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Abstract
The audit function plays a particularly important role as part of the corporate mechanism, due
to the extra value it provides with the corporate governance, which is why, over the years, this
issue has been assiduously studied and became the topic of numerous studies and analyses.
The objective of this article is to provide an analysis of the potential relationships between
the quality of external audit (assessed through membership to the Big Four: the largest four
auditing firms, namely PricewaterhouseCoopers, KPMG, Ernst & Young and Deloitte) and
financial performance (assessed by profitability, assets quality and solvency) of the banking
system in Romania. Hence, the authors tried to find answers, advocated by the results of the
conducted empirical analysis, to the following questions: "Does the quality of external audit
affects the financial performance of banks in Romania? How is registered the added value
of external audit quality at credit institutions level?"
In order to test the assumptions made, it was used a predominantly quantitative research
methodology, which is based on a deductive statistical analysis. The starting point is agency
theory, the main objective is to test and identify the potential cause-effect relationships,
while analyzing their significance weight.
As a result of this research, it can be concluded that there is a positive correlation between
external audit quality and financial performance of the credit institutions in the Romanian
banking system, although it is not a significant one.
*
Corresponding author, Mariana Bunea mariana.bunea@cig.ase.ro
Introduction
The recent financial crisis revealed not only the weaknesses of risk management, control
and governance processes in banks, but at the same time, proved the necessity to improve
the quality of external audits carried out by banks. The audit function plays an important
role in the corporate mechanism, particularly due to its capacity to add value to the
governing process. Therefore, over time, it became the main topic of various studies
focused on the issue of information transparency. Very often analyzed from the perspective
of audit committee, commended in terms of members number, mainly the independent
ones, as well as from the perspective of external audit quality, the audit function has mostly
proved to be positively correlated with the level of disclosed information by organizations.
The banks, by their operations nature, are exposed to a variety of risks that can have a
negative impact on their results or on their financial situation. These risk categories include,
but are not limited to, credit risk, liquidity risk, market risk, operational risk, solvency and
regulatory risk. Also, a variety of new risks may arise or significance of each risk can change
with time, due to various factors, either internal or external, that occur in banking business
area. Within audit planning and developing activities taking place in a bank, the external
auditor identifies and assesses the risks of occurrence of significant misstatements within the
contents of statements and financial reports. At the same time, the external auditor acquires a
proper understanding of the internal controls considered relevant for audit conducting,
including the control environment designed and implemented at the bank level.
Given the nature of banking activities, including those involving a high volume of
transactions, banks must implement controls aimed at addressing the potential risks arising
at the organization level, if applicable. Therefore, the external auditor of a bank shall
perform appropriate tests on relevant controls related to the preparation and presentation of
financial statements, so that to assess the extent they can rely on them in conducting the
audit mission.
The main purpose of this study is to examine if between the external audit quality, on one
hand, and the financial performance, assessed by the assets quality (in terms of non-
performing loans ratio - non-performing loan NPL) and the solvency indicators of
Romanian banking system, on the other hand, there is any possibility of interdependence.
Given the fact that in literature, audit quality was often appreciated and respected based on
the dimension of the audit firm, the external audit quality in Romanian banking system is
studied from the perspective of auditors membership to the Big Four
(PricewaterhouseCoopers, KPMG, Ernst & Young and Deloitte).
In the event that the external audits are being run by the same audit firm for several years,
the risk of familiarity or personal interest might threat external auditors objectivity and
independence. However, when the bank changes the external auditor, the risk is that short
knowledge and understanding of bank's activity and systems to occur. This change may
cause the instance that the new external auditor will not fully identify the financial
statements distortions and thus he/she will not issue the appropriate recommendations, thus
affecting audit quality.
Basel Committee for Banking Supervision recommends that, commensurate with the size,
complexity and diversity of banking activities and connected to the legal and regulatory
framework where banks activate, the external auditor must possess the expertise and skills
needed to run the banking audit and, where appropriate, to co-operate with banking experts.
Possessing the necessary knowledge and skills has a significant role in external auditors
proper exercising of professional judgment and in conducting the key aspects of audit
process, such as identifying and assessing distortions risks and designing and
recommending appropriate solutions to cover those risks. Professional skepticism is defined
as "an attitude that includes a questioning attitude, being alert to conditions which may
indicate possible significant distortions due to error or fraud and a critical assessment of the
evidence" (IAASB, 2012). It is especially important for an external auditor to exercise
professional skepticism in the audit activities, particularly in the following areas:
calculation of depreciation, determination of fair value and permanence assessment
methods, including related assessment and solvency indicators liquidity. In planning and
performing the audit, the external auditor should properly apply the concept of materiality.
Determination of significance level of financial statements as a whole depends on the
external auditor's judgment on possible distortions that can occur reasonably and could
influence the economic decisions of users made based of these financial statements.
According to generally and internationally accepted auditing standards, control system
components include: control environment; risk assessment process across the organization,
information system, including related business processes relevant to financial reporting and
communication, control and monitoring activities undertaken within bank. The mechanisms
for compensation or remuneration system of a bank can be a good indicator for the
assessment of organizational culture, as they are able to influence bank staff attitude towards
risk and the quality of corporate governance. In this context, the external auditor will pay
special attention to possible risks of significant distortion in financial statements that can
occur as a result of frauds, especially when banks use specific compensation arrangements
that may encourage excessive risk-taking or other inappropriate behaviors of the employees.
