Responding to an International Auditing and Assurance Standards Board discussion paper on the implication of financial statement disclosures on the outside auditor, the Big Four audit firms urged collaboration between audit and accounting standard setters and securities regulators since this not just an audit issue alone. Adequate and material disclosure is at the heart of securities regulation and the preparation of company financial statements. In its comment letter, KPMG urged the IAASB to work with IOSCO and the International Forum of Independent Audit Regulators, of which the PCAOB is a member, to help ensure that the objectives of any future projects on disclosures are understood and accepted. KPMG also recommended that the IAASB work closely with national auditing standard setters, in particular the PCAOB, to help ensure that any guidance developed in this area is as globally consistent as possible.
The IAASB 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.
Disclosures have always been considered an integral part of financial statements, noted KPMG, adding that the complexity and subjectivity of financial statement disclosures have evolved in a way that poses many challenges for the preparers of financial statements and their outside auditors. The auditor evaluates whether the financial statements as a whole are prepared, in all material respects, in accordance with the requirements of the applicable financial reporting framework. This requires the auditor to evaluate whether the disclosures include significant accounting policies selected and applied, are relevant, reliable, comparable, understandable, and adequate to enable the intended users to understand the effect of material transactions and events, and, evaluate whether the financial statements achieve fair presentation.
While supportive of an initiative to address the evolving complexity of financial statement disclosures, KPMG emphasized that this cannot be done solely by the IAASB and encouraged the Board to work with the IASB and other regulators, as well as with investors and preparers of financial statements. The Board should fully engage the accounting standards setters and regulators in order to address some of the challenges identified in the paper. While KPMG focused on the reporting requirements of IFRS as established by the IASB, the firm noted that the issues around financial statement disclosure apply equally to many national financial reporting frameworks that require a fair presentation.
Many IFRSs establish specific disclosure requirements. Broadly, IAS 1, Presentation of Financial Statements states that in virtually all circumstances a company achieves a fair presentation by compliance with applicable IFRS and that a fair presentation also requires additional disclosures when compliance with the specific requirements in IFRS are insufficient to enable users to understand the impact of particular transactions, other events and conditions on the company’s financial position and financial performance.
KPMG agreed with the suggestion in the paper that preparers and auditors tend to focus on the completeness of disclosures and are reluctant to have required disclosures omitted even when they are determined to be of low relevance to financial statement users. Similarly, in its comment letter, Deloitte noted that, while discussions do arise occasionally about the immateriality of disclosures, in the vast majority of cases companies have the mindset that if a disclosure is required by GAAP, then they will include it in the financial statements regardless of materiality. Since many companies approach disclosures with this compliance mindset, said Deloitte, there is an increased risk that disclosures that are needed to prevent the financial statements from being misleading may not be included.
KPMG reasoned that the reluctance to omit disclosures is out of a concern that, in the absence of guidance, judgments on disclosure will be questioned and therefore it is safer to focus on the completeness of disclosure in order to avoid being second guessed with respect to the relevance of any omitted disclosures. However, KPMG pointed out that the focus on completeness is in many ways also encouraged by the standards themselves.
In the absence of a broader framework to guide application of such requirements to a company’s particular circumstance, companies and their outside auditors will gravitate towards the completeness of detailed disclosure requirements. Some examples of disclosure requirements that KPMG believes contribute to an over emphasis on completeness at the cost of relevance and understandability are IFRS 3, Business Combinations and IFRS 7, Financial Instruments: Disclosures. These standards set out the objective of the disclosures for preparers, noted KPMG, but the standards then go on to list numerous disclosures that must be made with a requirement for additional disclosures if deemed necessary for the understanding. This tends to result in a checklist approach, said KPMG.
The materiality of a disclosure often is evaluated by reference to the quantitative materiality of the financial statement line item to which the disclosure relates. In some cases disclosures relate to line items that are material. However, all such disclosures may not be considered relevant to users in view of the industry or specific circumstances of the company. For example property, plant and equipment disclosures may be material and relevant to companies involved in manufacturing but may be less relevant to financial services firms. Similarly, some IFRS 7 disclosures are very significant and relevant for financial services firms and less relevant for companies that do not hold complex financial instruments.
KPMG thus supports initiatives aimed at helping preparers and auditors shift the focus of disclosures from completeness to relevance and understandability. And, in that context, guidance on disclosures and assessing their materiality needs to be developed.
KPMG asked the Board to encourage the IASB to work with other standard setters and undertake a project aimed at developing overarching guidance that enables preparers to assess the importance of required disclosures in specific IFRS in view of an entity’s specific circumstances and to omit them if they are deemed not necessary and do not have an impact on the fair presentation of the financial statements. This may be achieved by the development of an accounting disclosure framework that provides criteria for including disclosures in the financial statements and acknowledges the need to balance considerations relating to completeness, relevance and understandability in assessing the extent and presentation of disclosures.
A framework also would provide important guidance to management, auditors and audit committees to help them make judgments with respect to the evaluation of materiality of individual disclosures and whether the financial statements as a whole achieve a fair presentation.
Any plan to move to a model that places more emphasis on the understandability of disclosures as opposed to completeness will need the full buy in of securities and audit regulators, emphasized KPMG.
For its part, in its comment letter, Ernst & Young said there is a need for additional guidance for auditors on the auditing of disclosures and for evaluating if appropriate audit evidence has been obtained. The ongoing liaison between the IASB and the IAASB on financial reporting standards relating to disclosure is important. This will help the IAASB determine if additional guidance is needed for auditors or if changes to auditing standards are warranted to address new or changed financial reporting standards.
Echoing the call for a broad approach, in its comment letter PricewaterhouseCoopers noted that many of the disclosure issues are not solely audit issues. For example, the application of materiality to a judgment regarding disclosures is first an accounting issue. The view and actions of regulators will also influence judgments, as well as how materiality issues are interpreted and applied. Thus, PwC urged the IAASB to think holistically about the disclosure issues.
There is also the issue of the expectations gap, which 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. E&Y noted that the auditor’s report on the financial statements also covers disclosures and some users may believe that the disclosures are audited to the same level of precision as financial statement line items, which may contribute to the expectations gap. Thus, E&Y urged the IAASB to consider whether the auditor’s responsibility around disclosures should be clearly communicated in the auditor’s report on the company’s financial statements.