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A key to unlock audit matters

KAMs let investors know, at the onset, about the existence of and considerations for important accounting judgements.
Monday, October 19, 2015 - 05:50
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Auditors subject high risk areas in financial statements which may have a higher probability of significant misstatements to an increased level of scrutiny.

TRADING stocks based on the analysis of financial statements is a strategy known as fundamental analysis. Singapore corporate laws require an audit opinion to be provided with the financial statements of all companies with the exception of small companies, as defined by the Companies Act. Investors however, barely notice the audit opinion until there is an accounting problem.

The most common audit opinion is the unqualified opinion, or in layman's term, "clean opinion", which states that the financial statements are properly drawn up based on prescribed accounting standards in Singapore.

Auditors would occasionally modify their audit opinion should they find instances of non-compliance in a company's financial statements with prescribed accounting standards. The types of modified audit opinion are governed by auditing standards and vary based on the severity of the non-compliance found by auditors. It could be a "qualified" opinion for non-compliance that affects only certain parts of the financial statements or, an adverse opinion for non-compliance that distorts the fair presentation of financial statements.

An adverse opinion is rarely issued. The other type of modified opinion rarely issued is "disclaimer of opinion", which is reserved for very rare circumstances in which auditors could not form an opinion on the financial statements due to insufficient audit evidence or the existence of multiple uncertainties.

A clean audit opinion gives investors the assurance that the results of their fundamental analysis are sound. However, how auditors arrive at their audit opinion is a mystery to most investors.

The global financial crisis around 2007-2008 has also spurred users, in particular institutional investors and financial analysts, to want to know more about each individual audit, the audited entity and its financial statements.

This development led the International Auditing and Assurance Standards Board, the international standard-setting body, to develop a new international auditing standard, which is adopted by Singapore as SSA701: Communicating Key Audit Matters in the Independent Auditor's Report.

This standard will apply to audits of financial statements of listed companies only, and is effective for periods ending on or after Dec 15, 2016.The introduction of key audit matters (KAMs) enables investors to gain a better understanding of the audit opinion and get a glimpse of the thinking process that forms the basis for the audit opinion.

KEY AUDIT MATTERS EXPLAINED

It is prohibitively expensive to verify every transaction amount or balance in the financial statements. Thus, it makes more sense for auditors to focus their attention on areas in financial statements with higher risk of significant misstatements arising from fraud or error.

These areas encompass transactions which are more complex or uncertain in nature, or require a higher degree of judgment in accounting. Auditors will subject these high risk areas to an increased level of scrutiny. Not only will the auditors gather more evidence to support their conclusions, they will also increase the frequency as well as the rigour of discussions with the audit committee, board of directors and management.

Come 2017, should any of these high risk areas be determined to be of most significance in the auditing of the financial statements, they will be raised by auditors as key audit matters.

Key audit matters are most likely to arise in three overlapping areas.

First, key audit matters arise in areas with high risk of material misstatement. These include those of increased complexity and unusual transactions. For example, the use of special purpose vehicles that started with a legitimate purpose of allocating project risk among stakeholders may evolve into a complex structure that is out of the ordinary and hard to comprehend.

An overly complex business structure, the likes of Enron, is a fertile breeding ground for accounting issues and errors. It is highly likely that such a complex structure may be raised as a key audit matter under the new standard as its impact on the financial statements would be pervasive.

Second, key audit matters arise when accounting amounts have high estimation uncertainty. An example would be the use of valuation models to estimate the fair value of biological or intangible assets, with consequent effect on financial performance. These models use judgemental inputs to compute fair value, thus giving rise to estimation uncertainty. The use of judgmental inputs is controversial as it allows room for manipulation of financial statements.

Raising this uncertainty as a key audit matter and the consequential disclosure of how the matter was addressed by auditors should be a welcomed development as it may help companies fend off baseless accusation of accounting manipulation.

Third, key audit matters arise when there are economic, accounting, regulatory, industries or other developments that affect the management's assumptions or judgments. For instance, a ban imposed on the use of certain chemical substances may have a huge impact on its producers as well as manufacturers that use the substance in their end products.

These entities would be required to assess whether or not there is diminution in the value of their significant assets used for the production and manufacturing of this substance.

In addition, the assumptions on factors such as revenue growth rate and discount factor to be used by management in the current period of assessment may no longer be the same as those used in prior assessments. This would warrant a key audit matter to be raised for these affected entities.

The auditing standard SSA701 provides some guidelines and leaves much flexibility to auditors on the level of details in their description of each key audit matter. The intent is to make key audit matters entity-specific and prevent them from degrading to irrelevant boilerplate disclosures. Auditors can report no key audit matter, which is expected to be uncommon, or as many as needed, based on their professional judgement.

MISCONCEPTIONS ABOUT KAMs

The new auditing standard also addresses some misconceptions about key audit matters.

Firstly, key audit matters are not a substitute for management disclosures - it continues to be the management's responsibility to ensure adequate disclosure of information in the financial statements.

Secondly, there should also not be a separate audit opinion on individual key audit matters. There should only be one overall audit opinion on the financial statements.

Last but not least, auditors cannot use key audit matters as a substitute for modification of their opinion or reporting on a company's ability to continue operating as a going concern when circumstances warrant them to do so.

WHY ARE KAMs IMPORTANT?

Auditors need to report key audit matters in a new separate section of the audit report, with a standardised introduction under the heading "key audit matters". This is to catch the attention of users of financial statements, including investors. Greater transparency improves the confidence of the audit opinion and promotes good accounting.

The paradigm shift in accounting from historical cost to fair value, coupled with the increasing complexity of business transactions, means that preparation of financial statements requires more management judgment and consequently, higher auditor judgment.

Key audit matters let investors know, at the onset, about the existence of and considerations for important accounting judgements. This knowledge helps to focus conversations between investors and the companies to promote an orderly financial market. An orderly financial market saves companies from being saddled with confidence crises they could prevent, and instead enables them to focus on value-creating activities for the business.

  • Lim Ai Leen is former executive director, Technical Knowledge Centre & Quality Assurance and Tan Boon Seng is assistant director, research at the Institute of Singapore Chartered Accountants.