Key Audit Matters in Independent Auditor’s Report: Telecommunication Industry-Case Study 2
The new auditing standard ASA 701 communicating key audit matters in the independent auditor’s report was developed in the wake of the global financial crisis (note: following the demise of Lehman Brothers shortly after it received an unqualified audit report, i.e. no prior warning of its demise). This development is in response to calls from shareholders to know more about the companies they invest in (students would need to explain what happened in Lehman Brothers which would evidently be a key audit matter if such an auditing standard had existed then). Further, investors have also requested earlier warnings of potential issues that may exist with respect to an entity’s ability to continue as a going concern which resulted in the revision of ASA 570 (ISA 570) going concern (to include a going concern uncertainty paragraph. Note: during the global financial crisis there was an increase in emphasis of matter paragraph mainly relating to going concern uncertainty now replaced by a “material uncertainty related to going concern” paragraph).
Required: Students are required to research into the rationale for the new auditing standard ASA 701 and explain clearly what it is. Each student is to select an industry, eg. banking, mining, etc and analyse key audit matters in the independent auditor’s reports of all companies in that industry in ASX top 100 listed companies so as to evaluate the efficiency of reporting key audit matters in the independent auditor’s report (i.e. does key audit matters disclosure provide more information to users).
Solution
Executive Summary
The changing times has led the investors to expect that companies can undergo crisis at any moment. This has led the companies to be more cautious in their financial reporting, and auditing standards have been improved. The financial crisis of 2008, which was ignited by the failed auditing of Lehman Brothers is shown in the report as well. This crisis led to the establishment of the new standard of ASA 701, which is explained. The auditing practice of the telecommunications industry via its two main companies is shown in terms of the key audit matters requiring auditor attention. The audit companies, their opinion on the company financial reporting, and internal control are explained. The analysis of the audit reports of Australian telecommunication companies and their comparison shows that Telstra audit process for the key audit matters and its reporting is more comprehensive as compared to the reporting of the key audit matters by KPMG for TPG Limited.
Introduction:
With the world witnessing the financial crisis of 2008 and large multinationals tumbling down from the accounting irregularities reported in their reports, it was imperative to establish new standards which provide better regulation of accounting and financial reporting. Auditing is one function which is associated with the assurance of the right accounting information reported by companies. Any problem in the auditing standards or its implementation is, therefore, going to cause a lot of concerns in the business world. This is one of the reasons which lead the regulating bodies to establish new standards for the auditing of the company financial reports (Pinto & Morais, 2018).
Lehman Brother Case Study
The new standards of ASA 701 and ASA 570 were established in the backdrop of the financial crisis that was led by the fail of the Lehman Brothers. Lehmann Brothers were the internationally recognized organization which collapsed after filing bankruptcy protection in 2008 in the US. The collapse took everyone by surprise as it was one of the largest investment banks of that time. Even within the company, no one had foreseen such a situation for their company. The financial crisis was triggered by the crumple of the Lehman brothers. The main immediate reason for the financial crisis had been the boom in the housing industry of the US (Sirois et al., 2018). However, an alteration in the banking industry made it impossible for mortgage holders to pay back. This led the banking defaulting rate to go to unmanageable heights (Presley & Jones, 2013). The Lehman brother was the first one to feel the consequences of this situation. This led to a chain reaction in which many banks filed for bankruptcy after hit hard by the defaulting loaners. This was because all banks were interlinked, and most of these banks were more of risk-taking nature, which caused problems.
The ineffective and weak auditing had been the reason for the fail of the investment institution. The aim of the audit function is for evaluating the financial condition of the company for a period and its prediction of future financial conditions. In terms of Lehman brothers, the predictions for future cash flows were not precise, which led the company to be followed to collapse without any notice (Sharp, 2010). The negligence of the audit reports for Lehman caused them to expect that the cost of the housing sector would not change and fall. The long term projects were faulty as made in the audit reports. The audit report of the Lehman brothers should have shown how the excessive borrowing of the bank has raised the leverage ratio, which was above the required regulations of the US. The independent auditor report also did not communicate the repurchase agreement details, which showed over-collateralization. The bank had window dressed its accounting information to deceive the investors. The repurchase agreement was used for hiding the high leverage ratio of the company during the auditing. The audit report was also unable to detect that the firm had not entered the corresponding entries for the reports in the liabilities section (Greenlaw et al., 2008). The reports were treated as sales by the firm, which led the auditors to defend it as well. Ernst and Young, their auditor, claimed that this practice was supported by the auditing standards of that time. The lack of identification of the risk in the heavy investments made in the mortgage industry was a flaw which should have been reported by the audit company. The collapse could have been anticipated by efficient auditing; however, on the contrary, the report gave an unqualified opinion before the collapse (Brasel et al., 2016).
