The external audit of companies’ financial statements by independent audit firms plays a pivotal role in the proper functioning of the economy and the capital markets.
It helps ensure the reliability of accounting and financial information and fosters a climate of trust among investors, lenders, and members of a company’s senior management.
The Key Audit Matters (KAM) section was incorporated into the external auditors’ audit report in 2016 (International Standard on Auditing 701) and applies to companies listed on stock exchanges and other public-interest entities.
In this section, the auditors describe the key issues that arose during their audit engagement and which required them to exercise a heightened degree of professional judgment.
Significant audit matters, therefore, are those based on management’s estimates and consequently require a significant degree of attention due to their complexity and the risk of causing material misstatement in the financial statements of the entities.
However, how does a change in the auditing firm affect the reporting of material weaknesses, and what is their predictive ability in the timely identification of problems that may lead to corrections and restatements of companies’ financial statements?
These questions are critical for investors’ decision-making in the context of modern stock markets.
In our recent study, we examined the effect of changing audit firms on the number of material misstatements reported by the external auditor in their report. The study was based on a large sample of large, medium, and small companies listed on the London Stock Exchange.
According to the empirical findings, changing the audit firm increases the number of material misstatements in the year of the change. This phenomenon is observed primarily in medium-sized and smaller firms that are not included in the FTSE 100 index.
This finding is consistent with the phenomenon that the relevant literature refers to as the “fresh look” effect: the new audit firm brings a new (fresh) perspective to the audit, identifying more critical issues. This finding does not apply to the very large companies in the FTSE 100 index, which have a mature operational environment and better corporate governance.
At the same time, for these companies, auditor changes typically occur among the Big 4 audit firms. The picture changes for medium-sized and smaller listed companies, which are included in the London Stock Exchange’s Main Market (outside the FTSE 100) and AIM segments. Here, a change in audit firm leads to an increase in the number of material misstatements, indicating that the incoming external auditor views management’s judgments with greater skepticism.
Regarding the predictive power of AEs, we examined the extent to which the reporting of relevant AEs can provide timely indications of future corrections/restatements of financial statements related to accounting issues arising from business combinations. Business combinations are strategic decisions made by company management and typically involve complex accounting estimates and a high risk of errors.
To conduct the study, we again used a large sample of companies listed on the London Stock Exchange. Based on the empirical findings, financial statements related to business combinations provide early warning signs of risk and significantly increase the likelihood of a future restatement of financial statements for relevant accounting issues related to mergers and acquisitions.
This finding may be due to the fact that the accounting treatment of business combinations requires complex estimates by management regarding issues such as determining the fair value of the net assets of the acquired company, the estimation of the amount of goodwill arising from the acquisition, etc.
The majority of companies listed on modern stock markets make the necessary adjustments recommended by external auditors and receive an unqualified opinion on their financial statements.
The “Other Matters” section of the audit report is one of the few points that differentiate reports among companies with an unqualified audit opinion. Consequently, users of financial statements (e.g., investors) should carefully review the EIA to understand the critical accounting and auditing issues that concerned the external auditor during the performance of the audit engagement.
In this article, we examined two aspects of the contemporary literature that address: a) the effect of a change in audit firm on the number of reported material misstatements and b) the predictive ability of material misstatements to serve as early warning signs of future accounting problems, corrections, and restatements in companies’ financial statements.
The relevant literature highlights the multifaceted contribution of SSE to the quality of financial reporting. Consequently, it deserves the necessary attention from both external auditors and investors, financial analysts, and other users of financial statements to facilitate better decision-making.
* Mr. Efthymios Demoirakos is an Associate Professor in the Department of Accounting and Finance at the Athens University of Economics and Business
Mr. Charalambos Brilakis is a Ph.D. candidate in the Department of Accounting and Finance at the Athens University of Economics and Business