Key audit matters (ISA 701) and prescribed reports

A listed bank's audit report runs to several pages. Among them, readers find a section headed "Key audit matters" that says: loan impairment was the area of greatest judgement, and here is what the auditor did about it. Investors who never read the rest of the report read that section. It tells them where the audit effort went and why.

A different kind of report applies where the law fixes the form of the report, and a third issue arises when unaudited material, such as the chairman's statement, sits next to the audited statements.

This topic covers key audit matters under ISA 701, how they are chosen and described, the minimum content when law or regulation prescribes the report, and unaudited supplementary information. The previous topic covered the unmodified report, and the next covers reporting under the Companies and Allied Matters Act 2020.

Key terms in plain English

Syllabus check

This topic is in syllabus area C, audit evidence, completion and reporting (25% of marks). It covers:

• key audit matters (ISA 701)
• auditor's reports prescribed by law or regulation
• unaudited supplementary information

CAMA 2020 and prescribed reports

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.

The rules in more depth

Key audit matters: what and when

ISA 701, Communicating Key Audit Matters in the Independent Auditor's Report, was introduced in 2015 as part of the IAASB's revisions to the reporting standards, to make the report more informative and useful to users. Key audit matters (KAMs) must be communicated in the auditor's report of all listed companies and whenever the auditor is required by law or regulation to communicate them.

An auditor may also decide to communicate them voluntarily in other audits.

Determining KAMs

ISA 701 defines KAMs as those matters that, in the auditor's professional judgement, were of most significance in the audit of the financial statements of the current period. They are selected from the matters communicated with those charged with governance. Points to remember:

• KAMs are defined by reference to the auditor and not the user. They are the areas that needed significant auditor attention.
• KAMs are a standard element of the unmodified report for listed companies, and for other entities where required. They are not a modification of the report. They must not be confused with a modified opinion, an emphasis of matter or an other matter paragraph, which are decided with reference to the user.

In deciding the KAMs, the auditor takes into account:

1. areas of higher assessed risk of material misstatement, or significant risks;
2. significant auditor judgements relating to areas in the statements that involved significant management judgement, including estimates with high estimation uncertainty; and
3. the effect of significant events or transactions in the period.

The auditor then decides which of these matters were of most significance in the audit, and those are the KAMs. Typically, there are only a few, and they are the matters that took most of the time and attention of the engagement team.

Examples include impairment of goodwill, revenue recognition, valuation of inventory or investment properties, expected credit losses in a bank, going concern in a stressed company, a major acquisition or restructuring, and IT system changes that affect financial reporting.

Communicating KAMs

KAMs go in a separate section of the report headed "Key Audit Matters". An introduction says that KAMs are those matters that were of most significance, that they were addressed in the context of the audit of the statements as a whole and in forming the opinion, and that the auditor does not give a separate opinion on them. For each KAM, the description must explain:

• why the matter was considered of most significance and therefore a KAM; and
• how the matter was addressed in the audit.

A reference to the related disclosure in the financial statements is usually given. The description must be specific to the entity, not generic, and should not suggest that the matter is a modification of the opinion.

Illustration: goodwill. Under IFRS the group tests goodwill for impairment each year. This was significant to the audit because the balance was material and the assessment is complex and highly judgemental, based on assumptions about expected future market and economic conditions.

The audit procedures included using a valuation expert to help to evaluate the assumptions and methods, especially forecast revenue growth and profit margins, and focusing on the adequacy of the disclosures about those assumptions to which the outcome is most sensitive.

Illustration: revenue recognition. The amount of revenue and profit recognised depends on whether each long-term aftermarket service contract is linked to, or separate from, the contract for the sale of the product. The arrangements can be complex and judgement is needed. The risk is that sales and service agreements are treated as one, which would usually bring revenue and profit forward because the service margin is higher.

The audit procedures, for a significant risk, included testing controls with the help of IT specialists, including those over the input of campaign terms and pricing and the comparison of these with the contracts, and detailed analysis of revenue and the timing of recognition against expectations from industry knowledge and external market data, with follow-up of variances.