ASA 701 | Communicating Key Audit Matters in the Independent Auditor’s Report:
This standard was put forward by AUASB to establish the requirements and provide explanatory material and application connected to the communication of the key audit matters as presented in the independent audit report. The major points of this standard include several of which the main ones are discussed (AUASB, 2019). Firstly, it allows mandating of the communicating of the Key audit matters in the report of the audit for the listed firms. This standard also enables the other firm’s auditors to know if it is needed to take account of the key audit matters in the audit reports. The standard shows the method of determining the Key audit matters which is done by identification from the communicated matters with the ones charged with control of the entity for the matter that has substantial important and thus requires the auditor attention (Baker et al., 2014). Furthermore, the key audit matters can also be determined by identifying the high assesses risk areas, substantial auditor decisions, including the substantial judgments of management and the influence of the events or important dealings. Moreover, it can also be done by determining the important matters to include the auditor report (Christensen et al., 2014). Other than this, the standard of 701 also helps in understanding how the auditor would describe each of the key audit matter. It allows in identifying the situations for which the key audit matter identified is not reported in the report, and it also shows the requirements for documentation with regards to the key audit matters (Segal, 2017).
The standard has been operative since December 15th, 2016. The standard is established to bring the confidence of the public on the company and its reported financial reports and the process of auditing. The new standard has helped in providing the firms investors with a better alternative for transparency of the auditor responsibilities, and it also aids in providing insight into the key audit matters and how the auditor need to deal in these areas. The major reason for the standard is to offer the investors and public with better company disclosures and better information, helping them make better and informed decisions. Furthermore, this new standard has also been established to conform to the ISA 701 standard (AUASB, 2015).
The standard has helped to bring one significant change to the audit world. The standard is intended to address the judgment of the auditor in terms of what he intends to communicate and also in terms of the content and form of the audit matters. The aim is to enhance the value of the communication of the report by giving more transparency on the matters of audit that were performed (Ifac.org, 2017). Now the companies in Australia are required by law to publish all audit matters as well, along with their audit opinion. This is going to be depicted in the industry analysis in the later section.
ASA 570 | Going Concern
This standard main aim had been to establish the mandatory needs and also to give the guidance on the authorities of the auditor in terms of the financial report auditing in a going concern supposition for the making of the financial statements. This also includes the management evaluation of the firm capability to carry on as a going concern as audited by the audit company (Gimbar et al., 2016).
The standard 570 is needed to be read along with the Permeable of the AUASB standards that show the intentions of the AUASB in terms of the understanding of the Auditing standards, its interpretation, and its application. This standard has been operative since July 2006 (AUASB, 2006).
Telecommunications industry:
The telecommunications industry is segmented as per the major providers of Vodafone, Optus, Telstra, and TPG limited. The telecommunications industry provides around 39 billion dollars of revenue, and its annual growth has been around 0.2% (IBIS World, 2018). Around 2410 businesses are involved in the industry; a however major portion is captured by a few larger companies. Within the ASX 100 Index, around 100 largest companies of Australian exchange are listed. The companies are well diversified and include the companies from the financial industry, materials, health care, industrials, and real estate. The telecommunications services industry occupies only 2.8% of the ASX companies. The ASX Index is based on the companies with the market capitalization cut off of AUD 1.7 billion. These companies account for 74% of the share market capitalization of Australia (ASX 100 List, 2019). The two telecommunication companies that are listed in the ASX Index are Telstra Corporation and TPG Telecom Limited. These are selected as these are the only telecommunication services companies listed in the ASX 100 Index.
