Auditors, take note: Major changes afoot next year

By Melisa Galasso, CPA

On May 8, the American Institute of CPAs (AICPA) issued Statement Auditing Standards (SAS) 134, Auditor Reporting and Amendments, Including Addressing Disclosures in the Audit of Financial Statements. This statement will have a major impact on all audits performed for nonpublic entities. The standard replaces all extant reporting sections including AU-C 700, Forming an Opinion and Reporting on Financial Statements; AU-C 705, Modifications to the Opinion in the Independent Auditor’s Report; and AU-C 706, Emphasis-of-Matter Paragraphs and Other-Matter Paragraphs in the Independent Auditor’s Report.

SAS 134 also creates a new AU-C section, AU-C 701, Communicating Key Audit Matters in the Independent Auditor’s Report. These changes are a result of a massive project the Auditing Standards Board (ASB) has been focused on for quite some time. The project was not done in a vacuum; in fact, it was done primarily with the goal of convergence. Both the International Auditing and Assurance Standards Board (IAASB) and Public Company Accounting Oversight Board (PCAOB) have issued similar standards reorganizing and updating language in their auditor’s reports.

The new SAS primarily converges with the IAASB’s report, but the PCAOB has issued a very similar standard. The project is a result of feedback from users of financial statements. The response was that users liked the current pass-fail model, but wanted more information about significant aspects of audit. There was concern that most audit reports used boilerplate language with little transparency about the audit. 

AU-C 700: Opinion and Reporting

AU-C 700, Forming an Opinion and Reporting on Financial Statements, clearly indicates the objective of the auditor is to “[F]orm an opinion on the financial statements based on an evaluation of the audit evidence obtained, including evidence obtained about comparative financial statements or comparative financial information,” and “express clearly the opinion on the financial statements through a written report.” AU-C 700 addresses the most basic of the auditor’s reports.

The changes to the basic audit report primarily deal with wording and paragraph order. What most CPAs will notice right from the start is the reorganization of paragraphs. In fact, the first section of the report will be the opinion. Currently, the opinion is toward the end of the report as a conclusion. I like to think about the new report as starting with the end in mind. The initial paragraph in the opinion section will mirror the extant initial paragraph that introduces the entity, the financial statements and the financial statement period. The second paragraph in the opinion section will be the extant audit opinion paragraph in which the auditor will express an unmodified opinion on the financial statements. 

The next section of the report will be the basis of opinion section. Currently, auditors report a basis paragraph when modifying an opinion. Under the new SAS, all audit reports will include a basis section. The paragraph starts off with a statement asserting the auditor follows U.S. Generally Accepted Audit Standards (GAAS). The sentence is the same as in the extant auditor’s responsibilities paragraph. It is then followed by a statement that sends the reader to the auditor’s responsibilities paragraph. The next sentence explicitly addresses the independence of the auditor and their ethical responsibilities. The current standard only addresses independence of the auditor in the title. The paragraph closes with a statement regarding sufficiency of audit evidence, which is from the extant auditor’s responsibilities paragraph.

The next section of the report address management’s responsibilities for the financial statements. Similar to the current standard, the first paragraph addresses management’s responsibility for fair presentation and internal control. The second paragraph is new and addresses management’s responsibilities regarding going concern.

After management’s responsibilities, the report discusses the auditor’s responsibilities. Auditors will quickly note the length of the new section. The first paragraph addresses the objectives of the auditor as stated in AU-C 700. It then provides the user with a definition of reasonable assurance and material misstatement. It also addresses the difference between fraud and error and the difficulty in finding fraud due to the intentionality of the misstatement. The next paragraph is a bulleted list of the procedures that auditors perform as part of the audit. It addresses professional skepticism, risk assessment, internal controls, accounting policy and estimates and going concern. The last paragraph in the auditor’s report section addresses the auditor’s responsibilities regarding communications with those charged with governance.

