MD&A, governance and the new audit report

Public companies in Canada and the United States are required to engage independent external auditors to perform an audit of their annual financial statements.

Watch partner Robbie Leibel discuss details of new disclosure requirements for public companies.

The independent audit is a report prepared by an external auditor with the purpose of a fair presentation of financial statements, which accompanies the financial statements provided to investors. New auditing standards that are soon to be implemented will require additional disclosure in public company audit reports of “key audit matters” (KAMs) in Canada and “critical audit matters” (CAMs) in the United States.

Adoption and harmonization

Several other jurisdictions worldwide have already adopted KAM requirements for audit reports, including the UK and Australia. The impetus for change was in large part the financial crises of 2008 and the resulting push from the global investment community for greater transparency of the audit process, as noted by the U.S. Public Company Accounting Oversight Board (PCAOB) in 2017:

The [current] auditor’s report does little to address the information asymmetry between investors and auditors, even though investors have consistently asked to hear more from the auditor, an independent third-party expert whose work is undertaken for their benefit. The board believes that reducing the asymmetry between investors and auditors should, in turn, reduce the information asymmetry between investors and management.

Despite the interrelatedness of the U.S. and Canadian capital markets and market participants’ continued advocacy for regulatory harmonization, the new auditing standards are not harmonized in the United States and Canada. The Canadian model reflects International Standards on auditing while the U.S. model reflects auditing standards adopted by the PCAOB.

Canadian KAMs are the most significant matters in the audit of a company’s financial statements. U.S. CAMs are matters arising from the audit of the financial statements that relate to accounts or disclosures that are material to the financial statements and involved especially challenging, subjective or complex auditor judgment.

Both KAMs and CAMs are limited to audit matters that were discussed between the auditors and those at the company charged with governance. Commonly cited by accounting firms and industry organizations as likely candidates for KAMs/CAMs are revenue recognition, accounting for acquisitions, impairment of assets, valuation of investments and taxation.

It is not yet clear whether U.S. and Canadian regulators will agree to permit a combined audit report for cross-border public companies. If not, the unfortunate result will be that cross-border companies, including Canadian MJDS companies, will have to obtain two audit reports, and each report will be longer and more detailed than before.

Implementation details¹

New, complex disclosures

Similar to a public company’s disclosure of risk factors, an auditor’s explanation of KAMs/CAMs is meant to be company-specific. Consequently, the timeline for completion of a public company’s audit and the preparation of audit reports (especially in the first year or two) may need to be lengthened to accommodate the auditor’s preparation of new, and potentially complex, disclosures. Throughout an engagement, auditors, audit committees and management should maintain a robust dialogue on the matters that the auditors might identify as potential KAMs/CAMs. This will help avoid last-minute surprises regarding the contents of the audit report that could jeopardize related timelines such as filing financial statements with securities regulators or preparing a prospectus for a public offering of securities.

In addition, because audit reports will contain new qualitative information, public companies will need to be mindful of the potential for investors, analysts and other readers of financial statements to be confused by discrepancies, or perceived discrepancies, between the audit report and the company’s MD&A. MD&A must describe the critical accounting estimates used in preparing the company’s financial statements. These estimates require management to exercise judgement in making assumptions that could have a material impact on the company’s financial statements. While the authors, disclosure requirements and purposes of audit reports and MD&A differ, at least some degree of overlap in substance should now be expected.

Communicating KAM in the auditor’s report will… focus investors and other users on areas in the financial statements that are subject to significant management judgment and auditor attention…[and] provide users with a basis to engage further with management and audit committees.²

Moving forward

Management should take extra care in analyzing and drafting critical accounting estimates (and other relevant sections of the MD&A) to ensure the substance of the disclosures facilitates rather than frustrates the side-by-side readability and understandability of MD&A and KAMs/CAMs. Management and investor relations personnel should also be prepared for questions from investors, analysts, underwriters and/or regulators about the company’s MD&A in relation to the KAMs/CAMs in the audit report.

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¹ The Canadian information is subject to amendment as the Auditing and Assurance Standards Board is considering comments from market participants on its latest Exposure Draft (published in January 2019; comments were due by May 31).

² Canadian Accounting and Assurance Standards Board, 2019.