FRS 102, the Financial Reporting Standard applicable in the UK and Republic of Ireland, is considered to be the most significant change in financial reporting for a generation, explains Steve Collings.
Professional bodies are encouraging firms around the country to start planning for the transition as the rules are applied retrospectively. Auditors, of course, must also consider their position when it comes to the transition process - particularly in light of any ethical threats that may arise (for example where the auditor is actively involved in a client’s transition process).
While the Financial Reporting Council (FRC) has always foreseen the UK and Republic of Ireland to eventually report under an international-based framework, and hence has aligned UK GAAP in many respects to international counterparts, there are notable differences between UK GAAP currently and the new UK GAAP. Auditors must familiarise themselves with these differences and understand the impact that the transition process will have on audit clients. Consideration should be given to (among other things):
- The environment in which the client operates
- The technical ability of the staff undertaking the conversion
- The resources the client has available to deal with the conversion
- How will the system be tested to ensure compliance with FRS 102
- Whether there been any exceptions reported by the system which the auditor should be aware
- Changes to accounting policy as a result of the new standard
- The adequacy of the disclosures in the first year reporting under FRS 102
It is the responsibility of the directors of the company to ensure that the conversion process is undertaken without a material impact on the business. While auditors may inevitably be advising clients on the conversion process, they should be advising clients to start preparing for the transition as early as possible. This is because some companies will be more affected than others when it comes to the conversion and thus there will be varying degrees of work performed by auditors depending on the impact of the conversion. For example, if a client values stock using last-in first-out method, they will not be able to do so under FRS 102 and so this could have a material impact on previously reported figures. In addition, FRS 102 allows a choice in accounting policies in certain areas (for example writing off borrowing costs or capitalising such costs) and the auditor should be considering the appropriateness of accounting policy choices and whether such choices are appropriate in the company’s circumstances.
Once the accounting policies have been considered, the auditor should then be focussing their attention on the impact that the transition process has had on the business itself. Of particular concern might be bank covenants which should be reviewed in case such covenants are breached once the accounting policies of the client are converted to be FRS 102 compliant. The impact of the conversion on issues such as the reserves and dividend policies as well as the company’s tax issues are other examples of areas the auditor should be concerned with. There is no prescriptive list as to the considerations auditors should have with regards to their clients and the levels of work involved on the transition process and the sufficiency and appropriateness of the audit evidence gathered will clearly be a judgement call on the part of the auditor.
The transition process involves retrospective application of FRS 102. Auditors will need to ensure their work programmes are tailored to ensure the risk of material misstatement due to the transition process is reduced to an acceptable level. Section 35 Transition to this FRS requires retrospective application and the client needs to prepare an opening balance sheet as at the date of transition (which is the start date of the earliest period reported in the financial statements), so for a December 2015 year-end, the date of transition will be 1 January 2014. Clearly this is going to result in additional audit work than would otherwise normally be required and this will be an important factor to bring into the timetable.
The suitability of audit staff to audit the transition must also be carefully considered. In cases where the conversion process is particularly complex, suitable appropriate judgements will need to be made by the auditor so as not to compromise audit quality. Audit firms will need to ensure that the staff deployed on assignments in the year of transition are competent to perform such assignments. UK GAAP under FRS 102 is markedly different in a lot of areas and this in itself will increase the risk of material misstatement. Notwithstanding the ‘effective from’ date of 1 January 2015, the FRC have already issued proposed amendments to FRS 102 in respect of financial instruments and the reduced disclosure framework and so auditors must ensure that they keep abreast of all the latest developments where the new standard is concerned.
Specific issues to consider at planning stage
At the planning stage, the auditor will gain an understanding of how smoothly the transition process has been undertaken by the client. If the client has had considerable difficulties in dealing with the transition, or if exceptions have been reported by the accounting system during the process, this is going to have an impact on the overall risk assessment (i.e. there is an increased risk of material misstatement) and procedures should be tailored specifically to address these risks. Discussions with management at the planning stage should involve clearly identifying the information that the auditor will require and instructions from the engagement partner to the team in ensuring that the audit evidence gathered over the transition is of a high quality and would be able to stand up to scrutiny.
Issues that may be considered by the auditor at the planning stage are:
- Valuations of fixed assets: Does the client wish to switch from revaluation to depreciated historic cost? If so, has a previous GAAP valuation been used? If a previous GAAP revaluation has been used has the client accounted for depreciation between the date of the valuation and the date of transition? Is an auditor’s expert needed?
