AuditingKAM

24 January 2017

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Since last month, auditor’s reports on listed companies’ financial statements have become dramatically different from those that have been issued for many years. George W. Russell takes a look at what this means for auditors and other stakeholders in terms of challenges and benefits

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T his past financial year marked a sea change for the accounting profession in Hong Kong with the new and revised

auditor requirements becoming effective for the first time in the city on 15 December 2016.

“We have yet to see how well the require-ments have been implemented, and what are the challenges or improvements Hong Kong auditors have experienced,” notes Christina Ng, Director of Standard Setting at the Hong Kong Institute of CPAs.

However, audit firms in Hong Kong say they have been busy preparing both their staff and clients for the changes for some time. “As with most things, planning and pre-planning are the keys,” says Andrew Ross, Managing Director of Baker Tilly Hong Kong.

“This planning goes further than technical staff training and the subsequent reinforce-ment training we conducted in November and December 2016,” adds Ross, an Insti-tute member. “Education efforts cannot be restricted to audit staff alone.”

Prompted by the effects of the global financial crisis, investors and other financial

statement users around the world have long asked for a better auditor’s report, the key deliverable when communicating the results of the audit process. “Basically the stakeholders said, ‘I want more’,” says Eric Tong, Partner at Deloitte China and Chair of the Institute’s Auditing and Assurance Standards Committee.

As the Institute has noted, research, public consultations, and stakeholder outreach, including global roundtables, indicate that enhanced auditor reporting is critical to influencing the perceived value of the financial statement audit.

“It’s basically about more transparency and providing more information,” says Tong, also Institute Vice President. “When the accounting profession started to carry out an outreach programme, asking what stakeholders want and what else they need, the new auditor’s report was the outcome.”

The global audit community has largely been in agreement that previous reports have fallen short of ideal. “Much of what we have done in our audits, including the types of issues we’ve addressed and the judgments

we’ve made, has not been transparent to share-holders and other users,” says Bob Moritz, Global Chairman of PwC in New York.

The profession has also been eager to turn a new page. “As a role model of quality, integrity and being able to positively adapt to change is key,” says Marco van der Vegte, Partner at Deloitte Netherlands and a board member of the Foundation for Auditing Research. “It is also important that auditors recognize relevant matters and take the opportunity to make an impact and create what I would call an exceptional experience.”

KAM-do attitudeAt the heart of the new experience is the way that key audit matters, or KAM, are tackled. “The enhanced report gives you more information about KAM,” says Tong at Deloitte, “including what are the KAM, where are they in the financial statements, why do we as auditors believe they are KAM, and how we address them.”

KAM may include areas of complexity and significant management judgment that

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AuditingKAM

affected the auditors’ overall audit strategy, allocation of resources and extent of audit effort. “These requirements will make the auditors’ thought process more transparent and therefore make assessment of the quality of their work easier,” says Clement Chan, Managing Director of Assurance at BDO and a past president of the Institute.

The advent of KAM is likely to signifi-cantly change the structure and timeline of an audit. “Historically, for audits with no significant issues, preparing the auditor’s report has been a straightforward process usu-ally completed near the end of the audit,” notes Clare Wong, Professional Practice Partner, Assurance, at EY.

However, the introduction of the KAM will require a different approach, she forecasts. “With the need to report KAM in the auditor’s report moving forward, auditors need to start gathering and developing information as early as the planning phase of the audit.”

In the United Kingdom, KPMG U.K.’s audit of Rolls Royce Holdings for the year ended 31 December 2015 is held up as the current gold standard for the new auditor’s report. Of the company’s 18 key risks identified, eight merited being reported as KAM in view of inherent risks of material misstatement. They included revenue recognition, consolidation of special purpose vehicles and provisions for contingencies, bribery and corruption. The auditor describes the risks, responses and his own subjective views on whether estimates and management’s judgments had been

“balanced,” “mildly cautious” or “acceptable but mildly optimistic.”

Earlier, in a 2012-2013 audit of Gregg’s, Britain’s largest bakery chain, KPMG U.K. challenged the company’s impairment model, assessing its discounted cash flow and recov-erable value of assets. “We have also consid-ered the adequacy of the group’s disclosures about the degree of estimation involved in determining the amount of impairment and the sensitivity to key assumptions involved,” the auditors wrote.

Tong points out that much of such assess-ments – risks of material misstatements, significant audit risks and communication with the audit committees – have long been part of the audit report. “What that requires is auditors making the judgments on what audit risks are to be considered as the most significant ones as KAM,” he says.