Telstra Corporation
Telstra Corporation has occupied the weight of 2.49% of the total capitalization of the ASX 100 Index (ASX 100 List, 2019). The company is audited by the audit firm of Ernst and Young Limited. The company has given an unqualified opinion on the firm audited of the financial reports and for its subsidiaries as well (Telstra, 2018). As per the Audit standards requirement, the audit company has published the key audit matters for the company as well. The key audit matters of the company are;
Revenue Recognition:
In terms of the revenue recognition, Telstra has made judgments related to the accounting for the new plans and products, large network Application services contracts, and NBN revenue as per the Definitive Agreement. The completeness and accuracy of these revenue judgments pose a risk to the industry because of the billing systems complexity and the nature of the complex products and services, and the changes seen frequently in the prices throughout the year. This key audit matter was addressed by evaluating the key controls effectiveness in terms of the measurement of the revenue by also evaluating the related IT systems. A sample of the main high-risk NAS contracts was stratified and tested. The appropriateness of the judgments made was evaluated by looking at the accounting for the contracts. The contract life cycle was tested in terms of the controls effectiveness. The relevant section of the contracts was read for identifying the revenue streams, and the provisions in the situation of termination.
Reliance on Automated Controls and Processes:
The audit company has assessed the automated and manual controls of the company related to the IT systems. The IT specialists of the audit firm have audited the new IT systems and assessed the design of the controls and automated processed.
Impairment of the Intangible and Goodwill:
The impairment calculations done by Telstra are audited, which included the testing of the CGU recoverable amount. The indicators of the impairment were assessed as well by the audit firm. The approved cash flow projects by the board, which was used in the impairment model, were evaluated as well in terms of their reliability. The historical cash flow forecasts and their reliability are also looked into. The impairment models were assessed by the valuation specialists, and the reasonableness of the key assumptions was also evaluated. The company also performed a sensitivity analysis for the cash flow projections. The assumptions for the terminal growth rates, discount rates, and forecasted growth were also evaluated.
Capitalization and the Lives of the Assets:
The audit company has assessed the effectiveness of the control of the company of the disposal of the fixed assets and the acquisition. The appropriateness of the capitalization is also evaluated. The application of the annual life review of the assets is also assessed. The judgments on the nature of the costs capitalized and the assets lives applied for the amortization and depreciation are also evaluated.
Revenue from the Contracts with Customers:
The adoption of the new AASB 15 standard and the resulting disclosure of the financial impact expected of the revenue from the customer contracts are quite complex, which poses risks. The Audit Company has assessed the expected impact of the adoption of the new standard. The judgments and estimates of the financial impact are evaluated as well. The accuracy of the identified amounts of the adjustments to the retained earnings is evaluated as well.
TPG Telecom Limited
TPG Telecom Limited has occupied the weight of 0.39% of the total capitalization of the ASX 100 Index. The company is audited by the audit firm of KPMG Limited. The company has given an unqualified opinion on the firm audit of the financial reports and for its subsidiaries as well (TPG Telecom, 2018). As per the Audit standards requirement, the audit company has published the key audit matters for the company as well. The key audit matters of the company are;
Revenues:
The audit firm has worked with the IT specialists the company tested the automated and manual IT controls in the billing system and the other sub-levels. The test accessed the data and programs, operations, and changes to the control procedures of the computer. The end to end reconciliation of the controls was also tested. The movement of the transaction information from the point of transaction to the billing systems and ultimately to the general ledger are tested. The configuration of the system for the calculation of the automated bill generation is also tested.
Intangible Assets:
The procedure of the audit by KPMG included the assessment of the assumptions of forecasted growth rates, the APMUs, service costs, terminal growth rates, market share, and pricing forecasts are assessed. The valuation models are assessed for the forecasts approved by the board. The audit firm has also performed sensitivity analysis and identified the reasonability of the forecast assumptions. The group historical forecasting and its accuracy are also evaluated. The company has worked with valuation specialists for the assessment of the valuation model and its assumptions for growth rates, and terminal growth rates against the industry used growth rates. The quantitative and qualitative disclosures of the company were assessed as per the requirements of the accounting standard (TPG Telecom, 2018).
Looking at the similarities of the two audit reports of these two companies, the revenue recognition due to the complex system of the billing system for both companies is the same audit matter. The reliance on the automated processes and controls was also considered a key audit matter for both firms. Both audit firms used their IT specialists for testing the automated and manual IT controls for the billing systems. Similarly, the evaluation of the carrying value of the intangibles was also another key audit matter similar to both companies. In Both cases, the forecasts approved by the board for cash flow projects, comparison with the market used benchmarks for valuations and performing sensitivity analysis for the assumptions underlying the valuation model in terms of the growth rates, and discount rates were evaluated and conducted for both companies by both audit firms.
