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1The impact of the public audit

‘The impact of the public audit’

Empirical research into the effects of the financial statements audit and the audited organisation

Prof. dr. Leen Paape RA RO CIA

Dr. Joost van Buuren RA

Prof. dr. Leen Paape RA RO CIA

Dr. Joost van Buuren RA

‘The impact of the public audit’

Empirical research into the effects of the financial statements audit and the audited organisation

NBA_NBANyenrode Rapport ImpactPublicAudit ENG (Apr12) ALT.indd 1 18-04-12 15:34

2Nyenrode Business Universiteit

Information: telephone: +31 (0) 346291612 (press officer)Cover photograph: photograph by Erik Witpeerd, Nyenrode Business University colleague

© Nyenrode Business Universiteit Breukelen, April 2012 Copying is permitted provided Nyenrode Business University is cited as the source.



Voorwoord

We are suitably proud to present the results of the study ‘The impact of the public audit’. It is a unique project, in which the profession has taken a courageous step and has dared to make itself vulnerable. We hope that the results help to generate a balanced fact-based discussion on the functioning of auditors.

At the same time we hope that the report will help in the creation of an effective policy in which confidence in the accountancy profession is further enhanced. The report also provides various points of departure for self-reflection by auditors, both for those working in practice and for those who are in training.

We would like to sincerely thank all of the auditors who took part in this study for their efforts. The questionnaire was detailed and completing it often took a considerable amount of time and care.

We would also like to thank the NBA for taking the initiative and its constructive cooperation. In order to function independently, this research is fully funded by Nyenrode Business University, without additional external funding. Finally we would like to sincerely thank those who have read this report for their comments and suggestions.

Breukelen, April 2012

Prof. dr. Leen Paape RA RO CIADr. Joost van Buuren RA



Management summary

The function of auditors receives a lot of attention. A great deal is said and written about the relevance and performance of the profession. An auditor has a duty of confidentiality as a result of which he cannot provide full insight into the impact of audit on the annual report and on the audited organisation. This study attempts to provide more insight into this impact and also examines the factors which auditors take into consideration in their opinion-forming process in the financial statements audit.

The study was conducted using questionnaires completed by the representative auditors and in which confidentiality was guaranteed. Our analyses are based on 147 completed questionnaires originating from auditors employed by large organisations, financial institutions and pension funds in the Netherlands. In total 81 (55%) Public Interest Entities (PIE) were involved in the analyses and 52 (35%) of those organisations are publicly listed.

The results of the study make it clear that the auditor prepares his audit well and involves many of the risk factors rele-vant to the company in determining his audit approach. Both quantitative and qualitative factors which are focused on the specific dynamics and circumstances of the audited organisation are therefore involved in determining materiality. Auditors involve a wide range of risks in the risk analysis, such as business risks and fraud risks.

Corrections to the annual reportIn 63 % of the 147 audited organisations the account discovered audit differences. These differences concern principally factual errors, but also some estimates by management. Audit differences can have an impact on results and capital. For 8 of the 147 organisations the audit led to a modified auditor’s report:

• 2 reports with modified opinions with a material error;• 1 report with a disclaimer;• 1 report with a going concern emphasis of matter paragraph;• 1 report with a modified opinion with a material uncertainty;• 3 reports with voluntary emphasis of matter paragraphs.

In 23% (34 of the 147) of the amounts in the balance sheet and profit and loss accounts were corrected prior to the is-suing of the auditors’ opinion. This involves 8 listed companies and 29 other organisations. In 77 % (114 of the 147) of the audited organisations the auditor insisted on amending the notes to the annual report. Around 95 % of these amend-



ments were adjusted in the annual report by the board of the organisation. 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 differencesIt appears furthermore from our analyses that 25% of all audit differences discovered by the auditor (which therefore im-ply 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. Approximately 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. The results show that the balanced error remains below 50% of the predetermined error-margins. For half of the organi-zations, the auditor requested the supervisory council, such as the audit committee, to confirm that the audit difference is not material and consequently agreed to waive the difference. In one quarter of the organizations, the auditor detected the important audit difference too late, namely after the result was reported to the shareholders or foreign parent com-pany. For that reason, management was reluctant to adjust the audit difference.

Of all audit differences (both important as well as less important, which therefore have an influence of less than 5% on the result or critical boundaries) 36% were corrected in the financial statements. Furthermore it appears from our analy-ses that:• The provision of other services (Non-Audit Services, hereinafter: NAS) of more than 30% in relation to audit costs, significantly reduced the likelihood of amendment to less important audit differences. We observed that NAS has no effect on the reporting of important differences. In 37 of the 147 organisations (25%) more than 30% was provided in NAS. • A long term client relationship has a significant positive effect on the adjustment of audit differences. This applies to both the duration of the client relationship with an audit firm (longer than 10 years) and the duration of the client relationship with the individual external auditor responsible (longer than 5 years). • In larger organisations the likelihood of the reporting of audit differences is lower for less important audit differences.

Management letterFinally this study makes it clear that the management letter consists of a wide variety of subjects and recommendations. 22 % of the recommendations concern a direct financial risk, according to the auditor, and in 17 % a risk of fraud was identified. 55% of the recommendations in the management letter were followed and in 32% the management undertook to study the recommendations further. In 13% of the points in the management letter, management was reluctant to fol-low up the auditor’s recommendations.



Table of contents

Foreword 3

Management summary 5

Table of contents 7

1. Introduction 9 1.1 The aim of the study 9 1.2 Data collection 10 1.2.1 The unique nature of the study 10 1.2.2 Quality requirements for the questionnaire 10 1.2.3 Selection of organisations 11 1.3 The structure of the research 11

2 Planning phase 13 2.1 The determination of the maximum tolerable error in the annual report 13 2.1.1 The concept of materiality in the annual report 13 2.1.2 Materiality in the audit 14 2.2 Empirical research into the factors of materiality 14 2.2.1 The qualitative factors of materiality 14 2.2.2 The quantitative factors of materiality 16 2.2.3 Exceptional factors in materiality 16 2.2.4 Independence and determination of materiality 17 2.3 Elements of risk analysis 17 2.3.1 Identified business risks and significant risks 17 2.3.2 Follow-up steps arising from identified risks 19 2.4 Planning phase conclusions 20

3 Decision-making surrounding audit findings 21 3.1 The impact and cause of audit differences 21



3.2 Factors in the reporting of audit differences 24 3.2.1 Details of audit difference 24 3.2.2 Factors in the determination of materiality and audit differences 26 3.2.3 Elements of risk analysis and audit differences 26 3.2.4 Exceptional circumstances of the audited company 26 3.2.5 The auditor’s specialisation and audit differences 27 3.2.6 Independence and the reporting of audit differences 27 3.3 Other amendments to the annual report and other financial communication 28 3.3.1 Impact and reason for amendments 28 3.3.2 Reasons for amendment 29 3.3.3 Follow-up to the request for amendment 30 3.4 Conclusion 30

4 Management letter 33 4.1 Relevance and range of subjects in the management letter 33 4.2 Impact of the points in the management letter 35 4.3 Conclusion 35

5. Conclusions and research limitations 37 5.1 Conclusions 37 5.2 Research limitations 38

List of definitions and abbreviations 39

Literature 42

Appendix 1 Organisations and auditors background information 44

Appendix 2 Book of appendices table of contents 47



01 | Introduction

The accountancy profession receives a lot of attention. A great deal is said and written about the relevance and the functi-oning of the profession. The International Auditing & Assurance Standards Board (IAASB) therefore recently sent a consul-tation letter to its members and stakeholders regarding the ‘value of audits’. In addition to this governments and politicians are busy issuing the accountancy profession with extra safeguards in order to enhance its quality and credibility. This is evident from, amongst other things, the recent General Consultation by a delegation from the House of Representatives to the Minister of Finance regarding accountancy and the public debate following on from the Green Paper ‘Audit Policy, les-sons from the crisis’ by the European Commission (Barnier report). Various articles also appeared in the media in which the role of the auditor was assessed critically1.

Due to the duty of confidentiality an auditor has limited opportunity to provide insight into the impact of his activities. Which facets of a business does an auditor incorporate in his2 audit when auditing the annual report? What does he need to take into consideration when determining materiality, planning, implementation and in the formation of his opinion? To what audit findings does his work lead to and what are the consequences for the annual report? Insight into the answers to such questions benefit the public debate and contribute to the decision-making process surrounding the measures required to enhance the quality of professional practices. Nyenrode Business University has carried out this study upon the initiative of the Dutch professional body of accountants, the Nederlandse Beroepsorganisatie van Accountants (NBA). In this study we wish to develop the knowledge and insight into critical elements in the auditor’s audit process.

The study had two aims:

• To provide insight into the influence of the annual report audit of large companies, Public Interest Entities (PIE), and associated organisations within the Netherlands. Publicly listed companies and financial institutions are considered to be PIE’s. The definitive impact of an auditor on the quality of the annual report was studied. In addition the impact of the audit on the organisation and the audited companies’ business processes were also examined,

• Providing insight into the deliberations made by auditors in the dynamic and complex environments in which they work.

1.1 The aim of the study

1 The supervisory body for accountancy practices, The Financial Markets Authority (Autoriteit Financiële Markten - AFM), has published various critical reports regarding the role of auditors in particular industries and sectors (www.afm.nl).2 We mean both male and female auditors: ‘he’ or ‘his’ may be read as ‘she’ or ‘her’.



The study looks at the essential activities undertaken by an auditor in the planning and implementation of his audit, such as the evaluation of qualitative and quantitative elements in the determination of materiality (maximum permitted margin of error) and analysis of risks in the planning of his activities.

This report was generated on the basis of scientific methods of analysis. This report is written in ‘layman’s terms’ and we have therefore minimised the use of statistical details for the purpose of legibility. For those who are interested we have included all the necessary details of our analyses in the appendix to this report. To aid the reader we have also added a list of definitions.

Finally we would like to emphasise that we can draw no conclusions regarding the quality of the audits carried out on the audited organisations. This was not the aim of our research3.

1.2 Data collection

1.2.1 The unique nature of the study

This study was made possible due to the cooperation of the NBA, the profession and Nyenrode Business University. Until now only a limited number of scientific quantitative studies have been available4 which cover the subjects researched in this report such as; the determination of the margin of error, research into the elements involved in risk analysis, the degree of reporting of audit differences and subjects contained in the management letter. In many cases these studies concern only one audit firm and furthermore an American environment. What is unique about our research is that it concerns several audit firms, including the big four (Deloitte, Ernst & Young, KPMG and PwC) but also several medium-sized audit practices (BDO and Mazars). Moreover, most studies are fragmented by subject, whereas our research also examines various interrelationships between the various phases in the audit. An example of this is the issue of whether elements of the risk analysis are involved in the consideration of whether or not to report audit differences.

In order to guarantee independence, Nyenrode Business University conducted this research on a pro bono basis5. In ad-dition to this, the researchers are not employed by an audit firm and therefore have no interest whatsoever in the results of this research.

1.2.2 Quality requirements for the questionnaire

The research data was collected via an extensive questionnaire. This was compiled by Nyenrode Business University on the basis of a questionnaire from a current research project entitled ‘Risk assessment & materiality’6 and thereby already validated. The questionnaire was subsequently adapted for the purpose of the specific objectives of this study. The NBA subsequently assessed the questionnaire and where necessary made its own amendments. No formal pilot study took place, mainly due to the earlier positive experiences with this questionnaire in the aforementioned project. Some practices did carry out a pilot study themselves. It was evident from this that the questionnaire was fit-for-purpose. In addition the contacts at the practices were asked for feedback regarding the questionnaire and its completion. No significant intrinsic problems were forthcoming from this7 process. The aim of the study is described extensively in the questionnaire. The audi-tors were also asked to include the most important aspects of their activities and their audit findings in their responses, so that as relevant a picture as possible could be of the ‘impact of the audit’ could be reflected.

