The outbreak of COVID-19 has compelled the government to undertake measures such as complete lockdown, quarantine, social distancing, and travel bans to contain its further spread.
As a result of these restrictions imposed on travel, physical client meetings, etc, auditors have been increasingly facing challenges in undertaking audits.
With the current scenario preventing the auditors to access the client locations, it would be extremely challenging for them to collect sufficient, relevant audit evidence.
The very purpose of the audit is the scrutiny of financial statements by an independent third party so as to indicate that such financial statements are credible.
Thus, the challenges posed by COVID-19 should not prevent auditors from delivering high-quality audits.
In order to help the auditors undertake quality audits and adhere to the audit compliance standards, ICAI has released guidelines advising auditors with regards to conditions that may arise due to COVID-19, how they can carefully examine specific circumstances while undertaking audit and assess the risk accordingly.
Identifying and Assessing the Risk of Material Misstatements and Materiality in Planning and Performing an Audit
COVID-19 is certainly bound to pose increasing risk to entities located in geographies severely impacted by the pandemic.
In addition to this, it is also bound to impact entities whose suppliers, bankers, service providers, etc are located in areas immensely affected by Coronavirus.
Due to such uncertain conditions, auditors and entities would have to evaluate additional risks resulting from the following avenues:
- Operational interference leading to changes in the business model due to falling demand, reduced customers, supply chain disruptions, employee absenteeism, work-from-home, etc.
- Inability to comply with the contract due to contractual breaches, additional security requirements, or stressed asset valuations, reduced working capital or liquidity resulting in difficulty to service debt or need for additional working capital as a result of reduced cash flows.
- Asset valuations, that is, downward asset valuations resulting in compliance issues or liquidity challenges
What Should Auditors Do?
- When applying SA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment, the auditor must consider the impact of the above aspects while understanding the entity, its environment together with its objectives, strategies, and business objectives.
- Auditors must discuss with management and TCWG (Those Charged With Governance) whether they have considered the COVID-19 impact while assessing the risk and the manner in which they have identified and evaluated the emerging business risks.
- The auditors also need to consider if any disclosures are required in the financial statements in respect of the important assumptions made to reach such outcomes.
- Auditors may revise the audit materiality in cases where they have revised the risk assessment. They can refer to SA 320 – Materiality in Planning and Performing an Audit for the same.
Assessing Financial Impact and their Reasonable Estimation
There are a number of items in the financial statements that would get affected as a result of COVID-19. The list of such items has been mentioned in the accounting advisory issued by ICAI.
Apart from such items, there would be a number of accounting issues that would arise in the following avenues:
- Impairment of Goodwill, property, plant and equipment, intangible assets and valuation & impairment of receivables, loans, and advances.
- Valuation of defined benefit plans and obligations
- Contractual penalties
- Stock compensation performance conditions and obligations
- Employment termination benefits
- Insurance recoveries associated with business interruptions
- Onerous contract provisions
- Allowance of expected credit losses
Thus, management would have to make accounting estimates for the above items.
The assumptions made together with the projected cash flows that are used in these accounting estimates would be impacted by the Coronavirus.
Therefore, auditors need to use methods as provided by SA 540 – Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures. This is to ensure whether:
- Accounting estimates are reasonable
- The associated disclosures made in the financial statements are sufficient
Valuation of Inventory on a Date other than the Date of Financial Statements i.e. 31st March 2020
Due to the lockdown restrictions, business entities would not be able to conduct physical verification of inventory as on the date of financial statements, that is, March 31, 2020.
Thus, auditors need to plan for methods that would allow for physical inventory verification date to be either advanced before the year-end or could be deferred to a date after the year-end.
For this, auditors would have to comply with the procedures mentioned in Para 5 and 7 together para A9 to A14 of SA 501.
Audit of Consolidated Financial Statements where Components/ Component Auditors are Located in Severely Affected Places
While preparing financial statements, accounting advisory must follow the following:
- There are cases of entities where IND AS 110 – Consolidated Financial Statements is applicable. IND AS 110 claims that financial statements of parents and subsidiary companies that are used while preparing consolidated financial statements must be typically prepared up to the same date. However, it must be kept in mind that if there is any difference between the reporting dates, such a difference should not exceed 3 months.
