This study conducted by the Association of Chartered Certified Accountants reports on the results of a year of international reporting of “key audit matters,” the International Auditing and Assurance Standards Board’s analog to “critical audit matters” in the U.S.  The study looked at 560 audit reports across 11 countries.  These types of studies may provide some useful insights for companies in the U.S.: disclosure of “critical audit matters” will be required as part of the auditor’s report in the U.S. for audits of fiscal years ending on or after June 30, 2019 (for large accelerated filers) and December 15, 2020 (for all other companies to which the requirements apply). According to the study, financial reporting improved following the adoption of KAMs in 2016. Not only did the disclosures themselves provide better information, but the study saw improvements in governance, audit quality and corporate reporting.

Under the new international standard, “key audit matters” require the auditor to include, in a separate section of the audit report, “those matters that, in the auditor’s professional judgement, were of most significance in the audit of the financial statements of the current period… selected from matters communicated with those charged with governance.” By comparison,  “critical audit matters,” the concept in the U.S. accounting standard, is quite close: that is, “matters communicated or required to be communicated to the audit committee and that: (1) relate to accounts or disclosures that are material to the financial statements; and (2) involved especially challenging, subjective, or complex auditor judgment.” (See this PubCo post.)

The research for the study involved both quantitative analysis of the first year of KAM reporting, as well as qualitative observations from roundtable discussions with auditors, audit committee members, preparers and academics. In addition to providing useful information for investors—the key goal of the change to the audit standard—the analysis also found these key “hidden benefits”:

  1. Better governance: “Publication of KAMs has provided new focus for discussions between the auditor and the audit committee. For the first time, there is transparency in the most important audit issues that were discussed between the audit engagement partner and the audit committee. As a result, feedback from audit committee members shows that disclosure of KAMs has resulted in improvements in corporate governance.”
  1. Higher audit quality: “The process of reporting outputs from the auditor’s reporting to the audit committee appears to have had a positive impact on audit quality. There is, so far, no evidence of that KAMs are being used defensively to reduce the auditor’s liability. Indeed, some of the exceptional reporting… comes from audit teams who are prepared to consider complex matters requiring careful judgement and to explain their audit approach to these matters publicly in their audit reports….[Some] auditors suggested that KAMs would have a positive impact on quality, noting that once a matter has been selected as a KAM, audit supervisors will expect to see a commensurate response in the audit file. As well as getting auditors to focus appropriately on issues that are KAMs, it may also encourage auditors to—appropriately—do less work on lesser issues that are not KAMs. This could allow auditors to spend more time on the bigger issues.”
  2. Better financial reporting: “There is evidence…that reporting by the auditor in relation to part of the financial statements has, in some cases, led companies to add to the disclosures in the financial statements made in previous years. In this way, KAMs have catalysed better financial reporting.”

Interestingly, the study did not find evidence that concerns that had been raised in U.S. surrounding the introduction of the CAM requirement—that CAMs would be confusing to investors, used defensively and phrased in boilerplate to reduce risk—had actually materialized. (These concerns were also expressed by SEC Chair Jay Clayton.  See this PubCo post.) While these concerns were viewed as reasonable ones, the study was nevertheless optimistic, notwithstanding the “distinct” legal environment in the U.S. For example, with regard to the fear that auditors would rely on boilerplate language, the study reported that, “while there was evidence of common innovations among audit firm networks, ACCA has not seen widespread sharing of standardised wording.”

Among the issues raised during the various roundtables were the additional length and complexity of the new reports (which some viewed as potentially off-putting) and disclosure of too many KAMs in the UK (including, at least initially, disclosure of all significant risks as KAMs).

For the 560 audit reports reviewed in the study, there were 1,321 KAMs reported, the most common being KAMs referring to asset impairment (other than goodwill) identified in 162 reports (over 25% of reports reviewed), followed by revenue recognition (excluding any reference to fraud) identified in 102 reports, allowance for doubtful debt (95), goodwill impairment (90), taxation, including deferred tax (88), investments (87), financial instruments (84), valuation of inventories (80) and property valuation (79). There were 16 KAMs related to revenue recognition that did refer to fraud. In the UK, auditors tended to include an average of slightly over four KAMs, but the numbers were lower elsewhere.

Posted by Cydney Posner