3 In 139 (95%) of the organisations in the data set a favourable statement was provided. In one organisation a modified opinion with a material uncertainty was issued, in two organisations a modified opinion with a material error, one statement with a disclaimer, one report with a going-concern emphasis of matter and three unqualified opinions with voluntary emphasis of matter paragraphs.4 There are however many scientific behavioural studies available in which the behaviour of auditors has been studied in an experimental environment, for example using case studies and role playing. The number of studies using information from audit files is however very limited.5 That is to say from its own scientific budget without additional external finance.6 This questionnaire has been used previously by Accountancy Masters Students at Nyenrode. Up to November 2011 students completed approximately 150 questionnaires, under strict safeguards of quality and anonymity . To date approximately 80 Master’s theses in total have been written on the basis of the results.7 It was frequently stated that the completion of the questionnaire took a great deal of time and that its user-friendliness (in Excel format) left a little to be desired. The estimated time spent was 3 - 4 hours (based on our earlier experiences), but in some cases completion took (much) longer.



The questionnaires were designed in such a way that actual details are requested which are included in the audit files. This means we rely upon the internal quality assurance of the files from accountancy practices which fall under the super-vision of the AFM. The questionnaire is set up in such a way that confidentiality is fully protected. Individual organisa-tions, accountancy practices and external auditors are not traceable via the questionnaire. Many questions are therefore expressed in the form of a graduated scale, which means information value is lost and the likelihood of ‘measurement interference’ and some analyses become less accurate. The consequence is that certain effects are less measurable and perhaps incorrectly are not considered. The questionnaire is included in section 1 of the separate book of appendices.

Finally the external auditors responsible have signed a declaration stating that the questionnaire has been completed ‘accurately and fully’. The protection of confidentiality is guaranteed. The contact people at the accountancy practices have established that the questionnaire has been signed by the external auditor responsible. The contact people subsequently confirmed this to us. Finally the contact people satisfied themselves that the questionnaire was completely anonymous and subsequently forwarded them.

1.2.3 Selection of organisations

We were ourselves responsible for the selection of the large and very large companies in the Netherlands. In doing so we made use of the Mintglobal Europe database, complemented by the audit practices’ transparency reports8. The NBA subsequently asked the four large and two medium sized accountancy practices to participate in the study. The NBA then forwarded us the names of the contact people at the audit practices. We then communicated the list of selected companies to those contact people. The contact people forwarded the questionnaires to the external auditors responsible with the request to complete them. In this way we prevented ourselves from acquiring the knowledge of the company names and their external auditors, as a result of which anonymity can be guaranteed.

In total 485 organisations were selected by us, of which 60 appeared not to fulfil the selection criteria. The reasons for this are that these organisations are no longer clients of the practice or that they are not independent, but form a part of a larger organisation. Another reason is that the organisations did not fulfil the wider criteria9. The remaining 425 question-naires were subsequently sent out the external auditors. Ultimately 147 usable questionnaires were returned, of which 87 were from the Production and Service sector, 39 from Banking and Insurance and 21 from Social Institutions. This latter category mostly involved pension funds. The response-ratio is therefore 35% (147 of the 425). This considered good for such research, especially considering the scope of the questionnaire. The number of 147 organisations is sufficient for our statistical analyses. For further information about the composition of the dataset please refer to appendix 1.

1.3 The structure of the research

In chapter 2 we cover the auditor’s duties within the context of planning his audit. An element of this is the qualitative and quantitative factors of the maximum tolerable errors in the annual report (planning materiality). The second part of the planning phase concerns the analysis of commercial and significant risks for the annual report audit. In doing so, we inves-tigate the types of risk identified by an auditor and the follow-up steps he takes. The second part of the study is described in chapter 3. This part looks at the types of reported audit differences and the way in which the auditor manages his audit findings. This concerns his deliberations relating to whether or not he insists on the reporting of audit differences in the annual report. In doing so, the independence of the auditor is examined by the formation of a relationship between the provision of non-audit services (NAS) and the duration of the relationship of the audit firm or the individual auditor with the organisation. In addition to the assessment of audit differences, in this section we also set up an analysis regarding the reporting of audit findings concerning the directors’ report and the notes to the balance sheet and profit and loss account.

8 Companies were selected on the basis of four criteria, namely 1) the statutory annual report audit; 2) the organisation must have its registered office in the Netherlands and fall under the jurisdiction of the Netherlands; 3) preferably a large, publicly listed PIE; 4) the audit relates to the financial year ending between June 2010 and May 2011.9 The initial lower threshold is € 25 million turnover for medium sized accountancy practices and € 50 million turnover for large accountancy practices. This lower threshold applies specifically to small insurers and social institutions. See table in appendix 1 for a summary of organisations according to size.



The third part of our study report (chapter 4) looks at the influence of the annual report audit on the organisation and business processes of the audited organisation by the means of the management letter. For this purpose we assess the diversity of subjects handled therein and we analyses what the organisation did about the suggested recommendations.

Finally in chapter 5 the conclusions drawn about the results and limitations of the study are described.



02 | Planning phase

The most important conclusions from this chapter are:- In order to determine the maximum tolerable error in the annual report (planning materiality), in addition to quantitative factors such as company size and results, auditors involve various qualitative factors, focused on a company’s specific circumstances. - For the analysis of risks of significant errors in the annual report, auditors involve a wide range of risks, such as business risks and fraud risks. In his audit an auditor assesses risks which arise from the choices made during the management of the business by the board and their influence upon the annual report.

2.1.1 The concept of materiality in the annual report

The financial statements audit offers no absolute assurance that the annual report do not contain errors. One reason for this is that annual report contain many estimated items - which are therefore subjective - such as the determination and valuation of goodwill, the determination of the adequacy of a pension provision etc. according to audit standards an auditor must examine whether estimates are tenable for at least twelve months, calculated from the date of the balance sheet (NV COS 570.18). Nevertheless an auditor is expected to provide a statement to the annual report within four months of the date of the balance sheet. It is also impossible for an auditor to entirely audit all of the items and transactions in an organisation as such an audit would be prohibitively expensive. Furthermore it is not always possible for an auditor to be present in an organisation, as in that case the costs and benefits of an audit would not be in balance. The auditor can therefore give no more than what is referred to in the industry as ‘ a reasonable assurance’ that the annual report is a reliable representation of the economic situation of the audited organisation.

The definition of reasonable assurance is not clearly laid down in the audit standards. The properties of a reasonable degree of assurance are only indirectly described. Nor are reliability percentages stated in the audit report. According to the audit standards the reasonable degree of assurance must be linked to the maximum tolerable error in the annual report. This is referred to as planning materiality. The audit standards defined materiality as follows:

2.1 The determination of the maximum tolerable error in the annual report



“Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.” (NV COS 320.2)

The audit standards indicate explicitly that in addition to the scope of the error (quantitative materiality) the nature of the error (qualitative materiality) must also be considered (NV COS 320.A3, A5 and A10; BTA art. 36).

2.1.2 Materiality in the audit

Planning materialityThe auditor uses the concept of materiality in two phases, namely during the planning phase and in the final phase in the assessment of his audit findings. The concept of materiality is used in the planning phase for the determination of the maximum quantitative error in the financial statements10. An auditor must involve both quantitative and qualitative fea-tures in this error. Qualitative features are for example critical limits, in which relatively small amounts can have significant consequences. Examples of this are the manipulation of results so that a management bonus can be determined or so that a bank’s solvency requirements for a credit arrangement can be satisfied. For the expression of planning materiality the audit standards (NV COS 320.A3) assume a combination of percentages of balance sheet totals, equity and results, sup-plemented by qualitative factors. The combination of factors is often outlined in the audit firm’s specialist manuals.

2.2 Empirical research into the factors of materiality

2.2.1 The qualitative factors of materiality

The previous paragraph outlines that an auditor must also use qualitative factors alongside quantitative factors in the determination of the level of materiality. Until today there has been little empirical research into the factors which deter-mine this planning materiality (Messier et al., 2005, p. 160). It is evident from the survey-study by Blokdijk et al. (2003) of 108 Dutch companies from 1998-1999 that this materiality decreases relatively in accordance with the size of the audited organization. Blokdijk et al (2003) also reported that this planning materiality increases with an estimate by the auditor that there is high quality internal control and better profitability of the organisation. Planning materiality reduces however in the event that the complexity of the organisation increases.

We have assumed the survey-study by Blokdijk et al. (2003) as the starting point for this study and elaborated upon it. Thus various qualitative and quantitative factors which may be applicable are included in the questionnaire. It also in-cludes empty fields in which auditors can report additional factors. In general, it is assumed in the literature that a more conservative (lower) estimate of the materiality, increases the quality of the audit (Blokdijk et al., 2003). The quantitative and qualitative factors in the determination of materiality are presented in table 1.

The last column of table 1 shows the significant11 influence of factors on the extent of materiality12. For details of this ana-lysis please refer to the book of appendices.

It is evident from table 1 that the qualitative factors ‘agency conflicts’ (conflicts of interest between management and exter-nal stakeholders, such as investors and credit providers) and ‘economic risks’ (such as the pressure of competition and low profit margins) are used by auditors in all sectors in 94% and 82% of organisations respectively.

10 During the audit however the auditor does not use planning materiality for the planning of audit activities, but a lower amount, called ‘performance materiality’ (NV COS 320.10) or ‘tolerable error’. The auditor uses a ‘safety margin’ as it were in order to absorb undiscovered errors. The extent of this safety margin is often determined by the audit firm’s manual as 50% of planning materiality, but this percentage can often be higher or lower, dependent upon the circumstances. When we refer to ‘materiality’ in this report we mean planning materiality.11 In this report the term significant is intended to mean: statistically significant. We assume with statistical significance that the effect is not down to chance, but that the effect occurs systematically and consistently.12 These factors are measured by the number of times the factor is mentioned. We assume that if the factor is mentioned more frequently this increases the inherent risk - from an average point of view. In the questionnaire we have asked whether the effect of the factor on the inherent risk has been established on the audit file. This is not the case for many factors. As a result we can mainly determine average effects and make only a limited distinction between increasing and lowering effects on the inherent risk. The consequence is that the effects of planning materiality wrongly cannot be established.



The identification of agency conflicts and economic risks13 has a significantly lowering effect on the level of planning mate-riality (table 1, last column). The extent to which the qualitative factors fraud risk (both reporting fraud and theft) and com-pliance with legislation and regulation are involved in the determination of materiality, does not vary significantly by sector. The stability of the management and the Supervisory Board (RvC) is frequently mentioned in all sectors (63%). In 2010, the auditor assessed the stability of the management as a risk-lowering factor in 40 organisations (27%)14 (not shown).

Table 1 Factors used in the determination of planning materiality

13 This effect is only observed if the account has explicitly stated that the economic situation has an enhancing effect on the inherent risk (49 organisations – 33%). In five organisations (3%) a lowering effect was reported and for the remainder no explicit effect on the inherent risk was stated. (inherent risk = risk of a material error, before consideration of any internal controls).14 In six organisations (4%) it was referred to as a risk-enhancing factor and in the other companies the effect on inherent risks was not explicitly stated.

Agency conflicts

Economic risks

Fraud risks

Corporate governance stability and management

risks

Control and compliance risks

Management bonuses (> 50% fixed remuneration)

Size

Commercial performance

Financial health

Deviation from standard calculation of materiality

Explicit involvement of review partner

Financial sector

Social institution

Stock exchange listing

Specialisation: > 50% hours active in sector

Specialisation: partner has > 4 clients in sector

Non-audit services > 30%a,c

Duration of firm-client relationship > 10 yearsb,c

Duration of external auditor-client relationship > 5 yearsb,c

Bid-round < 3 years agoc

Qualitative factors (mentioned on one or more occasion)

Qualitative factors (mentioned on one or more occasion)

Details in the determination of materiality (% applicable)

Independence (% applicable)

Number of organisations in analysis

Banks and

Insurers

36 (93%)

34 (88%)

28 (71%)

21 (55%)

2 (3%)

9 (23%)

31 (83%)

34 (87%)

34 (87%)

10 (26%)

24 (24%)

39 (100%)

10 (26%)

19 (49%)

32 (82%)

4 (10%)

16 (41%)

11 (28%)

10 (25%)

39 (100%)

Social

Institutions

19 (90%)

17 (81%)

17 (81%)

20 (95%)

3 (14%)

3 (14%)

14 (67%)

14 (67%)

18 (86%)

1 (5%)

9 (43%)

21 (100%)

0 (0%)

9 (43%)

21 (100%)

3 (14%)

11 (55%)

9 (43%)

8 (38%)

21 (100%)

Total

organisations

138 (94%)

121 (82%)

102 (69%)

93 (63%)

12 (8%)

58 (40%)

123 (83%)

126 (86%)

106 (72%)

28 (19%)

78 (53%)

39 (27%)

21 (14%)

52 (35%)

42 (27%)

89 (61%)

28 (20%)

78 (54%)

52 (36%)

37 (25%)

147 (100%)

Influence on the

level of planning

materialityd

reduced

reduced

n.s.

n.s.

increased

n.s.

increased

n.s.

n.s.

n.s.

n.s.

n.s.

increased

n.s.

n.s.

n.s.

n.s.

n.s.

n.s.

n.s.

