Over the past few years, the Auditing and Assurance Standards Board (AASB) has been finalizing conclusions around proposed changes to audit reports.  These amendments, known as Key Audit Matters (KAM), require auditors to report significant new information.

KAM will soon affect Canadian companies listed on the Toronto Stock Exchange (TSX) and the requirements to disclose KAMs will be effective for financial years ending on or after December 15, 2020.  As such, they will be considered effective for companies with December 31, 2020, financial year ends.

With December around the corner, RSM Canada aims to clarify specific elements of KAM and provide an overview for our clients that will be affected by these amendments.

What are key audit matters?

KAM refer to matters of the most significance in the audit of the entity’s financial statements for the current period, in the auditor’s professional judgment. KAM will be additional information provided in the Independent Auditor’s Report; they are meant to provide more relevant information for the users of the financial statements, specifically regarding some of the significant areas of audit and the audit procedures performed to address those risks.

Auditors are responsible for the communication of KAM, not management or the audit committee, and they describe aspects of the audit process.

What types of companies will be affected?

KAM is required for audits of financial statements of the following types of entities:

• Companies listed on the TSX, excluding listed entities required to comply with National Instrument 81-106, Investment Fund Continuous Disclosure, for periods ending on or after ­­December 15, 2020.
• Other listed entities, excluding listed entities required to comply with National Instrument 81-106, Investment Fund Continuous Disclosure, for periods ending on or after December 15, 2022.
• All entities for periods ending on or after December 15, 2018, where:
  • The auditor decides to communicate KAM in the auditor's report; or
  • The law requires the auditor to communicate key audit matters in the auditor's report.

How will auditors identify KAM?

Auditors determine KAM from the matters communicated with those charged with governance. In making these determinations, the auditor will also consider the following:

• Areas of higher assessed risk of material misstatement, or significant risks
• Significant auditor judgments relating to areas in the financial statements that involved significant management judgment, including accounting estimates identified as having high estimation uncertainty
• The effect on the audit of significant events or transactions that occurred during the period.

How will KAM be communicated in the Audit Report?

When communicating KAM, the auditor must describe each key audit matter, using an appropriate subheading, in a separate section of the auditor’s report and under the heading “Key Audit Matters.”

The auditor is required to describe KAM in the auditor’s report as:

• Financial statement note disclosure – the reference to the related financial statement note disclosure (s), if any
• Issue (i.e., the KAM) – why the matter was considered to be one of the most significant in the audit and therefore determined to be KAM
• Audit response - how the matter was addressed in the audit

What areas of audit reports will likely be KAM?

Common KAM will likely relate to areas involving a high degree of estimation.  These may include acquisitions, business combinations, valuation or impairment of property and tangible assets, taxes, allowance for loan losses and illiquid investments. However, a KAM could be identified in an area that does not require significant estimation but instead represents an area of the audit that is especially challenging or more complex to audit. One example is auditing revenue where contract terms are complex; for example, situations involving long-term contracts, several modifications to contracts, or multiple performance obligations. In such cases, the significant judgments involved in recognizing revenue may lead to the auditing of revenue being a KAM.

There may also be industry-specific matters that involve a high degree of estimation. Examples include valuation of investment property in Real Estate Investment Trusts (REITs) or valuation of mining properties in the mining industry.

For each annual audit, the area (s) identified as KAM may be new or similar to those from the prior year, depending upon the circumstances of that particular year’s audit. For example, if a KAM is identified in one year related to income taxes, it is possible that in the next year income taxes no longer rise to the level of a KAM, even though income taxes remain as a line item in the financial statements. However, a matter wouldn’t cease to be a KAM in the following year just because another matter rose to the level of a KAM; if both matters meet the definition of a KAM in the current year, both would be identified as KAM. 

How many KAM should be communicated?

The number of matters that are reported as KAM will depend on the nature and complexity of each company’s audit. There is no specific number of KAM that should be communicated in the auditor’s report. While any matter communicated or required to be communicated to the audit committee could be a KAM, not every matter discussed with the audit committee will necessarily be a KAM.

What is the role of audit committees and management?

Auditors, management, and audit committees should work together to establish a process for reading the content of the KAM section of the auditor’s report and discussing them, as well as identifying the parties who will be involved at the company. In establishing the process, consideration should be given to the timing of when the process will start; dedicating time in audit committee meetings to discuss KAM, and establishing expectations for sharing and receiving the KAM section of the auditor’s report is essential. An established process helps avoid surprises.

The audit committee should exercise its role in oversight of the independent audit process. In order to effectively perform their duties, the following questions should be discussed with the auditor:

In conclusion, KAM adoption is not a check-the-box exercise. Rather, this process requires a thoughtful assessment of the areas of the audit. Significant auditor judgement will be required to report KAM and will vary from company to company and year to year. Auditors will be reporting the KAM, but audit committees and management have a critical role to play in evaluating the quality of KAM. Open, frequent and timely communication will help avoid any surprises and can significantly enhance the quality of auditor and audit committee communications. 

Appendix A: Sample Key Audit Matter

Key audit matter

Valuation of goodwill for Reporting Unit B (See Note X in the financial statements)
We identified the valuation of goodwill for Reporting Unit B as a key audit matter because of certain significant assumptions management makes in determining the estimate, including revenue and gross margin projections and the discount rate.

Auditing management’s assumptions of revenue and gross margin projections and the discount rate involved a high degree of auditor judgment and increased audit effort, including the use of valuation specialists, as changes in these assumptions could have a significant impact on the fair value of Reporting Unit B and potential impairment charges.

Audit response to address the key audit matter
Our audit procedures related to the Company’s valuation of goodwill for Reporting Unit B included the following, among others:

• We obtained an understanding of the relevant controls related to the development of forecasts of future revenues and gross margin projections and tested such controls for design and operating effectiveness.
• We tested the reasonableness of management’s revenue and gross margin projections by comparing management’s prior forecasts to historical results for the Company.
• We utilized an internal valuation specialist to assist in:
  • Testing the reasonableness of revenue growth rates and gross margins by comparing them to historical results for similar companies.
  • Developing independent estimates of the discount rates based on publicly available market data and comparing the resulting reporting unit fair values to management’s estimates.