Sustainable corporate governance and
new auditing issues: a preliminary
empirical evidence on key audit matters
Pietro Fera, Michele Pizzo, Rosa Vinciguerra and Giorgio Ricciardi
Pietro Fera, Michele Pizzo,
Rosa Vinciguerra and
Giorgio Ricciardi are all
based at the Department of
Economics, University of
Campania, Luigi Vanvitelli,
Capua, Italy.
Received 23 September 2020
Revised 11 February 2021
29 March 2021
23 June 2021
26 July 2021
Accepted 15 August 2021
PAGE 194 j CORPORATE GOVERNANCE j VOL. 22 NO. 1 2022, pp. 194-211, © Emerald Publishing Limited, ISSN 1472-0701
Abstract
Purpose – This paper aims to investigate the relationship between the quality of internal corporate
governance mechanisms and the audit issues disclosed by external auditors in their report, assuming the
beneficial effect related to the adoption of a sustainable corporate governance system.
Design/methodology/approach – This paper investigates the impact of the International Auditing and
Assurance Standards Board’s ISA 701 in the European context as a new auditing principle supporting the
key audit matters (KAMs) in reporting and disclosing auditing activities. The analysis is carried out
through a quantitative methodology using a sample composed of non-financial companies listed on the
Italian Stock Exchange.
Findings – Empirical findings highlight that firms having a high quality and sustainable corporate
governance system tend to have fewer KAMs arising from the audit process and then disclosed in the
audit report. To ensure the reliability of the empirical analysis, the authors controlled for a set of variables
that could affect the audit function and for the mediating role of the overall business complexity (as
proxied by the firm size).
Originality/value – This study is of interest to academics, practitioners and regulators, as it highlights the
role of a higher quality internal corporate governance on the perceived corporate riskiness and
complexity. It contributes to the recent debate on sustainable corporate governance, corporate
sustainability and auditing streams.
Keywords Corporate sustainability, Auditing, Key audit matters, Sustainable corporate governance
Paper type Research paper
1. Introduction
Among several studies analyzing corporate governance systems’ primary role, recent
papers document how it can be considered crucial to business sustainability. Scholars
highlight that the quality of corporate governance strongly depends on corporate
sustainability, which aims to achieve sustainability in all corporate practices (Hahn and
Scheermesser, 2006; Mudiyanselage, 2018; Schrippe and Ribeiro, 2019). Sustainable
corporate governance may impact both internal and external corporate functions, as the
audit one, which has been severely criticized in recent years.
The 2008–2009 financial crisis revealed all the flaws connected to the audit function. Enron,
Worldcom, Ahold and Parmalat’s defaults have shown that something was out-of-line with
corporate governance, financial reporting and above all with auditing, at the end of the
twentieth century (Knechel, 2007). Besides, the considerable losses reported from 2007 to
2009 by several banks raised questions on how auditors could have provided spotless
audit reports to their clients for those periods (Sikka, 2009). So that, in the past two
decades, we have witnessed a watershed period for the auditing profession (Knechel,
2007; Sikka, 2009).
DOI 10.1108/CG-09-2020-0427
In this regard, Boolaky and Quick (2016) considered the audit report the primary tool for
communicating with firms’ stakeholders. In the aftermath of the global financial and
economic crisis, the European Commission launched its Green Paper on audit policy
(European Commission, 2010), where auditors’ communication to stakeholders represents
one of its fundamental topics.
The auditor’s report is the final output of the whole audit process. It briefly describes the
audited financial statements, the management and auditor’s responsibilities, the audit
process and ends with the auditor’s opinion (ISA 700). However, despite its importance, it is
usually very concise and standardized.
Accordingly, some Authors criticize the audit report for being uninformative due to its over-
standardized nature (Bédard et al., 2016; Gutierrez et al., 2018). Others assert that, in most
countries, the auditors’ opinions were mainly consistent with each other and not related to
the company-specific information (Gutierrez et al., 2018). Consistently, many stakeholders
have questioned the effectiveness of auditor reporting because of the lack of company-
specific information in the audit report (Bédard et al., 2016).
In response to this criticism, standard setters and regulators have already implemented or
are in the process of implementing, a developed model of audit reporting (Humphrey et al.,
2009). Focusing on the European scenario, the European Council adopted the reform of the
audit market (Regulation EU no. 537/2014 of the European Parliament and the Council of the
European Union, 2014). Concurrently, the International Auditing and Assurance Standards
Board (IAASB) established the Key Audit Matters (KAMs) section in the audit report, aiming
to provide stakeholders with more information about the audit process and the
accompanying financial statements. Specifically, the IAASB issued a new standard, the ISA
701: Communicating KAMs in the Independent Auditor’s Report (International Auditing and
Assurance Standards Board [IAASB], 2015), that offers an as simple as effective definition:
KAMs are those matters that, in the auditor’s professional judgment, were of most
significance in the audit of the financial statements; KAMs are a selection of matters
communicated with those charged with governance (ISA 701, p. 8).
The IAASB contextually highlights the need for an interaction between the auditor and its client’s
corporate governance to address the KAMs issues adequately. It is not the first time that the
IAASB, recognizing the fundamental role of the characteristics and structure of the corporate
governance on different firms’ dimensions, deems the internal corporate governance crucial in
setting an auditing standard (e.g. ISA 260; ISA 315; ISA 700). For the above reasons, the
presence of high-quality and sustainable corporate governance, capable of effectively assisting
the auditor in the performance of its functions, can help pursue the new ISA 701 aim.
Enabling the development of reliable and sustainable corporate governance systems, many
regulators adopted self-regulatory codes, defining the main characteristics and the ideal
features of a proper governance model that focuses on the role and the structure of the
board of directors, as well as the functioning of internal committees (Tukker et al., 2008).
Indeed, the previous literature suggests that higher quality and sustainable corporate
governance system enhances the degree of market transparency and ensures better
protection for the whole set of stakeholders (Kang and Shivdasani, 1995; Mallin, 2002;
Black et al., 2006).
Relying on the beneficial effect related to the adoption of a sustainable corporate
governance system, many studies show both the interaction between the auditor and
the client (Bamber and Iyer, 2007; Hellman, 2011) and the impact of the quality of
corporate governance on the audit process (Cohen et al., 2002; Sharma et al., 2008).
Indeed, specific corporate governance characteristics impact the audit function and
play a key role in determining the audit opinion. In addition, focusing on the new audit
report requirements (ISA 701), there is preliminary evidence concerning the
relationship between the internal corporate governance structure and the KAM