Production

and Service

Provision

83 (95%)

70 (80%)

57 (66%)

52 (60%)

7 (10%)

46 (53%)

78 (90%)

78 (90%)

54 (62%)

17 (20%)

45 (51%)

42 (47%)

14 (16%)

36 (41%)

21 (24%)

51 (59%)

32 (37%)

19 (22%)

87 (100%)

n.s.= no statistically significant effect a= 5 missing values (n=142) b= 2 missing values (n=145) c= see appendix table B1-3 – B1-5 for distribution details d= see separate appendix book section 3 for detail information.



For Social Institutions this factor was significantly more frequently mentioned and was cited by seven institutions (33%) as a risk-reducing factor. Finally the risk of non-compliance with legislation and regulation in all sectors was scarcely menti-oned (12 organisations, 8%). Nevertheless this risk is associated with significantly higher planning materiality15. We have not yet been able to find any explanation for this.

2.2.2 The quantitative factors of materiality

The factor ‘size of the organisation’ is - as might be anticipated - significant in the determination of materiality. The larger the audited organisation, the higher the materiality. In accordance with the findings of Blokdijk et al. (2003) that increase is not proportional. The relative increase in materiality decreases non-proportionally with16 the increase in size.

Commercial performance (or the level of profitability) was used in to determine materiality in 86% of the organisations. But in contrast to the findings in the article by Blokdijk et al. (2003) the use of commercial performance has no significant influence on the level of materiality17.

In 72% of the audits, financial health formed part of the determination of materiality. Especially for Banks and Insurers (91%) and Social institutions (86%) this factor was used significantly more frequently. Nevertheless the use of financial health has no significant influence on the level of materiality18.

2.2.3 Exceptional factors in materiality

It is evident from table 1 that, except for in Social Institutions, in 19% of the audits the auditor deviates from the standard calculation of planning materiality according to the audit firm practice’s guidelines. However, we do not observe that devia-tion has significant influence on the level of materiality.

It is compulsory for a quality assurance system to be implemented by accountancy practices (NV COS 220). One of the mea-sures implemented for this purpose is the use of a second external auditor (review partner). The review partner assesses the quality of the decisions made in carrying out the audit. In approximately half of the audits (53%) the review partner is explicitly involved in determining materiality. This involvement however has no significant influence on the level of materia-lity. We established a sector-effect although we did not anticipate this It appears that the materiality in Social institutions (specifically pension funds) is on average significantly higher in relation to production and service organisations. Materia-lity for Banks and Insurers is not significantly higher than for service organisations.

In our dataset 47% of the Production and Services sector and 26% of Banks and Insurers are listed. It is evident from table 1 that the fact that a company is listed has no influence on materiality. It appears from notes to the questionnaire that auditors cite stock exchange listing as an ‘agency conflict’ factor.

We also involved the degree of specialisation by the auditor in our analyses. We measure specialisation via the parameters ‘over 50% of hours active in the relevant sector’ and more than four clients in the relevant sector’. The sectors Banks and Insurers and Social institutions are mostly served by auditors with a higher specialisation: in 49% and 43% of organisati-ons respectively auditors were active in the sector for over 50% of their time. In 82% and 100% respectively of the orga-nisations, auditors had more than four audit clients in the sector. In the Production and Services sector the specialisation appears lower: 16% of auditors spent over 50% of their time in the same sector and 41% have more than four clients in the sector. Specialisation (both types) has no significant influence on the level of materiality.

15 It is evident from an additional analysis that in 75% of the organisations the risk of non-compliance with legislation and regulation results in higher inherent risks.16 We measure the size of the organisation in terms of the level of audit costs. Balance sheet and/or total turnover do not reflect size accurately for Banks and Insurers in comparison with the Production and Services sector.17 We also assessed profitability (profit/turnover) and the annual change in profit/turnover. These factors also had no significant influence on the degree of planning materiality. We have not yet been able to find any explanation for this.18 As an alternative we used the debt ratio (total debt/total assets) and the annual change in the debt ratio in the analyses. These variables also had no significant influence on the degree of materiality.



One of the most quoted concerns in respect of auditors is that they no longer work independently if they also provide other services (NAS: tax consultancy and other consultancy)19 to audit clients. We therefore tested the effect on the determina-tion of materiality if auditors provide many NAS to audit clients and in doing so use more than 30% NAS in relation to the costs of the annual report audit.

It is evident from table 1 that auditors in the Production and Services sector provide more than 30% NAS to 21 organisati-ons (24%). This is significantly more than for Banks and Insurer (4 organisations or 10%) and Social Institutions (14%). It is evident from analyses however that the provision of more than 30% NAS in relation to audit costs has no significant effect on the level of materiality. Also in further analyses of tax consultancy alone and other consultancy alone there is no signifi-cant effect on the level of materiality established.

Another threat to independence and to an excessive degree of familiarity is the duration of the client relationship. In total 78 (54%) of the organisations had a client relationship with the audit firm of over 10 years in length. In 52 organisations (36%) the relationship with the individual auditor was longer than 5 years (see appendix 1, table B1-3 for details). The duration of the client relationship however has no significant effect on the level of materiality. In additional analyses with only very short (<1 year), short (1-3 years) and long (>10 years) length of relationship have shown no significant effect on materiality.

Another threat to independence could be that organisations often hold bid-rounds, in which auditors could lose their as-signment earlier. In 25% of audits a bid-round had taken place during the previous 3 years. Bid-pressure appears to have no effect on materiality however.

2.3 Elements of risk analysis

2.3.1 Identified business risks and significant risks

A second element of the planning phase of the audit concerns the implementation of the risk analysis. The risk analysis ensures an effective and efficient audit approach. The audit standards (NV COS 315) contain specific conditions for an ade-quate risk analysis. Elements of this are the assessment of business risks (risks that an organisation has not achieved its own objectives) and significant risks (risks that create an increased likelihood of material inaccuracy in the annual report). Auditors are expected to have a thorough understanding of the dynamics and complexity of the audited company and the environment in which it operates.

According to the literature the use of business risks makes the audit more effective and should enhance the discovery of management fraud (Bell et al., 1997; Lemon et al., 2000; Erickson et al., 2000; Eilifsen et al, 2001; Bell et al., 2005; Peecher et al., 2007; Bell et al., 2008). A broad approach to the audit via the assessment of business risks provides the auditor with a greater understanding of the organisation. O’Donald and Schultz (2005) report that a strong focus on the analysis of the business risks helps in forming the correct judgments in the event that the future perspective of the organisation is negative. In a follow-up study Schultz et al. (2010) establish that proper training is essential to an effective business risk analysis. Bell et al. (2008) report that the use of the business risk analysis leads to greater partner involvement and also to a more efficient audit. Business risk analysis is therefore essential in order to acquire sufficient understanding of the choices made by management in running the business and their reporting into business processes and the annual report.

Our questionnaire also makes it possible to gain insight into business risks and significant risks. How ‘rich’ is the analysis used by auditors in the audit? We cited 12 types of business risk and seven types of significant risk in the questionnaire. Participants were given the opportunity to add six types of risk. The types of risk were categorised by us into nine elements. These elements were presented in table 2.

19 We ignore the provision of other assurance services in this analysis because these pose no threat to independence (NVO).

2.2.4 Independence and determination of materiality



It is evident from this table that in 53% of the organisations the durability of the business model was included as a busi-ness risk. The high level of competition and the associated price and margin pressure on businesses was mostly referred to. For Social institutions this business risk was cited by eight organisations (38%), but this is not significantly lower than for the other two sectors. It is evident from an additional analysis that on average, auditors cited eight relevant risks and at least one to two risks per organisation (not illustrated).

Table 2 Elements of risk analysis classified by sector

The business risk of insufficient innovation capacity and the introduction of new products and services were cited for 30 organisations (20%). This business risk is cited significantly less frequently than for the Banks and Insurers sector. Based on expectations from literature (Bell et al, 1997; Bell et al, 2005; Peecher et al. 2007; Bell et al., 2008) and the standards (NV COS 315.11) we anticipated a more frequent use of business risks. It is exactly in regard to these aspects that the auditor can provide expertise on how the organisation knows how to operate in the economy (Knechel et al., 2007). This expertise can be significant in the consideration of whether actual values are realistic with the perspective on future yields.

Compliance with new regulations was significantly more frequently cited in the Social Institutions sector (71%). The busi-ness risk relating to the reliability of ICT was significantly more frequently cited in the Production and Services sector (57%). There were no significant discrepancies between the sectors for the other risks in table 2.

It is very possible that many business risks are not applicable or irrelevant. It could also be the case that auditors find it difficult to incorporate abstract business risks in their audit approach, which is confirmed by scientific research (Kne-chel, 2007; Curtis and Turley, 2007) and also recent research with small and medium-sized practitioners (SMP’s) auditors (Van Buuren et al., 2010). Significant risks which are characterised by their more definite nature are identified much more frequently by auditors.

Uncertainties in the annual report (82%) (such as valuation problems) and extraordinary transactions and ad hoc projects (86%) (such as takeovers) are often cited. Fraud (84%) is also considered to be a significant risk in many audits. The ele-ment ‘related parties’ was cited as a risk in 19% of cases.

Durability of business model < 5 years

Innovation capacity for new products and services

Compliance with (new) statutory requirements

Reliability of ICT

Financing problems

Risks involving quality of personnel

Fraud risks

Uncertainties in the annual report

Extraordinary transactions and ad hoc projects

Related parties

Business risks

Significant risks

Banks and

Insurers

(n=39)

19 (50%)

3 (8%)

15 (38%)

15 (38%)

17 (44%)

5 (13%)

25 (64%)

24 (62%)

36 (92%)

5 (13%)

Social

Institutions

(n=21)

8 (38%)

6 (29%)

15 (71%)

7 (33%)

9 (43%)

6 (29%)

19 (90%)

19 (90%)

21 (100%)

7 (33%)

Total

(n=147)

79 (53%)

30 (20%)

67 (46%)

72 (49%)

65 (44%)

35 (24%)

123 (84%)

121 (82%)

126 (86%)

28 (19%)

Number of organisations in which element is mentioned (% total)

Production

and Services

(n=87)

52 (60%)

21 (24%)

37 (43%)

50 (57%)

39 (45%)

24 (28%)

79 (91%)

78 (90%)

83 (95%)

16 (18%)



The identification of risks is important, but the definitive establishment of the impact of those risks on the accuracy of the annual report is, if possible, even more important. Table 3 contains a summary of the follow-up steps taken by auditors as a result of identified risks. In total risks 686 risks were cited by auditors for audited organisations.

The additional activities vary from the acquisition of information from the management (interviews), the interpretation of sets of figures and the formation of links between administrative data (analytical), the testing of whether internal control measures are effective in an organisation (tests or audits) and data-orientated audit activities, such as the definitive tes-ting of the existence of property, whether debtors have paid and whether debts are included in full in the annual report.

It is evident from table 3 that for most risks, auditors conduct interviews with management. Interviews also appear to be the most important method of approaching the more abstract risks such as the assessment of the durability of the business model, innovation capacity and risks concerning personnel. As an addition to these risks, analytical activities are mainly carried out. In approximately 20% of cases no additional activities were carried out. In the notes to the questions, it is sometimes stated that it was discussed ‘generally’ with management.