The report concludes with a signature, city and state of the auditor and date. Many auditors will find that the standard report, depending on formatting, will no longer fit on one page due to the expansion of the auditor’s responsibilities section. 

AU-C 701: Key Audit Matters

AU-C 701, Communicating Key Audit Matters in the Independent Auditor’s Report, is a new AU-C section which introduces the concept of Key Audit Matters (KAM). This section addresses the auditor’s responsibility to communicate KAM when the auditor is engaged to do so. This is a very important concept. The AICPA is not mandating the reporting of KAM. An auditor is only required to report KAM when so engaged. An auditor may be engaged to report KAM at the request of a bank, regulatory body or even a parent company. Once engaged to communicate KAM, the auditor then follows AU-C section 701.

KAM are defined as “Those matters that, in the auditor’s professional judgment, were of most significance in the audit of the financial statements of the current period. Key audit matters are selected from matters communicated with those charged with governance.” The PCAOB uses the term “critical audit matters,” which has a slightly different definition but the same intent — to provide audit and entity-specific information in the auditor’s report to address the user’s desire for less boilerplate language.

KAM are only permitted to be reported in an audit of a complete set of general-purpose financial statements. In fact, an auditor is prohibited from communicating KAM when expressing an adverse or disclaimer of opinion (unless required to by law or regulation). 

KAM are very judgmental and the guidance for identifying KAM is principle-based. The goal is to identify those items most significant that were communicated to those charged with governance. The determination of what was “most significant” will be based on professional judgment. Items to consider include those that required significant auditor attention — high-risk areas, significant auditor judgment — or that were challenging to obtain audit evidence. The auditor should also consider those areas that were complex and required significant management judgment as well as significant unusual transactions. KAM is intended to be entity-specific with no boilerplate language. The idea is that KAM is both entity- and audit-specific. KAM relates only to the current year, even when comparative years are shown, and are selected from those items communicated to those charged with governance. KAM are reported in the context of the auditor forming an opinion on the financial statements as a whole, meaning the auditor is not giving an opinion on individual KAM or providing a piecemeal opinion.

Once all potential KAM are identified, the auditor must identify which ones are MOST significant based on the concept of relative significance. This is also judgmental, as it is at the auditor’s discretion to determine the number of KAM and which items are selected. 

When reporting KAM, a separate section in the auditor’s report should be labeled “Key Audit Matters.” The auditor then includes an introductory paragraph defining KAM and informing the user that KAM was audited in relation to the audit of the financial statement as a whole. After the introductory paragraph, the auditor provides information about each audit matter identified. The order of KAM is also at the discretion of the auditor. Each description of KAM should include a reference to the related disclosures, if any, as well as an explanation as to why the matter was considered to be one of most significance by the auditor and how the matter was addressed in the audit. Auditors could provide a description of procedures performed, evidence obtained and aspects of the audit approach — while being sure not to imply an opinion on a particular KAM. 

It is possible that no KAM would be reported in an auditor’s report despite being engaged to communicate KAM. For example, a law or regulation prohibits disclosure about a matter or, in extremely rare circumstances, the auditor determined after a cost/benefit analysis that the matter should not be communicated in the auditor’s report because of potential adverse consequences. If no KAM is reported, the auditor would include an indication in the “Key Audit Matters” section that there are no matters to report. 

AU-C 705: Opinion Modifications

AU-C 705, Modifications to the Opinion in the Independent Auditor’s Report, address modifications to the auditor’s report including the issuance of qualified, adverse and disclaimer of opinions. The layout of a qualified opinion will be very similar to the standard report. In the opinion paragraph, similar to the current standard, the use of “except for” language is used in the opinion (second) paragraph. In addition, prior to the standard basis paragraph, a new paragraph explaining the reason for the qualification would be included similar to today’s basis paragraph. In an adverse opinion, similar to today’s standard, the opinion paragraph would state the financial statements “do no present fairly” the financial position and results of operations. Similar to the qualified opinion, a basis paragraph would be added before the standard basis paragraph explaining the reason for the adverse opinion. 

