A question for investors, big and small: When perusing companies' annual reports, when was the last time you took a good, long look at the letter from the outside accounting firm?
Can't remember? I understand. To say the letters are boilerplate may be unfair to boilerplate. Nearly every time, the letter says the firm conducted an audit, and in the firm's opinion, the financial statements fairly reflect the position of the company. It's pass/fail, and it fails the investors seeking a greater understanding of a company's accounting risks.
There has been a global movement to change that, however. Europe was first, with Britain producing some enlightening new auditors' reports. The United States, often churlish and recalcitrant, is now on board, thanks to a vote in October by the Securities and Exchange Commission.
It's Canada's move, now. And our auditing standards-setters find themselves caught between international rules, which Canada typically tries to follow, and the new U.S. policy, which is similar, yet different enough to cause problems for the many major Canadian companies that list on U.S. stock exchanges and which must comply with the American standard. Thanks to the U.S. implementation schedule, Canadian investors will have a similarly long wait for these new robust reports.
Let us first discuss how the report is changing, as illustrated by companies that are already using International Standards on Auditing, a sort of companion set of rules to International Financial Reporting Standards (IFRS). To expand upon that basic auditing report, in which the auditor merely says the company's financial statements conform to accounting standards, a new section of "Key Audit Matters" was added. The idea was to identify areas where there was a higher risk of a serious misstatement of the financials or where there was significant judgment used by management – the folks responsible for preparing the financial statements in the first place – or the auditor.
In a report last year, auditing firm KPMG tracked the results in Australia, which, with its resource-heavy market, offers interesting parallels to Canada. KPMG said that the most common Key Audit Matter – cited by 25 of 56 companies studied – related to the carrying value of goodwill or other intangible assets. That's an area that, historically, has resulted in large writedowns when companies decide the assets have lost value. KPMG notes the greater auditor attention results from three related reasons: the many large intangible-asset balances, a requirement that companies test the value of goodwill annually and the significant judgment required to model the future cash flows that determine value.
Okay, that sounds boring. Let me give you a personal example: Once upon a time, I wrote about a company called Qwest Communications International, a go-go telecom of the 1990s that nearly went bankrupt in the tech bust of the 2000s after investors found out how aggressively it was booking revenue. In a court case that followed, a document emerged that revealed that Arthur Andersen, its auditor, had a scale for evaluating managements' accounting philosophies. It had assigned the "maximum" risk rating to Qwest's policy for revenue recognition of sales and swaps of telecom network capacity. That would have been nice to know earlier, I thought.
While Canada has adopted International Auditing Standards, much as it has embraced IFRS, it stopped short of requiring companies to identify these Key Audit Matters. That's because there are roughly 300 Canadian companies that also list their shares in the United States, and that country, which has its own auditing standards, had until recently failed to adopt any variation of the expanded auditor's report.
Already, there is a reporting challenge: Companies that wish to list in the United States must conduct an audit according to U.S. standards. So some companies issue a "combined report" to investors that makes reference to both U.S. and Canadian standards (something that took a long time to craft, mind you), some simply use a U.S.-compliant report and others issue a U.S. report to American investors and a Canadian one to Canadian investors.
Now, the United States is on board with the expanded audit report, per the SEC's October decision. But the United States being the United States, it couldn't simply adopt the international Key Audit Matters standard. Instead, its "Critical Audit Matters" are similar to the international standards, but just different enough so that there will be two sets of rules and, likely, the need for Canadian cross-listed companies to create a "combined report."
One supposes Canada's Auditing and Assurance Standards Board (AASB), which must chart this country's path on this matter, could make it easier on the cross-listed companies by choosing the U.S. standard. But that would be a departure and an inconsistency for the majority of Canadian companies who have no need to comply with U.S. rules.
"Stakeholders have told us that it's important for them to be able to assert that Canadian auditing standards conform to international standards," says Darrell Jensen, an Ernst & Young partner who is also chair of the AASB. "So making changes to the standards to conform with U.S. standards for a limited number of cross-listed entities will prevent a large number of stakeholders from being able to assert this."
The United States implements its auditing-standard change for its largest companies in 2019, with the rest of the market to follow in 2020, so look for the Canadian solution by then. It means, sadly, a couple more years of boilerplate, even as investors in companies outside North America are getting the sense of key, or critical audit matters, already. But, once again, a case of better late than never.
David Milstead