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Communicating Key Audit Matters:

The basic premise based on which an audit report, for the general purpose financial statements,
was drafted by an independent auditor was to communicate the financial well-being of an entity. An
auditors report is matter of an opinion and not a certification. SA 700 Forming an Opinion and
Reporting on Financial Statement deals with the auditors responsibility to form an opinion on the
financial statements. It also deals with the form and content of the auditors report issued as a
result of an audit of financial statements.
Over a period of time, the expectation of the users of the financial statements have increased. The
topic of auditor reporting had been on the IAASB (International Auditing and Assurance Standards
Board). The comment letters received by IAASB indicates greater disclosure by the Auditor on the
professional judgements, conclusion and appropriateness on Going Concern of entities especially
when there lies a material uncertainty. IAASB, thereafter, issued ISA 701 Communicating Key
Audit Matters in the Independent Auditors Report for financial statements. On the similar lines
ICAI proposes to issue SA 701. Standard will be applicable for audit of financial statements
on or after 1st April 2017.
What are Key Audit Matters?
In the words of Sir David Tweedie, the former Chairman of the IAASB and National Technical
Partner of KPMG, suggested that investors should learn through the report: (i) what kept the
auditor awake at night, (ii) what arguments the auditor had with CFO, (iii) what the big estimates
are, (iv) what the contentious accounting policies are, and (v) what the going concern assumptions
From the above quote, one can infer that KAM are those issues which would have affected the
Auditors opinion on the financial statements. These matters are of that significance, the accounting
treatment, presentation or disclosure, managements judgement, etc., were indeed so material to
the financial statements that it could have influenced the auditors opinion on the financial
statements. Are all the audit matters, are so relevant to be reported to the users of the financial
statements? The standard has given the following steps to determine, which of the matters may
have to be reported:
1. Step 1: Have a population of all the audit matters.
2. Step 2: These matters should have been communicating with those charged with governance.
3. Step 3: Select those audit matters which are :
A. The nature of the underlying accounting policy relating to the matter or the complexity or
subjectivity involved in managements selection of an appropriate policy compared to other
entities within its industry

B. Any corrected or any uncorrected misstatements due to fraud or error

C. Instances where auditor had to rely upon an export to or a professional with specialized
knowledge or skill to apply audit procedures
D. Severity any control deficiencies identified relevant to the matter
E. Significant risk identified as per SA 315, or
F. Areas of higher assessed risk of material misstatement;
G. Accounting estimates that involved significant management judgement which could have a
degree of high estimation uncertainty;
H. Effect on the audit of significant events or transactions that occurred during the period.

What should be reported as Key Audit Matter?

a. Brief description of the audit issue;
b. Audit procedure applied;
c. Outcome of the audit procedure or Key observations;
d. Audit Conclusion on the KAM.
Refer sample KAM reported in Companies incorporated in Europe.
Consequent amendment to other SA, to align with SA 701 (Proposed)
a. What is a significant matter to be reported is to the judgement of the auditor. However, one of
the indicators are that those matters which are reported to those charged with governance
under SA 260. The proposed SA 260 (Revised) requires auditors to communicate to those
charged with governance about the significant issues which would be classified as KAM and
subsequently reported in the Audit Report.
e. SA 705 (Revised) caters to the scenarios where the auditor concludes that there is a material
misstatement relating to the appropriateness or adequacy of disclosures in the financial
statements and thereby leading to qualification, adverse or disclaimer of opinion. Qualification
or rendering an adverse opinion is no substitute of disclosure of KAM. Further, where the
auditor disclaims to given any opinion on the financial statement, KAM paragraph need not be

Proposed SA 706 (Revised) establishes mechanisms for auditors to include additional

paragraphs in the Audit Report by use of Emphasis of Matter paragraphs and Other Matter
paragraphs. These paragraphs are presented independent of KAM section. There may be a
matter that is no determined to be a KAM in accordance with SA 701 (Proposed), but which, in
the auditors judgement, is fundamental to users understanding of the financial statements
(e.g., a subsequent event). If the auditor considers it necessary to draw users attention to such

a matter, the matter is included in an Emphasis of Matter paragraph in the auditors report in
accordance with SA 706 (Revised).
g. Proposed SA 260 (Revised) requires the auditor to communicate with those charged with
governance about the significant risks identified by the auditor and how the auditor plans to
address areas of higher assessed risks of material misstatement.
a. Consequent Revision of SA 570:

Use of Going Concern Basis

Proposed SA 570 Requirement

Para 21- Adverse Opinion to be rendered

of Accounting is Inappropriate

Use of Going Concern Basis of Accounting is appropriate, but a material uncertainty exists:


Adequate disclosure is made

a) Para 22 - Unmodified Opinion to be rendered.

in financial statements

b) Audit Report shall include a separate section Material

Uncertainty Related to Going Concern
c) Draw attention to the note in the financials and the events /
conditions that leads to this disclosure.