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 disclosure. Specifically, Velte (2018) asserts that a specific corporate governance
variable (as proxied by the percentage of female members on the audit committee)
positively affects the KAM disclosure quality. Moreover, the financial expertise of the
audit committee members affects the KAM disclosure quality (Velte, 2019). Focusing on
the number of disclosed KAMs in the audit report, rather than on their quality
disclosure, Wuttichindanon and Issarawornrawanich (2020) assert that the amount of
disclosed KAMs has a positive and significant relationship with the number of
independent directors.
Based on these assumptions, the motivation of this study is twofold. First, it aims to fulfill the
need to further investigate the relationship between the quality of internal corporate governance
mechanisms and the new KAM issues, consistently with the previous literature highlighting a
strong relationship between the audit process and the client’s corporate governance
characteristics and with the IAASB underlining the need for an interaction between the auditor
and the client’s corporate governance representativeness. Second, as a few studies consider
the role of corporate governance on KAM disclosure and none of them analyze in-depth the
whole set of sustainable corporate governance characteristics, this paper fits into this lack of
research.
Therefore, this paper aims to present a preliminary empirical investigation on the possible
relationship between a sustainable corporate governance system and the amount of
disclosed KAMs in the audit report. Specifically, focusing on the Italian institutional setting,
we set up a corporate governance quality score, relying on 10 firms’ characteristics
affecting the quality of corporate governance. Then, through adopting a robust standard
errors panel data regression model, we found supporting evidence on an inverse
relationship between a sustainable corporate governance system and the amount of KAMs
disclosed in the audit report.
The remainder of the paper proceeds as follows. Section 2 outlines the theoretical
background and develops the research hypothesis. Section 3 describes the sample, while
Section 4 explains the research methodology. Section 5 discusses the empirical evidence
and the relative preliminary statistics. Section 6 concludes.

2. Theoretical background and hypothesis development

2.1 The impact of a sustainable corporate governance on the audit function
According to the early literature, the problem of corporate governance stems from the
separation between ownership and control and involves the issues related to possible
opportunistic behaviors of the corporate controller (Berle and Means, 1932; Jensen and
Meckling, 1976). Corporate governance has to deal also with the wealth of several other
stakeholders, such as employees, customers, suppliers, local community, environment and
society in general (Ayuso and Argandoña, 2009; Spitzeck and Hansen, 2010). Therefore,
many growing issues have been related to good corporate governance systems such as
legislation, codes of best practices adoption, relevance of stakeholders, shareholders and
their protection, identification of the management’s role and responsibilities (Trequattrini,
1999; Lombardi, 2012; Maglio et al., 2018).
In this scenario, corporate governance can be considered crucial to the business
sustainability and the growth of any economy, as the implementation of a proper corporate
governance framework can lead to growth and sustainability while opening up opportunities
for businesses (Zhang, 2012; Sundarasen et al., 2016; Harjoto and Wang, 2020). A
sustainable corporate governance system aims at preserving several aspects, such as
economy, environment and society (Hahn et al., 2010; Lozano and Huisingh, 2011; Lozano,
2013; Amini et al., 2018; Maglio et al., 2020), including the whole set of stakeholders. Thus,
the quality of corporate governance and its related issues are widely related to corporate