International Auditing Standards recommend external auditor to get an understanding of
control activities relevant for audit execution, so that they can be properly assessed
according to the risks of significant distortion in order to establish audit strategy. An
understanding of control activities related to the financial reporting process is essential for
planning the audit procedures appropriate for the assessed risks within bank. Thus, in
identifying and assessing significant distortions risks and in evaluating controls within
bank, external auditor must take into account the following factors:
competence and knowledge of those employees responsible for the development and
presentation of financial statements and of those that are in charge of the control functions
that can impact financial reporting;
requirements. The internal control system of a bank must be reliable and robust so that it
can cope with crisis environments.
2. Literature review
The coordination of internal and external audit activities, experienced especially during the
last decade, a special attention due to the understanding that those robust corporate
governance systems can help minimize the devastating impact that corporate bankruptcies /
crashes can generate (Rusak and Johnson, 2007).
This idea is underlined by the recognition of internal audit role in terms of financial
reporting quality improvement. Blue Ribbon Committee Report (1999) presents the audit
committees of boards of directors, internal and external audit functions as a three-
dimensional pillar of corporate governance that contribute to the maintaining and
perpetuating of financial reports reliability.
The use of financial information by boards (on behalf of shareholders) and the contribution
of internal and external audit in enhancing the usefulness of this information, which is
provided (and equally used) by management in its decision making (Fan and Wong 2004,
Jensen and Meckling 1976, Blue Ribbon Committee, 1999) provides an integrated picture
of existing connections among the four components of corporate governance.
The activities of internal and external audit increase the efficiency of the audit committees,
which are an essential tool serving as support for boards (DeZoort et al. 2002).The internal
audit is an essential resource in the context of corporate governance, providing services to
the other components of corporate governance (Gramling, et al, 2004;. DeZoort et al 2002).
The studies focused on the mechanisms of audit as a part of the corporate governance
system at the level of developing countries are, so far, relatively limited.
Fan and Wong (2004) demonstrate the role of external audit for corporate governance in
emerging economies, based on empirical studies conducted on developing countries.
However, there is small research focused on the connections between the mechanisms of
internal and external audit activities at the level developing countries and their impact on
corporate governance mechanism. The professional audit standards, namely, International
Standards on Auditing (ISA) 610 provide guidelines in terms of external auditors work in
conducting financial statements audits.
The literature also underlines that the confidence external auditors have in the internal audit
activity could contribute to significant cost savings by reducing the time allocated to
external audit process. The external auditors assess the activity of internal auditors in order
to determine whether the internal audit function can be trusted. Such confidence is also
particularly important, given the extra value that internal audit can bring to the company
through reduced audit fees (Krishnamoorthy, 2001, 2002; Morrill and Morrill, 2003; Mihret
2010; Mihret, James and Mula 2010).
No doubt, the opportunity to reduce costs generates the interest of the other two main
components of the corporate governance mechanism (boards of directors and the
management) which are interested in promoting constant cooperation between internal and
external audit.
The reputation in minimizing errors (DeAngelo, 1981; Beatty, 1989; Firth, 1979;
Chow, 1982; Ahmed and Nicolis, 1994). Large audit firms are willing to invest more to
maintain their reputation as suppliers of quality audit services, because if their reputation is
damaged they risk to lose more than small firms;
More experience, usually manifested through influences in encouraging the
leadership to disclose as much information to reduce the information asymmetry and
agency costs (Baiman, et al., 1987; Baiman, 1990; Wallace et al. 1994; Watts, 1977; Watts
and Zimmerman, 1986);
The higher degree of independence from the customers, given their large number,
which could compromise the quality of their work to a lesser extent than in the case of
small audit firms (Owusu-Ansah, 1998). Given their role to enhance disclosed information
level and quality, the independence status allows them to influence corporate financial
reporting to better meet the needs of external users (Barako et al., 2006).
3. Methodology
The methodology used to test the assumptions is mainly quantitative. This is based on a
deductive statistical analysis whose starting point was the agency theory, aimed at testing
and identifying the possible links of the type cause - effect, and analyzing their
significance.
This paper provides a comprehensive analysis of the connection of the external audit with
the financial performance at the level of Romanian banking system. It thus tries, by means
of empirical research, to find answers to the following question: Does the quality of the
external audit influence the financial performance of Romanian banks?
Based on the records of the previous literature, the following hypotheses were formulated:
H1: There is a significant positive association between the quality of external audit and the
financial performance of banks;
H2: There is a significant positive association between the quality of external audit and the
quality banks' assets;
H3: There is a significant positive association between the quality of external audit and the
solvency of banks.
Given the fact that in the technical literature, audit quality has often been appreciated taking
into consideration the dimension of the audit firm, the quality of external audit in Romanian
banking system is studied from the perspective of the auditor's being part of the group Big
Four.