Where law prevents public disclosure of a matter, or in extremely rare circumstances the adverse consequences of describing it would outweigh the public interest benefit, the matter is not described. If there are no KAMs to report, the report says so.

KAMs compared with other paragraphs

Report prescribed by law or regulation

If law or regulation, for example a national auditing standard, requires a specific layout or wording of the report, the report may refer to the ISAs only if it contains, at a minimum:

• a title;
• an addressee;
• an opinion section expressing an opinion on the statements and referring to the applicable framework;
• an identification of the statements audited;
• a statement that the auditor is independent of the entity under the relevant ethical requirements and has met the other ethical responsibilities, identifying the country of origin of the requirements or referring to the IFAC Code;
• where applicable, a section on material uncertainty about going concern (ISA 570);
• where applicable, a key audit matters section (ISA 701);
• where applicable, a section on other information (ISA 720);
• a description of management's responsibility for the preparation of the statements and an identification of those responsible for oversight of financial reporting;
• a reference to the ISAs and to the law or regulation, and a description of the auditor's responsibilities;
• for listed entities, the name of the engagement partner, unless in rare circumstances this would lead to a significant personal security threat;
• the auditor's signature;
• the auditor's address; and
• the date of the report.

These headings match those that ISA 700 requires in an unmodified report. In Nigeria, the report of a company's auditor follows the Companies and Allied Matters Act 2020 and the standards adopted by the Financial Reporting Council of Nigeria. A report that does not include the minimum elements cannot say that the audit was carried out under the ISAs, though it may refer to the national law.

Unaudited supplementary information

The annual report often includes information that the auditor does not audit, such as a chairman's statement, an employment report or a business review. The auditor must be satisfied that any unaudited supplementary information presented with the audited statements is clearly differentiated from them, since the opinion does not cover it. If it is not clearly differentiated, the auditor asks management to change the presentation.

If management refuses, the auditor explains in the report that the supplementary information has not been audited. ISA 720 deals with the auditor's other responsibilities for such information. These include reading it to see whether it is materially inconsistent with the statements or with what the auditor learned in the audit. Reporting if there is a material misstatement of the other information which management will not correct.

Writing a KAM in the exam

A good KAM answer has four parts:

• the matter, for example inventory valuation at a manufacturer
• why it was significant, such as the material amount, the judgement about net realisable value and the risk of obsolescence
• what the auditor did, such as attending the count, testing costs to invoices and challenging the provision for slow-moving items
• a reference to the note in the statements

A good answer avoids generic phrases and ties the matter to the facts given in the question.

Where an entity has more than one significant risk, the auditor ranks them by the significance in the audit, the time and resources spent, and the degree of judgement and challenge. The discussion with those charged with governance helps to select them, and the auditor documents why a matter was or was not a KAM.

If the KAM concerns a matter that also led to a modification of the opinion, such as a material misstatement, the matter is described in the basis for opinion and not as a KAM.

Worked examples

1. These are matters of higher risk, significant judgement and significant events.
2. The auditor decides which were most significant, and describes them as KAMs.

1. KAMs do not change the opinion.
2. They are a normal part of the report for listed entities.

1. The report may not refer to the ISAs unless it contains the minimum elements.
2. The auditor adds the statement or does not refer to the ISAs.

1. The auditor asks for a clear separation.
2. If refused, the report says that the information is unaudited.

How to score full marks

• Define KAMs from the auditor's view.
• List the three considerations for choosing them.
• Describe why and how for each KAM.
• Say that they are not a modification.

Common mistakes in the exam

• Treating KAMs as a qualification.
• Writing generic KAMs.
• Leaving out how the matter was addressed.
• Forgetting that listed companies must give KAMs.

Quick revision

• KAMs: most significant matters in the audit.
• Higher risk; judgement; significant events.
• Why and how.
• Prescribed reports: minimum elements.
• Unaudited information: separate it or say so.

Practice questions

Questions 1 to 10 are multiple choice. Questions 11 to 13 are written. Try each before opening the answer.

Model answers

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