An International Auditing and Assurance Standards Board discussion paper on the evolving nature of financial statement disclosure and its implications for the independent audit has been praised by PCAOB Standing Advisory Group members as containing a complete discussion of these highly important and sometimes contentious issues which arise against the backdrop of the efficacy of company financial statements for investors and other users. The study also arises as disclosures, which were once related directly to further explanations of line items on the face of the financial statements, have grown more complex and include items such as significant accounting policies, judgments made in the process of applying such policies, assumptions and models relevant to the calculation of items in the financial statements, and descriptions of risk management policies. Adding to the complexity is the use of fair value estimates for items measured at historical or amortized cost, or even by computer models, in order to disclose the fair value of reclassified financial assets.
At the same time, there has been some blurring of the boundaries of the traditional financial statements. For example, under IFRS 7, certain mandated disclosures can be presented outside of the financial statements in a document that is made available on the same terms as the financial statements and at the same time, using cross references from the financial statements.
A threshold issue identified by the Board is the materiality of disclosure, which is a pervasive concept in auditing, as well as in all federal securities law disclosures. One view is that accounting standard setters have applied a materiality filter in setting accounting standards and have judged disclosures to be material if the related line item is material. Since both preparers and auditors desire to have the financial statements include all required disclosures, some companies may believe that it is easier to include the requested disclosure rather than try to prove to the auditor that the disclosure is immaterial.
In the Board’s view, this could lead to voluminous disclosures that obscure important information from investors. IFRS 7 notes the need to strike a balance between overburdening financial statements with excessive detail that may not assist users and obscuring important information as a result of too much aggregation. This requires companies and auditors to exercise judgment in determining how much disclosure to provide and how it should be presented. That said, the Board noted that lengthy and complex disclosures may be necessary in many instances to fully inform users of financial statements of the key aspects of the company‘s financial position, performance and cash flows.
Another materiality issue concerns how to apply materiality to quantitative disclosures of financial instruments, such as disclosure of the nominal contract amounts of derivatives. In contrast, applying materiality to qualitative disclosures poses very different challenges. A key consideration is likely to be finding a balance between competing demands such as understandability of disclosures and excessively lengthy financial statements. Auditors need to consider whether the assertion of understandability has been met in respect of these disclosures, which is a subjective judgment, leading to disagreements with management that may be difficult to resolve.
The issue of materiality must be considered in the broader fair presentation context. Many financial reporting frameworks require financial statements to be true and fair (UK) or present fairly (US), which implies a need for the financial statements to do more than just comply with a checklist of accounting requirements and disclosures, but rather aim for overall transparency of the company’s financial position, performance and cash flows.
The concept of fair presentation has broken into two camps: those that believe that presents fairly means compliance with the financial reporting framework and those that believe that fair presentation is an overarching concept that goes beyond compliance with the financial reporting framework.
UK regulators have noted that, when the accounting standards do not specify disclosures, in such circumstances, the auditor needs to evaluate whether additional disclosures may be necessary to give a true and fair view, which means challenging management‘s accounting estimates and the appropriateness of their disclosures.
According to the IAASB, a key question to be explored is whether expectations in this regard can be reasonably met, recognizing that the adequacy of the disclosures is likely to be judged in hindsight once events have unfolded
A further aspect of presents fairly concerns the understandability, prominence and presentation of key disclosures in the context of the financial statements as a whole. Some would like auditors to give greater focus to the understandability of the financial statements, which may include the extent to which they tell the story of the company’s financial position, performance and cash flows. One factor in assessing presents fairly is the prominence of key disclosures. It may be argued by some that key disclosures should be easy to find and early in the notes to the financial statements, rather than towards the back of the financial statements.
Audit evidence is another important issue in the auditor‘s consideration of financial statement disclosures, that is, what constitutes sufficient appropriate audit evidence in relation to different categories of financial statement disclosures. It is important to recognize that the objective of the auditor is not to form an opinion on each individual disclosure in the financial statements.
International auditing standards require the auditor to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement. Auditors are looking for sufficient appropriate audit evidence to enable them to draw reasonable conclusions on which to base an opinion on whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework.
Different issues about audit evidence arise with different types of disclosures. The evidence regarding the amounts included in the related note disclosures, such as categories of property, plant and equipment and related amortization, will often be obtained in the course of auditing the assertions for the related line item rather than as a separate evidence gathering exercise. The auditor obtains some of the evidence regarding the information in operating segment disclosures in the process of obtaining evidence on the full financial statements.
A note disclosure supporting a line item recorded at fair value extends to describing the judgments, assumptions and model, if any, used. Therefore, the auditor seeks audit evidence about whether the disclosure is an accurate portrayal of the basis for the calculation of the fair value.
Another disclosure that helps illustrate the different issues is a risk disclosure required under IFRS 9, which includes a description of an internal control. For such a disclosure, questions arise as to whether the focus of the auditor‘s work is on whether the description of the control is accurate or whether the auditor is expected to test that the internal control is also operating effectively.
The ISAs are premised on management assuming responsibility for the preparation and fair presentation of the financial statements and, while not explicitly stated in the ISAs, having a sufficient basis, read evidence, to support their disclosures. This leads to the question of what is adequate support for management‘s disclosures, particularly for the newer and more subjective categories of disclosures.
Closely related to the topic of sufficient appropriate audit evidence are calls for an examination of the use of professional skepticism. UK regulators have emphasized the importance of auditors applying a high degree of professional skepticism when examining key areas of financial accounting and disclosure which depend critically on management judgment. Both the FSA and the FRC believe auditors need to challenge management more. The Board recognizes the perception that auditors may not be exercising sufficient judgment regarding disclosures in the financial statements, that they may not be sufficiently challenging management.