Comments by auditors immediately following the global financial crisis that they had had a ‘good’ crisis – referring to the absence of pertinent audit failures – begged the question as to the relevance of the audit and, more particularly, the auditor’s report. By Linda de Beer
Auditors play an important role in the financial reporting chain and are a key assurance provider for investors. However, if their reports are seemingly inconsequential in instances of corporate and bank failures that resulted in significant shareholder and stakeholder value erosion, change is inevitable.
As a result international regulators such as the Public Company Accounting Oversight Board (PCAOB) in the United States (US) and in the European Commission (EU) undertook projects to consider the relevance of the auditor’s report and the need for change. The International Auditing and Assurance Standards Board (IAASB), who sets International Standards on Auditing (ISA), followed suit and soon took the lead in this important project.
The IAASB issued its final standards to improve the auditor’s report on 15 January 2015.
THE AUDITOR’S INFORMATION GAP CREATED THE NEED FOR CHANGE
The assessment of the financial crisis in so far as corporate failures and the value of an audit are concerned, resulted in regulators and investors recognising that auditors have significant insight into the audited entity. However, the auditor’s report is written in standardised boilerplate language that does not provide any insight into this auditor knowledge of the entity other than a binary pass/fail opinion. This is not a matter of the auditor having to do more work, but merely giving insight into the work already done. Some investors expressed the need to be able to see the underlying entity through the eyes of the auditor. This is referred to us the auditor’s information gap.
Such a discussion automatically falls back to the age-old debate on the expectation gap – the gap between what some expect to gain from an audit (inter alia confirmation on the viability of the entity’s business model, its compliance with laws and the state of its governance, as well as the absence of fraud, in addition to the absolute accuracy of its financial statements) versus the actual assurance given by the auditor (a confirmation that the financial results and position in the financial statements is a fair reflection and thus reliable).
Reporting the auditor insights via the auditor’s report, and hence having a peek into the entity through the eyes of the auditor, runs the risk of extending the scope of the audit – not only to expand the auditor’s report but also to reduce the expectation gap, as it might be argued that auditors might have to do more work and/or that audit fees must increase. Post the financial crisis there was very little appetite for increased audit fees. Also, there was a recognition that changes were meant to address the information gap and not the expectation gap.
The IAASB’s project was therefore specifically scoped to enhance auditor reporting within the existing scope of the audit – thus the auditor’s work effort will not be expanded. It was merely an attempt to report on the work that was already performed by auditors, thus enhancing the communicative value of the auditor’s report.
WHAT WILL CHANGE?
Reporting on key audit matters
In future, effective for audits 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). A new auditing standard, ISA 701 (Communicating Key Audit Matters in the Independent Auditor’s Report), has been issued to give effect to this.
KAM are 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 under audit.
As KAM are meant to focus on the audit and give further useful information in respect of the audit to assist the reader to understand the entity better, they are 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 its transactions. The auditor’s role is to give assurance as to whether the financial statements prepared by management are a fair presentation.
This risk of the auditor being the originator of information via KAM was a concern initially raised by preparers of financial statements. A consequential future benefit of the KAM requirement might be that as management know that KAM will be reported, a reluctant preparer might be encouraged to consider and improve the transparency of the entity’s financial information.
Investors indicated that KAM should not be used to provide information overload on audit procedures and processes. The ‘so what’ question should be answered in the disclosure of a KAM.
Initially KAM will only be a requirement for listed entities. However, any auditor can elect to disclose KAM, but would obviously discuss that with the audit committee in the planning stages of the audit. Over time, experience and benefits will dictate whether the KAM requirement gets extended to the audits beyond those of listed entities.
Ideally investors would have liked to see every audit report making a positive statement as to whether the entity was correct in applying the going concern assumption in preparing the financial statements; as well as whether any material uncertainties exist that might threaten the going concern of the entity.
Unfortunately, the final changes to the ISAs did not go that far, mainly because the financial reporting standard-setters (such as the setters of International Financial Reporting Standards (IFRS) and US reporting standards) first needed to get their houses in order in enhancing financial reporting requirements regarding going concern.
The ISA changes require that, if management used the going concern basis of accounting inappropriately in preparing the financial statements, the auditor should express an adverse audit opinion. It further requires that, if management did not adequately disclose information about a material uncertainty, the auditor should express a qualified or adverse option and state in the basis for the qualification that material uncertainty exists 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. However, if management provided adequate disclosure about the material uncertainty, the auditor will give a clean opinion but alert users to the material uncertainty disclosed by management. This will be done under a separate heading in the auditor’s report to ensure that it is prominent.
It is important to note that the going concern requirements are not just applicable to the audit of listed entities but to all audits performed in accordance with ISA.
Communication with audit committees
Management and audit committees (‘those charged with governance’) have a vested interest in knowing which matters are of most significance to the auditor. Therefore, it would be counter-productive for investors if there is a disconnect between what the auditor reports as KAM and the level of information that the entity provides on the matter, or even worse, if the auditor reports a KAM and management or the audit committee is of the view that the matter is of no significance. To this end the ISA standard that deals with ‘communication with those charged with governance’ have been strengthened to ensure early and ongoing communication between the auditor and the audit committee.
However, it is the auditor’s prerogative to decide what should be reported as KAM. This cannot be changed or overruled either by management or by the audit committee, as it would not be in the public interest.
A few other changes
The auditor’s opinion will move right to the top of the report to enhance its prominence. There is now a requirement in ISA that the engagement partner’s name must be disclosed. This is of little significance in South Africa and many other countries, where such a disclosure requirement is embedded in law. However, it is new to some jurisdictions, notably in North America.
The auditor’s report must make reference to the relevant ethical requirements that related to the audit.
A significant consequential change is the clarification of the auditor’s reporting requirement for other information that accompany the financial statements (in South Africa, typically the integrated report). Previously the auditor’s report was silent as to whether the other information was audited, read, reviewed or not considered at all by the auditor. In future, the auditor’s report will clarify the work effort on such information beyond the financial statements.
INTENDED BENEFITS OF THE CHANGES
The IAASB lists a number of intended benefits of the auditor reporting project. These are primarily the enhancement of communication between auditors and investors, as well as between auditors and audit committees (‘those charged with governance’).
In addition, it is envisaged that both auditor and entity behaviour will improve. Auditors will have a renewed focus on matters to be reported as KAM, which should increase their levels of professional scepticism. On the other hand the preparers of financial statements would possibly 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.
All of this should serve the public interest through enhance transparency, higher audit quality and the improved informative value of both the financial statements and the auditor’s report, which in turn leads to increased user confidence in auditor reports and financial statements.
Some might be of the view that these changes to the auditor’s report were unnecessary and will increase audit fees, despite an objective not to do so. The investor groups that participate in the IAASB’s Consultative Advisory Group, such as the CFA Institute and the International Corporate Governance Network, argue that these changes are non-negotiable.
The changes made by the IAASB to the ISAs to enhance the communication value of the auditor’s report represent a significant step forward to enhance the value of the audit and the confidence in corporate reporting.
Linda de Beer CA(SA), Chartered Director (SA), is chairman of the Consultative Advisory Group of the IAASB