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sustainability and its tools, which are focused on achieving sustainability in all corporate
practices (Hahn and Scheermesser, 2006; Schrippe and Ribeiro, 2019).
Among the several impacts that sustainable corporate governance may, directly and indirectly,
have on the firms’ interests and stakeholders, this study focuses on the relation between the
internal corporate governance characteristics and the emerging tools concerning the audit
function.
Previous studies have found supporting evidence about both the interaction between the
auditor and the client (Bamber and Iyer, 2007; Hellman, 2011) and the impact of corporate
governance on the audit process (Cohen et al., 2002; Sharma et al., 2008).
Starting from the client-auditor relations, it may help analyze the treats of the auditor’s
independence. Specifically, prior studies suggest that close ties to the client may
menace auditor independence. Bamber and Iyer (2007) reported that auditors who
identified with their clients were more likely to agree to the client-preferred treatment of
a materiality issue. Consequently, it seems that a strong auditor-client relationship can
be detrimental to the audit function. On the other hand, too much distance between the
auditor and the client has adverse effects. Not surprisingly, the ISA 260 and the ISA 315
invite the auditor to understand the entity and its environment, which requires
interacting with those charged in corporate governance to gain knowledge regarding
business matters and internal control systems. In this regard, many scholars found
empirical evidence concerning different aspects of the client-auditor interaction.
Hellman (2011) asserts that the interaction between client representatives and
members of the audit team takes place at many different levels. Moreover, Knechel
(2007) also suggests that the increased reliance on control systems and performance
measurement tends to make the auditor’s relationship with management increasingly
symbiotic because of the close interaction needed.
Looking at the audit process, Cohen et al. (2002) highlight that corporate governance can
affect all phases of the auditing activities [1]. Starting from the client acceptance phase,
auditors should consider the firm’s corporate governance quality because the board of
directors plays a crucial role in setting and monitoring the firm’s strategies (Pfeffer, 1972;
Salancik and Pfeffer, 1978; Pfeffer and Salancik, 2003; Hillman and Dalziel, 2003).
Precisely, Sharma et al. (2008) asses that stronger corporate governance leads to a more
favorable client acceptance recommendation.
From the client acceptance to the risk assessment phase, the corporate governance’s
impact becomes even more robust, as there is a knowledge-based dependence between
auditors’ assessment of inherent risk and control environment risk (Messier and Austen,
2000). Moreover, corporate governance characteristics are likely to affect auditors’ risk
assessment. Specifically, a strong board of directors and an expert audit committee are
fundamental for effective internal control, representing the starting point of the auditors’ risk
assessment (Fama and Jensen, 1983; Cohen and Hanno, 2000). Furthermore, Sharma et al.
(2008) asses that a higher quality corporate governance system leads to lower inherent risk
and control environment risk assessment.
Finally, looking at the execution phase of the auditing process, there is evidence showing
that stronger corporate governance leads to less extensive substantive audit testing
(Sharma et al., 2008). So, as we mentioned before, considering the audit process in its
entirety, auditors look at the client governance when making audit decisions.
In summary, both the previous empirical evidence proving the beneficial impact of a
good client’s corporate governance on the whole audit process and ISA 701
recognizing the fundamental role of corporate governance’s characteristics on the
audit process, and hence, on KAM disclosure, legitimize the interest for this field of
study.

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 2.2 Regulatory framework: the new audit reporting standard
In providing an independent opinion on whether the financial statements are properly
prepared according to the financial reporting framework (ISA 700), auditors play an
essential role in enhancing financial stability, trust and market confidence. The audit report
is a bulwark for the capital markets’ efficiency as the auditors’ opinion represents a
fundamental basis for the decision-making process of investors and stakeholders. However,
after the recent corporate governance scandals and the global financial crisis, most of the
regulators, investors and scholars started arguing about the effectiveness of the audit
report. The main issue is related to the lack of company-specific information (Bédard et al.,
2016; Gutierrez et al., 2018). Specifically, stakeholders are unaware of the limitations of an
audit process, such as materiality, sampling techniques, role and responsibilities in the
detection of fraud and the responsibility of managers (European Commission, 2011). To
face these dynamics, regulators and standard setters worldwide (including Public
Company Accounting Oversight Board (PCAOB), IAASB, financial reporting council (FRC)
and the European Commission) have changed the audit reporting standards to require
auditors to disclose more information.
In the US, the PCAOB proposed, in August 2013, a new auditing standard focused on the
communication of critical audit matters (CAMs) intending to make the auditor’s report more
relevant to investors. Accordingly, the PCAOB issued a new auditing standard in June 2017
to change the audit report to provide more entity- and engagement-specific information
about the audit process (PCAOB, 2017). The standard requires, along with the auditor
tenure and the audit firm independence, to discuss the CAMs within the audit report.
Specifically, CAMs are defined as issues communicated to the audit committee that relate
to material financial statement accounts and involve challenging, subjective or complex
auditor judgment (PCAOB, 2017).
The European Commission, on its own, presented its proposals regarding the statutory
audit of public interest entities in November 2011 (European Commission, 2011). The
European Parliament settled the reform of the audit market on April 3, 2014, which then was
adopted by the European Council on April 14, 2014 (European Parliament and Council of
the European Union, 2014). In particular, the audit report should provide, in support of the
audit opinion:
䊏 Sufficient information on the independence of the statutory auditor or the audit firm.
䊏 A description of the most significant assessed risks of material misstatement, including
those due to fraud.
䊏 A summary of the auditor’s response to those risks and, if relevant, key observations
arising concerning those risks.

