Candidates preparing for P7, Advanced Audit and Assurance will be aware that the auditor’s report is the key output of the audit process, used to communicate primarily with the shareholders of the audited entity, as well as other stakeholders.
Recently, there have been some considerable changes in the requirements relating to auditor’s reports, with the regulatory bodies issuing new and revised International Standards on Auditing and other supplementary guidance.
The objective of this article is to outline the key changes, focusing on the new requirements relating to the Key Audit Matters paragraph for P7 International candidates, and Extended Auditor Reporting for P7 UK and Ireland candidates. It should be read in conjunction with the article entitled ‘The new auditor's report’ (see ‘Related links’), which is relevant for both F8 and P7 students and serves as an introduction to the issue.
The detail of the changes outlined below in relation to Key Audit Matters are relevant to P7 (INT) candidates from the September 2016 exams onwards.
P7 UK and Ireland candidates should note that the UK’s Financial Reporting Council (FRC) did not adopt the new ISA requirements into UK standards until June 2016, therefore ISA 701 (UK and Ireland) will not become a UK and Irish examinable documents until September 2017. However, candidates should be aware that the FRC Invitation to Comment on the IAASB Exposure Draft Reporting on Audited Financial Statements: Proposed new and Revised International Standards on Auditing, which includes the original proposals of the ISA 701 requirements, is examinable as a current issue in the exam year commencing September 2016.
Further, candidates sitting the UK exam are expected to understand the Extended Reporting requirements that are expected in the UK and these are discussed below.
Background to the changes to IAASB standards in relation to Key Audit Matters
In 2015 the IAASB issued a range of changes to auditor reporting, with the objective of enhancing auditor’s reports for investors and other users of financial statements. According to the IAASB, research and public consultations indicate that enhanced auditor reporting is critical to influencing the perceived value of the financial statement audit. The auditor’s report is the key deliverable communicating the results of the audit process. Investors and other financial statement users have asked for a more informative auditor’s report—in particular for auditors to provide more relevant information to users.
The IAASB suggests that the intended benefits of enhanced auditor reporting include the following:
- Enhanced communication between auditors and investors, as well as those charged with corporate governance.
- Increased user confidence in auditor’s reports and financial statements.
- Increased transparency, audit quality, and enhanced information value.
- Increased attention by management and financial statement preparers to disclosures referencing the auditor's report.
- Renewed auditor focus on matters to be reported that could result in an increase in professional scepticism.
- Enhanced financial reporting in the public interest.
Thus, the changes should be viewed not just as a development affecting individual financial statement audits, but as a move to enhance audit quality generally, which in turn will improve the credibility of financial reporting and the audit profession.
Key Audit Matters
ISA 701, Communicating Key Audit Matters in the Independent Auditor’s Report is a new standard that is required to be applied to the audit of all listed entities. According to ISA 701, the purpose of communicating key audit matters (KAM) is ‘to enhance the communicative value of the auditor’s report by providing greater transparency about the audit that was performed. Communicating key audit matters provides additional information to intended users of the financial statements to assist them in understanding those matters that, in the auditor’s professional judgment, were of most significance in the audit of the financial statements of the current period. Communicating key audit matters may also assist intended users in understanding the entity and areas of significant management judgment in the audited financial statements’.
It may be helpful to review the definition of KAM from ISA 701: ‘Those matters that, in the auditor’s professional judgment, were of most significance in the audit of the financial statements of the current period. Key audit matters are selected from matters communicated with those charged with governance’.
Determining Key Audit Matters
ISA 701 requires the auditor to include in the KAM paragraph those matters that required the most significant auditor attention in performing the audit. Thus, when preparing an auditor’s report for listed entities, the auditor will need to carefully select the matters that should be communicated in the KAM paragraph. This is likely to require the use of significant judgement in order for the auditor’s report to contain information on the matters that are most relevant to the intended users of the report, while avoiding information overload, which could obscure the important messages contained in the KAM paragraph.
There are three types of matter, according to ISA 701, which should be considered when determining key audit matters. All of these should have been communicated to those charged with governance as part of the audit process.
- Areas of higher assessed risk of material misstatement, or significant risks identified.
