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SA 701: Arrival of a communicative Audit Report

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The auditing profession is perhaps one of the most ‘standardized’ profession from the lot of all contemporary professions. So much so that even the outcome of the work performed by the auditors, i.e. the format of the audit report was a standardized format across companies.

The room for communicating the outcome and key challenges encountered during an audit was very limited. Given this straight-jacket approach, the users of the audit report were at a disadvantage by not being able to get a pulse of what transpired behind the scenes during the course of the audit process.

The audit reports for listed entities for the year ended 31st March, 2019 will embrace a welcome change by communicating Key Audit Matters (‘KAM’) to the users. These KAMs will significantly enhance the value-proposition of the audit report by providing material insights into the important matters that affected the audit process during the reporting period.

After three years of development, the International Auditing and Assurance Standards Board (IAASB) had released a set of standards acknowledging the criticality of auditor reporting to the value of financial statement audit and the audit profession. The Standards on Auditing (SAs) in India, being largely consistent with the International Standards on Auditing (ISAs) also adopted corresponding changes and issued the new and revised standards on the same lines as the IAASB.

The ICAI, on 17th May, 2016, issued a new Standard on Auditing, SA 701 “Communicating Key Audit Matters in the Independent Auditor’s Report.” The ICAI has also issued an Implementation Guide to SA 701 in February 2018 which includes focused and detailed guidance on issues relating to KAMs as well as frequently asked questions. In May 2018, the ICAI also issued the revised edition of “Implementation Guide on Reporting Standards” to align the same to revised standards.

This publication aims to provide an overview of the new reporting requirements comprised in the revised and new standards along with highlighting the additional guidance provided by the implementation guide.
“This innovation in auditor reporting is radical, a step-change as some have called it. It makes the auditor’s work more transparent and relevant to users. It stimulates public debate and analysis on what auditors’ reports are most helpful.” – Arnold Schilder, Chairman IAASB

 

All about KAMs

KAMs are those matters that, in the auditor’s professional judgement, were of most significance in the audit of the financial statements of the current period. KAMs are selected from matters communicated with those charged with governance.

As per the implementation guide, KAMs, in most of the cases, would relate to significant or complex matters disclosed in the financial statements. For example, valuation of goodwill, valuation of financial instruments, assessment of impairment, taxation matters etc.
1. Determination of KAM

SA 701 and the implementation guide provided an approach to determine which matters are required to be reported as KAM in the auditor’s report. According to the approach, following steps should be followed while determining a KAM:
Step 1: SA 260 (Revised) gives guidance on the matters which are required to be communicated with those charged with governance
Step 2: The areas that require significant auditor attention are areas of higher assessed risks of material misstatement, or identified significant risks; areas that involved significant management judgement, including accounting estimates that have been identified as having a high estimation uncertainty; and significant events or transactions that occurred during the year
Step 3: The auditor needs to exercise considerable professional judgement to determine which of the matters identified in Step 2 were of most significance in the audit of the financial statements of the current period
2. Presentation and manner of communication of KAM
KAM should be presented as a separate section after the basis for opinion section of an auditor’s report. In case KAMs identified relates to a modification, a statement to this effect is to be included under the KAM heading.
In case, ‘material uncertainty relating to going concern’ section is required as per revised SA 570, then KAM section is placed after that section.
Based on the auditor’s judgement as to the relative significance of the information included in the emphasis of matter paragraph, an emphasis of matter paragraph may be presented either directly before or after the KAMs section.
The description of each KAM in the KAM section of the auditor’s report should include a reference to the related disclosure(s), if any in the financial statements, as to:
a. Why a matter was considered to be one of most significance in the audit and therefore, determined to be a KAM and
b. How the matter was addressed in the audit.
It is important to note that communicating KAMs in the auditor’s report is in the context of the auditor having formed an opinion on the financial statements as a whole and not a separate opinion on individual matters reported as KAM.
A matter determined to be a KAM is not required to be communicated in the auditor’s report if:
a. Law or regulation prohibits public disclosure about the matter.
b. Communicating such matter would be against public interest. However, this will not be applicable if the entity itself publicly discloses about the same.
3. Effect of KAM on Emphasis of Matter (EOM) & Other Matter Paragraph
SA 706 (Revised), Emphasis of Matter Paragraphs and Other Matter paragraphs in the Independent Auditor’s Report establishes mechanisms for auditors of financial statements of all entities to include additional communication in the auditor’s report through the use of EOM and other matter paragraphs when the auditor considers it necessary to do so.
These paragraphs are presented separately from the KAM section in the auditor’s report.
SA 701 and the implementation guide provided following guidance with respect to EOM, other matter and KAM section:
a. In case a matter has been determined to be a KAM: The auditor is required to include the matter in the auditor’s report in accordance with SA 701. The auditor should not use an EOM paragraph or other matter paragraph to highlight the matter instead of the requirements of SA 701.
b. In case a matter is not determined to be a KAM as per SA 701 (i.e. it did not require significant auditor attention): If the matter is fundamental to the users’ understanding of the financial statements, then the matter should be reported in an EOM paragraph in the auditor’s report in accordance with SA 706.
Communicating KAMs in the auditor’s report is not:
• a substitute for disclosures in the financial statements
• a substitute for expressing a modified opinion when required as per SA 705 (Revised)
• a substitute for reporting in accordance with SA 570 (Revised)
• a separate opinion on individual matters
4. Going Concern as a KAM
SA 701 highlights that a material uncertainty related to going concern is, by its nature, a KAM. These matters are to be reported in accordance with SA 570. In the KAM section, reference to the basis of qualified/adverse opinion or the material uncertainty related to going concern section should be given.
5. Benefits of KAM

