Financial statement users’ understanding of the messages in the audit report

Present-day’s recommendations on the audit report

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4.2 Present-day’s recommendations on the audit report

In March 2009, the Auditing Practices Board (APB) published ISA (UK and Ireland) 700 (Revised), ‘The auditor’s report on financial statements’ in order to facilitate a more concise audit report.
The new ISA (UK and Ireland) 700 (Revised) facilitates shorter auditor’s reports, for example by allowing cross reference to a ‘Statement of the Scope of an Audit’ maintained on APB’s web-site or a ‘Statement of the Scope of an Audit’ that is included elsewhere in the annual report (APB, 2009, 2).
The second phase concerning the APB is to perform a research to investigate in which way the informative value of the audit report can improve. For example, to highlight matters that could be relevant to a proper understanding of the auditor’s work, including additional comment in the audit report (APB, 2009, 3).
Mock et al. (2009, 11) recommend to define clearly the message the profession wishes to communicate by issuance of an unqualified audit report and the level of assurance intended to communicate in regard to the audit and the associated financial statements.
Concerning ‘expanded disclosure’, the disclosure of matters found to be important to financial statement users, Mock et al. (2009, 12) mention two topics to be worthy of consideration: ‘materiality’, seeing that the level of assurance is confused with the concept of materiality and ‘independence’. Further research, for example, should examine the impact of disclosing additional information on issues that may potentially affect user perceptions of auditor independence and the corresponding level of assurance provided by the audit.
Mock et al. (2009, 17) call attention to the importance of reporting on certain business risks, including the potential effect on the financial statements of significant risks and exposures and uncertainties that are disclosed in the financial statements. “Such information could be of interest to financial statement users and should be examined as to the usefulness to financial statement users and the impact of such disclosures on user’s perceptions of the level of assurance provided by an unqualified auditor’s report.”
Based on their research findings, Porter et al. (2009, 182) set out some recommendations on steps the audit profession might take to narrow the audit expectation gap and to render the audit report more valuable to financial statement users.
Porter et al. (2009, viii) suggest that the audit profession gives increased focus to the auditor’s opinion by moving the opinion paragraph to the beginning of the report. The audit profession should ensure the wording of the audit report is clear and simple so that it may readily be understood. Porter et al. (2009, viii) further recommend including within the auditors’ responsibilities reporting:

  • More company specific information; for example information currently provided to

the auditee’s directors (management letter);

  • An appropriate regulatory authority untoward matters that are uncovered during an

audit (when it is in the public interest to do so).
Following the Auditing Practices Board (APB) in ISA (UK and Ireland) 700 (revised), Porter et al. (2009, viii) suggest to transfer some explanatory paragraphs (standardized wording) with a cross-reference to a location where the information is accessible to anyone who wishes read it.
As from their research findings, Gold et al. (2009, 28) conclude that detailed explanations of auditor and management responsibilities and of the task and scope of the audit in the ISA 700 (revised) audit report, are not effective in reducing the audit expectation gap. The authors suggest that the explanations need to be formulated stronger, more understandable, and less ambiguous, that is, leaving less room for individual interpretation.
W. Smieliauskas, R. Craig, and J. Amernic (2008) propose that the auditor’s report be revised to replace the words ‘true and fair view’ with ‘acceptable risk of material misstatement’. According to the authors (2008, 225), audit reports constitute an inadequate response to a thirty-year-old criticism that the audit report ‘may be unclear and ambiguous to the average reader’ (Cohen Commission, 1978).
Smieliauskas et al. (2008, 226) state that the audit report should communicate the results of an audit process to best reflect the auditor’s state of knowledge at the time the audit report is dated. They argue that the current wording of the standard audit report is deficient and that its expression, ‘true and fair view’, is operationally defective.
The concept of risk: ‘acceptable risk of material misstatement’ as proposed in this article (2008, 241), incorporates audit risks as well as accounting risks. Accounting risks are associated with making predictions in estimates used in applying GAAP. They are unrelated to the risks associated with gathering appropriate audit evidence.
The proposed modified standard audit report (Smieliauskas et al., 2008, 241) contains the following phrase: “Because of inherent limitations of estimates required in GAAP there may be material differences between the amounts recorded and what is realized ultimately. Such material differences arise from the need to use estimates and predictions of the future in financial reporting. These estimates and predictions are subject to the risk that they will become inadequate because of unexpected changes in conditions. We have identified acceptable levels of these risks for each of the accounts. The resulting estimates, related note disclosures, and account titles and account totals are within the bounds of these acceptable risk levels.”
The authors (2008, 241) pretend that their wording makes it clear that ‘acceptable risk of material misstatement’ includes failure to predict accounting estimates and to incorporate intentional and unintentional misstatements.