During the audit, especially at the planning stage, the auditor will identify risks of material misstatement. A significant risk as an identified and assessed risk of material misstatement that, in the auditor’s judgment, requires special audit consideration. Significant risks, including areas of management judgement and significant unusual transactions are often areas that require significant auditor attention, and thus should be considered for inclusion in the KAM paragraph.
- Significant auditor judgments relating to areas in the financial statements that involved significant management judgment, including accounting estimates that have been identified as having high estimation uncertainty.
Critical accounting estimates and related disclosures are likely to be areas of significant auditor attention and may be identified as significant risks. This could include, for example, fair value estimates in relation to financial instruments, estimates relating to the measurement of provisions, impairment and the recoverability of assets.
- The effect on the audit of significant events or transactions that occurred during the period.
This could include a one-off transaction or event within the reporting entity that has required significant auditor attention, for example the acquisition of a significant subsidiary within a group. In addition, significant economic, accounting, regulatory, industry, or other developments that affected management’s assumptions or judgments may also affect the auditor’s overall approach to the audit and result in a matter requiring significant auditor attention.
Given the multitude of matters that can arise during the audit process, the auditor may find that there are many matters that potentially could be included in the KAM paragraph. The auditor may need to prioritise the matters in order to ensure that, as required by ISA 701, it is the matters of most significance that are reported as KAM. ISA 701 explains that the concept of matters of most significance is applicable in the specific context of the entity and the audit that was performed. As such, the auditor’s determination and communication of key audit matters should identify matters specific to the audit and to involve making a judgment about their importance relative to other matters in the audit.
Specificity is therefore a key issue, and vague or boiler-plate disclosures are not in keeping with the requirements or spirit of the standard.
ISA 701 therefore gives further guidance on determining significance and whether a matter should be reported as a key audit matter:
- The importance of the matter to intended users’ understanding of the financial statements as a whole, and in particular, its materiality to the financial statements.
- The nature of the underlying accounting policy relating to the matter or the complexity or subjectivity involved in management’s selection of an appropriate policy compared to other entities within its industry.
- The nature and materiality, quantitatively or qualitatively, of corrected and accumulated uncorrected misstatements due to fraud or error related to the matter, if any.
- The nature and extent of audit effort needed to address the matter, including the extent of specialized skill or knowledge needed to apply audit procedures to address the matter or evaluate the results of those procedures, if any.
- The nature of consultations outside the engagement team regarding the matter.
- The nature and severity of difficulties in applying audit procedures, evaluating the results of those procedures, and obtaining relevant and reliable evidence on which to base the auditor’s opinion, in particular as the auditor’s judgments become more subjective.
- The severity of any control deficiencies identified in relation to the matter.
- Whether the matter involved a number of separate, but related, auditing considerations. For example, long-term contracts may involve significant auditor attention with respect to revenue recognition, litigation or other contingencies, and may have an effect on other accounting estimates.
ISA 701 does not state a particular number of key audit matters that should be communicated, discussing that the volume of disclosure will be affected by the size and complexity of the entity, the nature of its business and environment, and the facts and circumstances of the audit engagement. The standard is very clear in stating that ‘lengthy lists of key audit matters may be contrary to the notion of such matters being those of most significance in the audit’, requiring the use of professional judgement in prioritisation of matters to be communicated within the KAM paragraph.
Communicating Key Audit Matters
ISA 701 requires that the description of each key audit matter in the auditor’s report shall include a reference to the related disclosure(s), if any, in the financial statements and shall address:
- why the matter was considered to be one of most significance in the audit and therefore determined to be a key audit matter, and
- how the matter was addressed in the audit.
Though there is not a specific requirement in terms of placement of the KAM paragraph within the auditor’s report, ISA 701 does comment that placement of the KAM paragraph ‘in close proximity to the auditor’s opinion may give prominence to such information and acknowledge the perceived value of engagement-specific information to intended users’. Thus, the auditor may need to use judgement in deciding on the best position of the KAM paragraph.
The ordering of items within the KAM paragraph itself is also a matter of professional judgement. ISA 701 suggests that the information may be organized in order of relative importance, based on the auditor’s judgment, or may correspond to the manner in which matters are disclosed in the financial statements.
In deciding the amount and nature of description of each item within the KAM paragraph, the auditor is required to use their professional judgement, in order to ensure that each matter is adequately described in an understandable way.