Following this path, at its September 2014 meeting, the IAASB approved the ISA 701, which
deals with the auditor’s responsibility to communicate KAMs in the auditor’s report. The
purpose of communicating KAMs is to enhance the communicative value of the auditor’s
report by providing greater transparency about the performed audit process (ISA 701).
In the UK, the UK Financial Reporting Council has anticipated the IAASB, passing new
standards on the auditor’s report in June 2013 (FRC, 2013a, 2013b, 2013c). Indeed, the UK
was one of the first countries in Europe to adopt a new audit report regulation requiring its
implementation for the audit of financial statements starting from October 2012. We
additionally detected early adoption of the new standards in other institutional contexts,
including Australia, Germany, Hong Kong, The Netherlands, Poland, South Africa,
Singapore and Switzerland.
Finally, Italy has implemented the new auditing standard by enacting the Legislative Decree
135/16, which updated and amended the Legislative Decree 39/10 and Regulation (UE)

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537/14 concerning public interest entities. According to Regulation (UE) 537/14, KAMs should
be disclosed in the auditor’s report for the financial statements of public interest entities. The
latter include Italian companies with transferable securities listed on Italian and other EU
regulated markets, banks and insurance and reinsurance undertakings. In particular, the ISA
Italia No. 701 is effective for the audit of financial statements starting on or after 17 June 2016.

2.3 Key audit matters’ determinants and hypothesis development

Since their introduction, KAMs have drawn the attention of several scholars who focused on
understanding both their impact and determinants. In particular, it is possible to divide the
literature into three different strands. The first strand concerns the stakeholders’ reaction to KAM
disclosure. Specifically, focusing on financial statements users, it has been demonstrated that
KAM disclosure clarifies the auditing process (Cordos  and Fülöp, 2015; Sirois et al., 2018).
Moreover, KAMs are considered of high importance also by both financial institutions (Boolaky
and Quick, 2016; Trpeska et al., 2017) and general investors (Christensen et al., 2014). The
second strand of research, instead, focuses on the relationship between the new audit report and
the financial reporting quality. In this regard, it has been demonstrated that KAM disclosure
enhances earnings quality computed as a decrease in absolute abnormal accruals (Li et al.,
2019). Finally, a third strand, which is the most significant for the aim of our study, focuses on the
KAM’s determinants. Existing evidence shows that KAM disclosure is affected by both certain
auditor and client’s business characteristics (Lennox et al., 2019; Pinto and Morais, 2019; Sierra-
Garcı́a et al., 2019; Ferreira and Morais, 2020). Focusing on the firms’ characteristics, Pinto and
Morais (2019) have found that a higher number of business segments (complexity) and more
precise accounting standards lead to the disclosure of a higher number of KAMs. However,
Sierra-Garcı́a et al. (2019) reported that, in addition to the firm’s characteristics (i.e. industry type),
the amount of disclosed KAMs also depends on the auditor characteristics (i.e. type of auditor
and audit fee).
In addition to the auditor and client’s business characteristics, ISA 701 underlines the need for
an interaction between the auditor and the client’s corporate governance representativeness to
adequately disclosing the KAMs. Thus, it is possible that corporate governance characteristics
may influence the auditor’s decision on KAM disclosure. In this regard, Velte (2018) is one of the
first to consider corporate governance as a determinant of KAM disclosure. Specifically, the
author asserts that a higher percentage of women on audit committees have higher readability
of KAM disclosures. In addition, KAM readability has also been found to be related to the
financial expertise of the audit committee members (Velte, 2019). Finally, Wuttichindanon and
Issarawornrawanich (2020) assert that the number of KAMs has a positive and significant
relationship with the number of independent directors.
Consistently with the previous preliminary evidence, this paper aims to further investigate
the role of corporate governance mechanisms in determining the KAM disclosure by
analyzing different corporate governance aspects that, as a whole, strive to achieve
sustainability in all corporate practices. Indeed, an effective and sustainable corporate
governance system could ease tensions between the auditor and the client, and therefore,
positively impact the amount of KAMs disclosed.
Therefore, the reported reasoning and the literature above lead this study wants to test the
following hypothesis:
Hp. There is an inverse relationship between an effective and sustainable corporate
governance system and the amount of disclosed KAMs.

3. Sample construction and data selection

The sample consists of non-financial companies listed on the Italian Stock Exchange during
the reference period, from 2017 to 2019. We exclude all firms that refer to the global

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 industry classification standard (GICS 40) (financials) and GICS 60 (real estate) because of
their peculiar financial reporting and corporate governance rules. Then, we drop from the
sample firms with a lack of historical financial market, accounting and corporate
governance data and firms involved in business combinations that could lead to an
overestimated number of KAMs. At the same time, to rule out any possible survivorship bias
(Bartov et al., 2000; Ecker et al., 2006), we do not exclude firms that were delisted or went
bankrupt during the reference period.
As shown in Table 1, the basic sample comprises 118 firms from which we obtain a final
sample of 354 firm-year observations. The relatively small sample size is due to the limited
size of the Italian stock market, our sampling criteria and the recent introduction of the KAM
section in the audit report that narrows the reference population. Nevertheless, the sample
covers more than 75% of the Italian stock market capitalization in the reference period.
We collected data from different sources, namely, financial market and accounting data
were obtained from Thomson Reuters Eikon, Datastream and AIDA by Bureau van Dijk,
while corporate governance data were hand-picked from the online databases of Co.N.So.
B. (the Italian supervisory authority for financial markets) and by consulting the companies’
annual reports on their corporate governance and ownership structure.