Adequate disclosure is not

made in financial statements

a) Para 23 - Qualified Opinion or Adverse Opinion, as

b) Basis of Qualified / Adverse Opinion - Auditor to state that a
material uncertainty exists that may cast significant doubt on
entitys ability to continue as a going concern and that the
financial statements do not adequately disclose this matter.

Management Unwilling to

Para 24 - Auditor shall consider the implications on the Auditors

make or extend its

Report and report accordingly.

Assessment of going concern

Where should the KAM be presented in the Audit Report?

Standard mandates that the KAM paragraph should be in close proximity to the auditors
opinion. The paragraph has to be clearly titled as Key Audit Matter. The position of the
issue in the previous year (comparative period) also needs to be reported.
Challenges faced by Auditors

1. Behavioural / Relationship with the Management and Audit Committee: The

Management of the Company and Audit Committee would have to be communicated
about the changes in the auditors responsibility and the KAM that would be disclosed.
2. Where to draw the line? - Carving audit matters from those communicated to those
charged with governance would surely be a challenge to many of the auditors. It is the
professional judgement of the auditor to determine which audit issue needs to be
reported. The application paragraph (A59) also indicates it would be rare for the
auditor of listed entity would not determine at least one key audit matter from the
matters communicated with those charged with governance to be reported. And, in
certain limited circumstances (where entity has very limited operations) the auditor may
determine that there are no key audit matters to be reported. This would indicate, that
the auditors of the listed entities are obliged to remain at least one issue as KAM
(unless they are so contained due to clients limited operations).
3. Language used in the paragraph should not be indicative of the fact that the issue has
not been appropriately resolved or should not contain any opinion on material assertion
which is contrary to the opinion given on the overall financial statements.
4. To ensure that the auditor does not let out any sensitive or trade information relating to
the client in the audit report.
5. Ensure that there are no law or regulation precluding public disclosures about the
matter, or

Examples of Key Audit Matters reported by Auditors for various entities

Carclo Plc (y.e. 31st March 2015)
In arriving at our audit opinion above on the financial statements the risk of material misstatement
that had the greatest effect on our audit was as follows: Carrying value of patent and
development costs. Refer to pages 38 to 39 (Audit Committee Report), pages 66 to 67 and 69
(accounting policy) and pages 81 and 95 (financial disclosures).
The Risk: The group has conducted a significant level of technology development activity within the CIT
Technology business and continues to undertake development activity in the Diagnostics Solutions business
areas. Patent and development costs are capitalised if they meet the criteria as laid down in the relevant
accounting standard. These include, among others, an assessment of the future out-turn of the development

activity, for example, the technical feasibility and how the patents and development costs will generate
probable future economic benefits. Once these criteria are met the eligible patent and development costs are
required to be capitalised. There is judgement involved in both determining when the criteria are met and in
identifying the relevant costs to be capitalised, which include accurately capturing time and cost information
for the development activity.
Patents and development costs capitalised are tested for impairment in accordance with the relevant
accounting standard. The group applies judgement in determining realisable value by assessing the potential
future economic returns from the technology. These valuations have inherent uncertainties.
Our response: Our audit procedures included, among others,

As part of our assessment of costs capitalised during the year we challenged the group and third
party assessments of technical feasibility and how the patents and development costs will generate
probable future economic benefit.

We considered the groups cash flow forecasts and correspondence. We assessed the
appropriateness of key inputs, such as the value and timing of sales by reference toour knowledge of
the groups business, our experience of the industry, and consideration of publicly available
information, such as customer press releases. We performed sensitivity analysis on the valuations
and range of assumptions used by the group. We compared the groups discount rate assumptions
to externally derived data as well as our own assessments.

We have agreed a sample of the specific development costs that have been capitalised to supporting

We have also considered the adequacy of the groups disclosures in respect of patents and
development costs and impairment.

Rolls Royce Holdings Plc (31 December 2014)