Management and those charged with governance: Communicating KAM will ensure that management and those charged with governance always remain vigilant and provide the required disclosures in the financial statements & other reports in light of the fact that the matter will be communicated in the auditor’s report. For instance, providing robust information about the sensitivity of key assumptions used in accounting estimates or an entity’s rationale for a particular accounting practice.
Users of financial statements: Since KAM will provide additional information it is expected to provide the users of financial statements a better understanding of the Company’s management and financial statements.
6. Sample disclosure of KAM from certain global entities

• Valuation of completed Investment Properties (IP) and Investment Properties under Development (IPUD)*:

Key Audit Matter How the same was addressed in the audit
The Group holds a portfolio of investment properties (primarily retail and offices) located in Hong Kong and in major cities across Mainland China which accounted for 37% of the Group’s total assets as at 31 December 2017.

The fair values of the investment properties as at 31 December 2017 were assessed by the Group based on independent valuations prepared by a qualified external property valuer which took into account the net income of each property, allowing for reversionary potential and redevelopment potential, where appropriate.

The net changes in fair value of investment properties recorded in the consolidated income statement represented 8% of the Group’s profit before taxation for the year ended 31 December 2017.

We identified the valuation of IP and IPUD as a key audit matter because these properties represent the majority of the Group’s total assets and a small adjustment to or variances in the assumptions and data used to compute the valuation of individual properties, when aggregated, could have a significant impact on the Group’s profit and because the valuation of IP and IPUD is inherently subjective requiring significant judgment and estimation, particularly in determining market rents and capitalisation rates, which increases the risk of error or potential management bias.

Our audit procedures to assess the valuation of IP and IPUD included the following:

• obtaining and inspecting the valuation reports prepared by the external property valuer engaged by the Group;

• meeting the external property valuer to discuss and challenge the key estimates and assumptions adopted in the valuations, including prevailing market rents, market yields and comparable market transactions, and to assess the independence, objectivity, qualifications and expertise of the external property valuer in the properties being valued;

with the assistance of our internal property valuation specialists, assessing the valuation methodology adopted by the external property valuer and comparing the key estimates and assumptions adopted in the valuation of each investment property, including market rents and market yields, with available market data and government statistics; and

• conducting site visits to IP and comparing tenancy information, including market rents and occupancy rates adopted by the external property valuer with underlying contracts and related documentation, on a sample basis.
For IPUD our audit procedures also included the following:

• evaluating the design, implementation and operating effectiveness of key internal controls over the preparation, monitoring and management of the budgeted construction and other costs for each property development;

• comparing unit construction costs with research reports published by international property and construction consultants and other available market data; and

• conducting site visits to IPUD on a sample basis, discussing with management the progress of each property development and comparing the observed progress with the latest development budgets provided by management.

 

• Assessing the net realizable value of properties under development for sale (“PUD”)

Key Audit Matter How the same was addressed in the audit
The Group had a number of property development projects located in major cities across Mainland China which were stated at the lower of cost and net realisable value at an aggregate amount of HK $25.2 billion as at 31 December, 2017.

 

Our audit procedures to asses the net realizable value of PUD in Mainland China includes the following:

 

● evaluating the design, implementation and operating effectiveness of key internal controls over the preparation, monitoring and management of the budgeted construction and other costs for each property development project.

 

● conducting site visits to all property development projects, discussing with the Group’s internal property valuers the progress and comparing the observed progress with the latest development budgets for each property development project provided by management.

 

● assessing the internal property valuers’ qualifications, experience and expertise in the properties being valued.