4. Variables definition and model specification

This section defines the dependent variable, our proxy for the quality of corporate
governance and the other control variables. Then, it shows the appropriate model
specification.

4.1 Dependent variable: the disclosed key audit matters

Our dependent variable consists of the number of KAMs disclosed in the audit report
(No_KAM).
As a preliminary step, it is fundamental to understand how and when auditors determine
KAMs that could be seen as a measure of the number of risky aspects emerging from the
financial statement.
Among the issues discussed with who is charged with governance, the auditor shall
determine those matters that require significant care in performing the audit process.
Specifically, they include:
䊏 Areas of higher assessed risk of material misstatement or for which significant risks
have been identified.
䊏 Significant auditor judgments relating to areas of significant management judgment in
the financial statements, including accounting estimates subject to a significant degree
of uncertainty.
䊏 The effect on the audit of significant events or transactions that occurred in the
period.

Table 1 Sample selection process

Population of non-financial listed firms 228
Financial and accounting data not available 50
Corporate governance data not available 58
Companies involved in extraordinary operations 2
Basic sample 118

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Among the issues identified relying on the abovementioned criteria, the auditor should
select those matters that are more relevant in the audit of the financial statements, and
therefore, represent the KAMs. Therefore, KAMs are a selection of matters from the issues
that both have required significant auditor awareness in performing the audit of financial
statements and have been discussed with those charged with corporate governance.
To set up our dependent variable, we first collected all the annual reports for each firm-year
observations, then we examined the KAM section included in their related audit reports.
Specifically, the KAM section consists of a fixed structure that provides for the following
three main elements:

1. The title highlights the item each identified KAM refers to (i.e. Recoverability of
Intangible Assets, Valuation of Trademarks and Goodwill). When these events
occurred, we calculated a KAM for each of the items considered in the title.

2. The description of the motivations, which led the auditor to address a certain item as a
KAM.

3. The audit response describes the procedures performed by the auditor to address the
specific KAM.

To obtain the number of disclosed KAM, we focused our attention on the first part of the
KAM section that identifies, which item the KAM refers to. However, it is noteworthy that a
single KAM may also refer to multiple items. Thus, relying on the prevalence of substance
over form principle, this paper goes in-depth identifying how many items each KAM refers
to and, in turn, determining the basis of the dependent variable of this study.
Then, the variable No_KAM is computed as the number of disclosed KAMs (as previously
counted) for each firm-year observation divided by the average number of KAMs detected
in the relative fiscal year (Pinto and Morais, 2019; Wuttichindanon and Issarawornrawanich,
2020).

4.2 Independent variable: proxy for the quality of corporate governance

To single out firms with a righteous and sustainable corporate governance system from
those with weak corporate governance, we build a synthetic indicator for the quality of
corporate governance. Expressly, we set up a governance score (GovScore) relying on 10
items that impact the quality of corporate governance (Moscariello et al., 2020). Given that we
are aware that there is no optimal board configuration (Rebeiz, 2016), the literature clearly
highlights certain items that positively or negatively impact corporate governance quality
(Nordberg and Booth, 2019). Thus, consistent with the prior literature, we assume that seven of
them are positively related to the quality of corporate governance, namely, the percentage of
independent directors within the board and the control committee; the presence of minority
directors within the board, within the control committee and the internal audit committee; the
appointment of an internal audit committee; the number of the control committee’s meetings
(Rosenstein and Wyatt, 1990; Borokhovich et al., 1996; Cotter et al., 1997; Dahya et al., 2008;
Alipour et al., 2019; Agyei-Mensah, 2021). Moreover, we assume a negative relationship
between the quality of corporate governance and the remaining three items, namely, the
board size, control committee size and the chief executive officer duality (Fama and Jensen,
1983; Dechow et al., 1996; Yermack, 1996; Peasnell et al., 2005; Neifar et al., 2016; Garanina
and Kaikova, 2016).
For each firm-year observation, all elements are assessed and then converted into a
dummy variable, which takes the value of 1 if they positively affect the quality of corporate
governance (for values above or below the median, according to their expected effects on
corporate governance) and 0 otherwise.

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 Summing the total number of points awarded to each firm-year observation for all items, we
obtain the GovScore that can range from 0 (bad corporate governance) to 10 (high quality
and sustainable corporate governance):

X10  
GovScoreit ¼ j¼1
Ratingj it
(1)

where j is the single corporate governance item, i represents the firm and t indicates the
year.
After determining the GovScore for each firm-year observation, we turned it into a dummy
variable (CG_Score), which takes the value 1 if the total score (of a firm in a specific year) is
above the median and 0 otherwise. In particular, this step allows us to single out firms with a
strong and sustainable corporate governance from those with weak corporate governance.