Table 3 Follow-up steps arising from business risks and significant risks

For more definite risks such as non-compliance with legislations, ICT risks, financing problems and other significant risks, the auditor undertakes additional activities. For ICT risks an expert (EDP/IT-auditor) was frequently engaged (77%). These risks were mostly discussed with the Audit Committee (AC) and Supervisory Board. In three quarters of cases, these risks were also described in the management letter and/or long form to the supervisory board.


Innovation capacity for new products and services

Compliance with (new) statutory requirements

Reliability of ICT

Financing problems

Risks involving quality of personnel

Fraud risks



Related parties

Business risks

Significant risks

none

18%

19%

12%

6%

7%

22%

3%

1%

16%

0%

inter-

views

61%

71%

66%

60%

63%

69%

65%

65%

31%

55%

test of

controls

substan-

tive testing

9%

10%

16%

54%

18%

14%

53%

48%

22%

52%

9%

10%

16%

54%

18%

14%

53%

48%

22%

52%

Experts

engaged

AC/

RvC

ML/

AR

11%

3%

30%

77%

14%

0%

15%

36%

13%

7%

28%

19%

31%

48%

36%

29%

49%

52%

28%

62%

49%

39%

67%

74%

62%

41%

63%

69%

37%

72%

Number

of stated

risks

(n=686)

Elements of risk analysis Additional activities Communication

90

22

56

84

47

34

170

106

61

16

Analysis based on 143 organisations (values are missing for four organisations). In these 143 organisations a total of 686 risks were mentioned by the auditors. AC= Audit Committee; RvC= Supervisory Board; ML= Management Letter; AR=Long form to the supervisory board

2.3.2 Follow-up steps arising from identified risks

analy-

tical

33%

16%

17%

13%

45%

4%

55%

63%

25%

48%



In the analysis of materiality, risk analysis and audit activities the following picture emerges:• Quantitative and qualitative factors are used in the determination of the level of materiality. Quantitative factors, such as size, profitability and the financial situation of the company being audited are the most important. Furthermore, the provision of NAS appears to have no effect on the determination of materiality. No empirical evidence has been found to show that the length of the client relationship has any effect on the materiality used.• Auditors adopt a broad approach to their audit and identify various business risks and significant risks. The relationship between the management of the business and the annual report is expressed in this way. The assessment of such a relationship requires good knowledge of the dynamics and complexity of the company being audited. • The auditor appears to cite more abstract business risks (such as the assessment of the durability of the business model) relatively rarely. The audit activities arising from these more abstract business risks principally concern the acquisition of information from the company being audited.

2.4 Planning phase conclusions



03 | Decision-making surrounding audit findings

The most important conclusions in this chapter are:- 25% of the audit differences have an important impact on results or on critical limits. Approximately 72% of them are adjusted in the annual report. 36% Of all audit differences were actually corrected in the annual report.- The waiving of important audit differences (28%, concerning 14 organisations) is possible because in most cases audit differences resulting in an important increase respectively decrease of the result are balanced. For half of the organisations, the auditor asked the supervisory board and/or audit committee to confirm that the audit difference was not material. In one quarter of the organisations, the audit difference was detected after the result was reported to the shareholders or the parent company and was not corrected for that reason. - The specific circumstances of an organisation (qualitative factors) in the determination of planning materiality and various elements of risk analysis have an significant influence on the reporting of audit differences;- The size of the organisation and the provision of more than 30% NAS reduce the likelihood of less important audit differences. In 37 of the 147 organisations (25%) more than 30% was provided in NAS. NAS does not affect the likelihood of adjusting important differences.- A lengthy client relationship with the external auditor (> 5 years) and the audit firm (> 10 years) increases the likelihood of the reporting of both important and less important audit differences.- In 77% of the organisations the auditor requested an amendment to the notes to the balance sheet and the profit and loss account and the directors’ report. 95% Of these amendments were adjusted Example reports help the auditor to consider whether the information in the notes is sufficient.

3.1 The impact and cause of audit differences

The auditor determines planning materiality during the planning phase of the audit. He undertakes audit activities and compiles a summary of potential audit findings on the basis of the risk analysis. In this chapter we examine the delibera-tions made by the auditor regarding the follow-up to audit findings. In doing so we make a distinction between audit diffe-rences and other amendments. Audit differences relate to inaccuracies discovered in the draft balance sheet and the profit and loss account. The remaining amendments relate to shortcomings in the directors’ report and the notes to the balance sheet and the profit and loss account. The impact of the audit on the annual report is finally visible due to the reporting of these audit differences, amongst other things.



According to the audit standards, the auditor is not obliged to allow all audit differences to be adjusted (NV COS 320. 6; NV COS 450.10 and 11). It is the auditor’s responsibility to judge whether the audit differences alone and/or aggregated is suf-ficient to insist upon this. In doing so, the total picture of the financial statements relating to the organisations’ affairs and result for the year is taken into consideration. Audit differences which are not adjusted, however, must be communicated to the Supervisory Board and AC. The auditor must then ask the Supervisory Board and AC for confirmation that the uncorrec-ted differences are not material individually or jointly (NV COS 450.12-14).

Few studies are available from scientific literature which have investigated the considerations as to whether or not to insist upon correction (Beattie et al., 2001; Messier et al., 2005; Joe et al., 2011). These studies have principally been conducted in the United States of America. Using data from 1979-1981 Icerman and Hillison (1991) established that the larger the rela-tive size of the audit, the more frequently reporting occurs. The study by Wright and Wright (1997) using data from 1984-1985 confirms that the relative size of an audit difference is significant and they also found that greater objectivity (actual errors) in the audit difference leads to more corrections. Wright and Wright (1997) also found that the larger the client the likelihood of correction increases. The correction percentages of audit differences were 51% in Icerman and Hillison (1991) and 35% in Wright20 and Wright (1997)21. In a follow-up study by Joe, Wright and Wright (2011) based on data from 2002 it was evident that 24% of audit differences were adjusted. The results of this last study are not consistent with the Wright and Wright (1997) study. Thus, factors such as objectivity and materiality of the audit findings, the size of the organisation and financial health (loss) have no significant effect on the likelihood of corrections. Even a stock exchange listing does not lead to significantly more corrections. Joe et al. (2011) did, however, find that an audit difference with an impact on results was significantly more frequently corrected. They also observed that a lengthier client relationship with an audit firm did not lead to significantly fewer corrections of audit differences with an impact on results22. Furthermore audit differences which were also reported in previous years were adjusted significantly less often. Joel et al. are reserved in the interpre-tation of their findings, especially as the context of the year 2002 was exceptional with large scandals, such as Enron and Worldcom.

The questionnaire used in our research is based on the research of Wright & Wright (1997) and Joe et al. (2011) augmented by various other factors such as independence. In the questionnaire we asked the auditors to describe the five largest audit differences and to state whether these audit differences were adjusted in the annual report. These audit differences are laid down by the auditor in a summary of audit differences and ought to be discussed with the Supervisory Board and/or AC (NV COS 450.12), provided the audit differences could be reasonably material (NV COS 260.16).

In 50 organisations out of the population (34% of 147) the auditor in the questionnaire established no audit differences, which in 16 instances involved listed organisations23. In the notes to the questionnaire the reason that the organisation had already corrected the audit differences discovered in the draft annual report was stated on two occasions. For the remai-ning 48 organisations it was stated that that no audit differences had been discovered. In addition, we analysed whether NAS or client tenure affected the extent to which auditors reported audit differences, but we did not find any evidence to support this.

Table 4 shows the impact, cause and reporting of 294 audit differences across 93 organisations. It is evident from table 4 that the errors discovered by auditors have an important impact on results or critical limits in 25% of cases. For an im-portant impact on results we use an adjustment of 5%24 25, or more of the results and/or the exceeding of a critical limit. A critical limit is a qualitative factor with an important impact. These could be relatively small amounts in Euros yet still have significant consequences. These could be the fulfilment of criteria for a bonus for top management or the inability to comply with a bank’s credit agreement terms26.

20 Prof. dr. Arnold Wright is visiting professor from Nyenrode University. Elements of the questionnaire used by him have been used in our research. 21 47% of items which were greater than planning materiality were corrected (Wright and Wright, 1997)22 Joe et al. (2011) did establish that a longer client relationship leads to significantly fewer corrections of audit differences which have no impact on results. Joe et al. (2011) also reported that the estimate of the quality of internal control processes in the organisation has no influence on the likelihood of reporting of audit differences.23 Of the 16 listed organisations 38% (6) were very large organisations with over > € 2.5 million in audit costs and the remainder were similarly distributed across size categories. Of the 34 non-listed companies 91% (31) concerned smaller listed companies with up to € 250,000 in audit costs. The effects cannot be allocated according to sector.24 The lower limit of 5% is not derived from an audit standard or condition but is assumed as a lower threshold in the literature (Eilifsen et al., 2010, p.13 and Knechel et al., 2007, p. 397). This concerns the (net) result after tax.25 In the analysis we use an alternative of 20% of planning materiality as a lower limit (Wright and Wright, 1997) which involves 99 audit differences. Of the most important items with greater than 5% impact on results, 35% were greater than 20% of planning materiality.26 Please also refer to NV COS 450.A16 for more examples of critical limits.



In the case of ‘Equity, provisions and long term debts’ 14% (7 of the 49) of the audit differences leads to an increase of 5% or more in results. 26% (19 of the 73) of the errors in short term assets (stock, work in progress and debtors) has an important impact on a reduction in the results (9 of the 73) or a critical limit (10 of the 73). The impact on the results and the critical limit cannot specifically be attributed to certain elements of the annual report (see table 4). All items are roughly equally ‘represented’ in the list of audit differences.

Table 4 Impact, cause and extent of reporting of audit differences

In contrast the cause of errors can indeed be attributed to certain items. Thus, the auditor discovers significantly more often that a lack of expertise on the part of management to be the cause of inaccuracies in items surrounding fixed assets and costs. According to the auditors errors in estimation are more frequently the basis of inaccuracies in fixed and current assets and ‘Equity, provisions and long term debts’. Cut-off errors (items represented in the wrong period) cause significant-ly more frequent inaccuracies in current liabilities (creditors and short term debts). According to respondents the majo-rity (approximately 70%) of errors in all items were already suspected during the planning phase (results not illustrated), especially in respect of Equity, Provisions and long term debts and costs. This finding emphasises the importance of proper

> 5% increase in results

> 5% decrease in results

Critical limit

Subtotal important audit differences

Other audit differences

Total audit differences

Lack of expertise

Errors in estimation

Cut-off error

Accuracy

weak IC

Total

Management not in agreement with audit difference

Of which corrected

Correction of important audit differences

Correction of other audit differences

Total audit differences

Impact of audit differences

Cause of audit differences

Correction of audit differences

Current

assets

4

9

10

23

50

73

8

28

10

11

15

72

13

5

18

9

27

Equity, provi-

sions and LTDa

7

5

3

15

34

49

10

20

7

3

7

47

2

1

13

7

20

Short term

debt

Turn

over

5

3

1

9

45

54

6

10

20

9

8

53

6

1

5

17

22

1

1

2

4

18

22

3

3

12

0

3

21

7

1

4

3

7

Costs Total

2

4

5

11

35

46

15

10

9

6

3

43

3

2

5

10

15

23 (8%)

26 (9%)

25 (8%)

74 (25%)

220 (75%)

294 (100%)

57 (20%)

89 (31%)

60 (21%)

34 (12%)

46 (16%)

286 (100%)

33 /294 (11%)

10 /33 (30%)

53 /74 (72%)

51 /220 (23%)

104 /294 (36%)

Fixed

assets

Audit differences per section of the financial statements

4

4

4

12

38

50

15

18

2

5

10

50

2

0

8

5

13

Analysis is based on 281 audit differences in 93 organisations. Values are missing for four organisations. For one audit difference, the concerning section of the financial statements was missing, but other information was provided. a LTD = long term debt



risk analysis and the appraisal of figures during the planning phase. The detail audit on average provides little new and/or unsuspected audit differences, whereas in approximately a quarter of all cases an audit difference is discovered during the assessment of and evaluation of evidence.

