13 March 2003
Mr Jim Sylph
Technical Director
International Auditing and Assurance Standards Board
535 Fifth Avenue, 26th Floor
New York 10017 USA
Dear Jim
Audit Risk
We have reviewed the IFAC Exposure Drafts and generally concur with the guidance provided in the context of an historical financial reporting model. Responses to issues raised in Appendix 3 are provided below.
We also note that the IAASB’s Action Plan for 2003/2004 includes the following statement:
"The IAASB’s priority over the next two years will be on the maintenance and development of auditing standards relevant to historical financial information."
We have some overriding concerns regarding audit risk as we move away from a ‘historical cost financial reporting model’ and deeper into a ‘fair value financial reporting model’. We believe there are important ramifications for the audit process. The inherent risk that arises in respect of the audit of financial reports prepared using a fair value financial reporting model has not been adequately addressed in the Audit Risk exposure drafts. Also, the significant changes to the underlying principles that govern the preparation of a financial report using a fair value financial reporting model, raise serious concerns regarding the nature of the audit reports to be provided. These issues are explored in further detail below. We request that the IAASB would give urgent consideration to these issues.
Responses to Comments Requested in Appendix 3 to the Explanatory Memorandum
General re the Audit of Small Entities
Our comments have already been provided directly to the Rapid Response Task Force. Please contact us if you require further information.
AUS/ISA XX “Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement”
Internal control as a component of governance is of increasing importance in an entity. For some audit engagements there may be an expectation that auditors will examine the internal controls relating to preparation of the financial report, rather than a purely risk-based approach. Also, although the guidance provided is useful to gain understanding, it is not exhaustive and does not provide comprehensive criteria for evaluating the effectiveness of internal control procedures.
As stated in paragraph 50 the auditor obtains “understanding” to provide context for the risk assessment in paragraphs 95-103, but this does not necessarily translate into testing those systems.
We recommend:
•Paragraph 53 should include a clear statement that internal control is the responsibility of those charged with governance. Also that the auditor examines components of the internal control systems only to the extent that the auditor intends to depend on those systems for compilation of information to be incorporated in the financial report.
•Paragraph 53 should include a statement that any additional examination of internal control systems beyond the requirements of the audit of a financial report should be structured as a separate engagement. In Australia, this examination would be structured in accordance with AUS 810 “Special Purpose Reports on the Effectiveness of Control Procedures” (no ISA equivalent).
AUS/ISA XX “The Auditor’s Procedures in Response to Assessed Risks”
We are not comfortable with a time frame being specified in the black letter wording, as this is likely to become the default position. Given the broad diversity in organisations, control environments and information systems, the nature and timing of system testing should be a matter for professional judgment having regard to all the relevant circumstances.
We recommend:
•The information in paragraphs 38 and 39 should be combined. The requirement that the operating effectiveness of controls should be tested at least every third audit should be included as a recommendation in the grey letter discussion.
Documentation
Depending upon the documentation already available for individual clients, the requirements may be costly in the first year the standard is applied. However, this is essential audit evidence to support the risk assessment and audit plan, therefore guidance regarding documentation is appropriate.
Audit Risk in the Context of a Fair Value Financial Reporting Model
Although the financial report may be deemed to reflect historic events in the life cycle of a business, performance and valuations are increasingly determined by considering management’s future plans and expectations.
Certain accounting standards incorporate measurement criteria that are dependent on the present value of future net cash flows to determine asset values. Assessments of future cash flows are implicitly interrelated with management’s future plans and expectations. The nature of such measurement recognised in the financial report is comparable with the basis for measurement used in preparation of prospective financial information. Although ISA 545 “Auditing Fair Value Measurements and Disclosures” describes the audit process for auditing fair values, as the fair value basis becomes more pervasive, the inherent audit risk increases substantially.
In Australia, the Corporations Act 2001, the Australian Securities and Investment Commission (ASIC) and Auditing Guidance Statement 1062 “Reporting in Connection with Proposed Fundraising” (equivalent to ISA 810) raise various issues in respect of the quality of prospective financial information. ISA 810 paragraph 3 states: “Prospective financial information means financial information based on assumptions about events that may occur in the future and possible actions by an entity. It is highly subjective in nature and its preparation requires the exercise of considerable judgment…” Also, under Australian legislation, prospective financial information must have “reasonable grounds” for its inclusion in a disclosure document. Further, based on guidance provided by ASIC, a “projection” prepared on a basis of a mixture of hypothetical assumptions and best-estimates is likely to fail a “reasonable grounds” test.
As a consequence the terms of these engagements are given careful scrutiny and the audit report clearly identifies and segregates the work carried out on different components of the financial information. In particular, the auditor only provides a review report and negative assurance regarding the prospective financial information and the assumptions on which it is based.
There seems to be an inconsistency in the way we view reporting on prospective financial information, and the way we report on fair value assessments based on discounted cash flows.
