Loud and clear

New reporting rules requiring bespoke auditor commentary are now being broadly adopted in Australia. Tony Featherstone reports on the impact of these changes both here and overseas. 

PwC’s UK head of regulatory affairs, Gilly Lord, jokes about the rise of “rock-star” auditors in the UK after new reporting rules required them to say more about matters of concern when framing their opinion in the audit report.

Lord says the investors quickly picked up on bespoke commentary about UK-listed firms in their audit reports. Audit partners who provided useful, clearer information in their reports built a higher market profile.

“The investment community have told us that when they see a bland audit report it is now a black mark against the company’s management,” Lord says. “Conversely, shareholders are saying where the auditor writes an open, candid audit report, the relationship between the auditor and the firm must be strong, and the board must have a clear preference for the organisation to be as transparent as possible.”

The UK experience highlights the value that investors place on new audit commentary, which had been previously restricted to a statement of whether the financial accounts are not materially misstated. It also emphasises the risks and opportunities for boards and audit committees as the investment community pours over new information about key audit matters.

The changes, effective in the UK since the fourth quarter of 2013, are being broadly adopted in Australia. The Auditing and Assurances Standard Board (AUASB) in December 2015 issued auditing standards that adopted improvements made to the equivalent International Standards on Auditing by the International Auditing and Assurances Standards Board (IAASB).

The UK experience highlights the value that investors place on new audit commentary.

Chief among them is a requirement to include communication on key audit matters in the auditor report in the financial report for listed entities; the auditor’s responsibilities relating to other information; and a related greater focus on considering disclosures in financial statements.

AUASB chairman, Merran Kelsall, said: “This initiative by the AUASB, following on from the IAASB’s projects in this area, has now been finalised. It is the culmination of several years of important work and a comprehensive program of stakeholder engagement by both boards. The focusing of the auditor’s attention on financial statement disclosures comes at just the right time when there have been calls by regulators and standards-setters for a closer look at this area.”

Practically, the look and feel of the auditor’s report will improve, with the auditor’s opinion at the start of the report. Commentary on key audit matters will describe why certain matters in the audit were most significant and the auditor’s approach in addressing them.

The auditor might, for example, comment on a property valuation and impairment, or goodwill impairment, and the approach used in the audit. Or, the acquisition and disposal of operating activities, inventory valuation or revenue recognition.

The changes apply to the audit of financial reports for reporting periods ending on or after 15 December 2016. The auditors of ASX Ltd, Cochlear and Downer EDI were early adopters of the changes in Australia. PwC, in the 2015 auditor’s report for ASX, noted goodwill impairment assessment and the valuation and existence of available-for-sale financial assets, and explained how its audit addressed the matters.

Risk and reward

In some respects, the changes will unravel the ‘black box’ of auditing from an investor’s perspective. They will also broaden conversations between the board’s audit committee and the organisation’s audit firm, further elevate the role of audit committees in Australia, and give directors better insight into key audit risks and how they are being addressed.

But the changes have significant risk if handled poorly by audit committees. One risk is that new information about the company could be released to the market in the audit report, consequently threatening the company’s compliance with its continuous disclosure obligations. Another is the market responding negatively to the auditor’s interpretation on key audit matters and crushing the share price. In turn, this could create friction between the board and audit firm about the inclusion and communication of key audit matters to investors.

Another possibility is auditor commentary providing fuel for proxy advisers and shareholder activists, or later being used in shareholder class actions. Disgruntled investors will surely cross-reference how the company presented its financial reports against key matters raised by the auditor. Glaring, persistent inconsistencies could be a source of board pressure.

Lord says that has not been the case in the UK, which had less time to prepare for the changes compared to Australia. “It is early days, but we have had two years of the new audit reports and none so far have been subject to litigation in the UK. Fundamentally, the changes do not alter the audit process: we have always considered key audit risks and how they are handled. We now have greater scope to tell the market about the work being done.”

Initially in the UK, companies and auditors were nervous about providing more information on the audit to the market, and how investors would respond, Lord says. “But the changes have been well received among investors, companies, boards and the audit profession. The commentary has brought the audit report to life and helped a broader range of stakeholders understand what the audit report is, the value it offers, and how they can use it.”

Lord says the UK requirements have strengthened discussions between board audit committees and the audit firm. “Ten years ago you would present your audit plan to a board and it was hard to get deep engagement. UK boards are now looking at the audit plan at the start of the audit cycle in much more detail because they know a summary of the key audit matters will go into the public domain at the end of the cycle. It’s changed the relationship for the better.”

Lord’s colleague, Dale McKee, a partner in PwC’s assurance practice in Australia, says auditors will have to anticipate potential key audit matters earlier in the audit cycle and discuss them with the audit committee. “Our audit teams are presenting the first draft of their audit report at the start of the audit cycle and discussing them with audit committees throughout the cycle. It’s about anticipating and communicating rather than only responding to key audit matters.”

McKee says the goal is to give boards more time to reflect on key audit matters to ensure the company has responded to matters operationally and has a clearly enunciated position on them in the public domain that they are comfortable with.

McKee says boards should consider how investors will respond to the expanded commentary, and use the new audit report as another means of communicating with shareholders and stakeholders on the most important elements of the financial report.

“Investors will naturally flick to the biggest risks identified in the audit report, read the commentary and disclosures and consider how they were handled. Boards, in turn, need to consider their response to what could be some tough questions from proxy advisers and fund managers, and use the audit report as a tool for engagement with the investment community.”

Longer term, the audit changes could lead to fee pressure if they create extra work for accounting firms. They could also encourage mid-size ASX-listed entities to use larger accounting firms if the investment community places greater stock on the commentary and skills of the partner signing off on it.