In recent years, the International Auditing and Assurance Standards Board (IAASB) has considered the issue of auditing disclosures in financial statements, prompted by a number of factors including developments in IFRS requirements and the increased level of complexity and subjectivity involved in the preparation of information to be disclosed in financial statements. This article examines this issue, and reminds candidates to review the examinable documents list for guidance.
Disclosures in financial statements
Auditors are required to express an opinion on the financial statements as a whole. This includes the notes to the financial statements which are an integral part of the accounts, providing additional information on balances and transactions and other relevant information. Therefore, it is important that during all stages of the audit the auditor gives appropriate consideration to, and plans to obtain sufficient and appropriate audit evidence in relation to the disclosures made in the notes to the financial statements.
ISA 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International Standards on Auditing specifies that the financial statements include related notes which ‘comprise a summary of the significant accounting policies and other explanatory information’.
The notes to financial statements contain different types of information, some quantitative and some qualitative, as required by IFRS. Some examples are given below:
- Disaggregation and analysis of balances and transactions included in the financial statements, for example of property, plant and equipment, intangible assets, provisions, lease obligations, financial instruments.
- Segmental analysis of revenue, profit and certain other items, and information about major customers (for listed companies).
- Summarised financial information in relation to associates and joint ventures.
- Descriptions of significant accounting policies and areas where critical accounting judgement has been exercised, and rationale for any changes in accounting policies.
- Confirmation that the going concern assumption is appropriate, or discussion of significant doubt over going concern.
- Information on related parties, and related party transactions.
- Explanation of impairment losses recognised in the year.
- Discussion of areas of risk, for example those relating to financial instruments.
A key driver for the IAASB’s consultation and the exposure draft, Addressing Disclosures in the Audit of Financial Statements, issued in May 2014, is that in recent years, IFRS requirements in relation to disclosures in the notes to financial statements have become more onerous. The exposure draft states that ‘over the past decade, financial reporting disclosure requirements and practices have evolved. They now provide more extensive decision-useful information that is more detailed and often deals with matters that are subjective such as assumptions, models, alternative measurement bases and sources of estimation uncertainty. As these financial reporting disclosures continue to evolve, challenges have arisen for preparers and auditors in addressing new types of quantitative and non-quantitative information’.
The challenges for auditors
Risk of irrelevant disclosures and determining materiality
The IAASB is concerned that in some financial statements excessive disclosure is being provided, sometimes of immaterial matters that do not need to be disclosed. This makes it difficult for the reader of the financial statements to focus on the important matters due to the ‘information overload’. This is a difficult area for the auditor because often judgement is needed to decide whether or not a matter should be disclosed. Companies might prefer to provide too much information rather than too little, in the aim of full transparency, but end up providing irrelevant or unnecessary disclosures which obscure the rest of the information included.
Linked to the point above, it can be very difficult to apply materiality to disclosures, especially those of a quantitative nature. The IAASB has considered whether additional guidance should be given to auditors to help them to determine whether qualitative disclosures are material or not by making a preliminary determination at the planning stage of the audit of those disclosures that could reasonably be expected to influence the economic decisions of users. This would help the auditor to better identify disclosures material by their nature or their monetary value, and to plan appropriate audit procedures.
Sources of information
A key concern of the IAASB is that the information included in the notes to the financial statements, whether quantitative or qualitative in nature is derived from systems and processes that are not part of the general ledger system. Examples could include, forward looking statements, descriptions of models used in fair value measurements, descriptions of risk exposures and other narrative disclosures. This gives rise to several potential problems to the auditor, and respondents involved in the IAASB’s consultations noted that this issue poses some of the most challenging aspects of preparing and auditing disclosures.
One problem is whether the system or process from which information is derived, when it is outside of normal accounting processes, has any internal control to provide assurance on the completeness, accuracy and validity of the information. For example, information on financial instruments may be provided by a company’s treasury management function, which could have very different systems and procedures to the accounting function, with a different level of control risk attached. The systems and controls may be deficient, creating higher audit risk. This may particularly be the case when dealing with one-off disclosures, for example in relation to the situation causing an impairment loss. In some cases, due to lack of the documentation that would normally be expected for more routine transactions or events captured by the accounting system, it may be difficult to obtain sufficient, appropriate audit evidence on disclosures.
The IAASB notes that often disclosures are prepared by management very late in the audit process. Often, when the auditor is planning the audit, draft disclosures are not available, so it is not possible for the auditor to plan the audit of disclosures until much later in the audit process. This could lead to higher audit risk in that there may not be much time to assess the risk relating to disclosures and to perform the necessary audit procedures. This is especially the case where disclosures are complex, for example in relation to financial instruments, or subjective, for example in relation to fair value measurement.
The IAASB proposals
The IAASB has proposed additional guidance to help establish an appropriate focus on disclosures in the audit and encourage earlier auditor attention on them during the audit process. There is also a proposal to amend the definition of financial statements contained in the ISAs, to ensure an appropriate emphasis on the importance of disclosures as part of the financial statements.
Proposed changes to the ISAs include new application material to:
- Amend the term ‘financial statements’ as used in the ISAs to include all disclosures subject to audit and to include that such disclosures may be found in the related notes, on the face of the financial statements, or incorporated by cross-reference as allowable by some financial reporting frameworks.
- Emphasise the importance of giving appropriate attention to, and planning adequate time for addressing disclosures in the same way as classes of transactions, events and account balances, and early consideration of matters such as significant new or revised disclosures.
- Focus auditors on additional matters relating to disclosures that may be discussed with those charged with governance, in particular at the planning stage of the audit.
- Emphasise that, when agreeing the terms of engagement, the auditor should emphasise management’s responsibility, early in the audit process, to make available information relevant to disclosures.
- Provide additional examples of misstatements in disclosures to highlight the types of misstatements that may be found in disclosures, and to clarify that identified misstatements, including those in disclosures and irrespective of whether they occur in quantitative or non-quantitative information, need to be accumulated and evaluated for their effect on the financial statements.
In terms of specific planning considerations, the IAASB recommends improvements to some aspects of risk assessment and materiality determination in order to encourage a more robust risk assessment relating to disclosures:
- Expanding the guidance on matters to consider when the auditor is obtaining an understanding of the entity and its environment, including the entity’s internal control, and assessing the risks of material misstatement for disclosures, including materiality considerations for non-quantitative disclosures.
- Highlighting disclosures, including examples of relevant matters, for consideration during the discussion among the engagement team of the susceptibility of the entity’s financial statements to material misstatement, including from fraud.
- Integrating the separate category for assertions relating to presentation and disclosure into the categories for account balances and transactions to promote their more consistent and effective use.
- Acknowledging, and giving prominence to, disclosures where the information is not derived from the accounting system, and related considerations pertaining to this source of audit evidence.
- In relation to materiality, clarifying that the nature of potential misstatements in disclosures, in particular non-quantitative disclosures, is also relevant to the design of audit procedures to address the risks of material misstatement.
The IAASB has acknowledged that while disclosures have an increased prominence in financial statements, the audit of disclosures is difficult for a number of reasons. Through a process of public consultation, the IAASB has proposed additional guidance in this area, which should provide auditors with practical guidance and serve to reduce audit risk.
Written by a member of the P7 examining team