 

● evaluating the internal property valuers’ valuation methodology and assessing the key estimates, data inputs and assumptions adopted in the valuations, which included comparing expected future average selling prices with available market data such as recently transacted prices for similar properties located in the nearby vicinity of each property development project and comparing costs to complete each property development project with publicly available construction cost information for similar properties (taking into account both property type and location) and the sales budget plans maintained by the Group.

 

● re-performing the calculations made by the internal property valuers in arriving at the year end assessments of net realisable value, on a sample basis, and comparing the estimated costs to complete each development with the Group’s updated budgets; and

 

● performing sensitivity analyses to determine the extent of change in those estimates that, either individually or collectively, would be required for PUD to be materially misstated and considering the likelihood of such a movement in those key estimates arising and whether there was any evidence of management bias.

 

 

• Revenue recognition for Investment Properties (“IP”) and Development Properties (“DP”)

Key Audit Matter How the same was addressed in the audit
Revenue from the IP and DP segments accounted for 86% of the Group’s revenue for the year ended 31 December 2017.

Deposits from pre-sale of properties as at 31 December, 2017 totalled HK $9.1 billion.

Revenue from IP is recognised in equal instalments over the accounting periods covered by the lease term and includes contingent rental which is determined based on the turnover of certain retail outlets.

Revenue from DP is recognised upon the later of the execution of a formal sale and purchase agreement and the issue of the occupation/completion certificate by the relevant government authorities.

We identified the revenue recognition for IP and DP as a key audit matter because of its significance to the Group and because small errors in the revenue recognition, either individually or in aggregate, for each property could have a material impact on the Group’s profit for the year.

Our audit procedures to asses the revenue recognition for IP and DP included the following:

● evaluating the design, implementation of operating effectiveness of key internal controls over the recording of revenue for the investment property and development property segments.:

● comparing fixed rental revenue received and receivable with underlying tenancy information, including monthly rents and rental periods as set out in the signed rental agreements, on a sample basis, and assessing whether fixed rental revenue had been recorded in the appropriate accounting period. :

● re-performing the calculation of contingent rental received and receivable with reference to turnover reports submitted by the relevant retail outlets, on a sample basis, and assessing whether the contingent rental had been recorded and accounted for in the appropriate accounting period; and :

● inspecting occupation permits or completion certificates which had had been issued by the relevant government authorities on a sample basis for sales and pre-sales for each development property project and assessing whether the cash, for the s ample selected, had been received by comparing the amount received with bank statements and assessing whether revenue should be recorded in the current accounting period or should be deferred as deposits from pre-sale of properties. :

 

Note: Extract from the Annual Financial Statements of Wharf (Holdings) Limited for the year ended December 31, 2017

 

• Legal and Regulatory matters

Key Audit Matter How the same was addressed in the audit
There are a number of pending and ongoing legal disputes and regulatory investigations involving the Group. In certain litigation and regulatory matters significant judgement is required by management to determine whether a present obligation exists and whether a provision should be recognized.

If there is a present obligation there are significant judgements in determining the measurement of provisions, which are subject to the future outcome of legal or regulatory processes.

We focused on the risk of material misstatement arising from ongoing investigations by regulators, specifically in the US relating to the possible violation of US sanction laws and regulations.

Our procedures included:

● Enquiry of lawyers: Meetings with the Group’s external counsel in the US and UK and the PRA (who are in regular contact with US and other regulatory bodies) to understand the nature and status of legal disputes and regulatory investigations to determine whether or not a provision should recognized.

● Assessing provisions: We critically assessed and challenged the adequacy of provisions and contingent liability disclosures including management’s ability to reliably estimate any monetary penalties. Our procedures included comparing assumptions to historical data, approved settlement agreements and enquiry of lawyers.

● Assessing transparency: Assessed whether the disclosures related to significant litigation and regulatory matters adequately disclose the potential liabilities and the significant uncertainties that exist.

● Our results: We considered the provisions for legal and regulatory matters recognised, including the related disclosures and the contingent liability disclosure made in relevant note

 

Note: Extract from the Annual Financial Statements of Standard Chartered Bank for the year ended December 31, 2017
• Recoverability of parent company’s investment in subsidiaries

Key Audit Matter How the same was addressed in the audit
The carrying value of the Parent Company’s investment in subsidiaries represents 55 percent of the company’s total assets. Recoverability of the investment is not considered a high risk of significant misstatement or subject to significant judgement. However, due to the materiality of the investment in the context of the parent company financial statements, this is considered to be the area that had the greatest focus of our overall parent company audit. Our procedures included:

● Tests of detail: Comparing the carrying amount of a sample of the highest value investments, representing 99 percent of the total investment balance with the relevant subsidiaries’ draft balance sheet to identify whether their net assets, being an approximation of their minimum recoverable amount, were in excess of their carrying amount and assessing whether those subsidiaries have historically been profit-making.