4.3 European Commission Green Paper on Audit Policy

“Robust audit is key to re-establishing trust and market confidence; it contributes to investor protection and reduces the cost of capital for companies” (European Commission, 2010, 3).
In October 2010, the European Commission issued a consultation – Green Paper Audit Policy: Lessons from the Crisis. The Green Paper aims to draw the lessons from the crisis with respect to the external audit of companies. The Commission questions whether, to mitigate any future financial risk, the role of the audit could be enhanced.
Concerning the causes of the financial crisis, the Commission (2010, 3) states that while the role played by banks, hedge funds, rating agencies, supervisors, or central banks has been questioned in dept, limited attention has been given so far to how the audit function could be enhanced in order to contribute to increased financial stability.
The Commission recognizes that the audit is a key contributor to financial stability, and that auditors have an important ‘societal role’ in offering an opinion on whether the financial statements give a true and fair view. However, the Green Paper expresses a number of concerns, which begins with the relevance of the audit in today’s business environment, and the expectation gap between users’ expectations and the nature of an audit.

In addition, the Commission focuses on the governance and independence of audit firms and the structure of the audit profession, in particular the concentration of audit firms and the possibility of this, creating risks (European Commission, 2010, 4).

The Commission (2010, 6) notes that the statutory audit has evolved from substantive verification of income, expenditure, assets, and liabilities to a risk based approach. The Commission questions whether this creates an expectation gap and whether a ‘back to basics’ approach would be desirable.
According to the Commission (2010, 8), the auditor’s responsibilities to communicate may be revisited in order to improve the overall communication process. The Green Paper considers the extent to which information of public interest that is available to auditors should be communicated to the public, for example, the company’s exposure to future risks, and the risks to intellectual property.
The Commission states that it would like to reinforce the independence of auditors, and address the conflicts of interests. The Commission is consulting on, amongst others, the possibility of prohibiting non-audit services by audit firms. “Since audit firms provide an independent opinion on the financial health of companies, ideally they should not have any business interest in the company being audited” (European Commission, 2010, 12). In addition, the Commission is considering a scenario where the audit role is one of statutory inspection wherein the appointment, remuneration, and duration of the engagement would be the responsibility of a third party, perhaps a regulator.
Several comments on the Green Paper were found through the library service of the Communication & Information Resource Centre Administrator (CIRCA), an extranet tool where contributions of public consultations can be shared. Some interesting contributions to the consultation on Audit Policy, specifically those contributions concerning the auditor’s communications, are presented below and will further on be compared with the results of this research.
The Federation of European Accountants

The Federation of European Accountants (FEE) agrees with the European Commission’s observation that stakeholders, especially investors, may be insufficiently aware of the limitations of an audit. This include materiality, sampling techniques and testing, the responsibility of management and those charged with governance, the role of the auditor in the detection of fraud, and risk-based auditing, which may result in an expectation gap.

According to the FEE, a balance needs to be found between providing more information on the audit methodology and creating information overload which would hinder the objective to enhance users’ understanding. The FEE mentions that users could always refer to the ISA’s, whereby it needs to be acknowledged that a fair level of understanding of accounting, financial reporting and auditing is required.
The FEE notes that the auditor reports to the audit committee (or the supervisory board) on key matters arising from the audit, including material weaknesses in internal control, auditor’s independence, the entity’s accounting practices and policies, accounting estimates and financial statement disclosures, and significant matters in the auditor’s professional judgment. According to the FEE, such matters could also be reported publicly by the auditor in the audit report.
In addition, the FEE ventilates that the provision of some level of assurance on corporate governance statements by the auditor can increase the degree of confidence of users in corporate governance information.