The disclaimer of opinion presentation is likely the largest change from the standard report. The first paragraph of the opinion section is modified to indicate that the auditor was “engaged to” audit the financial statements as opposed to indicating they did audit the financial statements. In addition, the second paragraph is modified to state that the auditor does NOT express an opinion. In the basis for disclaimer paragraph, the standard paragraph is removed and only the paragraph explaining the reason for the disclaimer is kept. In addition, the auditor’s responsibility section is significantly scoped back. The auditor responsibility sentence is followed by a statement regarding the basis paragraph and how the auditor was unable to obtain sufficient appropriate evidence. The remainder of the section is then deleted. The section closes with a statement regarding ethics and independence, which would normally appear in the standard basis paragraph. The disclaimer opinion is therefore clearly shorter and different to more easily identify it is not a standard report.

AU-C 706: Emphasis of Matter

AU-C 706, Emphasis-of-Matter Paragraphs and Other-Matter Paragraphs in the Independent Auditor’s Report, addresses the interplay of KAM and emphasis-of-matter (EOM) and other-matter (OM) paragraphs. EOM paragraphs received an updated definition to indicate that the auditor would not be required to modify the opinion in accordance with AU-C 705 as a result of the matter and that the matter was not been determined to be a KAM. OM paragraphs also clarify that if the matter is determined to be KAM, it would not be reported as an OM paragraph. In terms of presentation, when KAM is presented, an EOM paragraph can be presented either directly before or after the KAM section. The order of presentation is up to the auditor.

When an OM paragraph is needed to address a matter related to other reporting responsibilities, the OM paragraph may be included in the section “Report on Other Legal and Regulatory Requirements.” When the matter is relevant to all the auditor’s responsibilities or to users’ understanding of the auditor’s report, the OM paragraph may be included as a separate section following the sections “Report on the Audit of the Financial Statements” and “Report on Other Legal and Regulatory Requirements.”

Conforming amendments & disclosures

While SAS 134 addresses major changes to the auditor’s report, the standard also includes significant changes related to the ASB’s disclosure project. Many AU-C sections are updated to include new requirements for auditors to consider related to disclosures. Frequently, the term “notes” is replaced with the term “disclosures.” AU-C 240 is updated to address the consideration of disclosures during the fraud brainstorming session. AU-C 300 is amended to address the auditor’s plan for risk assessment and further audit procedures related to disclosures. In addition, financial statement assertions received a significant update with respect to disclosures. 

The engagement letter receives significant updates as a result of the updated auditor report. AU-C 260 is changed to include communicating significant risks those charged with governance. AU-C 600 is updated to address how to format a financial statement that contains multiple components and the presentation of the group audit. 

Going concern is also amended significantly; it is no longer considered an emphasis-of-matter paragraph. As going concern is now standard wording for both the auditor and auditee, if there were substantial doubt about an entity’s ability to continue as a going concern, the auditor would include a required section titled “Substantial Doubt About An Entity’s Ability to Continue as a Going Concern” and would reference the note disclosure and indicate the report was not modified. If the disclosures were not adequate, the auditor would express an adverse or qualified opinion and then include an explanation in the basis paragraph. 

Effective date

As there were significant changes to the report as well as other areas, the effective date for SAS 134 is for audits of financial statements for periods ending on or after Dec. 15, 2020. Early implementation is not permitted. As a side note, SAS 134 is not applicable when the auditor is forming an opinion and reporting on financial statements of employee benefit plans subject to the Employee Retirement Income Security Act of 1974 (ERISA). A separate ERISA specific reporting standard is expected out later this year. 

Melisa Galasso, CPA, is the founder of Galasso Learning Solutions LLC in Charlotte, N.C., where she designs and facilitates courses in advanced technical accounting and auditing topics, including nonprofit and governmental accounting. She is a member of the VSCPA Board of Directors and sits on the Disclosures Editorial Task Force.