- There are cases of entities where IND AS is not applicable. But AS 21 applies to such entities. As per AS 21, financial statements of parent and subsidiary companies used for preparing consolidated financial statements must be typically prepared up to the same date. However, it must be kept in mind that if there is any difference between the reporting dates, such a difference should not exceed 6 months.
Roles and Responsibilities of the Auditor in Respect of Consolidated Financial Statements
Where the parent entity’s auditor is not the auditor of the component entities included in the consolidated financial statements, such an auditor of the consolidated financial statements must consider the requirements of SA 600.
SA 600 states that the principal auditor must undertake processes to obtain proper audit evidence by using the work of another auditor.
In other words, the principal auditor must establish that the work done by other auditors is sufficient for the principal auditor’s assignment and should consider the important findings of the other auditor.
While obtaining evidence, the principal auditor must take into consideration the impact of COVID-19 on the risk assessment, materiality, and the capacity to obtain adequate audit evidence in respect of components.
Some of the alternative methods to obtain evidence by the principal auditor could be:
- Cross border data sharing
- Video calls
- Questionnaires for the component auditors
- Previous work of the component auditors etc.
Subsequent Events or Events After the Reporting Date
AS 10 claims events that take place after the reporting period can be divided into two categories:
- Adjusting Events, that is, events that require adjustments to the amounts identified in the financial statements for the reporting period.
- Non-adjusting events, that is events that do not need adjustments to the amounts identified in the financial statements for the reporting period.
Management’s judgment is required in certain situations to identify events in one of the above categories.
Likewise, AS 4 relates to Contingencies and Events Occurring After the Balance Sheet Date.
As per AS 4, adjustments to assets and liabilities must be undertaken for events that take place after the balance sheet date. Only those assets and liabilities are adjusted that provide material information impacting the determination of the amounts on the balance sheet date.
That is to say, adjustments to assets and liabilities that do not relate to the conditions existing on the balance sheet are not appropriate.
Thus, auditors need to make a disclosure of the approving authority of the events taking place after the balance sheet date that result in material changes impacting the financial position of the entity.
Further, the disclosure also needs to be made of recognition and measurement uncertainties that arose due to the outbreak of COVID-19 while measuring the assets and liabilities and how the entities dealt with the same.
Responsibility of the Auditor for Subsequent Events, that is, Events Between Date of Financial Statements and Date of Audit Report
- The auditor must undertake the required audit procedures to obtain sufficient evidence that all events occurring between the date of financial statements and auditor’s report requiring adjustments or disclosures in the financial statements have been recognized. Further auditors need not perform an audit on matters where audit procedures have resulted in competent conclusions.
- The auditor needs to assess the risk in determining the nature and extent of audit procedures to be adopted as per the above point. This risk assessment could include:
- Understanding the procedures the management has come up with to identify subsequent events.
- Asking management and TCWG of any subsequent events that might impact financial statements.
- Reading minutes of the meeting of owners, management, and TCWG that took place after the date of financial statements.
- Going through the current subsequent interim financial statements of the entity.
- Determining that the events that required adjustment and disclosure in financial statements as mentioned in the above points have been appropriately reflected in the financial statements.
Coronavirus has resulted in operational interference due to supply-demand disruptions. As a result, many entities are facing an existential crisis.
Thus, both the auditors and the entities are required to consider the impact of COVID-19 on the assessment of going concern aspects of an entity and its feasibility in the financial reports.
In addition to this, they need to consider if such serious circumstances have the potential to result in operational disruption for long which could eventually impact the financial position of an entity.
As a part of the going concern assessment, auditors need to analyze if supply-demand disruptions posing a threat to the liquidity position of the entity can materially impact the going concern status of the entity for the coming 12 months.
In addition to this, auditors also need to look for events that hint towards entities’ inability to continue as a going concern beyond the period as assessed by the management.
So such an assessment could include seeing whether there exists sufficient evidence in support of assumptions made by the management while making the assessment and the consistency of such assumptions across the business entity’s activities.