In order to carry out the present research, we used specific tools for data processing, using
SPSS software under Windows (correlation and regression analysis tests).
At the end of 2013, the Romanian banking system had 40 credit institutions, out of which
31 were banks, Romanian legal entities (including credit cooperative organizations) and 9
were branches of foreign banks. Out of the 40 banking institutions, the sample analyzed
consisted of 21 banks, sample made up of Romanian legal entities. The 9 branches of
foreign banks were excluded from the analysis, in accordance with Regulation 25/30/2006
4. The solvency Solv the capital adequacy ratio - the ratio of Tier 1 and 2
adequacy of own funds to the risk of the credit
weighted assets institution and its
risk- weighted assets
In order to test the possible correlations between the researched variables, we used the
Pearson coefficient calculation, commonly used to assess the intensity of the linear
dependence between the two variables.
The correlation coefficient is denoted by (X, Y) and is defined by the formula:
(X,Y)= , i= , (1)
Where:
covariance: = ; (2)
The collection of the data needed for the present research was based exclusively on the
information posted on the websites of the analysed banks, of the National Bank of Romania
or through their annual financial statements and related reports of 2013 on transparency and
disclosure requirements designed in accordance with the NBR-NSC No 25/30/2014
amended and supplemented by Regulations NBR - NSC No. 21/26/2010 and 23/15/2011
and NBR Regulation No. 25 / 10.12.2010.
The same situation can be observed regarding the existence of an external audit influence
upon loan quality and solvency of credit institutions respectively, the identified correlation
being positive but rather weak, and the Pearson coefficient being 0.249 NLP and 0.133
respectively for the solvency ratio, and the value of Sig greater than 0.05.
The correlation analysis identified for each analysed independent variable, giving reasons
for acceptance or rejection of the formulated research hypotheses has also been based on
the results of the analysis of this dependence. The Pearson coefficient values for each
combination of variables are shown in Table no. 5.
Table no. 5: The correlation coefficients of the variables of the financial performance
ROA ROE NLP Solv
ROA Pearson Correlation 1 0.838** -0.157 0.364
Sig. (2-tailed) 0.000 0.498 0.105
N 21 21 21 21
**
ROE Pearson Correlation 0.838 1 -0.271 0.380
Sig. (2-tailed) 0.000 0.236 0.089
N 21 21 21 21
NLP Pearson Correlation -0.157 -0.271 1 -0.355
Sig. (2-tailed) 0.498 0.236 0.114
N 21 21 21 21
Solv Pearson Correlation 0.364 0.380 -0.355 1
Sig. (2-tailed) 0.105 0.089 0.114
N 21 21 21 21
From the interpretation of this data, we can conclude that the only variables significantly
correlated are the return on assets (ROA) and the return on equity (ROE) for which the
Pearson coefficient is equal to 0.838 and Sig is 0. Between the NPL and the other variables
used to measure the financial performance there is a negative correlation of low intensity,
the Pearson coefficient having values between -0.157 and -0.355 and Sig being higher than
0.05. The solvency index is positively correlated with profitability (The Pearson coefficient
being 0.364 and 0.380 for the ROA and ROE) and negatively with the NPL, but no such
links are significant because Sig is higher than 0.05.
Starting from the premise that the provided services, the reputation, the experience and the
independence are defining aspects underlying the audit quality assessment, and given the
fact that auditors from the "Big Four" have all the attributes which are essential to limit
managers' opportunistic behaviour through monitoring, the following hypotheses were
tested:
H1: There is a significant positive association between the quality of external audit and the
financial performance of banks;
H2: There is a significant positive association between the quality of external audit and the
quality banks' assets;
H3: There is a significant positive association between the quality of external audit and the
solvency of banks.
Conclusions
The study was designed in order to provide an analysis of possible connections between the
external audit quality (assessed through membership of the Big Four) and the financial
performance, portfolio quality and solvency of the banking system in Romania.
The testing of possible influences of the quality of the external audit upon the value of an
entity has been the subject of a wide range of research until now. In contrast, the research
performed in this study has a unique approach to this problem recorded in a specific field of
activity, the financial banking one, a field which has not been thoroughly researched from
this precise perspective until now. Furthermore, in this analysis, in addition to the
connection between the quality of external audit and financial performance, we also tried to
capture the links between this and risk management elements at the level of the banking
system (the non-performing loan ratio and the solvency indicator).
At the same time, the present study was focused on a single "key player," the external audit,
thus giving it its due consideration thanks to its role and place in the process of company
management. Moreover, the formulated hypotheses and the connections with the dependent
variables included in the analysis give the research a touch of originality and, by default,
value added.
The research also has a number of limitations, mainly caused by the sample size of the
banking institutions analysed, but also because the present study was based on information
related to a single calendar year (end of 2013); we consider all the above as challenges for
future research. Also, this study included only a few indicators that measure the
performance of the banking system, paving the way for future research of other indicators
used to analyze the performance and risk management of credit institutions (capital
adequacy of credit risk, market risk, operational risk, etc).
Despite all of these limitations, we consider that this study could be a useful source of
information and reflection for banking practitioners, representing challenges for future
research.
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