● Assessing subsidiary audits: We assessed the work performed by the subsidiary audit team on that sample of those subsidiaries and considered the results of that work, on those subsidiaries’ profits and net assets.

● Our results: We considered the Company’s assessment of the recoverability of the investment in subsidiaries to be acceptable.

 

Note: Extract from the Annual Financial Statements of Standard Chartered Bank for the year ended December 31, 2017
• Unbilled retail revenue

Key Audit Matter How the same was addressed in the audit
Retail electricity and gas revenues are recognised when electricity and gas are supplied to and consumed by the customers. The revenues are measured on the basis of periodic cycle meter readings and include an estimated accrual for the value of electricity and gas consumed from the meter reading date to the end of the reporting period (unbilled revenue). Unbilled retail revenue of the Group totalled HK $4,319 million at 31 December 2017.

In CLP Power Hong Kong Limited (CLP Power Hong Kong), unbilled revenue is calculated using estimates including consumption quantity based on the electricity sent-out adjusted by a loss factor, pattern of residential and non-residential consumption, weather and certain other factors.

In Energy Australia Holdings Limited (Energy Australia) the amount is calculated based on the electricity purchased and applicable tariffs for the mass market customer segment, as well as actual meter readings and contracted rates for commercial and industrial customers. The amount is adjusted for physical energy loss and other measurable factors.

Our procedures in relation to unbilled revenue included:

● Obtaining an understanding of and testing the key controls in place to determine the estimate of unbilled revenue for both CLP Power Hong Kong and Energy Australia, including the logic of any models.

● Testing the volume of electricity sent-out by CLP Power Hong Kong to supporting information.

● Testing the volume of electricity purchased by Energy Australia from the wholesale electricity market to the underlying Australian Energy Market Operator (AEMO) invoices on a sample basis and reconciling the total purchase volumes to revenue volumes; and

● Understanding and challenging the key assumptions relating to volumes and pricing used in determining the level of unbilled revenue for both CLP Power Hong Kong and Energy Australia by comparing against historical trends and against the weighted average tariff for prices.

Based on the work performed, the unbilled revenue amount is supported by the available evidence.

Note: Extract from the Annual Financial Statements of CLP Holdings Limited for the year ended December 31, 2017

• Measurement of Current and Deferred Taxes

Key Audit Matter How the same was addressed in the audit
There are various complexities relating to the treatment and recognition of current and deferred taxation, arising from significant or unusual transactions may be ambiguous and thereby require legal opinion. In addition, the determination of whether to recognize deferred taxation assets is dependent on the directors’ assessment of the utilisation of the historical taxation losses and the timing of realising temporary differences, which requires significant judgement.

With respect to uncertain taxation positions, the directors make provision for taxation based on the most probable outcome.

As a result, taxation is considered a key audit matter due to the complexities and judgement arising from the considerations relating to the calculation, recognition, and classification of current and deferred tax balances.

The disclosures relating to taxation and deferred taxation are contained in note 9 of the consolidated financial statements.

We involved our taxation specialists to evaluate the taxation provisions and potential exposures. This included:

● Analysing the taxation consequences arising on significant or unusual transactions to determine if the treatment adopted is appropriate under the circumstances, and/or based on appropriate legal counsel opinion obtained by the directors.

● Analysing the current and deferred taxation calculations for compliance with relevant taxation legislation

● Evaluating the directors’ assessment of the estimated manner in which the timing differences, including the recoverability of the deferred taxation assets, would be realised by comparing this to evidence obtained in respect of other areas of the audit, including cash flow forecasts, minutes of directors’ meetings and evidence obtained in other areas during the performance of our audit procedures.

● Critically evaluating the assumptions made by the directors for uncertain current and deferred taxation positions to assess whether appropriate current and deferred taxation provisions have been recognised and are based on the most probable outcome.

● We assessed the disclosures to ensure that this was accurately and appropriately recognised and found that the disclosures relating to the current and deferred tax are appropriate

 

Note: Extract from the Annual Financial Statements of Arcelor Mittal South Africa Limited for the year ended December 31, 2017.
The above article is authored by Umesh Lakhani, a Chartered Accountant, Partner and Madhavi Deodhar, a Chartered Account, Senior Manager at Bathiya & Associates LLP. The authors can be reached at umesh.lakhani@bathiya.com and madhavi.deodhar@bathiya.com

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