Evaluation of Work of Management’s Expert
A lot of estimation is involved while evaluating the impact of COVID-19 on financial statements of the entity and assessment of the going concern. In such situations, management can take the help of a management expert.
Management expert is a person who has expertise apart from accounting and auditing who can help the management in making such an assessment.
Now, in cases where a management expert makes such an assessment which is further used by the auditor in terms of the evidence, the auditor shall:
- Assess the competency, ability, and the objectivity of the expert
- Understand the work of the expert
- Assess the relevance of the experts work as audit evidence for an appropriate opinion
According to SA 580, auditors need to ask for written representations from the management. These representations relate to different assessments and estimates given by the management.
Furthermore, these representations must be:
- Contain the occurrence
- Reveal method of measurement
- Reflect completeness of transactions recorded and
- Must reflect the disclosure of the financial impacts in the financial statements
In addition to this, auditors must see if any specific representations need to be taken from the management in respect of the assessment of management regarding the impact of COVID-19 on financial statements for the year ending March 31, 2020, as well as the future.
According to SA 200, the objectives of an auditor include:
- Obtaining assurance that financial statements are free from any financial misstatement. This would help the auditor to give his opinion in respect of whether the financial statements are prepared according to the financial reporting framework.
- Giving a report on the financial statements and communicating as per his findings.
Reporting on Key Audit Matters
As per SA 701, it is the responsibility of the auditor to communicate key audit matters in the Auditor’s Report.
Key audit matters are defined as matters which as per the auditor’s professional judgment were most important while auditing the financial statements of the given period.
These key matters are selected from the matters which were communicated with TCWG.
Auditor’s Responsibility Relating to Other Information
Essay 720 states that auditors must read and take into consideration other information.
This is because other information that is materially not consistent with the financial statements or auditor’s knowledge as obtained by him as a part fo the audit may hint towards the fact that there is a material misstatement of financial statements or there exists material misstatement of other information.
Such material misstatements have the potentiality to challenge the credibility of the financial statements as well as the auditor’s report on such statements.
In addition to this, such material misstatements may also impact the economic decision of the users for whom the auditor’s report is prepared.
Thus, entities need to make additional disclosure in financial statements in respect of the following aspects:
- Risk assessment
- Management discussion and analysis
- Notes to financial statements
Internal Control Considerations
There could be some additional considerations that auditors might have to consider in cases where auditors are required to issue a report on internal financial controls and financial reporting.
These could be as follows:
- Companies would be required to execute new internal controls or change existing internal controls over financial reporting.
- Assess if any of the control is not functioning appropriately due to the absence of the responsible person on account of illness, quarantine, isolation, etc.
- Recognize alternative controls.
- See the company’s potential to finish the financial reporting process in time.
- See the company’s potentiality to design and implement controls related to the selection and application of GAAP for accounting and disclosure issues resulting from COVID-19.
The auditor’s response to the assessed risks necessitates that the auditor must ask for more convincing audit evidence in cases where the auditor’s assessment of risk is higher.
For this, the auditor can either increase the quantity of the evidence, obtain evidence that is more relevant, or both.
For instance, the auditor can concentrate on taking evidence directly from the third parties or related independent sources.
As a result of COVID-19, undertaking external confirmation procedures for seeking evidence may be ineffective either due to insufficient responses or non-responses to the confirmation requests sent by the auditor.
- If the auditor establishes that the response to the confirmation request sent is not reliable, the auditor will evaluate its impact on the assessment of the risk of material misstatement.
- Where the auditor receives no response, he can undertake alternate audit procedures to obtain reliable evidence.
Risk of Fraud
SA 240 claims the auditor undertaking the audit is responsible for acquiring reasonable assurance that the financial statements are free from material misstatement caused by either fraud or error.
Now, given the limitations of the audit, the risk of material misstatement in the financial statements is inevitable despite the audit being undertaken in a proper manner.
Therefore, the auditor needs to be skeptical throughout the audit process given that there exists a possibility of material misstatement due to fraud.
COVID-19 putting pressure on the management could raise the risk of fraud due to the pressure on the management.
Therefore, it is necessary that the auditor maintains a high degree of skepticism and undertake extended audit procedures to prevent the occurrence of fraud or material error in financial statements.