Rationale and Effectiveness of ASA 701 in Australian Banking Industry

This report discusses the rationale behind the introduction of new auditing standard ASA 701 and the effectiveness of auditors in treating Key Audit Matters in Australian banks.

Running head: AUDITING AND ASSURANCE SERVICES
Auditing and Assurance Services
Name of the Student
Name of the University
Author’s Note

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Executive Summary
The main aims of this report are to discuss about the rationale behind the introduction of new
auditing standard ASA 701 Communicating Key Audit Matters in the Independent
Auditor’s Report and the effectiveness of the auditors in the treat of Key Audit Matters in all
the banks under ASX top 100 listed companies in the Australian banking industry. The report
shows that the demise of Lehman Bros. contributed towards the inception of the new auditing
standard. The outcome of the report also indicates towards the efficiency of the auditors in
treating the Key Audit Matters of the banks in accordance with the new auditing standard.

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Table of Contents
Introduction................................................................................................................................3
Rationale for ASA 701...............................................................................................................3
Explanation on ASA 701...........................................................................................................4
KAMs of the Companies under Australian Banking Industry...................................................4
Industry Selection...................................................................................................................4
KAMs of the Australian Banks..............................................................................................4
ANZ Banking Group Limited............................................................................................4
Bank of Queensland...........................................................................................................4
Commonwealth Bank.........................................................................................................5
Medibank Private Limited..................................................................................................5
National Australian Bank...................................................................................................5
Westpac Banking Group....................................................................................................6
Conclusion and Recommendations............................................................................................6
Reference....................................................................................................................................8

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Introduction
In the recent years, major involvement of the auditors has been found in large
corporate collapses where auditors ignored crucial fraudulent events or transactions in the
financial statements that led to the collapse of those companies. In order to avoid these issues,
some crucial changes have been introduced in this process (Sirois, Bédard and Bera, 2018).
One of such changes is the inception of ASA 701 Communicating Key Audit Matters in the
Independent Auditor’s Report (ASA 701) that has increased the responsibility of the auditors
regarding the identification and reporting significant audit matters and issues for the
betterment of the audit clients and users of the financial statements. This report intends to
analyse the main rationales behind the introduction of this new auditing standards where
specific emphasis is given on the reasons for the collapse of Lehman Bros. After that, this
report also analyses the efficiency of the auditors in handling as well as reporting the Key
Audit Matters (KAMs) of the ASX to 100 listed banks in the Australian banking industry.
This report also provides a recommendation regarding ASA 701 based on the discussion.
Rationale for ASA 701
Auditors have the responsibility to test the financial statements for identifying the
areas of material misstatements. However, the recent years have witnessed major
deterioration in this specific responsibility of the auditors when their major involvement was
found in the collapses of some of the biggest corporations all over the world. The collapse of
Lehman Bros. is one of such cases where the auditor, Ernst & Young (EY), played a major
role in the collapse of the company (Azadinamin, 2013). The illegal use of Repos can be seen
by the management of Lehman Bros. for manipulating their leverage position in order to
present their financial statements in a better manner to the investors and other users. The
balance sheet of the company was improved by $50 billion with this illegal use of Repos
(Mawutor, 2014). In spite of being aware of this manipulation in the financial statements by
the management, the auditors of Lehman Bros. issued them with unqualified audit opinion by
ignoring these aspects. This contributed towards the collapse of Lehman Bros. which played
a major role in the world financial crisis of 2008 (Dodo, 2017).
The main logical reason for the inception of the new auditing standard ASA 701 is the
demise of Lehman Bros. and the occurrence of world financial crisis 2008. The main
intention of the regulators for the development of ASA 701 was to ensure addressing the
auditing problems which the auditor of Lehman Bros. failed in addressing (Azim, 2013).
There was major necessity to take into account the auditing gaps in the audit of Lehman Bros
because of inappropriate auditing and this led to the recommendation of the new audit
standard of ASA 701. As per the requirement of the new auditing standard ASA 701, it is
needed for the auditors to ensure effective disclosure of high-audit risk areas (Xu, et al.,
2013). At the same time, ASA 701 puts the obligation on the auditors to examine the
judgments used by the clients’ managements and they are needed to consider the impact of
significant transactions and events on the financial statements of the companies. Moreover, it
is needed under ASA 701 to disclose the description of the auditing issues based on the
significant matters in the audit report (Carson, Zhang and Fargher, 2014). It is noteworthy to
mention the fact in this aspect that it would be possible to save Lehman Bros. from the
collapse in case the new auditing standard ASA 701 was available at that time (Carson,
Zhang and Fargher, 2014).
Another major concern that raised from the collapse of Lehman Bros. is the ability of
the companies to continue as a going concern. The 2008 financial crisis showed how quickly
changes can take place in the financial markets which can lead to the collapse of large