The road so farGlobally, firms have been working to ensure a smooth adoption of those changes to the audit report. “It’s been the number one priority for the global auditing standard-setter commu-nity for the past three years,” Paul Fitzsimon, Audit and Assurance Partner at PwC Canada and Head of Reporting and Chief Accountant, noted in a recent presentation.

Feedback from jurisdictions with early adoption, such as the U.K., which brought in the new report at the end of 2013, has been encouraging. “I think the new standards are game-changing for all stakeholders,” says Diana Hillier, Standards and Future of Assurance Partner at PwC U.K. “It marks a move towards reports that are more informative, discursive and insightful.”

In Hong Kong, Ross at Baker Tilly expects there will be some issues in absorbing KAM into clients’ financial reporting systems and the audit process itself. “KAM have brought a significant disruptive change in the whole audit process and it is too early to say how significant or how disruptive the change will be,” he says.

Ross suggests that positive feedback from the U.K. and the Netherlands is not necessarily indicative of a similar reaction in Hong Kong. “There were a small number of earlier adopters in the 2016 reporting periods but they tended to be large, well resourced, international issuers so they are not good indicators of the likely effect of KAM on the large numbers of smaller Hong Kong issuers,” he says.

At least some Hong Kong companies have a wait-and-see attitude. “Communicating KAM in the independent auditor’s report involves matters of professional judgment,” notes Michael Ma, Chief Financial Officer of Truly International Holdings, a LCD manufacturer, and an Institute member. “That could become the arguable area between enterprises and auditors.”

To estimate which KAM are most likely to emerge, the U.K.’s Financial Reporting Council conducted a post-implementation review. In a survey of more than 150 auditor’s reports, the five most-reported KAM covered impairment of assets, tax, goodwill impairment, management override of controls, and fraud in revenue recognition.

Chan at BDO says that in Hong Kong, areas talked about as being most likely to be KAM include impairments and valuations of assets; financial instruments; property, plant and equipment; assets arising from business combinations; and accounts receivables.

The way aheadUnder the new auditor’s report there will be more signs of engagement between the auditor and the client. “The communications between auditors, management and audit commit-tees are more timely and robust than in the previous year,” says Loretta Fong, Assurance Partner at PwC Hong Kong, and a member of the Institute’s Council as well as Auditing and Assurance Standards Committee. “These included discussion of the significant matters and risks during the audit including the deter-mination of which are KAM.”

“ There were a small number of earlier adopters in the 2016 reporting periods but they tended to be large, well resourced, international issuers.”

26 January 2017

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AuditingKAM

28 January 2017

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This increased communication between auditor and audit committee will cover the “selection” or “ranking” of significant audit matters. “Discussions around how those matters will be described in the auditor’s report, and how they complement the financial statement disclosures, can provide new perspectives for the audit committee members and auditor,” says Wong at EY.

Tong at Deloitte warns that predicting the most likely KAM is difficult because different industries have different audit risks. “For financial institutions you might be concerned about loans, for real estate companies, it might be property valuations.”

Wong concurs, adding: “A matter that is considered key to one entity may not be a key matter to another entity in the same industry.

While we expect some commonalities, KAM are determined based on particular facts and circumstances.”

Whatever the result, says Chan at BDO, the new report is one of the most impact-ful revisions in recent times. “Auditors and management will find the enhanced trans-parency in audit opinions on KAM and the corresponding audit procedures and results challenging for obviously different reasons.”

For auditors, the new report will bring new responsibilities in terms of judgment for stakeholders used to the previous binary “pass or fail” opinion. “The description of auditor’s procedures contained in the KAM section of the auditor’s report might be misunderstood without proper context,” Wong cautions.

Management will have concerns about a reliance on KAM, she adds, including mak-ing the auditor’s report a primary source of “red flags,” such as a going concern; whether KAM would trigger a negative market response; or where KAM were seen as areas that management and those charged with governance failed to discharge their respon-sibilities properly.

The new report will also include an affir-mative statement of auditor fulfillment and independence. “From a legal and regulatory perspective, any affirmative statement in the auditor’s report presents a risk of being chal-lenged after-the-fact,” says Wong. “This new requirement drives auditors to better evaluate compliance with relevant ethical requirements.”

“ With the need to report KAM in the auditor’s report moving forward, auditors need to start gathering and developing information as early as the planning phase of the audit.”

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