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After decades of stagnation, the auditor’s report is changing.

Previously, during the audit of financial statements, only a company’s auditor and Board were privy to important matters. But now, some of the most significant matters, known as Key Audit Matters (KAMs), will be publicly disclosed through the auditor’s report for the benefit of all stakeholders of listed companies.

The auditor is required to comment on what these matters are, why the auditor judged these as significant, and which procedures the auditor applied to get comfortable with what the company’s financial statements say about these matters.

For example, an auditor may find that one of the most significant matters in the audit of financial statements of an airline is how it recognises revenue. The airline may be receiving cash from tickets sold well in advance of the flights. But many of the costs would be incurred only when the flights are actually operated. That is, early recognition could mean that revenue and costs do not match and resulting in misleading profits.

A company’s most significant matters will now be publicly disclosed through the auditor’s report for the benefit of all stakeholders of listed companies

To address this risk the auditor may check a sample of recorded revenue against flight departures and compare the amount recognised as revenue against the contracted ticket prices. The auditor may also analyse the gross margin across periods and segments to check if they show unusual movement.

There is a good reason behind the introduction of KAM. The ground reality of audit in Pakistan and elsewhere was that any two unqualified auditor reports differed only in client name and date. Investors have long questioned the justification of issuing a standardised audit opinion despite auditors having an abundance of company information, spending so much time in applying different audit procedures, and charging a considerable audit fee. Something had to happen to break the status quo — hence the KAMs.

KAMs involve judgement. Auditors have to judge what matter should be a KAM. That’s why multiple KAMs may be reported for companies operating in the same industry. It is also possible that there may not be any KAM in the audit of a company.

The UK experience shows that auditors reported around four KAMs in the first year with a slight drop in the second year. A survey of annual reports of listed companies in Hong Kong shows that over 90 per cent of the reports included one to three KAMs in the first year of implementation.

Most KAMs in these three jurisdictions pertained to valuation, impairment assessments and revenue recognition. Unsurprisingly, these are also the areas which tend to require significant judgement by the management of a company.

The financial year for many companies listed at the Pakistan Stock Exchange (PSX) has already ended on 30 June 2018. The annual report, including the enhanced auditor’s report with KAM, has to be issued within 120 days. A smooth implementation requires all stakeholders’ know the KAMs.

Auditors are probably far more familiar with the concept of KAMs than others owing to an established tradition of keeping up with new developments. But chief financial officers, audit committees, research analysts, investors, regulators and the tax authorities probably need catching up.

KAMs are not without a cost and risk. Auditors now have to put more time into writing customised reports. There are concerns regarding how listed companies, regulators and tax authorities will react to the enhanced disclosures. Some auditors may also think that they did not get a chance to factor in the cost of KAMs into their audit fee while accepting 2018 audit engagements. Others may prefer boilerplate KAMs to minimise effort and reduce perceived risk.

Internationally, audit regulators have also found some weaknesses in implementation. The matters reported as KAMs are not always sufficiently backed by audit working papers and described audit procedures are insufficiently performed. Similarly, rationale for not classifying some significant matters as KAM could be missing from the paperwork.

The potential risk and cost of KAMs need to be balanced against the fact that the enhanced auditor’s report is being introduced after an extended consultation by international standard setters and by the Securities and Exchange Commission of Pakistan nationally.

Auditors and listed companies have had ample time to prepare for KAMs. All that is changing is disclosure of information that was already available with the auditors and companies. KAMs are but a measured improvement in transparency of the audit and they should be welcomed by all stakeholders.

— The views expressed in this article are those of the authors.

— Usman Hayat is the CEO of Audit Oversight Board. He tweets @Usman_Hayat

— Shahid Karim is the Chief Regulatory Officer of Audit Oversight Board. He tweets @mkshahidkarim

Published in Dawn, The Business and Finance Weekly, September 10th, 2018