandemic but also by limiting the audit report, based on a sample of 95 companies listed on the Egyptian stock exchange (EGX), the econometric model included as dependent perception on the quality of interim financial reports (measured by the market value of equity) and MCA. Timeless audit reports were independent variables (more precisely, the natural logarithm of the number of days between the issuance of the interim report on September 30, 2020 and the date of the report). The results showed a positive relationship between audit reports and the quality of financial reporting from investors' point of view. Regarding the impact on the quality of the audit, the author found no evidence; this may be because the addition of the KAM paragraph on the COVID-19 pandemic is not a company specification; at the same time, it does not provide additional information to investors other than that available in the interim financial reports.
According to Audit Analytics,[30] auditors can address the risk of the future uncertainty of the COVID-19 pandemic in a specific KAM. Specifically, on November 13, 2020, the Big4 auditors reported 57% of the KAMs related to COVID-19, most of the companies being companies with small capitalization, below 100 million euro. However, the inherent risk of continuing economic uncertainty and its impact on financial resources and operations covers a broad spectrum that is not limited to smaller companies.
3. Research Design/Methodology
The data was collected from the Audit Analytics database on November 15, 2021. We opted for companies listed on the European market, namely European stock exchanges (EEA, UK, and Switzerland).
To select a relevant sample, we chose the companies that presented in the audit reports KAMs from 2016 to 2021. The additional filtering criteria were: all market indexes and all audit opinions.
We identified 1,720 companies that met the selection criteria and reported a total of 20,855 KAMs.
We grouped the data into two distinct periods to highlight the impact of the COVID-19 pandemic on the financial statements of the audited companies, respectively, a first period from 2016 to 2019, which focuses on KAMs reported as subsequent events and impact on the continuity of the activity of the entities, and the second period from 2020 to the present, which analyzes the impact reported as a result of the COVID-19 pandemic on the financial statements of the companies.
Table 1. The sample
Fiscal Year
Number of KAMs
Percentage
Impact
2016-2019
15,229
73%
Subsequent events and going concern
2020-2021
5,626
26%
Impact on financial statements - the COVID-19 pandemic
Total
20,855
100%
-
Source: own projection.
It can be seen that although the pandemic accelerated specific changes in the social and economic environment, the auditors reported a significant percentage of KAMs that reflected a transparent situation regarding the impact on the balance sheet elements but also on the continuity of the audited companies.
In order to highlight the importance of reporting KAMs by auditors as clearly as possible, we opted for a qualitative analysis based on the sample selected from the Audit Analytics database.
We detailed in the results section the categories of KAMs reported by the auditors, but also aspects related to the type of auditor (Big4 or non-Big4), the audit opinion issued, the reference country, and aspects related to entities and industries.
