The impact of the new auditor’s report
13 July 2015
Auditors play an important role in the financial reporting chain as an independent assurance provider to investors.Despite auditors having significant insight into the audited entity, the auditor’s report is written in boiler-plate language which does not share such knowledge beyond a binary pass/fail audit opinion. Regulators and investors alike expressed a need to be able to learn more about the entity by peeking through the eyes of the auditor.
As a result, international regulators such as the Public Company Accounting Oversight Board in the United States and the European Commission undertook auditor reform projects,
one element thereof being to consider enhancements to the auditor’s report. The International Auditor and Assurance Standards Board (IAASB) followed suite and recently issued its
final standards to improve the auditor’s report issued under International Auditing Standards (ISA). Boards, their audit committees and entity CFOs need to know what is changing, as these changes will affect us. The two most pertinent changes are as follows.
Reporting on key audit matters (KAM)
In future, effective for auditors of financial statements for periods ending on or after 15 December 2016, the auditor’s report of listed entities will include a section on key audit matters (KAM). KAM is defined as those matters that, in the auditor’s professional judgement, were of most significance in the audit of the financial statements of the current period. In determining
KAM the auditor will consider the areas of higher assessed risk of material misstatement, areas that require significant auditor and management judgement (for instance where accounting
estimates are used), as well as the effect of significant events or transactions that occurred during the year on the audit.
Note that the KAM disclosure is only required for listed entities. Auditors of other entities can disclose KAM on a voluntary basis, but interaction at a planning stage with the audit committee is important.
How will the KAMs affect audit committees and CFOs?
First, audit committee members should remember that the KAMs that the auditor will be reporting will be selected from the list of matters that the auditor will be discussing with the audit
committee. So there should be no surprises.
KAMs are intended, though, to focus on the audit and give further useful information in respect thereof to assist the reader to better understand the entity. KAM is not intended to supply
original information about the entity. It is the role of management to provide adequate and transparent disclosure in the financial statements on the entity, its activities and transactions.
However, instances can arise where the auditor believes that a matter relating to the audit (for example, consideration of the possible impairment of a business unit, ultimately resulting in
no impairment write-off), is one of the most significant matters that he experienced during the audit and should be disclosed as a KAM, but the entity holds a different view. To expand on the
example, the decision to impair or not could be an important area where the audit identified the risk of material misstatement in the financial statements. Management, on the other hand, in
light of the fact that the auditor was ultimately comfortable with the decision not to impair, might prefer to provide no disclosure in the financial statements in this regard. The auditor disclosing
the matter as a KAM could result in investors questioning why the financial statements did not provide transparency on the matter.
Herein lies the crux of the difficult debates that could take place between auditors, CFOs and audit committees. The ethics and attitude of the entity’s decision-making and governance
structures towards transparency will play a key role in determining how easy or difficult these discussions will be.
A consequential benefit of KAM disclosures might, therefore, be that a preparer of financial statements with a low appetite for transparent and honest disclosure might be encouraged to
increase this appetite, knowing that his independently minded auditor, in exercising his professional judgement in making KAM disclosure decisions, will act in the best interest of the
shareholders who appointed him.
Going concern disclosures in the auditor’s report
As part of the changes to the auditing standards, the auditor will have to raise certain going concerns flags in the auditor’s report in future. These are in the following instances:
• If management used the going concern basis of accounting inappropriately in preparing the financial statements, the auditor should express an adverse audit opinion.
• Also, if management did not adequately disclose information about material uncertainties, the auditor should express a qualified or adverse option and state in the basis for the qualification that material uncertainties existed that may cast significant doubt on the entity’s ability to continue as a going concern, and that the financial statements do not adequately disclose such matters.
• Where a material uncertainty exists, which has been adequately disclosed by the entity, the auditor’s report must include a paragraph to this effect.
Before these enhancements, it was virtually inconceivable that an auditor would flag a going concern issue, even though a vehicle for this existed under the previous auditor reporting standards regime. Even when an auditor flagged a going concern (the occurrence of which can only be described by directly translating from Afrikaans, as being ‘as scarce as chicken teeth’), the ‘clean’ audit opinion was unaffected by the going concern flag.
It is important to note that the going concern requirements are not just applicable to the audit of listed entities, but on all audits performed in terms of ISA.
How will the going concern requirements affect audit committees and CFOs?
In instances where an entity’s going concern status is questionable due to material uncertainties that exist, extensive discussion would always have taken place between the auditor, CFO and audit committee. Such discussions will most likely intensify in future due to the requirement for auditors to modify the audit opinion in this regard.
This is an important enhancement to the auditor’s report which dovetails with the Companies’ Act requirement applicable to directors in so far as their fiduciary duties are concerned, relating to going concern and the application of the solvency and liquidity test.
Benefits of the auditor reporting changes
The overarching benefit intended by these changes to the auditor’s report is the enhancement of communication between auditors, investors, audit committees and boards.
The article has already explored the envisaged improvement in both auditor- and entity-behaviour. Auditors will have a renewed focus on matters to be reported as KAM, which should increase their levels of professional scepticism. Preparers of financial statements, on the other hand, should give stronger attention to matters that auditors will be highlighting in KAM in cross-reference to financial statement disclosure, which will enhance the transparency of financial statements as a whole.
These changes also serve investor and, hence, the public interest, as the enhanced transparency, higher audit quality and an improved informative value of both the financial statements and the auditor’s report can only increase market confidence.
The benefits of the changes clearly outweigh the teething problems that auditors, audit committees and CFOs will have to go through to streamline the implementation thereof. It will
serve all of these parties well, however, to pro-actively consider the impact of the new requirement and, ideally, to do a dry run of KAMs, in the run-up to the effective date.