In terms of the differences, the Audit Report of Telstra showed the valuation for the impairment charges as a key audit matter as well. The Revenue from the contracts with customers was also considered as a key audit matter by Telstra while TPG Telecom did not report any such thing. Telstra also reported the reporting of the capitalization and the assets lives as key audit matter which was not present in TPG Audit report.
Comparing the two audit reports, it can be said that the Telstra audit process for the key audit matters and its reporting is more comprehensive as compared to the reporting of the key audit matters by KPMG for TPG Limited. Ernst and Young have also included the key audit matters of the impairment and amortization assumptions, revenues from specialized contracts, and their reliance on the automated systems and controls. On the other hand, KPMG has only reported the key audit matters in terms of the revenues and intangible assets.
Conclusion and Recommendations
Concluding, it shows that ASA 701 would help in building the confidence of the people on the auditing function of the companies. The report shows the effect of the newly established auditing standard of ASA 701 on the key audit matters reporting in the audit report, which was developed in the backdrop of the financial crisis of 2008. The report shows the background of the Lehman Brothers case, which became the typical case of failed auditing, causing the financial crisis of 2008. The new standard, its main purpose, and the auditing practice in the telecommunications industry, is evaluated in the report. The analysis of the audit reports of Australian telecommunication companies and their comparison shows that Telstra audit process for the key audit matters and its reporting is more comprehensive as compared to the reporting of the key audit matters by KPMG for TPG Limited.
References:
ASX 100 List, 2019. ASX 100 List. [Online] Available at: https://www.asx100list.com/ [Accessed 18 May 2019].
AUASB, 2006. Explanatory Statement ASA 570 Going Concern. [Online] Available at: https://www.auasb.gov.au/admin/file/content102/c3/ASA_570_-_Explanatory_Statement.pdf [Accessed 14 May 2019].
AUASB, 2015. Explanatory Statement ASA 701. [Online] Available at: https://www.auasb.gov.au/admin/file/content102/c3/ASA_701_Explanatory_Statement_2015.pdf [Accessed 14 May 2019].
AUASB, 2019. Auditing Standard ASA 701 Communicating Key Audit Matters in the Independent Auditor’s Report. [Online] Available at: https://www.auasb.gov.au/admin/file/content102/c3/ASA_701_Compiled_2019-FRL.pdf [Accessed 17 May 2019].
Baker, R.C., Bedard, J. & Hauret, C.P., 2014. The regulation of statutory auditing: an institutional theory approach. Managerial Auditing Journal, 29(5), pp.371-94.
Brasel, K., Doxey, M.M., Grenier, J.H. & Reffett, 2016. Risk disclosure preceding negative outcomes: The effects of reporting critical audit matters on judgments of auditor liability. The Accounting Review, 91(5), pp.1345-62.
Christensen, B.E., Glover, S.M. & Wolfe, C.J., 2014. Do Critical Audit Matter Paragraphs in the Audit Report Change Nonprofessional Investors’ Decision to Invest? A Journal of Practice & Theory, 33(4), pp.71-93.
Gimbar, C., Hansen, B. & Ozlanski, M.E., 2016. Early Evidence on the Effects of Critical Audit Matters on Auditor Liability. Current Issues in Auditing, 10(1), pp.A24-33.
Greenlaw, D., Hatzius, J., Kashyap, A.K. & Shin, H.S., 2008. Leveraged Losses, Lessons from the Mortage Market Meltdown. In U.S. Monetary Policy Forum 2008., 2008.
IBIS World, 2018. Telecommunications Services – Australia Market Research Report. [Online] Available at: https://www.ibisworld.com.au/industry-trends/market-research-reports/information-media-telecommunications/services/telecommunications-services.html [Accessed 18 May 2019].
Ifac.org, 2017. Auditor Reporting Standards Implementation: Key Audit Matters. [Online] Available at: https://www.ifac.org/global-knowledge-gateway/audit-assurance/discussion/auditor-reporting-standards-implementation-key [Accessed 18 May 2019].
Pinto, I. & Morais, A.I., 2018. What matters in disclosures of key audit matters: Evidence from Europe. Journal of International Financial Management & Accounting, 1(1), pp.1-18.
Presley, T. & Jones, B., 2013. Law and Accounting, Did Lehman Brothers use of Repo 105 Transaction violate accounting and legal rules? Journal of Legal, Ethical and Regulatory Issues, 16(2), pp.55-91.