4.3 Control variables

We include several control variables that are frequently used in recent corporate
governance and audit research. We control for the size (Size), measured as the natural
logarithm of total assets, expecting a positive link with the amount of KAM disclosed, as
more assets involve more audit procedures. We also include two different performance
measures, namely, the variable ROA (return on assets), computed as the net income before
extraordinary items relative to total assets and the TobinsQ, computed as the ratio between
the market value of a company and the book value of its equity and liabilities. The Leverage,
as the ratio between long-term debt and total assets, is also included as a control variable in
our model, assuming or a direct relationship with a firm overall risk, which leads to an
increased number of KAM disclosed or an inverse relationship with the response variable,
assuming the leverage as an additional external corporate governance mechanism. The
same relation is expected for the current ratio (Curr), measured as the ratio between current
assets and total assets, as it was linked with earnings management. We also include the
intangibility (Intangibility), as the ratio between the intangible assets and the total assets,
expecting a direct relation with the amount of KAMs, as a greater presence of intangible
assets leads to more audit procedures. Finally, we also control for the auditor
characteristics that may affect their KAM disclosures. Specifically, Big4 is a dummy variable
that takes the value of 1 if a company is audited by one of the Big Four audit firms (Deloitte,
EY, KPMG or PWC). In addition, we include a set of dummy variables to control for each
industry and year.

4.4 Model specification

To test our hypothesis, we set up the following robust standard errors panel data regression
model for evaluating if the quality of corporate governance has an impact on the amount of
disclosed KAMs:

No KAMit ¼ b 0 þ b 1 CG Scoreit þ b 2 Sizeit þ b 3 ROAit þ b 4 TobinsQit þ

þ X b 5 Leverageit þ b 6 CurrXit þ b 7 Intangibilityit þ b 8 Big4it þ (2a)
þ ðYear Effects Þit þ ðIndustry Effects Þit þ « it

where i is the specific firm, t indicates the reference year and « it stands for the regression
error. The dependent variable (No_KAM), as defined in Section 4.1, consists of the amount
of KAMs disclosed in the audit report, while the main independent variable (CG_Score) is
our proxy for the quality of corporate governance as defined in Section 4.2.
However, it is reasonable to assume that there is a direct relationship between the firm’s
size and the quality of corporate governance. Indeed, bigger companies tend to improve

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their corporate governance mechanisms because of their greater complexity and stronger
control from external parties. Therefore, it is reasonable to believe that companies with a
large size tend to have a greater CG_Score (our proxy for the quality of corporate
governance), as many elements involved in this indicator represent a common trait of larger
companies. At the same time, as we stated before, a larger size leads to a greater business
complexity, and therefore, should entail a greater number of KAMs (Pinto and Morais,
2019). For these reasons, the firm size could act as a moderator in the relationship between
the quality of corporate governance and the number of KAMs disclosed. Therefore, to
better test our hypothesis, it is necessary to rule out the potential bias caused by the firm
size and assess the effect that the CG_Score has per se on the number of KAMs disclosed.
To this end, we use the same regression model described above (Model 2a), adding a new
main independent variable (Bigger_CG_Score), an iteration variable given by the product
between the variables CG_Score and Size. Thus, through the CG_Score variable, it is
possible to assess the impact of the quality of corporate governance on the number of
KAMs without this relationship being driven by the company size:

No KAMit ¼ b 0 þ b 1 CG Scoreit þ b 2 Bigger CGScoreit þ b 3 Sizeit þ b 4 ROAit

þ b 5 TobinsQit þ b 6 Leverageit þ b 7 Currit þ b 8 Intangibilityit
X X
þ b 9 Big4it þ ðYear Effects Þit þ ðIndustry Effects Þit þ « it (2b)

where i is the specific firm, t indicates the reference year and « it stands for the regression
error.

5. Results and discussion

This section presents the descriptive statistics of the variables defined in Section 4, followed
by the univariate correlation matrix and the discussion of the results from the multivariate
analysis.

5.1 Descriptive statistics

Table 2 shows that the average value of the amount of disclosed KAMs is about two (with a
median value of 2), though there are firms with no KAMs in their audit reports and, on the
other end, others disclosing up to 7 KAMs.
Moreover, Table 2 highlights that 153 of 354 firm-year observations (about 43.2%) have a
high quality and sustainable corporate governance system and that 319 of the 354 firm-year
observations (approximately 90%) use one of the big four audit firms.

Table 2 Descriptive statistics

Variable Obs Min Max Mean Median Std dev

No_KAM 354 0 7 2.046 2 1.167

CG_Score 153 – – – – –
Size 354 16.257 25.831 20.400 20.174 1.911
ROA 354 83.75 20.85 3.310 4.56 10.593
TobinsQ 354 0.002 5.043 0.773 0.495 0.855
Leverage 354 0.123 1,033.3 6.569 1.389 67.21
Curr 354 0.001 0.991 0.496 0.495 0.197
Intangibility 354 0 0.723 0.219 0.185 0.181
Big4 319 – – – – –

VOL. 22 NO. 1 2022 j CORPORATE GOVERNANCE j PAGE 203

 5.2 Univariate analysis
Table 3 provides the Pairwise correlations matrix for all variables. Contrary to our
expectation, the amount of the disclosed KAMs (No_KAM) is significantly and positively
correlated with the quality of corporate governance (CG_Score).
However, consistent with the assumption discussed in the previous section, it is important to
note that there is a significant and positive correlation between Size and CG_Score and
between the former and the dependent variable of our empirical model (No_KAM). Thus,
larger companies present a better quality of corporate governance, strengthening the
reasoning behind the second empirical model (Model 2b).
As expected, we detected a positive correlation between the variable Intangibility; and the
dependent variable of our model. Instead, the ROA, the current ratio (Curr) and the TobinsQ
negatively impact the number of disclosed KAMs.