Consider the following scenario, which might be encountered in the Australian audit environment. Although the references provided are to Australian accounting standards (AASB), they are indicative of the requirements of the equivalent IFRS.
A client’s business incorporates a fruit farm with orchards. Therefore the client applies AASB 1037 – Self-Generating and Rejuvenating Assets.•Impacts on measurement of reported revenue, result, net assets. / Assumptions factored into net market value include:
•Future sales quantities
•Future sale prices
•Future cash flow
•Future exchange rates
•Discount rate
•Competitors actions in the future
The client has specialised non-current assets, which are carried at fair value in accordance with AASB 1041.
•Impacts on net assets, depreciation charge and result. / Applying provisions of AASB 1041.5.1.8 5.1.10 – the assumptions include:
•Future level of activity
•Future net cash inflows
•Discount rate
•Adjustment to current market prices to reflect the asset’s remaining future economic benefits – interrelated with management assumptions regarding future activity levels..
The client has purchased a new business unit during the year. The acquisition has been funded by the issue of equity instruments. The acquisition includes the purchase of brand names. The client applies AASB 1013 Accounting for Goodwill and AASB 1015 Acquisition of Assets.
•Impacts on measurement of net assets, depreciation and amortisation charges. / •Determination of cost of acquisition by reference to fair value of the equity instruments
•If the market is not active, the fair value might be determined by reference to the fair value of the underlying assets acquired – interrelated with expectations of future activity..
•Allocation of fair values to reflect value to the business.
•Measurement of goodwill.
The client is considering closing down one of its production lines and is in the process of negotiating a sale to a third party. It is likely that the client will need to make a recoverable amount write down in accordance with AASB 1010 Recoverable Amount of Non-Current Assets. / Assumptions included:
•Expected net cash inflows
•Level of activity
•Discount rate (if discounted)
•Likelihood of a successful sale
•Impacts on net assets and result for the period.
The client carries out research and development expenditure to develop new products and applies AASB 1011 Accounting for Research and Development Costs.
•Impacts on net assets and result. / Assumptions include:
•Management plans
•Stage of development
•Market expectations
•Projected cash flows
The client issues share options to employees that are exercisable at the end of a three year period subject to the share price increasing by 10% during that period. The client considers the future impact of IASB ED 2 Share Based Payments on the expenses that might arise as a consequence.
•Impacts on equity and result / Use of an option valuation model and identifying value received includes assumptions about:
•Expected volatility
•Number of employees that will remain in employment
•Timing of departures
•Likelihood that performance hurdle will be reached.
The client is part of a larger group which is considering whether or not to elect for tax consolidation
•Impact on net assets and result. / Management intentions determine:
•Recoverability of deferred tax assets and liabilities
•Whether or not the subsidiary will be assessable for income tax.
In any medium to large audit it is likely that an auditor will need to address the use of fair values, which implicitly hinge on managements’ future plans and expectations in a manner not dissimilar to the assumptions used for prospective financial information.
For each item above it is possible to derive a valuation for revenue, expense or carrying amount and to include appropriate note disclosures in the financial report. However, whether or not independent experts’ reports are used to support these calculations, there is still a high degree of subjectivity incorporated into the valuation basis, largely related to management expectations and plans. A very small variation in any one of the assumptions could produce a material difference. In these scenarios it would be very difficult for an auditor to prove that the difference is a “misstatement” or that the difference indicated that the financial report is “wrong”. In most cases the client would be able to justify a valuation, just as easily as disproving it. The scope for manipulation through tiny changes to assumptions is evident. In these scenarios audit risk cannot be related to financial statements being “wrong” but rather that “they fall outside a wide range of possible outcomes”. The nature of this type of audit risk is very different to the nature of audit risk arising in relation to financial reports that reflect transactions recorded at historical cost.
As a consequence we question the ability of the auditor to provide a “true and fair” report in an increasing number of situations. An auditor could report that nothing has come to the auditor’s attention that suggests the directors’ assumptions do not provide reasonable grounds for the determination of fair value.
The nature of guidance provided in current auditing literature needs to reflect the changing nature of accounting standards, to remain relevant and to address expectation gap issues. By definition the audit risk increases if management’s plans change after the financial report has been finalised. In a dynamic business environment it is not unreasonable that management plans could change to respond to opportunities that arise, with significant impact on the financial report.
This fundamental paradigm shift needs to be explained to our market and reflected in our audit reports as a matter of urgency. The fact that the financial report is prepared on the basis of the best available information at the reporting date is unlikely to be of much consolation to disappointed investors. Similarly the impact on audit risk is far greater than the consideration given in ISA 545, which anticipates the audit of individual items measured at fair value rather than the pervasive impact of fair value measurements throughout the financial report.
Please contact Dianne ( ) if you would like to discuss any issues arising.
Yours sincerely
Terry Benfold
PARTNER
S. Dianne Azoor Hughes
TECHNICAL DIRECTOR
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Pitcher Partners Submission IFAC Audit Risk