Audit committee should be talking to the auditor

Corporate frauds, accounting scandals and business failures continue to unravel across the globe, leaving investors not only bitter but also losing confidence in financial reporting. Regulators now want to significantly enhance corporate governance practices.

One such measure involves fostering a constructive dialogue between auditors and the audit committee on the accounting and auditing aspects of companies. While some of this communication may already be ongoing due to existing requirements in India, or from adoption of international practices, it would be useful to reiterate some of these.

Seeking information

The audit committee has insights into the company’s operations, internal controls, and financial reporting. Therefore, it would be useful for the auditor to directly obtain information from the committee about its assessment of risks of material misstatement, fraud risks, and laws and regulations. Such insights will complement the auditor’s own risk assessment process and enhance audit effectiveness.

Overview of audit strategy

Being a two-way dialogue, the auditor should provide the audit committee an overview of the audit strategy and timing, and discuss the significant risks identified. This could include information on the use of persons with specialised skills, including IT, tax, forensic, valuation or environmental specialists.

Timely observations

This is one of the most significant stages of the two-way communication. The audit committee not only receives significant information on the quality of the financial reporting process but, more importantly, can also determine the course of action based on it. This information may include

Management’s initial selection of, or changes in significant accounting policies. It may also be relevant to discuss the effect of such policies in controversial areas or those for which there is a lack of authoritative guidance or diversity in practice. This would assist the committee in evaluating the company’s financial results, and also benchmarking the accounting policies vis-à-vis others.

Description of the management process used to develop critical accounting estimates, significant assumptions used, especially those that have a high degree of subjectivity, and the auditor’s basis for conclusion on the reasonableness of such estimates. This is extremely important in today’s uncertain economic environment, when factors such as volatile exchange rates, interest rates, inflation or competition can have a major effect on various fair value measurements used in financial reporting (such as impairment of tangible and intangible assets including goodwill, valuation of financial instruments such as derivatives and so on).

Communication regarding significant unusual transactions — those outside the normal course of the company’s business, or otherwise unusual due to their timing, size, or nature. Such transactions may potentially include business acquisitions, dispositions, and restructurings.

The auditors may explain their understanding of the business rationale of such transactions. Such conversation would be extremely helpful when the transaction is overly complex — so that its effects can be appropriately reflected and disclosed in the financial statements.

Alternative permissible accounting treatments that the auditor may have discussed with the management, including their ramifications, and the treatment preferred by the auditor. For instance, some companies may write off goodwill on acquisitions whereas others may not. Knowing such alternatives and their effect on financial results will assist the audit committee in making informed decisions on the company’s financial reporting practices.

Departures from the auditor’s standard report — such as qualifications, emphasis of matter paragraphs, going concern considerations, and so on, including the language and reasons for such modifications. Such communication will be increasingly relevant for the audit committee of a listed company, as the market regulator SEBI has proposed a new review mechanism for qualifications in an auditor’s report.

Details of corrected and uncorrected misstatements related to accounts and disclosures. Sometimes these misstatements may not get corrected, as the management may conclude them to be immaterial. In such situations, the auditor should communicate the basis and qualitative factors behind the decision.

The Public Company Accounting Oversight Board (PCAOB), the US audit regulator, recently issued a new auditing standard No.16 on Communications with Audit Committees, prescribing additional communication requirements (some of which have been described above).

In India, the proposed Companies Bill 2012 contemplates a National Financial Reporting Authority to advise on matters relating to auditing standards; so, enhancing audit committee communication may be an important area.

A well-informed audit committee would be better equipped to perform its financial oversight role — improving the ‘relevance and reliability’ of financial reporting, strengthening audit quality and, ultimately, benefiting various stakeholders.

The author is Partner and Head, US GAAP and SEC Services, KPMG in India

COMMENT NOW