5.3 Empirical results and discussion

After controlling for a set of variables that influence the audit process and the firm’s specific
perceived risk, Model 2a and Model 2b allow assessing how the corporate governance
characteristics affect the amount of KAMs disclosed within the audit report.

Table 3 Univariate correlations matrix

Variable ID Variable (1) (2) (3) (4) (5) (6) (7) (8) (9)

(1) No_KAM 1.000

(2) CG_Score 0.270 1.000
(3) Size 0.447 0.363 1.000
(4) ROA 0.107 0.149 0.316 1.000
(5) TobinsQ 0.245 0.086 0.101 0.280 1.000
(6) Leverage 0.049 0.050 0.001 0.182 0.053 1.000
(7) Curr 0.223 0.270 0.443 0.080 0.155 0.061 1.000
(8) Intangibility 0.224 0.205 0.231 0.092 0.034 0.071 0.512 1.000
(9) Big4 0.038 0.060 0.388 0.293 0.146 0.008 0.088 0.058 1.000

Note: indicates a significance level under 0.1

Table 4 Multivariate analysis

Dependent variable: Model 2a Model 2b
No_KAM Coeff. t-stat P > jtj Coeff. t-stat P > jtj

Intercept 2.084 3.10 0.002 0.768 0.87 0.384

CG_Score 0.142 1.36 0.099 2.072 2.15 0.034
Bigger_CGScore 0.109 2.32 0.022
Size 0.150 4.95 0.000 0.082 1.92 0.057
ROA 0.012 2.05 0.043 0.011 1.76 0.082
TobinsQ 0.072 1.33 0.185 0.081 1.50 0.137
Leverage 0.001 5.14 0.000 0.001 4.32 0.000
Curr 0.242 0.76 0.447 0.162 0.53 0.594
Intangibility 0.556 2.33 0.021 0.539 2.32 0.022
Big4 0.114 0.64 0.526 0.086 0.49 0.623
Year effects Included Included
Industry effects Included Included
R2 0.3641 0.3873
F-value 10.46 8.72
Prob. > F 0.0000 0.0000
Root MSE 0.4743 0.4663
No. of observations 354 354
No. of groups 118 118

PAGE 204 j CORPORATE GOVERNANCE j VOL. 22 NO. 1 2022

In particular, Model 2a reveals a positive, although marginally significant relationship (jtj =
1.36/pv = 0.099), between the quality of corporate governance (CG_Score) and the number
of disclosed KAMs (No_KAM). This result so oddly highlights that companies with strong
corporate governance mechanisms tend to be riskier and, consequently, to have more
KAMs emerging from the audit process. Such a result appears to be inconsistent with both
the previous microstructure literature and the expectations arising from the IAASB’s
recommendations, underling the need for an interaction between the auditor and the client’s
corporate governance to disclose the KAMs adequately.
However, the model finds a positive and strongly significant relationship between the
No_KAM and the firm size (jtj = 4.95/pv = 0.000). The result confirms that bigger companies
have a greater complexity that affects the audit process through higher perceived riskiness
(Pinto and Morais, 2019).
As for the other control variables, Model 2a highlights a positive relationship between
Intangibility and the No_KAM and a negative relationship between the latter and Leverage
and ROA.
Thus, the hypothesis, according to which there is an inverse relationship between an
effective and sustainable corporate governance system and the amount of disclosed KAMs,
should be rejected, as the preliminary empirical evidence provides for an inverse
relationship between the quality of corporate governance and the number of KAMs.
Such a conclusion, however, could consider just one side of the ledger. It has been argued
that the quality of internal corporate governance is highly related to the firm’s overall size
and complexity, with the latter affecting the perceived riskiness of a company and, in turn,
the KAMs disclosed in the audit report (Pinto and Morais, 2019). Indeed, when we consider
the moderating role of a firm’s overall complexity on the relationship between sustainable
corporate governance and the number of disclosed KAMs, reversed outcomes are
obtained, consistent with the previous preliminary literature.
Specifically, findings from Model 2b show a negative and strongly significant relationship
between the quality of corporate governance and the number of disclosed KAMs (jtj = 2.15/
pv = 0.034). Notwithstanding, a positive and significant correlation between Bigger_CGScore
and No_KAM (jtj = 2.32/pv = 0.022) confirms that the impact of the quality of corporate
governance on the number of disclosed KAMs can be influenced by the mediating role of a
firm’s overall complexity and riskiness, as reported by Pinto and Morais (2019).
Therefore, the negative and significant relationship between the quality of corporate
governance and the number of KAMs obtained from Model 2b highlights a positive
incremental effect of a sustainable corporate governance per se in mitigating a firm’s
perceived riskiness and, consequently, in reducing the number of disclosed KAMs.
In addition, to assess the full effect of the quality of corporate governance per se on the
number of KAMs, we perform the parametric test of Wald on ( b 1 þ b 2) from Model 2b. The
sum of these coefficients is negative (1.963) and statistically significant (F = 4.59, Prob >
F = 0.034), confirming the hypothesis according to which a sustainable corporate
governance system comes with lower perceived riskiness and fewer KAMs. Therefore, this
study assumes that the whole set of characteristics of the internal corporate governance
affects the amount of disclosed KAMs.
As far as it concerns the control variables, Model 2b’s results are the same as discussed for
Model 2a.
Overall, the combined evidence from Model 2a and Model 2b leads to accepting the
hypothesis. The number of disclosed KAMs tends to decrease for firms having a high-
quality and sustainable corporate governance system.