- Has the client considered deferred tax implications on revalued assets under FRS 102 at the transition date?
- Are short-term employee benefits accrued by employees but not paid until the next financial year (for example holiday pay) material? If not, would they become material when aggregated with other misstatements identified during the transition stage?
- Does the client have any financial instruments that need to be measured at fair value in the scope of Section 12 Other Financial Instruments Issues? If so, who has valued these? Will the auditor need to use the services of an auditor’s expert?
- Are there any ethical threats to independence and objectivity (for example where the audit firm has been actively assisting the client in the transition process). If so, how can these threats be reduced to an acceptable level?
- Are there any particular areas of concern at the planning stage relating to the conversion process? For example, has the client struggled when dealing with the conversion process?
- Are the audit staff deployed on the assignment fully conversant with the requirements of FRS 102 - in particular the requirements in Section 35 Transition to this FRS?
- The need to maintain professional scepticism where fraud is concerned bearing in mind that the first set of FRS 102 financial statements may give rise to increased opportunities for fraud due to accounting policy alignments and the increased use of fair value accounting in FRS 102?
- Consideration of the taxation implications of the transition process (note HMRC have issued an overview paper relating to FRS 102 which should be considered by the auditor)
- Are there any increased pressures on the client to deliver a certain level of results? If so, how does this affect the risk assessment at the planning stage?
- How reliable is the client’s accounting system? If it is not reliable or there are ongoing problems with the system this will increase the risk of material misstatement due to the conversion
This list is by no means exhaustive and is merely intended as a prompt of some of the main issues auditors may want to consider.
Auditors will need to carefully consider the procedures generated by their audit software programmes. This is an important point to emphasise because procedures must ensure that sufficient and appropriate audit evidence is generated to enable the auditor to form an overall conclusion as to the effectiveness of the transition process. In turn, the transition process may require the auditor to rely on the work of experts (for example in valuing property, pension funds or financial instruments) and therefore the provisions in ISA (UK and Ireland) 620 Using the work of an auditor’s expert might become particularly relevant when auditing the transition.
The work undertaken on the conversion process must be clearly documented in order that the audit engagement partner can form a conclusion as to whether the financial statements are free from material misstatement due to the transition process. This will also include forming a conclusion as to whether the transitional disclosures are adequate and enable the users of the financial statements to understand the impact that the transition process has had on the entity’s financial performance, financial position and cash flows.
What auditor’s need to consider now
Some audit clients may well want their auditors to offer some form of assurance at an early stage in the conversion process (for example on the appropriateness of accounting policies). Some assurance work at an early stage in the conversion process may go to serve as forms of audit evidence provided they are adequately documented. This may be the case if, for example, the client requests the auditor to review the opening FRS 102 balance sheet after transition to offer comfort to the client that the transition process has been undertaken properly. Care should be taken by the auditor if a review engagement is undertaken before the detailed audit work because the procedures in a review engagement are limited and may not, therefore, generate sufficient and appropriate audit evidence over the transition process in isolation and additional procedures should be implemented to ensure the sufficiency and appropriateness of the audit evidence.
When dealing with the transition process, auditors must also have consideration to the quality of the information from which the FRS 102 information has been generated. In addition, the auditor should also factor into their planning specific procedures to audit the information system that produces the FRS 102 information.
Preliminary analytical review procedures can also be invaluable in the context of a transition because these may highlight trends or fluctuations which the auditor is not expecting and therefore appropriate attention should be devoted to these areas which will invariably mean further audit procedures are needed and thus a change to the audit plan.
For clients with specific reporting requirements (e.g. deadlines for submission of the financial statements to a regulatory body) auditors will need to have specific reporting timelines factored into the overall audit plan. As the transition process will inevitably require additional work, careful consideration needs to be given to reporting dates to discuss the audit with the client. This may involve additional audit staff being assigned to certain audits to ensure compliance with the reporting timetable and hence an impact on the firm’s resources.
Finally, auditors should start to consider their own processes and audit methodologies. For example, ensuring the firm’s procedures adequately address the risk of fraud, keeping in mind the increased emphasis of fair value accounting, accounting policy choices and the restatement of previous year’s financial statements. Additional written representations may also be considered necessary, especially where management’s assumptions relating to the valuation of assets and liabilities are considered crucial.
Steve Collings is the audit and technical partner at Leavitt Walmsley Associates and the author of ‘Interpretation and Application of International Standards on Auditing’.