by NG KIAN HUI
The audit industry has been subjected to increased scrutiny in recent years to uphold audit quality and public interest. The 2019 Novel Coronavirus Outbreak (Covid-19) has further increased the challenges for auditors in performing their audits, not only in complying with the auditing standards but also in managing the expectations of the various stakeholders.
The Covid-19 situation poses a serious public health threat and has interrupted the movement of people and goods throughout the world. Governments the world over are instituting restrictions on individuals and businesses which may likely leave a lasting impact on financial reporting for the financial year 2020 and beyond. On top of those financial implications faced by the business, all these measures have further imposed challenges for auditors in the financial statements audit.
In this article, we will bring you through some of the key audit challenges and implications from Covid-19, and share how auditors can navigate through the upcoming audit peak season. We will go through the journey together from audit planning through to audit execution and reporting.
SSA 315 (Revised) Identifying And Assessing The Risks Of Material Misstatement Through Understanding The Entity And Its Environment requires auditors to identify and assess the risks of material misstatement (RMM), whether due to fraud or error, at the financial statement and assertion levels, through understanding the entity and its environment, including the entity’s internal control, thereby providing a basis for designing and implementing responses to the assessed RMM.
Given the uncertain economic and business environment, auditors must assess the impact to their risk assessments critically and consider whether any additional risk areas need to be included. Areas of RMM which require continuous updates may include but are not limited to the following:
- Changes to management’s processes, systems and controls;
- Management’s override and bias;
- Going concern assessment;
- Impairment of assets;
- Expected credit loss allowance for financial assets at amortised cost;
- Breach or modification in revenue contracts with customers and its financial impacts; or
- Breach of loan covenants.
Other than the continuous and iterative risk assessment process, another key audit planning challenge arising from Covid-19 would be the determination of audit materiality in accordance with SSA 320 Materiality In Planning And Performing An Audit.
Figure 1 Determining appropriate audit materiality
In view of the changing environment and the higher level of uncertainty associated with Covid-19, auditors need to identify whether there are new users or whether the needs of the existing users have changed. Auditors of the financial statements need to exercise professional judgements to understand the characteristics of the primary users of the financial statements and the decisions they make.
- Selecting appropriate benchmark
An appropriate benchmark is selected when setting materiality, which is based on what is important to the financial statement users (for example, profit before taxes, revenue, total assets, or net assets). Auditors need to consider, during the Covid-19 period, whether current users still look at the same items for their decision-making purposes (for example, are the operations of the entity so negatively impacted that liquidity is a more critical concern?)
Once a benchmark is selected, auditors may consider:
– Whether there is a need to normalise or average the benchmark;
– Whether a specific materiality is required for certain balances, transactions or disclosures that are of particular importance to users, or
– Whether there is a need to reassess the materiality as circumstances evolve.
In addition, SSA 330 The Auditor’s Responses To Assessed Risks requires auditors to respond to assessed risks by obtaining sufficient appropriate audit evidence regarding the assessed risk of material misstatement, through designing and implementing appropriate responses to those risks. The planned audit approach may be significantly different from the past; auditors need to revisit the planned audit approach due to work-from-home (WFH) arrangements, or the internal controls system of the client may not be operating as usual.
Greater focus or emphasis should be placed on the following but they are not limited to the response to the assessed RMM:
- The financial statement closing process (particularly journal entries and other adjustments made as they are more susceptible to RMM due to fraud and management’s bias);
- The auditor’s evaluation of the overall presentation of financial statements, including consideration of whether adequate disclosure has been made (going concern, financial risk management, impairment etc).
Figure 2 Audit risks
Due to the WFH arrangements and greater reliance being placed on electronic form of documents, audit risks are higher as the volume of electronic form or non-original documents used in an audit increases (Figure 2). Even though electronic form of documents could increase the audit effectiveness and efficiency, auditors should bear in mind that the quality of audit evidence cannot be compromised.
Additional procedures (for example, authentication, remaining alert to possible unauthorised signatories or modification) should be considered when electronic form or non-original documents are used and form part of audit evidence. In addition, auditors are reminded to ensure consistency of electronic audit evidence with other evidence obtained during the course of audit.
Auditing accounting estimates has always been a key focus of auditors. The uncertainty in light of Covid-19 poses greater challenges for management when making such accounting estimates. Auditors are reminded to remain sceptical when assessing management’s judgements and estimates. Some areas that require greater focus could include whether assumptions, such as discount rate or growth rate used by management, remain appropriate; whether data used by management is relevant and reliable, as well as any changes in regulatory factors that may affect management’s estimates.
Due to the adverse impact of the Covid-19 pandemic on the profitability, asset values and market capitalisation of many companies, the indicators for impairment are more present now than before.
The case study below illustrates some of the key areas of focus auditors should bear in mind in reviewing the impairment assessment of non-financial assets by management.
Case study 1: Impairment assessment of non-financial assets
– Sense Co. is a retailer specialising in low-cost but fashionable clothing for youth. They have a 31 December year-end and Sense Co. adopted SFRS(I) 16 on 1 January 2019.
– Sense Co. has operations in over 26 countries and leases all of its retail space from various landlords.
– Sense Co. also has a head office in Singapore, from where all the administrative and IT staff work.
