The Auditor’s Discussion and Analysis (AD&A), the new improvement of the auditor’s reporting model

On June 21, 2011, the Public Company Accounting Oversight Board (PCAOB) issued the Concept Release on Possible Revisions to PCAOB Standards Related to Reports on Audited Financial Statements.

As stated in the publication, the purpose of issuing this concept release is to seek public comment on potential changes to the auditor’s reporting model based on concerns of investors and other financial statement users. Auditors, as a result of the performance of required audit procedures, often have significant information regarding a company’s financial statements and the audit of such financial statement, that is not today reported in the standard auditor’s report to the financial statements users. This information might be useful to investors and other financial statement users and could lead to more efficient markets and improved allocations of capital.

The objective of this concept release is to discuss several alternatives for changing the auditor’s reporting model that could increase its transparency and relevance to financial statement users, while not compromising audit quality.

The alternatives presented in the concept release are :

• Auditor’s Discussion and Analysis (AD&A),
• Required and expanded use of emphasis paragraphs,
• Auditor assurance on other information outside the financial statements, and
• Clarification of language in the standard auditor’s report.

The above alternatives are not mutually exclusive. A revised auditor’s report could include one or a combination of these alternatives or elements of these alternatives. Additionally, there may be other alternatives to consider that this concept release does not present.

Regarding the Auditor’s Discussion and Analysis (AD&A), the concept release proposes that a revised auditor’s reporting model could include a supplemental narrative report, which some have described as an Auditor’s Discussion and Analysis (AD&A). An AD&A could provide investors and other financial statement users with a view of the audit and the financial statements “through the auditor’s eyes.”

Further, the concept release described that the intent of an AD&A would be to provide the auditor with the ability to discuss in a narrative format his or her views regarding significant matters. The AD&A could include information about the audit, such as audit risk identified in the audit, audit procedures and results, and auditor independence. It also could include a discussion of the auditor’s views regarding the company’s financial statements, such as management’s judgments and estimates, accounting policies and practices, and difficult or contentious issues, including “close calls.”.

Additionally, an AD&A could provide the auditor with discretion to comment on those material matters that might be in technical compliance with the applicable financial reporting framework, but in the auditor’s view, the disclosure of such matters could be enhanced to provide the investor with an improved understanding of the matters and their impact on the financial statements.

Read further the full version of the Concept Release in here : PCAOB : Concept Release.

The comment period for the concept release ends on September 30, 2011.

Read also another related article : What were the Auditors Thinking?

The Importance of External Confirmations as Audit Evidence

ISA 505 deals with the auditor’s use of external confirmation procedures to obtain audit evidence in accordance with the requirements of ISA 330 regarding The Auditor’s Responses to Assessed Risks, and ISA 500 regarding Audit Evidence. It does not address inquiries regarding litigation and claims, which are dealt with in ISA 501 regarding Audit Evidence – Specific Considerations for Selected Items.

ISA 500 indicates that the reliability of audit evidence is influenced by its source and by its nature, and is dependent on the individual circumstances under which it is obtained. That ISA also includes the following generalizations applicable to audit evidence :

• Audit evidence is more reliable when it is obtained from independent sources outside the entity
• Audit evidence obtained directly by the auditor is more reliable than audit evidence obtained indirectly or by inference
• Audit evidence is more reliable when it exists in documentary form, whether paper, electronic or other medium

Accordingly, depending on the circumstances of the audit, audit evidence in the form of external confirmations received directly by the auditor from confirming parties may be more reliable than evidence generated internally by the entity. This ISA is intended to assist the auditor in designing and performing external confirmation procedures to obtain relevant and reliable audit evidence.

Other ISAs recognize the importance of external confirmations as audit evidence, for example :

(1) ISA 330 discusses the auditor’s responsibility to design and implement overall responses to address the assessed risks of material misstatement at the financial statement level, and to design and perform further audit procedures whose nature, timing and extent are based on, and are responsive to, the assessed risks of material misstatement at the assertion level. In addition, ISA 330 requires that, irrespective of the assessed risks of material misstatement, the auditor designs and performs substantive procedures for each material class of transactions, account balance, and disclosure. The auditor is also required to consider whether external confirmation procedures are to be performed as substantive audit procedures

(2)  ISA 330 requires that the auditor obtain more persuasive audit evidence the higher the auditor’s assessment risk. To do this, the auditor may increase the quantity of the evidence or obtain evidence that is more relevant or reliable, or both. For example, the auditor may place more emphasis on obtaining evidence directly from third parties or obtaining corroborating evidence from a number of independent sources. ISA 330 also indicates that external confirmation procedures may assist the auditor in obtaining audit evidence with the high level of reliability that the auditor requires to respond to significant risks of material misstatement, whether due to fraud or error.

(3)  ISA 240 indicates that the auditor may design confirmation requests to obtain additional corroborative information as a response to address the assessed risks of material misstatement due to fraud at the assertion level.

(4)  ISA 500 indicates that corroborating information obtained from a source independent of the entity, such as external confirmations, may increase the assurance the auditor obtains from evidence existing within the accounting records or from representations made by management.

Source of this article : ISA 505 – External Confirmations, paragraphs 1-3

What Circumstances Meet the Condition that the Auditor is Unable to Obtain Sufficient Appropriate Audit Evidence ?

The auditor’s inability to obtain sufficient appropriate audit evidence (also referred to as a limitation on the scope of the audit) may arise from :

1. Circumstances beyond the control of the entity;
2. Circumstances relating to the nature or timing or the auditor’s work; or
3. Limitations imposed by management

An inability to perform a specific procedures does not constitute a limitation on the scope of the audit if the auditor is able to obtain sufficient appropriate audit evidence by performing alternative procedures.