The majority (75%) of audit differences are subsequently discussed with the AC and/or Supervisory Board and in 60% of the audit differences it was included in the long form to the supervisory board (results not illustrated). In 33 of the 294 audit differences (11%) the management ‘disagreed’ with the auditor. Nevertheless of these audit differences 30% (10 of the 33) were still adjusted. There was significantly more frequent discussion between the auditor and the board of directors sur-rounding the items ‘current assets’ and ‘turnover’. We established that despite the board’s agreement with the audit diffe-rence, 36% (104 of the 294) audit differences were adjusted. Of all the audit differences therefore no adjustment occurred in 190 (64%) cases, whereas the auditor stated in 89% of the cases that the board did ‘agree’ with the auditor’s assessment. The correction of important audit differences is significantly higher: 72% (53 of the 74) were corrected27. On average 73% (19 of 26) of the audit differences with a results-lowering effect were corrected, 61% (14 of 23) with a results-enhancing effect and 80% (20 of 25) of the audit differences involved a critical limit. The adjustment ratios for important differences is the same for listed and non-listed organisations28. There is no difference between these categories of items and the degree of correction. To examine the background and reason for not correcting 28% of the important audit differences, a follow-up research was conducted in February 2012 (see book of appendices). Partners of the 59 engagements with one or more waived audit adjustments were asked to fill in follow-up questionnaires. 40 Questionnaires were returned, rendering a res-ponse rate of 68%, including 12 of 14 engagements with important waived audit differences (concerns 14 organisations).

The outcomes of the follow-up survey show that ‘important’ differences are indeed important. The results indicate that mag-nitude of the individual audit differences with a result impact of more than 5% represent in 62% (8 of 13, there are three mis-sing values) of the cases of 48% to 125% of the materiality. The other five waived important audit differences with more than 5% result impact, had an individual magnitude of 10%-33% of materiality. The reason that these audit differences could be waived is due to balancing important audit differences with a positive impact on earnings with differences with a negative impact on earnings. This balancing of audit differences resulted in a net-audit difference of 6%-50% of the planning mate-riality. The four (there is one missing value) waived critical limit audit differences also were important. These audit differen-ces concern various topics, such as the processing of agreements with external parties in the financial statements, audit differences relating to effective tax rates and an audit difference that would turn a profit into a loss. In all cases, manage-ment had the opinion that the audit difference was not material and in 90% of the organisations, management confirmed this in the letter of representation (LOR). For 50% of the organisations, the auditor requested the supervisory body and/or audit committee to confirm that the important audit difference was not material. Finally, the auditors reported that in one quarter of the organizations, the audit differences were detected too late, i.e. after management reported the results to shareholders or the foreign parent company. Consequently, management was reluctant to adjust the audit difference.

3.2 Factors in the reporting of audit differences

3.2.1 Details of audit differences

The analysis templates of Wright and Wright (1997) and Joe et al. (2011) form the basis of our research. What is unique to our research however that we can also assess the effects of the determination of materiality, identified risks, specialisation and the independence of the auditor on the reporting of audit differences. The results are presented in table 5. First of all we analyse the general features of an audit difference. In the majority (75%) of audit differences objectivity (concerning ac-tual errors) is high. It therefore involves factual inaccuracies. In contrast to the Wright and Wright (1997) study, the analysis shows no significant effect on the likelihood of correction29. In 58% of the audit differences the error is established with a high degree of precision (that is to say that there is no discussion over the size of the sum. Nevertheless the likelihood of correction as a result does not increase significantly.

27 In the event that a lower threshold of significant audit differences of 20% of planning materiality (Wright en Wright, 1997) is used, 52% (12 of the 23) results-enhancing corrections are corrected, 38% (15 of the 26) of the results-lowering corrections and 68% (17 of the 25) involved a critical limit . 28 For listed companies seven important differences are observed. Of these differences 100% (2 of 2) were corrected which lowered the results by more than 5% and 0% (0 of 1) of the audit differences which enhanced results by more than 5% and 50% (2 of 4) of audit differences involving a critical limit.29 We have also conducted this analysis using only audit differences which are objective (n=233). The results of this analysis is similar to those in table 5.



In the event that a critical limit is exceeded due to the correction of an audit difference, the likelihood of correction occur-ring increases significantly. The same applies to errors which have a results-lowering effect of more than 5%: these audit differences are significantly more frequently adjusted. A significant effect was also established for results-enhancing corrections of over 5% (see also table 4).

Table 5 Analysis of factors which explain the reporting of audit differences

Audit difference details

High objectivity difference

Difference precision is higher

Involves critical limit

> 5% results-decreasing

> 5% results-increasing

> 5% increase in annual report item

> 5% decrease in annual report item

Reclassification of annual report item

Effective controls

Factors in the determination of materialitya

Economic risks

Control and compliance risks

Agency conflict

Elements of risk analysisa


Innovation capacity

Reliability of ICT

Financing problems

Fraud risks



Associated parties

Company details

Financial sector

Social institution

Management bonuses (> 50% fixed remuneration)

Stock exchange listing

Improved profitabilityb

Loss in current accounting yearb

Auditor specialisation

Specialisation: > 50% hours

Specialisation: > 4 clients

Independence

size of client

NAS > 30%c

Duration of firm-client relationshipc

Duration of auditor-client relationship > 5 yearsc

Bid-round < 3 years agoc

Influence on the likelihood of the correction of audit differencesb

n.s.

n.s.

increased

increased

increased

increased

n.s.

increased

n.s.

reduced

increased

increased

n.s.

n.s.

n.s.

increased

increased

n.s.

reduced

n.s.

n.s.

n.s.

n.s.

reduced

reduced

increased

n.s.

n.s.

reduced

reduced

increased

increased

n.s.

Total (n=295)

220 (75%)

170 (58%)

25 (8%)

26 (9%)

23 (8%)

29 (10%)

32 (11%)

50 (17%)

44 (15%)

56 (19%)

10 (3%)

121 (41%)

121 (41%)

50 (17%)

156 (56%)

94 (32%)

148 (50%)

109 (37%)

65 (22%)

n.s.= no effect Analysis is based on 93 companies and 295 audit differences. a = see table 1 and table 2 respectively for distribution detailsb = see book of appendices chapter 3 for distribution details and analyses c = see appendix table B1-3 – B1-5 for distribution details



In addition to an impact on results, audit differences can also have a significant influence on the amount of an item in the annual report. It is evident from table 5 that if an audit difference increases by more than 5%, the likelihood of reporting also increases significantly. This does not apply to an audit difference which reduces an annual report item by more than 5%.

Audit differences relating to a reclassification are significantly more frequently corrected. Reclassification involves a shift between balance sheet items or between items from the profit and loss account which have no impact on results. We subsequently analysed whether there is a balancing effect of audit differences. If there are current results-enhancing audit differences and results-reducing audit differences, on balance the audit differences may be significant. In 38 of the 93 organisations in the analyses the possibility of balancing of results-enhancing and results-lowering audit differences is conceivable. In 21% of these cases (8 of 38) this could be the reason that significant audit differences are not corrected. It is apparent from our analyses however that the balancing of differences has no significant influence on the likelihood of correction occurring30.

Finally an evaluation was made of whether the auditor relies upon his positive assessment of the effectiveness of the internal controls of the process in which the audit difference occurred. A positive assessment can reduce the likelihood of amendment (Joe et al., 2011). On the other hand it could be that the auditor is rightly more circumspect because he did not anticipate this error. In 15% of cases the auditor issued a positive assessment. A positive assessment however has no significant influence on the likelihood of corrections as a result of established audit differences.

3.2.2 Factors in the determination of materiality and audit differences

We subsequently assess whether the factors used by auditors in the determination of materiality are taken into account in the handling of audit differences. We anticipate that in the event that the auditor identifies more qualitative factors the complexity, dynamics and risks are greater and that he is therefore more cautious and more likely to insist upon correction. It is evident from table 5 that if economic risks (high level of competition, margin pressure etc.) are stated in the determi-nation of materiality, there is less likelihood that an audit difference will be corrected31. This is against our expectations and we can offer no explanation for it. However, if the auditor cited the qualitative factors ‘compliance with regulations’ and agency conflicts’ in the determination of materiality, the likelihood of the correction of audit differences is significantly gre-ater. This is in accordance with our expectations as these factors can increase the risk of inaccuracies in the annual report.

3.2.3 Elements of risk analysis and audit differences

Because risk analysis is an important step in the identification of potential material errors in the annual report we have assessed the effect of various elements of the risk analysis on the degree of adjusting of audit differences. We anticipate that an auditor would be more conservative in the event that the number of risks identified by him increases. It is evident from the analysis in table 5 that the finance risk and fraud risk indeed significantly increase the likelihood of the repor-ting of audit differences. But if auditors have indicated that there are significant risks relating to extraordinary and ad hoc items, the likelihood of correction is correctly lower. We have not yet been able to find any explanation for this32.

3.2.4 Exceptional circumstances of the audited company

An exceptional context exists if a considerable proportion (over 50%) of the top management’s remuneration is acquired from performance-related pay. We anticipated that pressure on auditors may increase due to performance-related pay and

30 We examined whether for audit differences (question 7a) which have a joint net effect which is more (less) than 20% of planning materiality, correction occurs more (less) frequently. We did not establish any significant effect. We also investigated what the effect is in the event that the net effect of all audit differences (question 7p and 7q) is greater (lower) than 20% of planning materiality. Also in this case, there is no significantly higher (lower) likelihood of correction.31 We also obtain this result if we use only economic results which increase the inherent risk. Nor do we finds any effect if we relate economic risks to profitability and/or financial health (debt ratio) of organisations. The effect is perhaps caused because planning materiality is established at a lower level due to the economic risks.32 Complex and ad hoc items are often audited separately by the auditor. This effect does not relate to the items themselves but to the context of the existence of complex and ad hoc items.



that the board will allow audit differences to be corrected less frequently. It was apparent from our analyses that this is not the case however. If a business is listed on the stock exchange, we anticipate the auditor to be more conservative due to the visibility of the organisation and its supervision by the AFM. It is however evident from table 5 that a stock exchange listing does reduce this effect. This effect only relates to less important differences. If a company makes a loss the likelihood of re-porting is significantly greater. The auditor is therefore more cautious. In contrast however if the organisation achieves good results, the likelihood of adjustments diminishes.

3.2.5 The auditor’s specialisation and audit differences

How the expertise of specialists is utilised when considering whether or not to correct audit differences is not clear before-hand. It could be that due to his expertise, a specialist is more assertive and insists upon the reporting of audit differences. It could also be the case that a specialist can properly evaluate the risk of waiving and seeks the extreme limits of accep-table audit and/or accounting solutions. It appears from the analysis in table 5 however, that the involvement of specialists has no effect on the likelihood of adjustment.

3.2.6 Independence and the reporting of audit differences

First of all we analysed the influence of the size of the audited organisation. Wright and Wright (1997) observed that the likelihood of correction diminishes in large clients. It appears from table 5 that the larger the organisation, the lower the likelihood that an audit difference will be corrected. This effect concerns less important audit differences. We subsequently assessed to what extent the provision of NAS influences the adjustment of audit differences. In the discussion regarding the independence of the auditor it is important to make a distinction between perceived independence (independence in appearance) and actual independence in thought and spirit (independence in fact) (Further Conditions regarding the Independence of the public auditor, NVO). For perceived independence scientific research (Francis and Ke, 2006; Lim and Tan, 2008) shows that capital markets view the provision of a great deal of NAS as a threat to the quality of the audit. The picture which emerges from scientific literature of independence in fact is more sophisticated however. The results of these studies are often inconsistent (Frankel et al., 2002; Larcker and Richardson, 2004; Ashbaugh et al., 2003; Chung and Kallapur, 2003; Kinney et al., 2004; Srinidhi and Gul, 2007; Lim and Tan, 2008, Van Buuren, 2009). Nevertheless a number of studies show that the provision of NAS, measured by the ratio of non-audit services divided by the audit fee, has a negative effect on the quality of the annual report (Frankel et al., 2002; Larcker and Richardson, 2004; Ashbaugh et al., 2003; Chung and Kallapur, 2003; Srinidhi and Gul, 2007). The restriction on these studies is that the influence of NAS on the audit quality is measured indirectly on the basis of annual report information once the audit has been conducted. We can measure the effect more directly, as we can analyse the influence of NAS on the reporting or waiving of audit differences. The NVO consi-ders the provision of consultancy services to be a threat to independence. It is therefore to be expected that if a significant proportion of turnover with a client consists of NAS services, the likelihood of correction is significantly lower.

