Tuesday, May 17, 2011

IAASB Will Consult on Enhancing External Audit Report by Closing Expectation and Information Gaps

Noting a growing perception among market participants that auditor reporting is not meeting the information needs of financial statement users in a global business environment with increasingly complex financial reporting requirements, the IAASB has launched a consultation to determine how the independent audit report, and more broadly the role of the outside auditor, can be enhanced to provide more useful auditor reporting to investors and other users of financial statements. Research indicates that investors and other users of company financial statements currently perceive little information value in any content of the auditor‘s report other than the opinion on the audited financial statements. Thus, the Board will examine issues with current financial reporting, including the perceived expectation and information gaps and explore options for change that could enhance auditor reporting and the communicative value of the auditor's report.

The longstanding expectation gap with outside auditor reports has been joined more recently by the information gap. Broadly, the expectations gap is the difference between what users of company financial statements expect from the auditor and the financial statement audit, and the reality of what an audit is. The information gap is when users of corporate financial information point to the existence of a gap between the information they believe is needed to make informed investment and fiduciary decisions, and what is available to them through the entity‘s audited financial statements or other publicly available information

The expectation gap often is attributed to a misunderstanding by users about the nature of an audit, including its scope, objectives and inherent limitations. More specifically, there continues to be a difference between public perceptions about the auditor‘s ability to detect financial statement fraud and the auditor‘s responsibilities relating to fraud under existing professional standards. The expectation gap results, in part, from the manner in which auditors communicate their findings to users of financial statements. Because the standard auditor‘s report uses generic language to describe the auditor‘s work effort, users do not get a complete picture about the extent of the auditor‘s procedures on a particular audit and therefore feel left with a gap between what is actually done and what they perceive is done in connection with the audit.

Research shows that user perceptions of audit quality are influenced by the communicative value of the auditor‘s report. The standard auditor‘s report provides little information to evaluate the quality of the audit, in part, because it does not disclose information about the procedures performed and the extensive judgments made by the auditor in forming the audit opinion. Increased transparency about the audit process may therefore have a beneficial effect on perceptions of audit quality.

Regarding the information gap, this could be narrowed by the disclosure of additional information that is currently not available to users. In principle, such information could be provided to users through some combination of additional reporting by management or the audit committee, or by the auditor. Some investors and analysts view the auditor‘s insight into the company’s business obtained through the audit of the financial statements as being especially relevant information for their needs, and have suggested that the auditor could report on additional information, including key business, operational and audit risks the auditor believes exist.

The outside auditor could also give its perspective on the key assumptions underlying the judgments that materially affect the financial statements, and whether those assumptions are at the low, most likely, or high end of the range of possible outcomes. Similarly, the external auditor could discuss key audit issues and their resolution which the engagement partner documents in a final, summary audit memo. Auditors could also opine on the appropriateness of the accounting policies adopted, including any that are inconsistent with industry practice, as well as changes to accounting policies that have a significant impact. More broadly, auditors could provide information going to the quality and effectiveness of the governance structure and risk management.

The standard auditor‘s report in most jurisdictions is silent with respect to the auditor‘s responsibility for, or involvement with, other information. Management Discussion and Analysis (MD&A), operating and financial review (OFR) statements, or other narrative sections of a company’s financial report are increasingly being used by management to communicate relevant information to users, and, for their part, investors are attaching greater importance to such information for decision-making.

Reasoning by analogy, the Board will explore whether outside auditors should be required to include a statement in their report about the auditor‘s responsibilities relating to other information in documents containing audited financial statements, or even a conclusion regarding such other information. A vehicle for this exploration will be ISA 720, The Auditor’s Responsibilities Relating to Other Information in Documents Containing Audited Financial Statements, which the Board is currently revising. As part of this revision, the IAASB will consider whether the ISA continues to specify appropriate responsibilities of the auditor relating to the range of other information in documents containing or accompanying the audited financial statements and the auditor‘s report thereon.

In addition, the Board will examine whether the standard auditor‘s report should provide further information about the audit. For example, the audit report could disclose key areas of risk of material misstatement of the financial statements identified by the auditor. The audit report could also discuss areas of significant auditor judgment, such as judgments about material uncertainties that may cast doubt about a company‘s ability to continue as a going concern. Moreover, the level of materiality applied by the auditor to perform the audit could be disclosed.