Key Audit Matters of Financial Statements
When investing in a company, investors need to understand the fundamentals including its financial aspects. Financial statements provide information about the financial position and performance of a company. They are used by a wide range of stakeholders, especially investors, in making investment decisions.
Independent and high-quality audits are essential in ensuring those statements are trustworthy and reliable. Auditors express an opinion to conclude whether the information in a company’s financial statements is free from material misstatement that may have been caused by fraud or errors. This gives investors confidence that the financial information can be trusted when considering investment opportunities.
When reading auditor’s report, apart from considering the auditor’s opinion, investors should read the financial statements in the context of the key audit matters as identified by the auditor. Key audit matters are, in the auditor’s professional judgement, the most significant matters in the audit of the financial statements of the current period. These help investors understand what might have kept the auditor awake at night, how these matters were dealt with in the audit and their respective impacts on the financial statements.
Key Audit Matters
Key audit matters usually include the areas where the assessed risks of material misstatement to be highest, or those where significant management or auditor judgments were involved. Here are some areas commonly addressed in key audit matters:
- Revenue recognition
Revenue is a critical measure of financial performance that reveals how well a company can generate money from its businesses. Unless rebutted, the auditor must presume that there is a risk of material misstatement due to fraud in revenue recognition. A sudden increase in revenue or gross margin coupled with complex or aggressive revenue recognition policies which involve significant management judgement and estimation often make revenue recognition a key audit matter. Investors should pay attention to how the auditor addresses those key audit risks to ensure that the appropriate amount of revenue is recognised in the appropriate accounting period.
- Impairment of assets
Investors may evaluate the reasonableness of a company’s share price based on its net asset value (i.e. total assets minus total liabilities) of each share. Therefore, assessment of the impairment testing prepared by management is an important audit area to ensure assets are not overstated. This is a complex area of financial reporting that requires careful judgement about uncertain future events and conditions. The degree of uncertainty may cause material adjustments in the carrying amount of assets. Investors should pay attention to the judgement made by management, the degree of its uncertainty, and the auditor’s assessment on its reasonableness.
- Valuation of financial instruments
Financial instruments measured based on a valuation method selected by management usually involves management’s judgement and assumptions. Valuation results can vary significantly when different valuation methods and assumptions are applied. Investors should consider whether the valuation method and assumptions applied are in line with industry norms, and take into account the auditor’s comments on the reasonableness of the assumptions made and sensitivity analyses performed by management.
- Provisions and contingent liabilities
It is common for listed companies to make provisions for tax risks, work related risks or legal disputes. These may involve analysis of complex information and data and judgement about outcomes that are subject to significant uncertainties. A typical example is the outcome of a significant pending legal case. Investors should pay attention to the assessment of the likelihood and magnitude of any liabilities that may arise, and take into account the auditor’s comments on the adequacy of disclosures in the financial statements.
Key audit matters provide greater transparency to the users of financial statements about how an audit is performed. Therefore, all responsible investors should read the key audit matters in conjunction with the related disclosures in the financial statements to better assess the integrity of the financial statements.
About the AFRC
The Accounting and Financial Reporting Council is an independent body established under the Accounting and Financial Reporting Council Ordinance. As an independent regulator, AFRC spearheads and leads the accounting profession to constantly raise the level of quality of professional accountants, and thus protects the public interest.
For more information about the statutory functions of the AFRC, please visit https://www.afrc.org.hk.