The new audit report, initiated by the International Auditing and Assurance Standards Boards (IAASB) in response to calls for greater transparency in the wake of the financial crisis, gives a thorough insight into the audit process. It is an opportunity for organisations to strengthen their reputation by providing additional information.
Have oversight bodies, controls and auditors all failed? Many people were asking this question in the wake of the financial crisis as they tried to come to terms with what had happened. This uncertainty prompted the IAASB, the body responsible for the formulation and development of internationally recognised auditing standards, to overhaul the requirements for the auditor’s report.
Transparency builds trust
The main aim of the new report is to help close the expectation gap between the auditing firm and an organisation’s stakeholders, particularly investors. The extended coverage of the report and the additional information it provides are designed to present the material financial risks to which an organisation is exposed and explain the way these risks were addressed in the audit. The new report builds trust in the audit by forcing everyone involved to engage more closely with the auditor’s remit and how the audit is conducted.
Straight talk from the IAASB
As part of the reform project, the IAASB revised various International Standards on Auditing (ISAs) and stipulated diverse changes to the auditor’s report. The changes concern the structure of the report (for example, the auditor’s opinion is now placed at the beginning) and the new components that have to be included. The big change is related to the so-called key audit matters (KAMs) assessed in the course of the audit. There is now a new ISA stipulating that these KAMs must be described in the auditor’s report for entities that have quoted equity or debt in their accounts, regardless of the financial reporting standards under which the financial statements for the individual entity or group are produced. The new standard describes the background to KAMs and how they’re determined. Since the significant risks are contained both in the audit plan and in the comprehensive report to the audit committee and board of directors, the key audit matters are points that the management and audit committee are already aware of. KAMs must be described in the auditor’s report in such a way that the reader can perceive the associated risk from the auditor’s point of view. The entity’s point of view is also represented in the auditor’s report, by making reference to the corresponding note to the entity or group’s financial statements. Then the auditor draws an objective conclusion.
The new and revised ISAs must be adopted by entities whose financial year ends on or after 15 December 2016. This includes all entities listed in Switzerland. The UK and the Netherlands have taken a pioneering role in this respect, with regulations already requiring application of the new reporting requirements for periods ending 2013 (UK) and 2014 (Netherlands). The response from organisations and investors in these countries has been very positive.
Goodwill as a KAM – an example
The following excerpt from the 2014 auditor’s report for the Sage Group (UK) shows the extent to which the external auditors might define goodwill as a KAM and address this in the audit.
Goodwill impairment assessment
We focused on this area due to the size of the goodwill balance (£1,433 million as at 30 September 2014), and because the directors’ assessment of the “value in use” of the group’s Cash Generating Units (CGUs) involves judgements about the future results of the business and the discount rates applied to future cash flow forecasts. In particular, we focused our audit effort on goodwill recognised in relation to the Brazilian CGU due to the impairment charge of £44.3 million recognised in the current year. The remaining goodwill balance related to Brazil is approximately £76.8 million. The Brazilian business was acquired by the group in 2012, but performance since acquisition has been impacted by a general deterioration in the macroeconomic environment in Brazil, resulting in the current year impairment. The most significant element of the goodwill balance is that recognised on the two US CGUs, SBS and SPS, totaling £687.7m. Although, based on historical performance, the directors believe there is significant headroom between the value in use of the CGUs and their carrying value, this remained an area of focus for us as a result of the size of the related goodwill balance.
How our audit addressed the area of focus
We evaluated and challenged the composition of management’s future cash flow forecasts, and the process by which they were drawn up. In particular, we focused on whether they had identified all the relevant CGUs, including Brazil and the US. We found that management had followed their clearly documented process for drawing up the future cash flow forecasts, which was subject to timely oversight and challenge by the directors and which was consistent with the board approved budgets. We compared the current year actual results with the FY14 figures included in the prior year forecast to consider whether any forecasts included assumptions that, with hindsight, had been optimistic. Actual performance in Brazil was found to be lower than what had been expected and therefore management has reflected actual FY14 revenue growth rates and operating margins in this year’s model. We feel this judgment is appropriate given the past performance of Brazil. For all CGUs, and in particular, Brazil and the US we also challenged management’s assumptions in the forecasts for:
- Long term growth rates, by comparing them to economic and industry forecasts, and
- The discount rate, by assessing the cost of capital for the company and comparable organisations, as well as considering territory-specific factors.
We found the assumptions to be consistent and in line with our expectations. We challenged management on the adequacy of their sensitivity calculations over all their identified CGUs. We determined that the calculations were most sensitive to assumptions for revenue growth rates and discount rates. For all CGUs other than Brazil we calculated the degree to which these assumptions would need to move before an impairment conclusion was triggered. We discussed the likelihood of such a movement with management and agreed with their conclusion that it was unlikely. In respect of Brazil we found the assumptions for revenue growth (11% per annum), operating margin (26%) and discount rate (17%) to be acceptable although note that any change in these assumptions would have direct impact on the impairment charge.
KAMs: key to reading
KAMs can include both financial and non-financial matters. Examples of non-financial KAMs include the IT systems or internal controls that are relevant to the financial statements. Key auditing matters of a financial nature can be found in areas such as goodwill, provisions, taxes and revenue recognition. Auditors determine KAMs on the basis of close dialogue with the decision-makers and people responsible at the client organisation, and on insights from previous years’ audits (see Figure 1).
| Starting population: information relevant to the ongoing audit gained by communicating with those responsible bodies at the client organisation and insights from previous years | |||
| 1 Determination of matters that required significant auditor attention in performing the audit |
2 On the basis of these matters, determination of key audit matters (KAMs) |
3 Permission to carve out ‘sensitive matters’ |
4 Key audit matters to be described in the auditor’s report |
The content should be presented objectively and as comprehensively as necessary. While it is not obligatory to draw conclusions about a KAM, it is advisable to do so because it gives readers key information and valuable input as the basis for their decision-making.
More to it, more in it
The new auditor’s report brings in many fundamental changes in terms of both form and content. As before, the structure is clearly laid down. However, it now has to be much more detailed and individual, because the report a) has to give a more comprehensive insight into the performance of the audit, and b) includes comments on the KAMs. In addition to the ISA, there is now legislation in the UK and the Netherlands requiring the inclusion of information on materiality and scoping, giving even deeper insights. We are planning to include materiality and scope in addition to a presentation of the audit approach in reports for Swiss listed companies, as this information creates much greater transparency.
Figure 2 shows the new auditor’s report in schematic form, showing what elements have been retained, and what elements are new.
