As you may recall, auditors of large accelerated filers will be required to report on CAMs—critical audit matters—in their auditor’s reports for fiscal years ending on or after June 30, 2019 and in auditor’s reports for all other companies (except EGCs) to which the requirements apply for fiscal years ending on or after December 15, 2020. (See this PubCo post.) As SEC Commissioner Kara Stein observed in her statement on approval of the new rule, the new “standard marks the first significant change to the auditor’s report in more than 70 years.” In Europe, a similar concept has been in operation since 2016: “key audit matters.” What has been the experience so far?
In the U.S., under the new auditing standard for the auditor’s report (AS 3101), CAMs are defined as “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.” Essentially, the concept is intended to capture the matters that kept the auditor up at night, so long as they meet the standard’s criteria.
KAMs are a similar concept. The Center for Audit Quality observes that, although the processes for identifying KAMs differs from that for CAMs, some of the criteria and communication requirements are similar, so that some of the same matters could be reported under both approaches.
According to the CPA Journal, International Standard on Auditing (ISA) 701, Communicating Key Audit Matters in the Independent Auditor’s Report, requires “auditors to communicate ‘key audit matters’ (KAM) selected from among the most significant matters communicated to those charged with governance, such as the audit committee. This requirement became effective for audits of financial statements of listed companies for periods ending on or after December 15, 2016.” EY advises that auditors will select, from “all the matters on which they communicated with the company’s management and audit committee,…KAMs from those matters that required ‘significant auditor attention.’ In particular, [auditors] should explicitly consider areas where there might be a higher risk of material misstatement or those where significant management or auditor judgments were involved.”
An EY partner explained, with regard to KAMs, the “‘concept is that these are the areas that were of greatest focus in the audit, and typically the areas of greatest risk for the audit as well….Where were the areas of subjectivity? Which areas required a significant application of judgment?’ She highlights impairment – of an investment, of goodwill or of another intangible asset – as being likely to feature as a KAM, because of the significant amount of judgment involved with these.” EY observes that the industry sector may well determine the types of KAMs. For example, KAMs related to revenue recognition may be more prevalent among software and telecommunications companies, which tend to have more complex revenue recognition policies. However, EY suggests that taxation “will probably be a KAM for most companies, whichever sector they operate in…. For a lot of businesses, tax is really complex….[the EY partner noted] It’s also an area where there is a high amount of litigation, as well as disputes between tax authorities and companies, so it often requires significant auditor attention.’”
In this article, Audit Analytics discusses the trends discerned from its examination of KAM disclosures of more than 2,300 audit reports for about 1,200 companies. These reports included almost 6,900 KAMs, about three per audit opinion, although firms other than the Big Four had slightly fewer on average. According to the survey, in 2017, the most common KAM disclosed was “asset impairment and recoverability” disclosed in 3,300 reports by 1,100 companies (20% of all KAMs). Next were “revenue and other income” (16%), “valuation of investments (including fair value)” (11%) and “income taxes” (9%). Breaking down the asset impairment category, Audit Analytics found that, in 2017, 15% of those KAMs related to impairment or recoverability of goodwill and other intangible assets. Classified by industry, KAMs related to asset impairment and recoverability were most commonly disclosed by companies in the manufacturing industry (79%), followed by services (76%), retail trade (69%), wholesale trade (56%) and finance, insurance and real estate (22%). With regard to KAMs related to revenue and other income, companies in the services industry disclosed that KAM most often (65%), followed by manufacturing (45%), finance, insurance and real estate (40%), retail trade (37%) and wholesale trade (32%). Not surprisingly, KAMs regarding valuation of investments were disclosed most often by companies in finance, insurance and real estate (74%), while KAMs regarding inventory were common to the retail trade (71%).
Will the disclosure regarding CAMs be similar to that of KAMs? According to the Center for Audit Quality’s Critical Audit Matters: Lessons Learned, Questions to Consider, and an Illustrative Example, the most common CAMs are likely to be those involving “high degrees of estimation uncertainty and that require significant management judgment.” Good candidates for CAM status are “goodwill impairment, intangible asset impairment, business combinations, aspects of revenue recognition, income taxes, legal contingencies, and hard to fair value financial instruments.” (See this PubCo post.) Those topics appear quite similar to the most common KAMs. Whether the percentages and distribution will be comparable remains to be seen.