In order to establish what constitutes a significant proportion of NAS we use the threshold of more than 30% NAS in rela-tion to audit costs33.

In 25% (37 of the 147) of all organisations more than 30% was spent on NAS. The same percentage figure of 25 (20 of the 81) applies to listed companies, in which 10% (8 of the 81) of the companies more than 30% was spent on other consultan-cy (not including tax consultancy). It appears from table 5 that the provision of more than 30% NAS significantly decreases the likelihood of the correction of audit differences. On the grounds of our analysis we estimate the likelihood of reporting to be 3 times lower34, in the event that more than 30% NAS is supplied. If we examine tax consultancy and other consul-tancy individually, it appears that this effect only occurs for other consultancy. It is evident from another analysis that when less than 30%35 of the total audit cost is spent on other consultancy, there is no significant effect on the reporting of audit

33 In the analyses we also as an alternative the limits of 10% and 20% of other consultancy costs in relation to audit costs. It appears from our analyses however that the effects relate to more than 30% NAS.34 See chapter 4 of the book of appendices for further details. Relates to the exponent of coefficient of NAS minus 1: ( e1.446-1)≈3 with a 95% confidence interval from 0.2 to 15. 35 This effect concerns the 10%-30% on other services group. In this analysis the effects of other service provision assessed both in total and as individual tax consultancy and other consultancy services.



differences. We discover the negative effect of NAS for both more important (i.e. > 20% of planning materiality) and less significant audit differences, with the difference that we only find an effect regarding more important audit differences in the case of other consultancy (NAS excluding tax consultancy)36. However, we do not observe an effect in the case of only important differences (more than 5% result impact or critical limit).

NAS also appeared to be of importance for listed organisations. In listed companies with more than 30% NAS on average 8% (4 of 46) of the audit differences were adjusted and for non-listed organisations this was 61% (28 of 48)37. Despite the higher percentage of reporting for non-listed organisations, we discovered that the likelihood of inclusion of audit differen-ces is significantly lower if more than 30% NAS is supplied.

We also assessed the influence of the length of the client relationship. It is also important to make a distinction between effects perceived by financial statements users and actual effects on audit quality. A longer client relationship with the audit firm is valued positively by capital markets (Ghosh and Moon, 2005). The studies into the effects of the length of the client relationship on audit quality do not yield consistent results however. There are various studies which observed nega-tive effects of a long client relationship (Carey and Simnett, 2006; Geiger and Raghunandan, 2002; O’keefe et al., 1994 and Copley and Doucet, 1993). On the other hand there are also studies which observed positive effects of a long client relation-ship on audit quality (Carcello and Nagy, 2004; Caramanis and Lennox, 2008; Chen et al., 2008; Manry et al., 2008). Joe et al. (2011) report that a lengthy client relationship does not lead to fewer corrections of results-lowering audit differences, but to fewer corrections of other less important audit differences.

It appears from table 5 that in 50% of the organisations the client’s relationship with the audit firm is longer than 10 years. This appears to increase the likelihood of the reporting of audit differences. The same applies to the length of the client relationship with the individual external auditor. In the event that this relationship is longer than 5 years, the likelihood of correction is also greater. In 37% of the organisations the relationship with the auditor responsible is longer than 5 years. the positive influence of a lengthy client relationship applies to both important and less important audit differences38.

We also assessed the effects of short client relationships (longer than 1 year and shorter than 4 years) and a medium dura-tion (4 to 10 years for firms and 4 to 5 years for auditors). This appears to have reducing effect on the likelihood of correction of audit differences.

3.3.1 Impact and reason for amendments

During the audit the external auditor not only assesses the financial figures in the annual report, but also assesses whether the notes to the balance sheet and the profit and loss accounts in the annual report are adequate and whether the directors’ report and the annual report reflects economic reality. Organisations communicate not only via the annual report but also via press releases and other reports. In the questionnaire, we asked the auditors to describe the five most impor-tant audit findings concerning the notes to the balance sheet and profit and loss account or other financial communication (for example quarterly figures). This question was formulated as an ‘assisted’ question, as the questionnaire contained a list of subjects to which an amendment could refer. Auditors could also add topics where necessary. The results are presen-ted in table 6.

Of the 147 organisations auditors had requested an amendment to elements of the notes to the balance sheet and profit and loss account in the annual report or in another report, such as quarterly reports, in 114 organisations (77%).

36 This is evident from an analysis using only significant audit differences (impact on results, annual report item impact, over 20% of planning materiality) with 215 observations in total. 37 In supplying more than 30% in other consultancy (NAS excluding tax consultancy) audit differences were adjusted in 50% (9 of 18) listed organisations and 0% (0 of 5) in non-listed organisations. 38 This is evident from an analysis of only significant audit differences. Please refer to the book of appendices for details of this analysis.

3.3 Other amendments to the annual report and other financial communication



In total this involved 307 amendments, of which 23 were too diverse to be meaningfully classified. The analysis in table 6 is therefore based on 284 amendments.

In approximately 60% (170 of 284) errors and inaccuracies in the text or numbers and figures included in the text constitute the reason for the requested amendments. The percentage of amendments (impact) varies significantly from the catego-ries in the notes. The ‘risk section and remuneration policy’ (for upper management) and ‘other requirements for the notes’ are often referred to here.

According to the auditor, in approximately 40% (114 of 284) of the cases the amendment leads to more extensive notes or to more relevant notes. Furthermore there are no significant differences in the degree of amendments between the types of notes.

3.3.2 Reasons for amendment

Table 6 shows the reasons upon which an auditor bases his request for the amendment of the notes. Firstly, the auditor uses the ‘best practice’ examples which are usually provided by the audit firm or the NBA as a basis.

In addition the external auditor and his audit team must independently devise what must be explained and how, or in other words, how a business-specific solution has been developed. It could also be the case that legislation and regulation impo-ses specific requirements on the notes. Auditors could cite several reasons for each amendment request.

Amendment of text, numbers and figures

More and/or more relevant disclosure

Total amendments

Example reports

Specific solution

Regulation

Sensitive information

Yield cost (too) great

Impact of amendment by auditor:

The reason for amendment is based ona:

Management objections:

Financial

instruments

8

10

18

9

3

7

6

4

Equity

provisions

and LTDb

18

11

29

7

6

18

7

1

P&L Business

develop-

ments

15

5

20

3

10

11

2

3

14

10

24

10

5

12

4

3

Risk section

and remune-

ration policy

Other

Disclosure

requirements

36

24

60

26

10

32

14

1

51

32

83

38

16

35

19

10

170

114

284

112

66

139

63

30

Assets

Other amendments by type of disclosure:

Balance sheet, Profit and Loss account Directors’ report

Total

28

22

50

19

16

24

11

8

This analysis is based on 114 organisations with 284 amendments. P&L= profit & loss account; E= equity a = auditors could specify several reasons for each amendment requestedb LTD = long term debt

Table 6 The impact and reason for other amendments to the annual report and other communication



The importance of example reports (best practice)It appears from table 6 that example reports are an important tool for the auditor in determining what information must be included. In 39% (112 of 284) of the amendments example reports are cited as the reason. In 23% (66 of 284) of the cases a solution was developed by the audit team and in 49% (139 of 284) regulation is cited. The use of example reports cannot specifically be assigned to one sector.

Business-specific solutions by the audit teamBest practice reports appear to be necessary in practice, but usually require further formulation. In the Production and Ser-vices a solution appeared to have been developed by the audit team in 45% of amendments to the profit and loss account (results not shown). In the Banks and Insurers sector it applied that in addition to best practices for ‘equity, provisions and long term loan capital’ (67%) and the directors’ report in respect of commercial developments (50%) a business-specific solution was found by the audit team (results not shown).

RegulationFinally, regulation was often cited as a reason for amendments to the asset elements of ‘equity, provisions and long term loan capital’, the results account, business development and the risk section. It is striking that regulation concerning finan-cial instruments is not cited in banks and insurers and social institutions (results not shown). The same applies to the risk and remuneration section for social institutions (results not shown).

3.3.3 Follow-up to the request for amendment

According to auditors 95% of the requested amendments are also (largely) adjusted (270 of the 284). It is evident from table 6 that the board of the audited organisations expressed objections in approximately 22% (63 of 284) of the requested amendments, because the information would be commercially sensitive. In approximately 10% (30 of 284) of the amend-ments, the board found that the provision of the information cost too much time and money. This objection cannot be at-tributed to a particular type of note. Despite these objections the majority of amendments requested were adjusted.

3.4 Conclusion

This chapter outlines the impact of the audit on the annual report and the notes to them. On the grounds of our research we have arrived at the following conclusions:• 25% of all audit differences have an important impact on results with a greater than 5% adjustment or regarding critical limits, such as compliance with credit agreements or the expectations of analysts. 72% Of the important audit differences were adjusted.• The waiving of important audit differences (28%, concerning 14 organisations) is possible because in most cases audit differences resulting in an important increase respectively decrease of the result are balanced. For half of the organisations, the auditor asked the supervisory board and/or audit committee to confirm that the audit difference was not material. In one quarter of the organisations, the audit difference was detected after the result was reported to the shareholders or the parent company and was not corrected for that reason.• 36% of all audit differences (both significant and less significant) were adjusted in the annual report. 64% of them were not corrected, despite the board ‘agreeing’ with the auditor in 89%39 of cases. • Approximately 70% of the audit differences were already suspected during the planning phase (risk analysis and numeric evaluation) of the annual report. This emphasises the importance of the planning phase. In approximately 25% of audit differences, these were noticed at a later stage during the evaluation of the audit information collated. • Audit differences (both important and less important) are discussed with the AC and/or Supervisory Board in approximately 75% of cases. Approximately 60% of the (both important and less important) audit differences were stated in the auditor’s long form to the supervisory board.

39 Of the uncorrected audit differences the auditors reported that 75% involved a factual inaccuracy and in 58% of the audit differences there was no discussion of the size of the amount according to the auditors.



• Qualitative factors for the determination of materiality have an effect on the degree of reporting of audit differences. The same applies to the factors cited in the risk analysis. Audit differences are more frequently adjusted for companies reporting a loss.• The larger the client the fewer adjustments there are of less important audit differences. • In the event that more than 30% NAS are supplied to audit clients, the probability of the amendment of differences decreases. As long as this percentage of other consultancy remains below 30% no significant negative effect on the correction of audit differences is found. In 37 of the 147 organisations (25%) more than 30% was provided in tax and other consultancy services. We found no effects for the provision of more than 30% in tax consultancy alone. Further - more, we observed no effect of NAS on important audit differences.• The length of client relationship has a positive effect on the reporting of both important and less important audit differences. It applies to both the relationship at firm level as well as the relationship with the individual external auditor that the longer the relationship, the greater the probability of the reporting of audit differences. We observed this effect for both important and less important differences.• 95% of the proposed amendments to notes to the balance sheet and profit and loss account are incorporated in the annual report. Example reports (best practices) appear to be an important tool in determining amendments. In addition to notes to the balance sheet and the profit and loss account, the ‘risk section and remuneration policy’ (of the upper management) is also often cited in this.



04 | Management letter

The most important conclusions in this chapter are:- The management letter contains a large number of different subjects, varying from estimates in the financial statements and risk management through to the effectiveness of commercial processes and automation;- 55% of the points in the management letter are followed up and 31% are examined further by the board. The board did not follow the recommendations in 14% of cases.

4.1 Relevance and range of subjects in the management letter

Chapter 3 outlined the impact of the audit on the annual report and the notes to them. This chapter outlines the impact of the audit on the organisation of companies and commercial processes.

As the finishing touch to the audit the auditor is legally obliged40 to report his audit findings to the board and to the Super-visory Board. It is customary for the auditor to compile two reports. The first one, the management letter, contains audit findings which focus on the effectiveness of the internal organisation and the management of commercial processes. The second report involves the long-form, which is compiled for the benefit of the Supervisory Board. The most important points in the management letter and the audit findings arising from the assessment of items in the financial statements and the notes to the financial statements are included in the long-form together with the judgment regarding the reliabi-lity of the financial statements. The auditor is also obliged to state his audit findings relating to the reliability and conti-nuity of automated data processing in the auditor’s report.

in the questionnaire we asked the external auditors to outline the five most important management letter points. This question was in the form of an ‘assisted’ question, in which a list of potential management letter subjects was provided. This list was not exhaustive and auditors could add other subjects. The subjects were subsequently categorised by us into seven main headings. The results are presented in table 7.

