One year on, the new requirements for the Enhanced Auditors’ Report (EAR) have tangibly improved engagement, communications and corporate governance, according to a joint study by the AOB, MIA and ACCA. Now, where do we go from here?
by Nazatul Izma
Enhanced auditor reporting requirements have been in effect for a little more than a year, effective for all annual reports with financial periods ending on or after 15 December 2016, meaning that hundreds of enhanced auditors’ reports (EARs) reached the market throughout 2017.
Old versus New
Key differences can be observed between previous audit reports and the new EARs, explained Alex Ooi, Executive Officer, Audit Oversight Board, at a media briefing and launch of the joint AOB-MIA-ACCA study entitled Enhanced Auditors’ Report: A review of first-year implementation experience in Malaysia:
- The previous auditor’s report was in binary form and with boilerplate standard wordings, whereas the new EAR has Key Audit Matters (KAMs) that are entity-specific, written in the context of the organisation being audited and the industry in which it operates. KAMs are matters that were of most significance in the audit of the financial statements. Auditors are also required to communicate how the audit addressed those matters.
- The audit opinion is placed at the beginning of the auditors’ report to give greater prominence as to whether the financial statements are true and fair in accordance with the applicable financial reporting framework.
- Auditors are required to include an explicit affirmative statement about the auditors’ independence and compliance with ethical standards.
- If material uncertainty related to going concern exists, auditors are required to include a paragraph disclosing this in the EAR.
- Auditors are required to provide an explicit statement on the outcome of their work in relation to information other than the financial statements and the auditors’ report included in an annual report.
Key Audit Matters (KAMs)
Unsurprisingly, the market has focused on KAMs as a vital part of the EAR. “The auditors are required to highlight the issues that worry them and what keeps them awake at night in their auditors’ reports,” said Ooi.
When disclosing KAMs, auditors are required to address why the matter was determined as a KAM and how these KAMs had been addressed in the audit. The KAMs also need to be referenced to related disclosures in the financial statements as well as other parts of the annual report to give a holistic view.
Readers of the KAMs must bear in mind that KAMs are not red flags about mismanagement, but rather the auditors’ disclosure of what they consider to be audit risk areas. “We need to be mindful and to educate investors, public, Audit Committees and auditors that the KAMs are not a new or standalone opinion. It is just highlighting that when they issue an opinion on the overall financial statements on whether they are true and fair, these are the matters that require the most significant amount of attention,” said Ooi.
“The number of KAMs as highlighted by the auditors should not be a yardstick to measure management’s performance. It does not mean that when a company has four or five, six or seven KAMs that the company is not good. It means that there are certain risk factors and the auditors have highlighted these and how management has addressed these issues.”
Enhanced Auditors’ Report: A review of first-year implementation experience in Malaysia
At the same event, MIA CEO Dr. Nurmazilah Dato’ Mahzan shared her insights into the review of 190 auditors’ reports for annual reports for the financial period ended 31 December 2016, which had been undertaken as part of the joint study between the AOB, MIA and ACCA. The study found that:
- The finance sector reported the highest average number of KAMs per EAR of 2.5. Construction and property sectors also reported similar high average numbers of KAMs per EAR. “In certain industries where the risks are higher, you can see the auditors raise a few more issues because of the riskiness of that sector,” she said.
- The top eight areas identified as KAMs and reported in the first year of EAR implementation are:* revenue recognition (not fraud risk),
* impairment of receivables,
* impairment of goodwill and intangible assets,
* valuation of inventories,
* impairment of investments,
* accruals and provisions,
* impairment of PPE (other than properties), and
* valuation of properties under fair value.
The primary reason for identification as KAMs was overwhelmingly significant management judgement, found in 70.8% of the KAMs. “If you look closely at the eight KAM types that are most often raised among auditors, those areas involve significant judgements by management,” said Dr. Nurmazilah.
This is because under the applicable financial reporting standards, the preparation of financial statements involves significant management judgements and estimates. Examples include impairment of assets involving cashflow analysis and assumptions, or a significant subsidiary operating in a foreign country where information is not very accessible, which could cause challenges or difficulties in the audit. Basically, any area where the auditor needs to put in extra effort or warrants highlighting is then reported as a KAM.
Dr. Nurmazilah added that the rise of technology means that many assets are now non-tangible or intangible; management must exercise estimates and judgement of asset values based on the best available data, and auditors will verify these based on the best available data as well. Similarly, technology has seen different operating and business models emerging, and how these companies derive revenue is also different. “Hence, how the audit is done will have to evolve with time and potentially could be more challenging than before.”
Chiew Chun Wee, Regional Head of Policy, Asia Pacific, ACCA and Board Member of the IAASB stressed that the responsibility of determining the value rests with management. “For example, if an item is included in the financial statements based on fair value, management needs to include sufficient information to let the readers know how they have arrived at that value, the estimation uncertainties and judgement involved, and the auditors’ role is to audit that valuation and disclosures.”
Is EAR Meeting Expectations?
Chiew explained that the three bodies also set out to assess if the EAR is meeting market expectations based on the first year’s implementation. Online surveys conducted as part of the study involved close to 170 Audit Committee members and investors, and further insights were obtained from focus group discussions participated in by close to 20 Audit Committee members and investors.
Below are some of the key observations:
- 78% of Audit Committee members and 73% of investors prefer the new EAR.