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corporations like Lehman Bros. It implies that the adverse events can put the ability of the
companies to continue as a going concern in risk. The auditors of Lehman Bros. did not
consider the assessment of crucial events that could affect the company’s ability to continue
as a going concern and it was a major reason for the collapse of the firm. This incident of
Lehman Bros. led to the revision of the auditing standard of ASA 570 Going Concern that
now requires the auditors to obtain adequate sufficient audit evidence to assess the
management’s use of going concern basis of accounting so that material misstatement can be
identified regarding the firm’s ability to continue as a going concern (auasb.gov.au, 2019).
Explanation on ASA 701
ASA 701 is referred to the new auditing standard which aims at the audit and
communication of the crucial audit matters in the report of the auditors (auasb.gov.au, 2019).
The presence of certain features can be seen in ASA 701. They are compulsory
communication of KAMs in the audit report of the listed firms; make the auditors able in
deciding the inclusion of KAMs in the audit report; specific processes for the determination
of KAMs like from the matters communicated with the employees charged with governance,
consideration of highest risk areas and determination of the most significant issue in the audit
report; ways to describe KAMs in the audit report; consideration of situations when KAMs
are not communicated in the auditor’s report; and required audit documentation for KAMs
(auasb.gov.au, 2019). There are certain requirements of ASA 701 that the auditors are needed
to comply with (ey.com, 2019). First, the auditors are needed to determine the KAMs while
considering the required aspects; second, the auditors are needed to ensure the effective
communication of KAMs in the appropriate sections of auditor’s report; third, they are
needed to communicate the KAMs with the personnel charged with governance; and last, the
auditors are required to ensure the proper documentation of the KAMs (assets.kpmg, 2019).
KAMs of the Companies under Australian Banking Industry
Industry Selection
Australian banking industry is taken into consideration where the banks under the top
100 ASX listed companies are considered for the analysis of their KAMs. It shows whether
the auditors have effectively analysed the KAMs of these banks.
KAMs of the Australian Banks
ANZ Banking Group Limited
The auditors have identified four KAMs in this ban; they are provision for credit
impairment and disclosures for the predicted impact of AASB 9, financial instrument
valuation that are held in fair value, provision for customer remediation, accounting for
divestment and IT systems and controls. The auditors have tested key controls, performed
credit assessment, and tested the group’s process for model validation for the first KAM. For
the second KAM, they have tested the access right, internal control, and governance and
approval control (Bédard, Gonthier-Besacier and Schatt, 2014). For the third KAM, the
auditors have gained understanding on the bank’s process to identify and asses the customer
remediation activities, testing completeness assertion and others. For the fourth KAM, the
auditors have assessed as well as tested the internal control of the bank for divestments. For
the last KAM, the auditors have tested the governance control, access rights, tested
preventive controls and tested operative effectiveness (shareholder.anz.com, 2019). In
addition, the auditors have provided the reasons or rationale for considering these matters as
KAMs for the operation of the banks.

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Bank of Queensland
There are five KAMs identified by the auditors. They are specific and collective
provision for loan impairment and advances for amortization cost, goodwill valuation,
intangible compute software valuation, value measurement of financial instruments and IT
system as well as control environment (boq.com.au, 2019). For the determination of these
KAMs, the auditors have considered the assessment of specific impairment provisions and
collectively assessed provisions; assessing the crucial forward-looking assumptions applied
in the value-in-use model which includes the assessment of forecasted operating cash flows
and discount rate; assessment of the crucial assumptions for the estimation of capitalization
of costs and expected useful lives; testing the presence of inherent complexities in the fair
value estimation process; and testing the IT systems as well as control environment of the
bank. Based on the outcome of these assessments, the auditors have developed the audit
procedures that include sample testing regarding specific and collective provisions, assessing
the process of CGU determination of the bank, evaluating the capitalization policies of the
bank and others (Cordoş and Fülöp, 2015).
Commonwealth Bank
The identified KAMs of the bank identified by the auditors are loan impairment
provision, judgemental valuation of financial instruments, provision for conduct risk and
regulatory action, valuation of insurance policyholder liabilities and operation of financial
reporting IT systems and controls. The auditors have determined these KAMs through certain
actions such as assessment of the assumptions and calculations used by the bank regarding
loan impairment provision, testing the judgments of the management in determining the
values of complex derivatives, assessing the judgments involved in the determination of
probability of financial outcome of the provision for risk and regulation actions on the basis
of the available information, testing the used assumptions in the expected timing, claims and
duration of the insurance policyholder liabilities and testing the framework of governance and
other aspects of the IT system and control (commbank.com.au, 2019). The auditors have
undertaken both the substantive audit procedures as well as analytical audit procedures on the
basis of the assessment of the KAMs in the bank. In addition, they have disclosed them in the
KAM section of the audit report (Sirois, Bédard and Bera, 2018).
Medibank Private Limited
The auditors have identified two KAMs in the bank which are estimation of
outstanding claims liability worth $379.8 million and reliance on automated processes and
controls. For the first KAM, the auditors have tested the applied judgments for the estimation
of types and amounts of claims, speed of processing claims and claims cost inflation and
medical trends having impact on benefit utilization. The adopted audit procedures for this
KAM are testing the control designs as well as operating effectiveness and claims received
after the year end and the bank’s use of actuarial expertise (medibank.com.au, 2019). For the
second KAM, the auditors have considered it as a KAM because of the heavy reliance of the
bank on operation and financial reporting processes related IT system and changes in system
as well as underlying business processes. The undertaken audit procedures are assessment of
the operating effectiveness of the IT system, testing the sample of key automated calculations
and testing the aspects of program development and changes (Christensen, Glover and Wolfe,
2014).
National Australian Bank
The auditors have identified four KAMs in the bank which are provision for credit
impairment on loans at amortized costs, conduct risk and provisions, restructuring provision
and IT systems as well as control over financial reporting. The auditors have considered the