The description of each key audit matter should be a succinct and balanced explanation to enable intended users to understand why the matter was one of most significance in the audit and how the matter was addressed in the audit. ISA 701 suggests that technical jargon should be avoided, stating that ‘limiting the use of highly technical auditing terms also helps to enable intended users who do not have a reasonable knowledge of auditing to understand the basis for the auditor’s focus on particular matters during the audit’.
It is likely that many key audit matters will have been discussed in the financial statements. For example, information in relation to a significant estimated value for a provision should have been disclosed in the notes to the financial statements in accordance with the relevant IFRS requirement. ISA 701 suggests that the description of a key audit matter should not be a duplicate of information that is already disclosed in the financial statements. However, a reference to any related disclosures should be included to enable intended users of the auditor’s report to further understand how management has addressed the matter in preparing the financial statements.
The amount of detail to be provided in the auditor’s report to describe how a key audit matter was addressed in the audit is also a matter of professional judgment. The auditor may choose to describe:
- aspects of the auditor’s response or approach that were most relevant to the matter or specific to the assessed risk of material misstatement
- a brief overview of procedures performed
- an indication of the outcome of the auditor’s procedures, or
- key observations with respect to the matter.
In summary, the introduction of ISA 701 will require auditors to exercise significant judgement in preparing the KAM section of the auditor’s report. To help with implementation of the standard, the IAASB has published a range of supplementary guidance to assist auditors of listed entities.
Note than the KAM paragraph is therefore not a substitute for expressing a modified opinion or reporting on going concern issues in accordance with the requirements of the relevant ISA. The interaction between ISA 701 and ISA 705 is explained in the article ‘The new auditor's report’ (see 'Related links'), which is relevant for both F8 and P7 students.
The Extended Auditor’s Report
Note – this section is relevant to candidates attempting the UK and Irish P7 adapted papers only. The FRC document Extended auditor’s reports – A review of experience in the first year is an examinable document for UK and Irish students.
The UK Financial Reporting Council has issued additional requirements that form part of revised ISA 700 (UK and Ireland) The independent auditor’s report on financial statements. ISA 700 requires the auditor’s report issued in relation to the financial statements of entities adopting the UK Corporate Governance Code to include information that addresses similar issue to those seen in respect of Key Audit Matters discussed in the previous section of this article. The objectives are to provide more information about key issues that arose during the audit, how they affected the audit process, and to allow better understanding of areas where the auditor used judgement, particularly in relation to materiality.
Specifically, ISA 700 requires the auditor’s report of companies that apply the UK Corporate Governance Code to include:
- a description of those assessed risks of material misstatement that were identified by the auditor and that had the greatest effect on the overall strategy; the allocation of resources in the audit; and directing the efforts of the engagement team
- an explanation of how the auditor applied the concept of materiality, and
- a summary of the audit scope, including an explanation of how the scope was responsive to the assessed risks of material misstatement and the concept of materiality as described above.
Similar to the issues discussed above in respect of Key Audit Matters, when UK and Irish auditors are applying these requirements of ISA 700, they will need to use judgement to decide which risks of material misstatement should be described, and in deciding how much information to provide in relation to each aspect of the disclosure.
The FRC encourages audit firms to be innovative in the way they communicate information in the Extended Auditor’s Report. The auditor should consider the most effective way to present and describe the information, which should be tailored as far as possible to give specific and therefore useful information. Disclosures of a ‘boiler-plate’ type are discouraged as they do not provide worthwhile information. Explanations, for example on the application of materiality, need to be sufficiently detailed so that they are understandable, but not so detailed that there is information overload. Providing just the right amount and type of information is a matter of judgement and can be difficult to achieve.
It can be seen that both the IAASB and the FRC have taken steps to enhance disclosures provided in the auditor’s reports of listed entities. The overall objective is that these disclosures enhance the value of the auditor’s report by better communication of key issues relevant to the audit process. Auditors will need to use their judgement in deciding what to report, and how to communicate, and some auditor’s reports will be more useful than others, but the regulatory bodies are in agreement that the additional disclosure adds value to reporting by auditors to those who have appointed them.
Written by a member of the P7 examining team