VOL. 22 NO. 1 2022 j CORPORATE GOVERNANCE j PAGE 205

 These results, on the one hand, are consistent with both the literature concerning the impact of
corporate governance characteristics on the audit process (Cohen et al., 2002; Sharma et al.,
2008) and the existence of a relationship between corporate governance characteristics and
KAM disclosure (Velte, 2018; Velte, 2019). On the other hand, as far as we know, this is the
first study that identifies corporate governance as a determinant among the studies that focus
on the amount of disclosed KAMs. In this regard, our results add new evidence, proving that
the client corporate governance could affect the number of disclosed KAMs.

6. Concluding remarks, limitations and future research

This paper investigates whether the quality of corporate governance affects the amount of
disclosed KAMs in a sample of Italian non-financial listed firms from 2017 to 2018.
Calls for research on board composition, corporate governance sustainability and auditor
reporting stemmed from regulators, practices and researchers and increased after the
financial crisis of 2008/2009. The IAASB, through the establishment of the ISA Italia 701, has
implemented KAM disclosures as new content of the audit report for listed companies with
fiscal years beginning on or after June 17, 2016. According to the new standard, the audit
opinion must contain company-specific information about the most significant risks of
material misstatement, the application of materiality and the audit’s scope. In particular, it
has been established the KAMs section in the audit report aiming to provide investors with
more information about the audit and accompanying financial statements. Specifically, the
IAASB providing the KAMs’ definition, assert that: KAMs are, in all cases, a selection of
matters communicated with those charged with governance (IAASB, 2015: ISA 701, p. 8).
As there is an extensive literature concerning the impact of corporate governance
characteristics on the audit function, we assumed that high quality and sustainable
corporate governance system has a beneficial effect on the perceived riskiness of an entity
and, consequently, on the number of KAMs arising from the audit process.
After controlling for a set of variables that could affect the audit function and for the mediating
role played by the overall business complexity (as proxied by the firm size), we found that high
quality and sustainable corporate governance firms tend to disclose fewer KAMs.
By analyzing a still unexplored topic, this study contributes to recent empirical corporate
governance and audit debate by adding new evidence on the role of internal corporate
governance characteristics on the audit process. To the best of our knowledge, this is the first
study to provide a comprehensive analysis relative to the whole set of characteristics of
sustainable corporate governance on the perceived riskiness of a firm during the audit report
and, in turn, on the disclosed KAMs.
Indeed, previous studies focus on the auditor characteristics or some firm-specific features
as a determinant of KAMs. Still, none of them considers the combined effect of the whole
corporate governance structure, controlling for a firm’s overall complexity. Therefore, this
paper offers new insights on the role of internal corporate governance systems in fostering
the sustainability of business entities by enhancing transparency, trust and market
confidence that led to the wealth of shareholders and several other stakeholders. Finally,
this study presents several practical and theoretical implications, as its findings are
doubtless of interest for practitioners and regulators. In particular, our findings reveal that
corporate governance attributes influence KAM disclosure, so they are useful to standard
setters in identifying the factors that influence the amount of KAMs. Moreover, as results
show that a higher corporate governance quality eases the relationship between auditor
and client and, in turn, improves the audit process, this study offers regulators valuable
insight to foster the enforcement of better corporate governance rules. Finally, it gives
managers a better understanding of the critical factors that influence the processes behind
the auditors’ decisions to disclose KAMs.

PAGE 206 j CORPORATE GOVERNANCE j VOL. 22 NO. 1 2022

However, this study also comes with some potential caveats to be addressed in future research.
First, it focuses only on one country; thus, we intend to overcome this limitation by enriching the
empirical evidence with a cross-country analysis. Second, it relies on a limited reference period
because of the recent introduction of its topic, implying a relatively small sample size. Regarding
this aspect, in future research, we intend to repeat the analysis referring to a more extended time
series to rely on a more significant number of observations and to reach more reliable results.
Finally, as this paper analyze the role of the whole corporate governance system in its entirety,
we intend to examine the impact of specific corporate governance characteristics on the new
audit report and, in particular, on the KAMs.

Note
1. The audit process can be divided into two macro phases, which are the planning and the execution.
The planning phase consists of the client engagements and the planning of specific audit. The latter, in
turn, is divided into the risk assessment and the program planning ( Bierstaker et al.,2006).

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International Auditing and Assurance Standards Board (IAASB) (2013a), “A framework for audit quality”,
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Corresponding author
Pietro Fera can be contacted at: pietro.fera@unicampania.it

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