(a) Kilmister Co – Critical appraisal of extract from draft auditor’s report
Presentation and structure of auditor’s report extract
The structure and format of the auditor’s report is prescribed by ISA 700 Forming an Opinion and Reporting on Financial Statements. The auditor’s report should be addressed solely to the shareholders of the reporting entity and the title should not include any reference to the directors of Kilmister Co. In addition, the first two paragraphs are presented in the incorrect order, the Opinion paragraph should precede the Basis for Opinion paragraph.
Reference to ethical code
ISA 700 requires that in the Basis for Opinion paragraph, the auditor should identify the relevant ethical code, naming the IESBA International Code of Ethics for Professional Accountants. The draft auditor’s report does not specifically refer to the ethical code which has been applied during the audit and is therefore not in compliance with the requirements of ISA 700.
Material uncertainty regarding going concern
ISA 570 Going Concern provides guidance on how an auditor should report uncertainties regarding going concern in the auditor’s report. According to ISA 570, if adequate disclosure about the material uncertainty is not made in the financial statements, the auditor should express a qualified opinion or adverse opinion as appropriate.
The use of a ‘material uncertainty regarding going concern’ paragraph in the draft auditor’s report extract is therefore incorrect. This paragraph should only be used when adequate disclosure has been made by the directors in the financial statements and would include a cross reference to this disclosure. Given that this disclosure has not been made, this is therefore not appropriate in this case.
In this case, therefore, the absence of any disclosure in the financial statements in relation to the uncertainties regarding going concern is grounds for a modification of the auditor’s opinion. The modification is due to a material misstatement in relation to the absence of this key disclosure. If, in the auditor’s professional judgement, the impact of this non-disclosure on the financial statements is material but not pervasive, a qualified ‘except for’ opinion should be issued. In this case, the opinion paragraph should be headed ‘qualified opinion’ and this should be followed immediately by a ‘basis for qualified opinion’ paragraph. If, on the other hand, the auditor believes that the impact on the financial statements of the non-disclosure is both material and pervasive, an adverse opinion should be given. The opinion paragraph should then be headed ‘adverse opinion’ and should be followed immediately by a ‘basis for adverse opinion’ paragraph.
In addition, details of the uncertainty regarding going concern should be given in the basis for qualified or adverse opinion paragraph.
Long-term contracts
The use of the ‘other information’ section in this context is inappropriate. This section should be used to describe the auditor’s responsibilities for ‘other information’ (e.g. the rest of the annual report, including the management report) and the outcome of fulfilling those responsibilities.
The disclosure regarding long-term contracts is more in line with the requirements of ISA 701 Communicating Key Audit Matters in the Independent Auditor’s Report, where key audit matters are those which in the auditor’s professional judgement were of most significance to the audit. In determining which matters to report, the auditor should take into account areas of significant auditor attention in performing the audit, including:
– Areas of higher assessed risk of material misstatement, or significant risks identified in accordance with ISA 315 (Revised) Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment.
– Significant auditor judgements relating to areas in the financial statements which involved significant management judgement, including accounting estimates which have been identified as having high estimation uncertainty
– The effect on the audit of significant events or transactions which occurred during the period.
The extract from the draft auditor’s report states that significant judgement is applied in assessing the percentage of completeness of material long-term contracts and that this percentage is then applied in calculating the revenue for the year. This is a matter of high risk requiring significant auditor attention and given that Kilmister Co is a listed entity, it would be appropriate for this to be disclosed in the KAM section of the auditor’s report. The KAM section of the auditor’s report should begin with an introductory paragraph explaining what a KAM is. The KAM section should then explain why this matter is considered to be a KAM due to the significant judgement involved in assessing the percentage completeness of the long-term contracts and the high risk of material misstatement associated with this judgement process. The KAM section should also include an explanation of how the KAM was addressed by the audit process. In this case, this might include, for example, an evaluation of the controls designed and implemented by Kilmister Co to monitor the progress of and the amounts owing on service and construction contracts; a review of the financial performance of key contracts against budgets and historical trends; and challenging management’s estimates and judgements in respect of the progress to date on the contracts.
