An insight into the new auditors’ report

Gathering the storm 

Before deliberating on the new auditors’ report it is important to know the sequence of events that created the necessity to bring in changes to the auditor’s report. At the outset it is worthy of noting that ‘auditing; has become the mostly misunderstood profession in the eyes of the public. It seems the days were gone that the auditor was seen as a watchdog rather than a bloodhound.   

At the dawn of the new millennia, there were a series of high profile corporate failures. Enron, Xerox, WorldCom, Parmalat and many more corporates added on to the list. At that time, the markets were recovering from the dotcom bubble. Amidst this, some of the high profile auditors also went into bankruptcy. The stakeholders started questioning the role of the regulators and that of the auditors. 

These failures were considered as accounting scandals. However, I carry the view that these were corporate governance scandals. This is because there is no room for an accounting scandal if the corporate governance environment and practices are strong. These corporate failures resulted in many changes to the disciplines of corporate governance, accounting, auditing and certain laws governing the above aspects. 

Introduction of the Sarbanes-Oxley Act (SOX) in the USA can be considered as the ground breaking law which exerted substantial influence in bringing in so many changes to the accounting and auditing profession. In the context of globalisation, it took little time to spread the best practices as prescribed in the SOX across the world. SOX brought in additional reporting requirements to the auditors.  Discussions were slowly started in strengthening the financial reporting function and auditors’ reporting. 

With the advancement of technology and related information and communication, new business opportunities were created and some of the existing businesses had going concern issues. Truly speaking disruptive technologies made certain business models obsolete creating more emphasis on going concern. 

All these developments have brought in continuous changes to the financial reporting and auditing literature. 

Then the world faced the Global Financial Crisis during 2007/2008. The US domestic issue mainly due to subprime mortgage loans (NINJA loans) became a global issue as a result of the cross border investments. Some of the high profile investment bankers, insurance companies and rating agencies were directly hit and so many other companies had indirect impact and capital markets were seriously affected.   

Fact-finding  

Again the auditors’ role was questioned, especially in the context of going concern of such impacted entities. Stakeholder’s started to demand more transparency and relevance in auditors’ reporting. In the above context prominent professional accounting bodies commissioned international academic research on user perceptions. 

Also the International Accounting and Auditing Standards Board (IAASB) carried out public consultations, round table discussions and interaction with regulators, policy makers and national standard setters to clearly understand the perceptions and concerns on auditors’ reporting. Having deliberated on the feedback received from the general public through various means, the IAASB had finally brought in substantial changes to the auditors’ reporting. 

Changes to the auditors’ report 

• Key changes to the auditors’ report on a listed company’s financial statements can be highlighted as follows:
• New section to communicate Key Audit Matters (KAM) 
• Disclosure of the name of the engagement partner
• Audit opinion section required to be presented at the beginning 
• Enhanced auditors’ reporting on going concern of the entity
• Affirmative statement about the auditors independence and fulfilment of ethical responsibilities
• Enhanced description of the auditors’ responsibilities and key features of an audit.   

Impact on audit committee and management 

Out of the above stated changes, the most significant one is the requirement to have a separate section on the Key Audit Matters (KAM) in the auditors’ report of the public quoted companies. This requires the auditor to disclose the matters that the auditor thought would be detrimental to the audit and how the auditor approached these key audit matters in obtaining comfort to express his/her opinion. In other words, this requirement may make the auditor to disclose certain information which the management may deem to consider as sensitive. In the above context the audit committee has got a significant role to play. 

The audit committee should consider the timing of meetings of the audit committee and management and whether these will accommodate the audit process and reporting time frame. The timing and methods of communications with the auditor will be affected since:

• Key audit matters are derived from matters communicated with the audit committee. Therefore early communication of all relevant matters affecting the audit are critical.
• The audit committee should challenge the auditor as early as possible on the auditor’s responses to the key audit matters and whether these are appropriate.
• The audit committee will want to review an early draft of the auditor’s report in order to be able to understand which key audit matters are being reported.
• The report is likely to go through rigorous review processes within the entity and the audit firm and therefore time frames need to be carefully considered to accommodate this.
• The audit committee should question disclosures in the financial statements and the annual report:
• Whether the disclosures adequately and fairly describe the matters to which the key audit matters pertain in accordance with the financial reporting framework.
• Whether additional disclosures or commentary beyond those required by the financial reporting framework are necessary in order for users to fully understand the key audit matters identified by the auditor, and to ensure the auditor is not the original provider of information (Such disclosures may be in the financial statements or the annual report.)
• The audit committee should question management’s response to the key audit matters, although not disclosed by the auditor or in the financial statements, the audit committee may want to question how management manages and responds to the key audit matters and whether this is appropriate.

Independence and ethics

The audit committee should annually or regularly evaluate whether the auditor is independent in terms of the relevant Codes and the Companies Act by:

• Monitoring and pre-approving all non-audit services provided by the audit firm
• Monitoring non-audit services provided by other auditing firms due to the potential impact of rotation requirement, particularly for entities with affiliations in the UK and Europe.
• Assessing the independence of the auditor, both the firm and the individual engagement partner, when nominating the auditor for Appointment

Going concern/responsibility of auditor, management and those charged with governance

• The audit committee should scrutinise management’s process for assessing the entity’s ability to continue as a going concern. Although these responsibilities are not new, there is increased focus on going concern and the related disclosures. Therefore, it is a good opportunity to evaluate these processes.
• The audit committee should examine the relevance and completeness of the entity’s disclosures in the financial statements related to going concern, particularly for entities who have “close call” situations (i.e. where there are events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern, but management has mitigating plans, and the conclusion is that no material uncertainty exists)

Changes to the auditor’s report would expect to bridge any expectation gap that prevail with the stakeholders. In Sri Lanka the new auditors’ report is effective for auditors of financial statements for periods ending on or after 31 March 2018. 

[The writer, FCA, CPFA (UK), ACMA, CISA, MBA (Finance) (Col.), is Head of Audit and Assurance at BDO Partners.]