The American Accounting Association

The Auditing Standards Committee of the Auditing Section of the American Accounting Association (AAA), notes that the complexity and estimation uncertainty inherent in financial statements have changed dramatically over the past few decades. However, the format of financial statements, the nature of assurance provided for accounting estimates, and content in the auditor’s report have changed very little. Without revisions to the audit report, and the financial reporting models, the expectation gap will keep increasing.

According to the AAA, more non-financial indicators, such as customer and employee satisfaction, should be audited and included in the financial reports. Auditors can use nonfinancial measures to assess the reasonableness of financial performance and, thereby, help detect financial statement fraud.

The NBA: the Dutch Professional Accountancy Association (Nederlandse Beroepsorganisatie van Accountants), suggests a mandatory requirement for the audit opinion to address specific aspects, in the form of a required emphasis of matter paragraph, regarding:

  • risk management;

  • funding and client’s status as a going concern;

  • management estimates; and

  • key accounting principles

Ernst & Young

In discussions and interactions with investors, Ernst & Young Global Limited, the central entity of the global Ernst & Young organization, found that some of them are looking for enhanced disclosure of financial statement risks, judgments and estimates, more than additional information about the audit methodology.

Ernst & Young suggests that management or audit committee reporting of this information (perhaps with auditor attestation) could perhaps be more beneficial in bridging the expectation gap. According to Ernst & Young, consideration should be given to requiring a report to shareholders from the Audit Committee describing the key financial statement risks and critical judgments and estimates discussed with management and the auditors.

PricewaterhouseCoopers (PWC) believes that greater transparency around the presentation of financial statements and the audit process, including transparency about the dialogue between auditors and the audit committee, should help to bridge the expectation gap and clarify the role of audit.

PWC refers to the situation in the France, where the audit report includes a specific reference to the key assumptions underlying most significant accounting judgments. According to PWC, in Sweden it is common for auditors to speak at the shareholders’ meeting about important aspects of the audit process such as major risks, in which way these have been addressed in the audit, and the auditor’s interaction with management, the audit committee, and the board.

PWC supports an improvement in the information disclosed by companies about the risks facing their business and in which way these risks are managed. This information should not be limited to the risks affecting the valuation of assets and liabilities, but should provide an insight into the key risk management activities of the board. According to PWC, the key message is that users are looking for information about the way in which companies manage risks, rather than assurances that internal controls and governance arrangements meet an external benchmark.

The International Federation of Accountants

The IFAC notes some additional areas where stakeholder awareness could be enhanced:

  • A greater understanding of the role of the auditor and the implications of the auditor’s work;

  • Enhanced disclosure about critical areas of risk which may occur in discussions between the auditor and the audit committee;

  • The criteria used by audit committees and boards for selecting an auditor;

  • A greater understanding of the various communications by the auditor beyond the auditor’s report (e.g., more comprehensive and detailed communication to those charged with governance).

In response to the European Commission Green Paper on Audit Policy, the IAASB agrees that taking steps to narrow the expectation gap and further enhance stakeholders’ understanding of the role of the auditor is of continuing importance. The IAASB intends to explore further the practice in France whereby the audit report includes a so-called ‘justification of assessments’, and considers the additional information conventionally provided in public sector audit reports.

KPMG International

According to KPMG, the provision of additional information by the company to external stakeholders has the potential to contribute to improving the overall communication process and, where covered by assurance, raise the value added by an audit. KPMG recommends the following reporting areas to be further considered:

  • Explaining the entity’s business model and the key value drivers and how they relate to the historical financial results;

  • Setting out the main business risks that might impact the relevant business model and how management seek to manage them;

  • Achieving a more balanced approach to the reporting of financial and non-financial KPIs;

  • Confirming that there have been no major weaknesses in internal control during the period or explanation of what these were and what remedial action was taken to mitigate their effects; and

  • Audit committees reporting on the process by which they have satisfied themselves in areas of subjectivity, including risks, areas of judgment and significant estimates made in the financial statements.

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