International auditing tightens
At last the Audit Profession has decided to move in the Twenty First Century with 111 countries, including Australia (and China), committing to adopt new audit standards from December 2016. These new audit standards will make audit reports more informative, transparent and revealing with the introduction of ISA 701, which requires auditors of listed companies to specify key audit matters (KAMs).
Key audit matters will vary from company to company and will deal with areas that are most critical to the particular business. Auditors will be required to put their own perspective on those critical issues, drawing attention to matters that are disclosed in the financial report. Importantly, this will spell the end of the bland boilerplate text from the audit profession. Investors can now expect commentary on areas of high-risk, material uncertainty and significant transactions or events.
Carolyn Ralph, a partner at KPMG, gave an example of their audit report on Downer EDI, which focused on the role that judgement played in a range of results, including key contract revenue and valuations of goodwill, plant and equipment.
Auditors will now have to justify certain areas where they have been heavily reliant on management judgements. I believe there will (now) be a laser focus on things like the value of intangibles and goodwill, particularly for those businesses in industries experiencing structural deterioration and disruption.
It will be interesting to view the key audit matters and the level of transparency with respect to a large number of listed Chinese companies – particularly where annual operational earnings is well below interest expense, as detailed here.
The Chinese smelting and materials sector are currently the most vulnerable – over half the companies surveyed by Macquarie Research was loss making in 2014 – and with conditions deteriorating greatly in 2015 that percentage is likely to have dramatically increased.
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Roger Montgomery
:
Tristan asks: I’m glad to hear this David. Is there going to be a change in the accounting where (correct me if I’m wrong):
A company can recognise revenue/earnings from a subsidiary/a company it has an interest in, even if the parent company doesn’t receive any of that revenue? As that can really skew results.
Tristan
Joshua Roziel
:
While it is heartening to see a long overdue update I still feel that with the competitive land scape for winning let alone not losing audit clients there is still great scope for company management to push back on what goes on the report and I feel that only the most obvious matters would be reported on and phrased very euphemistically
David Buckland
:
You may be right Joshua. I think class actions against auditors could in fact become a bigger threat than pandering to management of a company when lacking transparency on matters of significant risk.
Paul T
:
Very interesting David. This is a topic close to my heart. Investing for me is not only looking in the rear view mirror (financial reports) but also looking to the future, which can be a bit of hit and miss. Sometimes the positives are clear and the negatives are hidden or disguised. Even CEO reports which accompany the annual reports sometimes carry a degree of optimism (looking forward) which isn’t really there. Our job is to try and work out who is honest and who is perhaps not as honest and merely trying to prop up their share price.
I look forward to anything that will make financial reporting more transparent.
David Buckland
:
Yes Paul, unfortunately these guys communications are too often directed by their PR / Management Consulting teams.
How often do we read a Chairmans Address or CEO Report which begins “ I am delighted to report x” where x is a significant (structural) decline in revenue and earnings.
Or where the changing competitive landscape is getting worse and this is detailed right at the end of their reports, or not at all.