In total, 375 management letter points were mentioned by the auditors, relating to 104 organisations. For 43 organisati-ons out of the 147 organisations (29%) no management letter was compiled. Of these 11 were businesses which formed part of a larger foreign company and in eight cases the administration was outsourced to an administrative organisation

40 Civil Code, book 2, heading 9, article 393 and has been further formulated as audit standard NV COS 260.



(specifically pension funds). In 3 cases no management letter was compiled because the management was not familiar with it or found the content too general. In the remaining cases the management letter points were included in the audi-tor’s long form (6x), or stated in the reports prepared by the internal accounting department (3x) or it was communicated verbally (10x). In two companies the management letter was drafted at divisional level.

Table 7 Relevance and impact of management letter subjects

Table 7 shows that 11% of management letter points relate to estimates, establishment of results and other uncertain-ties in the annual report, 19% to problems with the segregation of duties, 14% to non-compliance with regulations, 16% to the effectiveness of audit-related business processes, 9% to the quality of internal information provision, 15% to risk management processes and 17% to subjects relating to automation.

Auditors were asked to which risks the management letter points related. Several responses could be provided for each management letter point. In 22% (84 of 375) the auditor stated that the point involved a direct financial risk to the organi-sation. In 17% (64 of 375) a risk of fraud was identified, primarily due to faults in the segregation of duties (35 of 64). Risks relating to the poor quality of information for the purpose of internal decision-making were most frequently cited (138), in which the causes lay in non-compliance with regulations (20), ineffective management of commercial processes (22) and poor internal processes relating to the provision of information (24).

Direct financial risks

Fraud risks

Quality of information

Non-compliance with regulation

Improvement business processes

Total

Subject percentage

Production and Services

Banks and Insurers

Social Institutions

No or limited implementation

Implementation deferred

Recommendations implemented

Total

Relevance

Distribution by sector

Follow-up to management lettera

Separation

of functions

19

35

11

2

3

70

19%

58

7

5

11

30

29

70

Regulation

10

1

20

20

0

51

14%

25

19

7

5

11

33

49

Business

processes

Internal inform.

provision

5

7

22

2

23

59

16%

27

23

9

7

13

39

59

2

2

24

0

6

34

9%

22

8

4

6

14

14

34

Risk

management

Automation Total

16

6

16

9

10

57

15%

44

8

5

10

21

25

56

9

11

31

0

12

63

17%

38

23

2

8

22

33

63

84

64

138

35

54

375

100%

238

100

37

51

116

201

368

Uncertainty in

annual figures

Subjects in management letter

23

2

14

2

0

41

11%

24

12

5

4

5

28

37

This analysis is based on 375 management letter points from 104 organisations. a = 7 values are missing in this analysis



The subjects mentioned vary according to sector. Thus poor segregation of duties and insufficient quality of risk ma-nagement processes were mentioned significantly more frequently in the Production and Services sector. In contrast the subjects ‘compliance with regulations’ and ‘ineffective business processes’ were mentioned significantly more frequently in the Banks and Insurers and Social Institutions sectors. The automation process was also covered significantly more frequently in the management letter in the Banks and Insurers sector.

Finally, an additional analysis was conducted into the relationship between subjects and the size of the organisation (re-sults not shown). It was evident from this analysis that uncertainties in the annual report occur significantly more often in very large organisations: (25%) compared to the average (12%). It also appears that problems surrounding the segregation of functions occur most frequently in smaller organisations with audit costs of between €50,000 - € 250,000: 25% compa-red to the average of 17%.

4.2 Impact of the points in the management letter

According to the auditors 55% of the management letter points were followed up in total or to a significant extent by the board, whereas in 31% of the points the board deferred action until the following year, but promised to study the recom-mendations closely (results not shown). Management stated that they would not follow up on management letter points in 14% of management letter points. It is evident from the analyses that management letter points regarding uncertain-ties in the annual report, non-compliance with regulations and ineffective business processes are followed up the most often.

4.3 Conclusion

In this chapter, we have examined the relevance, range of subjects and impact of the management letter. On the grounds of our research we have arrived at the following conclusions:• The management letter contains a large number of different subjects, varying from estimates in the annual report and risk management through to the effectiveness of business processes and automation;• 55% of management letter points were followed up by the board, 31% of the points were deferred until the following year, with the commitment that the recommendations would be seriously considered and the recommendations were not followed in only 14% of cases.



05 | Conclusions and research limitations

This research focuses on the development of the knowledge and insight into critical elements in the auditor’s audit process. In doing so we have two objectives:• The provision of insight into the influence of the financial statements audit of large companies, Public Interest Entity (PIE), and PIE-related organisations within the Netherlands. • Providing insight into the deliberations made by accountants in dynamic and complex environments in which they work.

We conducted our research on the basis of questionnaires completed by 147 external auditors regarding audits carried out on public interest entities (PIE’s) in the Netherlands. The questionnaires were rendered anonymous. Three critical subjects were examined in the study: the considerations in planning the audit, the degree of adjusting audit differences and the reporting of audit findings in the management letter.The most important conclusions are:- Most auditors adopted a broad approach to the audit during the planning phase. They included various significant risks and business risks in their risk analysis. The relationship between the board’s decisions regarding the management of the business and the quality of the annual report are expressed in the audit. This relationship requires good knowledge of the dynamics and complexity of the organisation being audited. The auditor appears to identify the more abstract yet very relevant and significant risks and business risks, like durability of the business model and innovation capacity for new products and services, less often. The audit activities for this category remain primarily limited to the acquisition of information about the organisation being audited. - 25% of the audit differences have an important impact on results. An adjustment of more than 5% up or down applies to this and to critical limits, such as fulfilment of credit agreements or compliance with the expectations of analysts. On average approximately 72% of these significant audit differences were adjusted.- The waiving of important audit differences (28%, concerning 14 organisations) is possible because in most cases audit differences resulting in an important increase respectively decrease of the result are balanced. For half of the organisations, the auditor asked the supervisory board and/or audit committee to confirm that the audit difference was not material. In one quarter of the organisations, the audit difference was detected after the result was reported to the shareholders or the parent company and was not corrected for that reason. - On average approximately 36% of all audit differences were corrected in the annual report 64% of audit differences were not corrected despite the management’s ‘agreement’ with the auditor in 89% of these differences.

5.1 Conclusions



- The provision of more than 30% NAS in relation to total audit costs for the annual report reduces the probability of correction of less important audit findings. The provision of many other consultancy services in addition to the annual report audit therefore has a negative influence on the impact of the audit. In 37 of the 147 organisations (25%) more than 30% was provided in NAS. We did not discover any negative effects for the provision of NAS below 30%. Finally, we do not observe that NAS affects the adjustment of important audit differences.- The length of the client relationship has a positive effect on the impact of the audit. External auditors who have a client relationship of more than 5 years achieve more frequent corrections of both significant and less significant audit differences. The same applies to audit firms with a client relationship longer than 10 years. This effect is observed for both important and less important audit differences. - The management letter contains many different subjects, varying from estimates in the annual report and risk management through to the effectiveness of commercial processes and automation;- 55% of the management letter points were followed up by the board. 31% of the recommendations were deferred until the following year, with the board promising to study the recommendations closely. 14% of the recommendations were not followed up by the organisation.

5.2 Research limitations

The limitations on this study included the following. Many details in the questionnaire were asked in the form of scales and not in exact amounts or totals. This makes the measurement of the effects of factors and elements less accurate, as a result of which certain potential effects may incorrectly not have been measured.

In research using questionnaires there is also a risk that the questions are not understood properly or are interpreted incor-rectly, especially if fairly complex questions are involved. It could be the case that answers to certain questions were not immediately available from the audit file due to the structure of the audit file. The researchers were not able to supervise the correct completion of the questionnaires in offices. Otherwise, we had good experiences with the project “risk assessment and materiality”. In the meantime, we also made enquiries with the contact people at the various offices and it was evident from this that there were no intrinsic problems with the questionnaire. Furthermore we referred to the audit standards or used concepts from them as much as possible.

Moreover we had no opportunity to establish whether the accountancy practices had made a selection in terms of the quality of the audit assignments. A consequence of this is that the results may possibly reflect a more positive image of the auditor’s activities. We have had no indications that any such selection occurred.

The determination of whether items could be material individually or together could not be established from the question-naire but only reasonably assumed that they could be material. In this study we refer to such items as ‘important’ audit differences.

In the analyses we assume that the auditor has made the correct findings and is correct. Because audit work is done by human beings, however, that may not always be the case.



List of definitions and abbreviations

Amendment (requests)In this study the term amendments is used to describe audit findings relating to shortcomings, omissions and inaccuracies in the directors’ report and the notes to the annual report.

AFMDutch Financial Markets Authority.

ACAudit committee.

Assurance engagementAn engagement in which the external auditor expresses a conclusion designed to enhance the degree of confidence of inten-ded users other than the responsible party about the outcome of evaluation or measurement of subject matter against criteria.

Audit findingAudit findings concern the list of established inaccuracies (such as audit differences) and other shortcomings of a research item (for example the annual report)

Audit differencesA difference between the amount, classification, presentation or notes of a reported item in a financial summary and the amount, classification, presentation or notes required to comply with the applicable financial reporting system. Differences can arise from errors or fraud. When an auditor expresses an opinion on the question of whether they are faithful in all aspects of material importance, and/or that they represent a true picture, contain differences or amendments to amounts, classification, presentation or notes, which in the opinion of the auditor are necessary in order to enable the financial sum-maries to be presented faithfully in all aspects of material importance.

Business riskThe risk arising from significant conditions, events, actions or failure to act, which could have a negative effect on the entity’s capacity to achieve its objectives and implement its strategies, and/or from the establishment of unsuitable objectives and strategies.



BTASupervision of Audit Organisations Decree

Critical limit audit differences‘Critical limit’ audit differences is understood to mean the qualitative materiality of an audit difference.

External auditorAn external auditor is the individual who is employed by or associated with an accountancy organisation and who is responsible for carrying out a statutory audit.

Inherent riskSee Risk of material misstatements.

Important audit differences and critical limitThe term important differences (see also the description of audit difference) in this report is intended to mean audit dif-ferences which could reasonably be considered to be an material inaccuracy or shortcoming in the annual report. We have too little information however at our disposal to establish that it is actually a material inaccuracy or shortcoming. By the description ‘important impact’ in this report we mean that we reasonably suspect that the effect is of material significance.

Internal control riskSee risk of difference of material significance

Long form (AR)Report by the auditor to the supervisory body and the board of an organisation including its findings arising from the annual report audit. In this report the auditor reports the most significant points in the management letter and the findings arising from the year end audit together with the reasoning behind the content of the auditor’s declaration.

Management letterReport by the auditor to the board of an organisation containing audit findings arising from his audit of the effectiveness of internal commercial and data-processing processes.

MaterialityThe term materiality used in this report refers to planning materiality. By quantitative materiality we mean inaccuracies and omissions which are significant due to their relative magnitude (Euros). By qualitative materiality we mean inaccuracies and omissions which are significant due to their nature. These could be small sums but which have great influence on economic decisions.

NASNon-audit services

NBADutch Professional auditors Organisation

NV COSFurther Conditions for Audits and Other Standards. Concerns the Dutch version of the IFAC’s International Standards of Auditing (ISA’s).

NVOFurther conditions relating to the independence of the public auditor. NVO represents the Dutch version of the part B of the IFAC’s Code of Ethics regarding independence.



Planning materiality (also: materiality)Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.

