In the spotlight: Corporate reporting
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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.
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.
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 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:
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.
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.
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).
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.
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.
The new auditor’s report has to be published in full, regardless of whether a Swiss entity reports under IFRS, US GAAP or Swiss GAAP FER. Because it is more comprehensive, the report will create a certain amount of extra work for management, who will now have to engage more closely with the significant risks mentioned above as well as materiality and scope. This discussion will continue to take place behind closed doors – however now the auditors will communicate the outcome of the debate in their report. It is very possible that management will have to provide stakeholders with answers to more questions in the future. The best way of preparing for this is to start taking an in-depth look at the scope and content of the audit early on.
We at PwC are committed to implement the amended and new ISAs to build public trust in the audit. Besides information on the audit approach, our auditor’s reports will also cover materiality and scoping. Our aim is to present KAMs as specifically as possible and draw objective conclusions. This way we will actively help organisations further build their reputation.
Investors have great expectations of the audit. By the end of 2016 at the latest, the new auditor’s report will be having a positive impact on the audit. International experts believe that the new report will make it significantly easier to understand an entity’s economic position, building trust both inside and outside the organisation. The IAASB’s aim is for the greater transparency provided by the report to boost understanding in terms of the objectivity and reputation of the audit.
In Switzerland the design of the auditor’s report is set down in the Swiss Auditing Standards. These standards, the result of intensive dialogue between the association of auditors (EXPERTsuisse) and the auditing firms, represent the implementation of the ISAs in Switzerland. We can expect to see different auditing firms adopting different approaches in the areas of reporting (materiality, scope and conclusions) that are voluntary under the ISAs. EXPERTsuisse is also in the process of evaluating whether reporting on KAMs subverts the auditors’ duty to maintain confidentiality. The Federal Audit Oversight Authority (FAOA) has now issued a circular that declares that the new auditing standard for listed companies is applicable for periods ending on or after 21 December 2016. Early adoption for the 2015 financial year is also possible. These new regulations mean that Switzerland is proceeding more quickly than Germany, where the new ISA isn’t due to be implemented until 2017.
The implications of the new auditor reporting requirements for listed companies go beyond merely redesigning the report. They’re a great opportunity to build reputation and trust in your organisation. When implementing the requirements we recommend going into as much concrete detail as possible in the report, as this creates more transparency and gives added depth to management’s engagement with the audit. To this extent, we truly believe the new report constitutes a revolution in auditing.