– Management has identified indicators of impairment (reduced sales and foot traffic at all stores), so they are preparing to provide impairment calculations (value in use or VIU) in accordance with SFRS(I) 1-36 to their auditors for 31 December 2020 year-end.
What should auditors focus on, in reviewing the impairment assessment of management?
The discount rate must reflect the current market assessment of the time value of money and the risk specific to the assets. The risks and uncertainties arising from Covid-19 will generally increase the rate of return that a market participant would require. This is particularly true in industries most impacted by the effects of Covid-19, such as retail, as in the case of Sense Co. As such, it is unlikely that the discount rate used in the prior year’s impairment test would be acceptable for use in the 31 December 2020 impairment test.
- Multiple cash flow scenarios
In normal circumstances, a single best estimate of cash flows will be used for VIU calculation in the assessment for impairment of non-financial assets. However, significant uncertainties may exist as at 31 December 2020 as the cash flow model is impacted by uncertainty concerning future customer behaviour, effects of global supply chain, store operation and government regulations, etc. Hence, it may not be possible to use a single best estimate to reflect all the uncertainties in a single discount rate. Management may need to have multiple cash flow scenarios and apply probability weighting to determine the VIU amount.
- Lease period versus forecast period
Existing lease term for respective store might be shorter than the forecast period. Sense Co. should forecast market rental costs and include those cash flows, as operating the store requires a leased space. The inclusion of these cash flows is, in substance, similar to capital expenditure or maintenance cash flows as they are required for the cash generating unit (CGU) to operate.
One of the common errors in accounting for impairment of non-financial assets is not testing impairment at the correct “unit of account”. When there is an indicator that an asset or group of assets is impaired, that asset (or group of assets) must be tested for impairment. Determining the level at which impairment testing takes place (the “unit of account”) involves significant judgement.
- Allocation of corporate assets
Sense Co. has central corporate functions at their head office in Singapore. This includes a portion of the head office (including right-of-use assets), other assets and the servers used to administer the IT function for all of the various store locations. The stores cannot function without these assets as they provide payroll, IT and other necessary functions. Therefore, these corporate assets need to be allocated to respective store’s CGU.
Case study 2: Expected credit loss of trade receivables
Similar challenges will be faced by management in relation to determining the expected credit loss of financial assets under SFRS(I) 9 Financial Instruments. To illustrate using an example, assume the entity is in the business of selling bottled drinks to restaurants and supermarkets, with 30-day credit terms. SFRS(I) 9 Financial Instruments requires loss allowance for lifetime expected credit losses (simplified method) to be provided for all its trade receivables as at reporting date.
Figure 3 Trade receivables balance, aging and loss allowance as at 30 June 2020
Management has used its historical loss provision data in prior years and adjusted them to reflect its current and future conditions in order to derive the expected credit loss allowance for its trade receivables as at 30 June 2020. Auditors are reminded to challenge management’s basis of the expected credit loss rate applied as restaurant customers are likely to be more severely impacted by Covid-19 as compared to supermarket customers.
Therefore, further segmentation is required, based on the industries in which the customers operate, since certain industries may be more impacted as compared to others (that is, higher loss allowance is expected for restaurant customers as compared to supermarket customers).
GOING CONCERN CONSIDERATION
In reviewing the management’s going concern assessment in accordance with SSA 570 Going Concern, auditors should critically evaluate that management’s use of going concern assumption remains appropriate by understanding the impacts of Covid-19 on the entity’s operations and forecasts including liquidity.
Figure 4 Possible outcomes on management’s going concern assessment
Where significant uncertainties surround the outcome of future events, it may be appropriate for management to model multiple scenarios and weigh their likelihood of achieving the “worst case” scenario included in an assessment. It may have to consider little to no revenue for extended periods of time if the entity is required to cease or suspend trading operations. “Negative” or “worst case” scenarios may also need to be weighted quite heavily. Auditors should be alert to changes in conditions up to the date of the audit report when performing the evaluation of management’s assessment on the entity’s ability to continue as a going concern.
AUDIT COMPLETION AND REPORTING
In this rapidly changing and uncertain environment, auditors should continue to maintain professional scepticism throughout the audit and engage its client as early as possible to understand the possible impacts from Covid-19. It is expected that more time and effort will be required by auditors to complete the upcoming audit and ensure sufficient documentation of the work done. It will also be important to consider involvement of experts in auditing management’s estimates, and ensure sufficient time is catered to address key issues and to finalise audit opinion.
In forming an opinion, the auditors should ensure that issues arising from the Covid-19 outbreak have been sufficiently addressed, and appropriate sufficient audit evidence has been obtained. If auditors are unable to obtain sufficient audit evidence surrounding the financial statements, the audit report would need to be modified accordingly. Depending on circumstances, auditors may consider it necessary to draw users’ attention to certain matters relating to Covid-19 even though sufficient appropriate audit evidence has been obtained.
It is pertinent for auditors to step up and remain relevant during these uncertain times by delivering quality audit and continuing to contribute positively to the financial ecosystem.
Ng Kian Hui is Audit Partner, Head of Audit & Assurance, BDO Singapore.
This article was first published by ISCA in the ISCA Journal in December of 2020. The original article can be viewed by clicking here