- Although these issues are not new to the discussions that are required to be held between auditors and Audit Committees, the difference is that these concerns are now publicly disclosed in the auditors’ report, said Chiew. “There is a spotlight being shone on these issues right now. What is the behavioural change that will result given that the public and investors will look at these issues more closely?” The majority of Audit Committees and investors thought the new EAR is an improvement over the old boilerplate format.85% of Audit Committees said they are now having a more robust conversation with auditors, non-Audit Committee board members, the management and executive directors.Audit Committees revealed that the EAR has “strengthened their position” within the organisation because the executive directors (EDs) are now taking a keener interest in the Audit Committee’s work. “The EDs are now even more involved in understanding the financial reporting risks and issues. They participate more in the conversation. Given that these are typically the most important issues facing the company, the increased attention is a big positive from a corporate governance perspective.”Another consequential benefit of the spotlight is that the directors are also saying, “I’d better tidy up my financial statements disclosures and make sure we are providing good quality, sufficient information.”
- 64% made improvements to disclosures in the financial statements whereas 59% made improvements to disclosures on other elements within the annual report. “Users are getting enhanced information; it is not just a better audit report but as a result of that, better information overall,” explained Chiew.Investors especially are benefiting because financial statements are becoming more complicated and it is not always easy to understand what financial statements are trying to convey. Therefore, the KAMs are highly appreciated. “Reading KAMs is like watching a movie trailer – it gives you the best bits. Or like reading a book where the sleeve gives you the summary. So KAMs give you the key things that you as the public or investor should be focusing on,” quipped Chiew.
- 86% of investors are now more inclined to read the auditors’ report before the financial statements, due to the enhanced information. “Before, unmodified auditors’ reports were all binary, all boilerplate; why would one invest time to read them? Now they are more informative and they are telling you what to focus on. It is testament to their values now that investors are reading the auditors’ reports first before the financial statements,” he said.
- 86% of Audit Committees and 67% of investors are getting deeper insights into financial reporting risks, thanks to the EAR. And an overwhelming 80% of investors said that thanks to EAR and KAMs, they now know what questions to ask at the AGMs.However, even though investors are now better informed, they are still reticent to ask questions, as observed by auditors and the Audit Committees. “Perhaps a better platform and a more conducive environment is needed for investors to raise their concerns,” recommended Chiew.Conversely, no questions being asked could also mean that investors and the public are satisfied with the information disclosed through the EARs and the KAMs, negating the need to ask questions. Going forward, Ooi emphasised that the general public must be further educated on the EAR in order to heighten their understanding and enable them to ask more penetrating questions.
- 82% of investors said that it is important that the Audit Committee responds to the KAMs. Chiew explained that in Malaysia, Audit Committees are not required to explicitly address KAMs in their Audit Committee report, but they have to talk about how they discharge their responsibilities, so some disclosure on KAMs would be expected. The study asked investors whether they were satisfied with how Audit Committee disclosure had addressed the issues highlighted in the KAMs – one third said it was satisfactory, one third were dissatisfied and one-third had not given it any thought, so there is clearly space to further enhance the Audit Committee report.
- Finally, 78% of Audit Committees and 67% of investors say they have greater insights into how auditors conduct audits; 77% of Audit Committees and 57% of investors have more confidence in the quality of audits in Malaysia. The increased confidence is good news for auditors. The enhancement in how audit is perceived may have a positive impact on how audit is compensated.
So what can we conclude? At the end of the day, the purpose of EAR is “not just to enhance audit reporting but to effect the behavioural change and improvement in the other aspects. I think in our first year of implementation, while there clearly remains room for improvement, we are off to a great start,” enthused Chiew.
While the EAR has taken off positively, there is space for all parties in the financial reporting chain – auditors, directors, management and investors – to improve governance and accountability to the shareholders and users of financial statements.
Ooi said that post-study, there are key messages that the three bodies – AOB, MIA and ACCA – want to get across to all stakeholders of the financial reporting ecosystem:
Improve shareholders’ participation in AGM. “Investors should take advantage of these new insights to better understand companies’ performance and actively ask questions during the AGM to management or to clarify matters with the auditors, to ensure that good governance is being put in place in the company.”
Audit Committees should take this opportunity to have more robust discussions with auditors and to educate their fellow directors as well as drive improvements to companies’ corporate governance practices and financial reporting functions. They should investigate the issues highlighted by the auditors, and work with the company’s management to ensure that a corresponding heightened level of attention is being directed at these matters, so that they are addressed on a timely basis.
EAR is an opportunity for auditors to demonstrate and enhance the value of audit. EAR is also an avenue for auditors to differentiate themselves from their competitors.
Ooi reminded auditors to work harder to highlight issues of concern to the investing public and users of financial statements. He also highlighted that the EAR must be entity-specific and related to the industry in which the company operates and the company practices. In line with the standard, auditors should, as far as possible, use simple and easy to understand words, so investors can understand the report clearly.
Ooi commended auditors for working closely with the Audit Committees, especially on the KAMs and the EARs. A majority of Audit Committee members (68%) witnessed an increased involvement of the audit partner in the audit, and 84% of this group considered the increased effort to be sufficient. “Audit engagement partners need to be involved in discussions with the Audit Committees and drafting of the KAMs as the audit opinion will be signed off by them,” he said.
“It is also important for auditors to close the loop and find out from investors what they want from the auditors. Auditors expect the shareholders and investors to use their new-found insights from the KAMs to engage auditors in conversation.”
Companies with a good focus on corporate governance are using KAMs to improve transparency and open engagement channels with investors and other stakeholders. “With EAR, management knows that they should always be on top of their job and improve on the financial reporting of the company.” Ooi also cautioned management not to put up hurdles that prevent auditors from providing genuinely tailored and useful KAMs. Keep in mind that the number of KAMs does not directly correlate to the quality of management as it is also reflective of the complexity of the business environment in which the company operates and other unique circumstances inherent in its industry.
By doing all of the above, the EAR and financial statements will become more useful to users of financial statements, especially shareholders. “This would help raise the level of corporate governance, which is crucial. That’s why we call this EAR a gamechanger and a foundation to better governance in future,” concluded Ooi.