Public Interest Entity (PIE)Organisations are considered to be PIE if: - a corporate body in Dutch law registered in the Netherlands the effects of which are subject to trade in a regulated market as defined in article 1:1 of the Financial Supervision Act;- a credit institution with its registered office in the Netherlands as defined in article 1:1 of the Financial Supervision Act to which a licence has been granted in accordance with that law;- a central credit institution with its registered office in the Netherlands as defined in article 1:1 of the Financial Super- vision Act to which a licence has been granted in accordance with that law;- a life insurance society or non-life insurer with its registered office in the Netherlands as defined in article 1:1 of the Financial Supervision Act to which a licence has been granted in accordance with that law;- a company, institution or public body belonging to one of the categories designated in article 2;

Risk of material misstatementRisk of material misstatement - The risk that the financial statements are materially misstated prior to audit. This consists of two components, described as follows at the assertion level:(a) Inherent risk - The susceptibility of an assertion about a class of transaction, account balance or disclosure to a misstatement that could be material, either individually or when aggregated with other misstatements, before consideration of any related controls.(b) Control risk - The risk that a misstatement that could occur in an assertion about a class of transaction, account balance or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity’s internal control.

Significant riskThe recognised and estimated risk of a material misstatement, to which, in the opinion of the auditor, special attention must be paid during the audit.

Significant effectThe term significant effect used in this report refers to a statistically significant effect. If the influence of factor A on factor B is significant, the meaning of this is that with at least 95% assurance this effect can be judged not to be coincidental but a systematic and consistent effect.

Tolerable error (also: Performance materiality) The tolerable error (performance materiality) means the amount or amounts set by the auditor at less than materiality for the financial statements as a whole to reduce to an appropriately low level the probability that the aggregate of uncorrec-ted and undetected misstatements exceeds materiality for the financial statements as a whole. If applicable, performance materiality also refers to the amount or amounts set by the auditor at less than the materiality level or levels for particular classes of transactions, account balances or disclosures.



Literature

Chapter 2

MaterialityAutoriteit Financiële Markten (2010). “Aandachtspunten Financiële Verslaggeving 2010 Toezicht Financiële Verslaggeving”. www.afm.nlBlokdijk, H, F. Drieënhuizen, D.A. Simunic and M.T. Stein (2003). “Factors affecting auditors’ assessment of planning materiality.” Auditing: A Journal of Practice and Theory 22(2, September): 297-307.Messier jr., W.F., N. Martinov-Bennie and A. Eilifsen (2005). “A review and integration of empirical research on materiality: two decades later.” Auditing: A Journal of Practice and Theory 24(2): 153-187.Business risksBell, T.B., M.E. Peecher and I. Solomon (2005). The 21st century public company audit: conceptual elements KPMG’s global audit methodology, KPMG LLP.Knechel, W.R. (2007). “The business risk audit: origins, obstacles and opportunities.” Accounting, Organizations and Society 32(4-5): 383-408.Curtis, E., and S. Turley (2007). “The business risk audit - A longitudinal case study of an audit engagement.” Accounting, Organizations and Society 32(3): 439-461.Van Buuren, J.P., C. Koch, C.M. van Nieuw Amerongen and A.M. Wright (2011). “The use of business risk perspectives by non-big 4 audit firms.” Working paper. Nyenrode Business Universiteit. (July)Van Buuren, J.P. en N. van Nieuw Amerongen (2011) “Business Risk Auditing in de 21e eeuw, uniform toepasbaar?!” Maandblad voor Accountancy en Bedrijfseconomie 85(10):512-520

Chapter 3

IndependenceAshbaugh, H., R. LaFond and B.W.Mayhew (2003). “Do nonaudit services compromise auditor independence? Further evidence.” The Accounting Review 78(3): 611-639.Chung, H. and S. Kallapur (2003). “Client importance, nonaudit services and abnormal accruals.” The Accounting Review 78(4): 931-955.



Francis, J.R. and Ke, B. (2006). “Disclosure of fees paid to auditors and the market valuation of earnings surprises.” Review of Accounting Studies 11(December): 495-523.Kinney jr, W.R., Z.V. Palmrose and S. Scholz (2004). “Auditor independence, non-audit services and restatements: Was the U.S. government right?” Journal of Accounting Research 42(3): 561-588.Larcker, D.F. and S.A. Richardson (2004). “Fees paid to audit firms, accrual choices corporate governance.” Journal of Accounting Research 42(3): 625-658.Lim, C.Y. and H.T. Tan (2008). “Non-audit service fees and audit quality: the impact of auditor specialization.” Journal of Accounting Research 46(1): 199-246.Reynolds, J.K. and J.R. Francis (2001). “Does size matter? The influence of large clients on office-level auditor reporting decisions.” Journal of Accounting and Economics 35(December): 375-400.Simunic, D. (1984). “Auditing, consulting and auditor independence.” Journal of Accounting Research 12(Autumn): 679-702.Srinidhi, B.N. and F.A. Gul (2007). “The differential effects of auditors’ nonaudit and audit fees on accrual quality.” Contem-porary Accounting Research 24(2): 595-629.

Length of client relationshipCarey, P. and R. Simnett (2006). “Audit partner tenure and audit quality.” The Accounting Review 81(3): 653-676.Caramanis , C. and C. Lennox (2008). “Audit effort and earnings management.” Journal of Accounting and Economics.45(1): 116-138Carcello, J.V. and A.L. Nagy (2004). “Audit firm tenure and fraudulent financial reporting.” Auditing: A Journal of Practice and Theory 23(2 (September)): 55-69.Chen, C.Y., C.J. Lin and Y.C. Lin (2008). “Audit partner tenure, audit firm tenure and discretionary accruals: does long auditor tenure impair earnings quality?” Contemporary Accounting Research 25(2): 415-445.Chi, W. and H. Huang (2005). “Discretionary accruals, audit firm tenure and audit partner tenure: empirical evidence from Taiwan.” Journal of Contemporary Accounting and Economics 1(1): 65-92.Copley, P.A. and M.S. Doucet (1993). “Auditor tenure, fixed fee contracts and the supply of substandard single audits.” Public Budgeting & Finance 13(Fall): 23-35.Geiger, A.M. and K. Raghunandan (2002). “Auditor tenure and audit reporting failures.” Auditing: A Journal of Practice and Theory 21(1, March): 67-78.Ghosh, A. and D. Moon (2005). “Auditor tenure and perceptions of audit quality.” The Accounting Review 80(2): 585-612.Manry, D.L., T.J. Mock and J.L. Turner (2008). “Does increased audit partner tenure reduce audit quality?” Journal of Accoun-ting, Auditing & Finance 23(4): 553-572.Mansi, S.A., W.F. Maxwell and D.P. Miller (2004). “Does auditor quality and tenure matter to investors? Evidence from the bond market.” Journal of Accounting Research 42(4): 755-793.O’Keefe, T., D.A. Simunic and M.T. Stein (1994b). “The production of audit services: Evidence from a major public accounting firm.” Journal of Accounting Research 32(2): 241-261.Buuren, J.P. van (2009). “On the nature of auditing: The audit partner effect. Research on the effect of individual audit partners on audit quality and the information dynamics of accounting data.” Dissertation. Nyenrode Business Universiteit.

Reporting of audit differences and negotiationsBeattie, V., S. Fearnley and R. Brandt (2001). Behind closed doors: what company audit is really about. Houndmills, Palgrave.Gibbins, M., S. Salterio and A.Webb (2001). “Evidence about auditor-client management negotiations concerning client’s financial reporting.” Journal of Accounting Research 39(3): 535-563.Icerman, R.C. and W.A. Hillison (1991). “Disposition of audit-detected errors: some evidence on evaluative materiality.” Auditing: A Journal of Practice & Theory 10(1): 22-34Joe, J. , A., and S. Wright (1997). “The impact of client and misstatement characteristics on the disposition of proposed audit adjustments.” Auditing: A Journal of Practice & Theory 30(2): 103-124Wright, A., and S. Wright (1997). “An examination of factors affecting the decision to waive audit adjustments.” Journal of Accounting, Auditing & Finance 12(1): 15-36.



Appendix 1 Organisations and auditors background information

Total number of questionnaires issued*

less: PIE’s which do not fulfil criteria

Questionnaires forwarded

less: questionnaires not submitted

less: unusable questionnaires

Remaining usable questionnaires

Small (<50.000)

50.000-100.000

100.000-250.000

250.000-500.000

500.000-1.000.000

1.000.000-2.500.000

Very large (>2.500.000)

Total organisations in analyses

Numbers

Production and Services Banks and Insurers Social Institutions

Total %Audit costs (in Euros) Sectors

Panel A Summary of all the organisations in the analyses

485

-60

425

-275

-3

147

3

11

28

21

8

6

10

87

12

7

5

5

2

4

4

39

4

10

6

1

0

0

0

21

19

28

39

27

10

10

14

147

13%

19%

26%

18%

7%

7%

9%

100%

* selection made on the basis of Mintglobal Europe database and list of PIE’s from the transparency reports of audit firms.

Table B1-1 Summary of questionnaires issued and returned

Table B1-2 Summary of organisations by size and sector



Table B1-3 Summary of length of client-auditor relationship by duration and company sizea

Table B1-4 Summary of external auditor specialisation and company sizea

Small (<50.000)

50.000-100.000

100.000-250.000

250.000-500.000

500.000-1.000.000

1.000.000-2.500.000

Very large (>2.500.000)

Total PIE organisations

< 50.000

50.000-100.000

100.000-250.000

250.000-500.000

500.000-1.000.000

1.000.000-2.500.000

> 2.500.000

Total

< 50.000

50.000-100.000

100.000-250.000

250.000-500.000

500.000-1.000.000

1.000.000-2.500.000

> 2.500.000

Total

Production and Services Banks and Insurers

Total %Audit costs (in Euros)

Size of company

Size of company

PIEs

Firm-client duration in years

Specialisation in hours expended

External auditor-client duration in years

Specialisation: number of clients in sector

Panel B Summary of PIE organisations in the analyses

1

4

10

8

4

6

9

42

<4

0

5

8

3

0

1

1

18

12%

<15%

5

11

28

16

2

5

2

69

48%

4-10

11

8

15

9

2

4

1

50

34%

15-50%

3

6

7

4

6

2

3

31

22%

>10

7

15

17

15

7

5

12

78

54%

>50%

10

11

3

7

1

2

8

42

30%

total

18

28

38

27

9

9

13

142

100%

total

18

28

38

27

9

9

13

142

100%

1st

0

2

7

4

2

3

4

22

16%

1

-

2

7

4

2

3

4

22

16%

2-3

0

5

9

7

1

2

5

29

20%

2-3

0

5

9

7

1

2

5

29

20%

4-5

5

8

13

7

3

3

3

42

30%

4-10

5

8

13

7

3

3

3

42

30%

>5

12

10

10

8

3

2

2

47

34%

>10

12

10

10

8

3

2

2

47

34%

total

17

25

39

26

9

10

14

140

100%

total

17

25

39

26

9

10

14

140

100%

12

7

5

5

2

4

4

39

13

11

15

13

6

10

13

81

11%

14%

19%

16%

7%

15%

16%

100%

a = for these analyses there are 5 and 7 missing values respectively

a = for these analyses there are 5 and 7 missing values respectively



Tabel B1-5 Summary of number of organisations with more than 30% turnover in other

services in relation to total costs of the financial statements audit

< 50.000

50.000-100.000

100.000-250.000

250.000-500.000

500.000-1.000.000

1.000.000-2.500.000

> 2.500.000

Total

Tax Consultancy

> 30%

Other consultancy

> 30%

Non-audit services (tax and

other consultancy) >30%

Other consultancy

> 10%

Other consultancy

> 20%

Total

1

2

6

6

3

2

1

21

1

0

3

3

2

0

0

9

2

4

9

10

6

2

4

37

3

4

8

7

7

1

4

34

1

1

4

9

5

3

4

27

This table shows the number of organisations which have spent more than 30% on other services in relation to the costs of the annual report. The third column is not the sum of the first two columns because individually the service may remain below the 30% threshold but may jointly exceed the threshold of 30%.



Appendix 2 Book of appendices table of contents

The book of appendices which can be downloaded from the website of Nyenrode Business University (www.nyenrode.nl) includes the following elements:

1. The questionnaires used2. The list of variables used3. Information regarding the regression analysis on the degree of planning materiality (chapter 2)4. Information regarding the regression analysis on the reporting of audit differences (chapter 3)


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