(b) Taylor Co – Report to those charged with governance
A report to those charged with governance (TCWG) is produced to communicate matters relating to the external audit to those who are ultimately responsible for the financial statements. ISA 260 Communication With Those Charged With Governance requires the auditor to communicate many matters including independence and other ethical issues and the significant findings from the audit. In the case of Taylor Co, the matters to be communicated would include the following:
Revaluation of property portfolio​​​​​​​
According to ISA 260, the significant findings from the audit include the auditor’s views about significant qualitative aspects of the entity’s accounting practices including accounting policies and any circumstances which affect the form and content of the auditor’s report. In the case of Taylor Co, therefore, the significant findings from the audit would relate to the changes in the accounting policy in relation to the revaluation of property and related material misstatements and the following matters should be communicated:
IAS 16 Property, Plant and Equipment states the revaluation policy should be consistent across a class of assets. However, four properties, which are material to the statement of financial position at 2·1% of total assets, are still carried at depreciated historic cost. This therefore represents a breach of IAS 16 and a material misstatement, which will impact on the form and content of the auditor’s report.
According to ISA 260, the significant findings from the audit also include significant difficulties encountered during audit such as information delays. The independent external valuation reports requested by Eddie & Co at the planning stage were not available when requested by the auditor and it took three weeks before they were received by the audit team. The auditor should report this delay to those charged with governance, detailing its impact on the efficiency of the audit process together with any resulting increase in the audit fee.
Renovation of car parking facilities​​​​​​​
The renovation expenditure on the car parking facilities at Taylor Co’s properties should be recognised as an asset according to IAS 16 if it is probable that future economic benefits associated with the item will flow to the entity and the cost of the item can be measured reliably. In Taylor Co’s case, the cost has been quantified as $13·2 million and it has already derived economic benefits in the form of a significant increase in customer numbers and revenue at each of these locations. The expenditure should therefore be capitalised and its inclusion in operating expenses is not in compliance with IAS 16. The amount of $13·2 million is also material to the statement of financial position at 2·5% of total assets. The incorrect application of IAS 16 and the material misstatement should be included in a report to TCWG as a significant finding from the audit which will impact on the form and content of the auditor’s report.
ISA 265 Communicating Deficiencies in Internal Control to Those Charged With Governance and Management requires the auditor to communicate appropriately to those charged with governance deficiencies in internal control which the auditor has identified during the audit and which, in the auditor’s professional judgement, are of sufficient importance to merit their respective attentions. The audit working papers include minutes of discussions with management which confirm that authorisation had not been gained for this expenditure. The lack of authorisation indicates a lack of management oversight and a serious weakness in control which could allow fraud to occur. Furthermore, the lack of integrity shown by management in going ahead with the renovation works without the necessary permission is an example of management override and could be indicative of the tone set throughout the organisation. This therefore represents a high risk matter and they may wish to implement controls and procedures to prevent further breaches. The report to those charged with governance should include full details on this significant deficiency in internal control and should include recommendations to management in order to reduce the associated business risk.
Long association of audit partner​​​​​​​
As discussed above, ISA 260 requires the auditor to communicate matters in relation to auditor independence. Bryony Robertson has acted as audit engagement partner for Taylor Co for eight consecutive years. According to the IESBA Code of Ethics for Professional Accountants (the Code), her long association with the audit client creates both familiarity and self-interest threats to auditor independence. The familiarity threat arises due to the long and potentially close relationship which she has with the staff of Taylor Co leading to her being too sympathetic to their interests or too accepting of their work. This in turn gives rise to a self-interest threat in that her long association and close relationship with the client create a personal interest which may inappropriately influence her professional judgement or behaviour. In order to address these risks, the Code requires that an audit partner in a listed entity should be rotated at least every seven years and therefore her eight-year tenure as the audit partner of Taylor Co appears to be in clear breach of this provision. However, the Code does allow for an engagement partner to serve for an additional year if the required rotation is not possible due to unforeseen circumstances such as the illness of the intended engagement partner, in this case Philip Campbell. In these circumstances, safeguards should be applied such as the independent review of the engagement which is being performed and this should be communicated to those charged with governance. Going forward beyond the current year, if it remains impossible to rotate the audit partner due to a lack of alternative expertise within the firm, it may be possible for Bryony Robertson to continue as the audit partner if special dispensation is received from the relevant regulator and the necessary safeguards are applied such as the engagement is subject to regular review by an independent, external expert.