Examples of circumstances beyond the control of the entity include when :

1. The entity’s accounting records have been destroyed
2. The accounting records of a significant component have been seized indefinitely by governmental authorities

Examples of circumstances relating to the nature of timing of the auditor’s work include when :

1. The entity is required to use the equity method of accounting for an associated entity, and the auditor is unable to obtain sufficient appropriate audit evidence about the latter’s financial information to evaluate whether the equity method has been appropriately applied
2. The timing of the auditor’s appointment is such that the auditor is unable to observe the counting of the physical inventories
3. The auditor determines that performing substantive procedures alone is not sufficient, but the entity’s controls are not effective

Examples of an inability to obtain sufficient appropriate audit evidence arising from a limitation on the scope of the audit imposed by management include when :

1. Management prevents the auditor from observing the counting of the physical inventory
2. Management prevents the auditor from requesting external confirmation of specific account balances.

Source : IAS 705 – Modifications to the Opinion in the Independent Auditor’s Report paragraphs A8 - A12

In What Circumstances the Material Misstatements of Financial Statements May Arise ?

ISA 700 requires the auditor, in order to form an opinion on the financial statements, to conclude as to whether reasonable assurance has been obtained about whether the financial statements as a whole are free from material misstatement. This conclusion takes into account the auditor’s evaluation of uncorrected misstatements, if any, on the financial statements in accordance with ISA 450.

ISA 450 defines a  misstatement as a difference between the amount, classification, presentation, or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that is required for the item to be in accordance with the applicable financial reporting framework.

Accordingly, a material misstatement of the financial statements may arise in relation to :

1. The appropriateness of the selected accounting policies;
2. The application of the selected accounting policies; or
3. The appropriateness or adequacy of disclosures in the financial statements

Appropriateness of the Selected Accounting Policies

In relation to the appropriateness of the accounting policies management has selected, material misstatements of the financial statements may arise when :

1. The selected accounting policies are not consistent with the applicable financial reporting framework; or
2. The financial statements, including the related notes, do not represent the underlying transactions and events in a manner that achieves fair presentation

Financial reporting frameworks often contain requirements for the accounting for, and disclosure of, changes in accounting policies. Where the entity has changed its selection of significant accounting policies, a material misstatement of the financial statements may arise when the entity has not complied with these requirements.

Application of the Selected Accounting Policies

In relation to the application of the selected accounting policies, material misstatements of the financial statements may arise :

1. When management has not applied the selected accounting policies consistently with the financial reporting framework, including when management has not applied the selected accounting policies consistently between periods or to similar transactions and events (consistency in application); or
2. Due to the method of application of the selected accounting policies (such as an unintentional error in application).

Appropriateness or Adequacy of Disclosures in the Financial Statements

In relation to the appropriateness or adequacy of disclosures in the financial statements, material misstatements of the financial statements may arise when :

1. The financial statements do not include all of the disclosures required by the applicable financial reporting framework;
2. The disclosures in the financial statements are not presented in accordance with the applicable financial reporting framework; or
3. The financial statements do not provide the disclosures necessary to achieve fair presentation.

Source : ISA 705 – Modifications to the Opinion in the Independent Auditor’s Report paragraphs A2 - A7

The 2010 Big Four Firms Performance Analysis by www.Big4.com

Big4.com is the accounting, tax consulting and IT professions’ premier resource that focused on professionals and alumni of the Big Four Accounting and Consulting Firms – Accenture, Deloitte, Ernst & Young (E&Y), KPMG, PricewaterhouseCoopers PwC, Andersen, BearingPoint and Capgemini. It is not affiliated with any Big Four firm.

Recently, it has published “The 2010 Big Four Firms Performance Analysis”, an analysis report of the 2010 Financial Performance of the World’s Largest Accounting Firms, PricewaterhouseCoopers PwC, Deloitte Touche Tohmatsu, Ernst & Young and KPMG.

Within the executive summary, it reports that after an extraordinary period of continuous revenue growth from the early 2000s to 2008, combined revenue for the four firms in fiscal 2009 fell by 7% from fiscal 2008 in US dollar terms, ranged from negative 5% for Deloitte to negative 7% each for Ernst & Young and PricewaterhouseCoopers to negative 11% for KPMG. However, in 2010 the situation improved remarkably, with $95 billion combined revenue for the four firms in fiscal 2010 increasing 1.4% from $94 billion in fiscal 2009 in US dollar terms, ranged from negative 0.9% for Ernst & Young, 1.5% for PwC, 1.8% for Deloitte and 2.6% for the fastest-grower, KPMG.

The big story of 2010 was that Deloitte with its 1.8% growth was able to beat PricewaterhouseCoopers with its 1.5% growth to gain first place and become the largest accounting firm on the planet. In 2009, PwC was narrowly ahead of Deloitte, but Deloitte’s 2010 revenues of $26.578 billion was ahead of PwC’s 2010 revenues of $26.569 billion by an ultra-slim, but very significant, $9 million. Ernst & Young took the third spot at $21.3 billion, and KPMG maintained its position as the smallest of the Big Four firms at $20.6 billion, but narrowed the gap against E&Y.

While the outlook for 2011 and beyond is quite optimistic. Revenue is expected to grow at a steady pace, with help from strong emerging markets and advisory services. 2011 will also prove whether Deloitte can maintain its lead over PwC; and whether the gap between E&Y and KPMG will narrow further.

The full study can be downloaded as Adobe pdf at http://www.big4.com/bigfourperformanceanalysis.html