Come April, Auditors Will Have To Be More Transparent And Investors Will Benefit

Starting this year, enhanced disclosures in audit reports will help shareholders.

Employees sits in a meeting room. (Photographer: Yuriko Nakao/Bloomberg) 
Employees sits in a meeting room. (Photographer: Yuriko Nakao/Bloomberg) 

Starting next financial year, India Inc.’s auditors will have to be more transparent in how they assess financials of listed companies. April onwards, a new auditing standard- Key Audit Matters- will apply to financial statements of listed companies. The standard will require auditors to disclose areas where they exercised significant judgment and methods they used to arrive at conclusions. These areas will have to be selected from matters communicated with those charged with governance i.e. audit committees, board and the management.

Broadly speaking, this is good news for shareholders and investors.

So far, audit reports have been extremely boilerplate and do not require an auditor to explain what he did other than saying that he carried out the audit in accordance with auditing standards, PR Ramesh, chairman, Deloitte India pointed out.

Auditing standards are already very comprehensive in what an auditor should do including a standard on communication with those charged with governance. But so far this has been internal communication. The implementation of the new auditing standard will expand that, he added.

Statutory auditors make presentations to boards, audit committees etc. It was felt that why should this communication be internal when auditors are appointed by shareholders. So, the risk areas that statutory auditors have been discussing with audit committees so far will now be shared with investors and shareholders as well. 
PR Ramesh, Chairman, Deloitte India

The idea is to move from away mere pass-fail reports to getting auditors to list significant matters of judgment, Jamil Khatri, partner at BSR & Co. said.

KAM Scope?

In most cases, Key Audit Matters will relate to significant or complex matters disclosed in the financial statements. Illustrations provided by the Institute of Chartered Accountants of India’s guidance note include-

  • Certain complex areas relating to revenue recognition
  • Provisions and contingencies
  • Taxation matters - multiple tax jurisdictions, uncertain tax positions, deferred tax assets
  • Assessment of impairment
  • Put arrangements over non-controlling interests
  • IT systems and controls
In short, areas where there are significant estimates or judgment involved, where the auditor has the need to use experts, seek consultation, where there are significant transactions with related parties that are outside the normal course of business, any matter that has the potential to have a significant effect on the auditor’s overall strategy, are good starting points in determining key audit matters.
ICAI Guidance Note

Khatri suggested a funnelling approach - take all the matters an auditor reports to the audit committee and of those, pick areas that involve a lot of audit effort - where the auditor spends time confirming whether the management approach is accurate. These are the matters that should feature under KAM, he said, adding that they would differ from industry to industry.

For example, for an automobile company, it will likely be research and development expenditure – whether the company capitalises R&D expenditure is based on the level of uncertainty on the product they are developing. Let’s say a company has decided that once the R&D for a product has reached a certain stage, they will capitalise it and not charge it to the profits. Here, the company has made judgment calls that one, the product will be developed and two, it will be successful in the market. That fact, along with how the auditor has satisfied himself on this decision, will now be disclosed.
Jamil Khatri, Partner, BSR & Co.

Even today, he added, statutory auditors are exercising this judgment – in this case, an auditor would look at the past history of the company in developing products, is it an existing technology that’s being enhanced or a new one like electric vehicles – the fact that this uncertainty exists and the tools an auditor has used to satisfy himself will be disclosed to shareholders now, Khatri explained.

Ramesh pointed to a potential risk area in the infrastructure sector – for fixed price contracts, revenue is recognised on the basis of percentage completion method which involves taking a judgment call on how much of the project is complete, how much revenue and thereafter profit should be recognised.

From now on, an auditor is his report will say this is a significant area, it involves these uncertainties, and these are the tests we have carried out to satisfy ourselves. So, it’s more speaking in terms of what he did.
PR Ramesh, Chairman, Deloitte India

KAM: Investor Benefits?

As per the ICAI, the purpose of communicating key audit matters is to enhance the value of the auditor’s report by providing greater transparency about the audit that was performed.

Ramesh recommends investors and shareholders should compare companies within the same sector. Let’s say auditor for automotive company A says here are the risks. Another auditor for automotive company B lists some other risk areas. Investors should ask if both the companies are operating in the same geography, why are the risks different? Is the audit quality different in each of these? So, investors should read disclosures under KAM carefully, Ramesh explained.

Another way to view the enhanced disclosures would be to look at company-specific risks, for instance, litigation, Khatri said. Going over information under KAM would give investors a deeper understanding of the financials and potential risks for a particular company, he said.

Watch the discussion with PR Ramesha nd Jamil Khatri here...