Segal, M., 2017. ISA 701: Key Audit Matters – An exploration of the rationale and possible unintended consequences in a South African. Journal of Economic and Financial Sciences, 10(2), pp.376-91.
Sharp, A., 2010. Lehman Brothers’ ‘Repo 105’ Accounting Scandal Accounting Gimmicks or Outright Fraud? [Online] Available at: http://www.wealthdaily.com/articles/lehman-brothers-enron-accounting-gimmicks/2375 [Accessed 13 May 2019].
Sirois, L.P., Jean, B. & Bera, P., 2018. The Informational Value of Key Audit Matters in the Auditor’s Report: Evidence from an Eye-Tracking Study. Accounting Horizons, 32(2), pp.141-62.
Telstra, 2018. Telstra Annual Report. Telstra.
TPG Telecom, 2018. TPG Telecom Annual Report 2018. TPG Telecom.
Appendices:
Appendix A: Telstra Audit Report | Key Audit Matters
| Key Audit Matters | How it was Addressed |
| Revenue Recognition | |
| Accounting for the new plans and products
Accounting for the contracts of Network Application Services Accounting for the NBN Revenues Disclosures in terms of revenue recognitions The complexity of the billing system Reliance on the Automated controls and processes Completeness and accuracy of the revenue amounts recorded |
Evaluation of key controls for measurement of the revenue transactions
Examination of processes and controls for the timing of the revenue recognition of the new plans and products Testing a sample of NAS contracts by reading all relevant sections of the contracts and their key provisions, future forecasts, comparison with historical forecasts results, and assessing these. Assessment of the appropriateness of the estimates used in NBNs |
| Reliance on Automated Controls and Processes | |
| Complex environment and diverse business processes
Combination of automated and manual controls Several internal and external controls Complex billing system |
Worked with the IT specialists for assessment of manual and automated controls
Analysis of new designs of the automated processes and controls and new systems |
| Impairment and Intangible Assets | |
| Material impairments changes to goodwill, and noncurrent and intangible assets
Significant judgments underlying the Cash generating units about future Cash flows An impairment charge of $242 million recorded in 2017 related to Ooyala CGU |
Evaluation of Group impairment and testing of the recoverable amounts of CGUs
·Evaluation of indicators of impairment or their reversals Evaluation of the reasonableness of the approved cash flow projections by board Evaluation of valuation models for impairment Performed sensitivity analysis for key drivers of cash flow projections Evaluation of the adequacy of the reported impairment in 2017 |
| Capitalization and Asset Lives | |
| The decision of expense costs or capitalization
The annual asset life Timeliness of the transfer of the asset while construction from assets Disclosures relating to writing off and capitalization of assets |
Evaluated the effectiveness of controls on acquisitions
Evaluated the effectiveness of controls on disposals Appropriateness of the policies for capitalization The appropriateness of the lives of the assets used for amortization and the depreciations |
| Revenue from Contracts from Customers | |
| Adoption of the new standard of AASB 15
Restatement of the financial performance of 2018 Disclosures related to the expected financial impact of the adoption of the standard |
Evaluation of the estimating of the expected impact of the adoption of the new standard
Estimated, judgments and key systems, controls, and processes were evaluated Appropriateness of the methods used was assessed Adequacy of the disclosures was evaluated |
Appendix B: TPG Telecom | Key Audit Matters
| Key Audit Matters | How it was addressed |
| Revenue | |
| Complex revenue IT systems and controls
Automated billing systems Frequent changes to prices Relevant controls of the systems |
Testing of the automated and manual controls of It systems
Testing of the billing systems Testing of the end-to-end reconciliation of the movement of the data of transaction Testing of the automated customer bill generation |
| Intangible Assets | |
| Carrying value of the goodwill
The largest asset of Group is good will @ $1911 million Complex forward-looking statements Competitive technology-oriented company reliant on technology Business forecasts for recoverability The output of the valuation models for CGUs Judgments used in the recoverability assessments Discount rates used for cash flow forecasts Assumption for AMPUs |
Comparison of data in valuation models with approved forecasts of board
Comparing with market demand and industry reports Comparing with historical forecasts of Groups Performing sensitivity analysis Assessment of the assumptions of the valuation models Assessment of the qualitative and quantitative disclosures |