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first matter as KAM due to the presence of key judgments in the areas of interpretation of
requirements to determine impairment, exposure identification and incorporation of forward-
looking information. The auditors have assessed the key areas of judgments related to the risk
and provisions; tested judgements related to the restructuring provisions and assessed the
extent of the reliance of the bank on their IT system and control (nab.com.au, 2019). The
undertaken audit procedures include the assessment of the banks expected credit loss model,
test of relevant controls related to data used for the determination of provisions, consideration
of the bank’s process to identify the conduct related matters, analysis of the restructuring plan
of the bank regarding provisions and assessment of the effectiveness of the implemented IT
system by sample testing of key transactions.
Westpac Banking Group
The auditors of this bank have identified five KAMs which are provision for
impairment charges, AASB 9 Financial Instruments, fair values of financial assets and
financial liabilities, operation of IT systems and controls and provisions and contingent
liabilities. The first KAM is identified due to the presence of high level of subjectivity in the
estimation of loan impairment provisions. The second KAM is considered in the presence of
high judgment applied for the determination of exposure that leads to increased risk. The
reasons behind the third KAM are the magnitude of the financial instruments held under fair
value and the involvement of judgments and inherent complexities (westpac.com.au, 2019).
The reason behind the fourth KAM is the heavy dependence of the bank on the IT system and
control. The reason behind the last KAM is the presence of compliance, regulation and
remediation provision and contingent liabilities. The auditors have developed the required
audit procedures on the basis of the nature of the KAMs identified.
According to the above discussion, the auditors of the above-discussed banks have
effectively segregated their responsibilities in two parts. In the first part, they have provided
the logical rationales behind the selection of the KAMs where they have effectively assessed
the aspects like key judgments, assumptions, estimates and others. After that, in the second
part, the auditors have undertaken the appropriate audit procedures on the basis of the nature
of the KAMs and the outcome of the first section (Christensen, Glover and Wolfe, 2014).
This aspect has created a balance between these two parts. In this aspect, it needs to be
mentioned that the disclosure of KAMs in the auditor’s report works as a major source of
information for the investors and other users because they gain additional information of the
areas of the financial statements with significant audit issues. This is helpful for the users in
the decision-making process (Christensen, Glover and Wolfe, 2014).
Conclusion and Recommendations
As per the requirements of ASA 701, the auditors are needed to consider the KAMs in
the auditing process. For this reason, it is recommended to the companies to implement
effective audit risk management strategies as well as policies so that the occurrence of
significant events and transactions can be avoided. At the same time, it is recommended to
the auditors that they are needed to effectively communicate the crucial audit matters that
involve possible risky transactions and events which can lead to major material misstatements
in the financial statements. At the same time, it is also recommended to the auditors that they
are needed to be more professional as well as ethical at the time of dealing with the KAMs
while complying with the policies and standards of ASA 701. The requirement for the
auditors is to stay alert while auditing the financial statements of the clients so that they can
effectively identify significant transactions and events that can lead to material
misstatements. Moreover, it is also recommended to the auditors to treat the KAMs in
accordance with the policies and guidelines provided in ASA 701 since it will lead to the

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effective handling of the KAMs. At the same time, it will be possible to communicate the
treatments of these KAMs with the related parties in an effective manner. On the overall
basis, the auditors are recommended to comply with the new auditing standard ASA 701 for
efficient treatment of KAMs.

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