The longer the audit tenure the better says Dutch research

RECENTLY, there has been much debate about the relevance, performance and impact of the accountancy profession. Governments and politicians are busy devising extra safeguards particularly in audit to enhance quality and credibility. However, due to the auditors’ duty of confidentiality, little is known about the impact of audit reports by the external auditors.

Independent research carried out by the Nyenrode Business Universiteit in the Netherlands studied the impact of external auditors on annual reports. It looked at Dutch external auditors who were asked to fill in a questionnaire based on information from the audit file, including information on risk analyses, applied materiality, audit differences and management letters. The unique information collected allowed the researchers to closely examine the considerations made by external auditors.

The majority of the audits (55%) concern Public Interest Entities (PIE: listed companies and financial institutions); the other 45% concern very large privately held companies and PIE-related institutions, such as pension funds and is based on 2010 data. Like in the UK, Dutch auditors have to fully comply with the International Standards of Auditing (ISA).

Corrections to the annual report

In 63 % of the 147 organisations looked at, the auditor discovered errors. These errors are principally factual mistakes, but also some estimates by management.  The errors or audit differences can have an impact on results and capital. For eight of the 147 organisations the audit led to a modified auditor’s report. In 23% (34 of the 147) of the amounts in the balance sheet and profit and loss accounts were corrected prior to the issuing of the auditors’ opinion. This involved eight listed companies and 29 other organisations. In 77 % (114 of the 147) of cases the auditor insisted on amending the notes to the annual report. Around 95% of these amendments were adjusted in the annual report by the board. In doing so, in addition to the notes to the balance sheet and profit and loss account, the auditor also paid attention to the description of risk management and the remuneration section.

Reporting of audit differences

It appears furthermore from our analyses that 25% of all audit differences discovered by the auditor (which therefore imply inaccuracies in the financial statements) were important. These differences relate to a desirable correction of at least 5% of the result or in relation to a critical limit. Critical limits might be considered to be the ability to fulfil a bank’s credit conditions or other contracts and agreements. About 72% of these significant audit differences were actually corrected in the annual report.

Waiving of important audit differences (28% – concerning 14 organisations) was in most cases possible, because audit differences with an important positive impact and audit differences with an important negative impact, were balanced and remained within the predetermined materiality level. For half of these organisations, the auditor requested the audit committee, to confirm the audit difference is not material and consequently agreed to waive the difference. In 75% of the cases, the audit differences were discussed with the audit committee or reported in the long form to the supervisory board.

Overall, 36% of all audit differences both important (where it will have a substantial effect on the company) and less important (where the impact would be minor) were corrected in the financial statements. We observed that in the case of identified agency conflicts, control and compliance risks, fraud risks and financing risks, the audit differences were corrected more frequently. However, we also observed that in the case of listed companies and larger clients, the probability of correction of less important differences was lower.

In our research, we paid specific attention to proposals regarding a total ban on non-audit services (NAS) and mandatory audit firm rotation.

Looking at NAS the research found that if an external auditor is doing non-audit work that equates to 30% or more of the overall audit fee, they are three times less likely to correct a less important discrepancy. However, in cases where there was 30% or less of non-audit work undertaken as part of the overall fee there was no effect as to whether or not a discrepancy was corrected.

It should be noted that the research found no effect on whether or not tax advice was given as part of the audit fees. Finally, the researchers examined whether NAS negatively affected the probability of detecting errors at all, but did not find any evidence to support this notion. There were 37 organisations looked at that received more than 30% of non-audit services as part of their overall fee.

We also looked at the effects of auditor tenure. We observed that a long term client relationship has a significant positive effect on the adjustment of audit differences. The probability of correction increases, concerning both less and more important audit differences. This applies to both audit firm tenure (longer than 10 years) and the duration of the client relationship with the individual external auditor (longer than 5 years).

Also, the opposite is true, short auditor tenure reduces the probability of correcting of less imporant errors. This effect counts for both very short (less than three years) as medium-length auditor tenure (three to ten years). These results lead to questions about whether mandatory rotation of audit firms, as proposed by the EU Commissioner Michel Barnier, will enhance external audits.

The research concluded that the public audit has significant impact. That’s the good news. This study also provides empirical evidence into the debate of the total ban of NAS and mandatory firm rotation. However, the research also raises several questions, like: what do these results mean to financial statements users, should they have a say in the determination of materiality, and what does the corrective role of audit committees entail? Although there are several unanswered questions, the study has given us a glimpse into the complexity and dynamics of the audit profession.

Dr Joost van Buuren is associate professor of auditing and assurance of Nyenrode Business Universiteit in the Netherlands.

Dr Leen Paape is professor of accounting information systems and dean of Nyenrode Business Universiteit in the Netherlands.