Importance of Key Audit Matter ASA 701 in Annual Reports

This article discusses the importance of Key Audit Matter ASA 701 in annual reports and how it can prevent the concealment of crucial information. It includes a case study of Lehman Brothers and the auditing issues surrounding its collapse. It also explores the key audit matters in the mining industry.

AUDITING &
ASSURANCE
HP
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Audit ASA 701
Executive Summary
The auditing standards and the audit procedure underwent a huge change with the downfall of
Lehman Brothers. It is observed from the case of Lehman that major information was
concealed as ASA 701 was not present at that point of the item. The report further states the
importance of Key audit matter ASA 701 in the annual report. From the Lehman brother case
report it can be commented that it is highly important for the auditors to ensure that the audit
processes are conducted in a manner that makes it impossible for the board and senior
managers to hide key audit matters of an organization. It is the duty of the auditors to
implement auditing standards in a manner that it becomes easier to detect key audit matters of
an organization and the same must be later used in the preparation and representation of audit
reports. The failure of audit in respect of Lehman Brothers led to the case of KAM and the
same is discussed in the initial part of the report. The second part of the report deals about
the KAM of the mining industry.

Audit ASA 701
Contents
Introduction...........................................................................................................................................2
Case of Lehman Brothers & Relevance of ASA 701 in the case..............................................................2
Auditing Issues surrounding the Lehman Collapse:...............................................................................3
MINING Industry....................................................................................................................................5
1. BHP BILLITON.................................................................................................................................5
2. RIO TINTO......................................................................................................................................6
3. Alumina Limited.............................................................................................................................7
4. Evolution Mining............................................................................................................................7
Conclusion.............................................................................................................................................9
References...........................................................................................................................................10

Audit ASA 701
Introduction
ASA 701 is a new accounting standard formulated so as to make it mandatory for an auditor
to address the key audit matters based on his findings in the auditors’ report. The matters
detected by an auditor must be identified as key audit matter based on their probable impact
on the well being of the company. An auditor must prioritize areas that are prone to material
misstatements and reflects the presence of a related party transaction. KAM are such issues
that are crucial in the judgment of an auditor. Key audit matters are matters that hold an
utmost significance in the eyes of an auditor. These matters are detected by the auditors from
the financial statements of an organization and are highlighted as the key on the basis of their
significance. If key audit matters are not adequately dealt on time then these can have an
adverse impact on the financial well being of the company. The auditors are required to
report KAMs to the management of the company in the audit committee meetings and must
also offer a professional judgment on how to deal with the same. The audit report looks more
desirable to the users of the same when it is supported by necessary KAMs.
There are various matters that the auditor must prioritize in his audit function with respect to
KAMs. An auditor must necessarily label such matters as KAMs that makes it difficult for
him to construe a judgment on the financials of the company. An auditor must identify areas
that are prone to a higher level of material risks and also where the presence of management
and auditors’ judgment is involved. An auditor must necessarily dig into areas where there
are probabilities of the presence of a significant matter on account of internal quality control
team and also areas that reflect even the slightest of related party transactions and other
complicated transactions. The auditor must also assess such transactions that have seemingly
affected the audit procedure in general.
The auditor must communicate identified KAM to the management of the company and must
also provide a professional judgment on the same.
Case study of Lehman Brothers & Rise of ASA 701
The auditors failed to disclose key audit matters in the case of Lehman Brothers. Concealing
these matters was one of the main reason that attributed to the disintegration of the company.
The investors of the Lehman Brothers suffered huge losses on account of non-disclosure of
KAM which is ultimately why the company collapsed all of sudden.

Audit ASA 701
There were many facts that were concealed by the auditors of the company which required
necessary disclosure in the auditors’ report. There was a use of Repo 105 and such other
transactions so as to enhance the financials of the company. The auditors were aware of such
a practice but they did not feel the urge to disclose in their auditors’ report of the company.
There was a significant drop in the leverage ratios of the company (Wiggins, Piontek, &
Metrick, 2014). This significant decrease was detected by the auditors but they did not feel
the need to address such a key audit matter in their reports. This drop in the leverage ratios
was on account of the rise in the borrowings of the company (Venanci, 2012). Also, the
company paid interest on these borrowings from time to time which made its funds suffer to a
huge extent. Also, the company bought back the securities at a very high amount and the
same was reflected as a lower rate as derivatives. Therefore, the same was not adequately
disclosed in the financials of the company. If the auditors would have portrayed all these
necessary disclosures in their reports then the company must not have disintegrated so
quickly (Niemi & Sundgren, 2012). The auditors refrained from projecting all the necessary
KAMs in their audit reports which ultimately created trouble on the well being and thus, the
existence of the company. The auditors would not have concealed such material facts in their
reports and the company would not have thus disintegrated if there was a prevalence of the
new standard ASA 701 at that time.
Auditing Issues surrounding the Lehman Collapse:
With the disintegration of Lehman Brothers, it is very clear that the auditors play a significant
role in the well being of an organization. If the auditors of Lehman Brothers made necessary
disclosures based on their findings in the auditors’ report, then the company might not have
collapsed. The new standard ASA 701 has made it mandatory for the auditors to disclose all
the key audit matters in their audit reports.
• Incorrect classification and Raise of funds through Repo transactions
The company opted for Repo transactions where the same ascertained its short-term financing
transactions as sales. The company opted to portray in its balance sheet a lesser amount of
liabilities in contrast to the actual amount so as to project that its liabilities are reduced due to
the sale of securities (Malkiel, 2013). The company also removed its collateral securities
from the balance sheet. This is why the leverage of the company dropped. The collateral
securities were supposed to be treated as per Repo transaction and the same was needed to be

Audit ASA 701
reported in the balance sheet of the same. Nowhere it was described about the loan taken
from other parties while the securities that were projected as sold was deducted from the
assets. The actual treatment of the loan taken from the third parties was required to be
projected in the balance sheet of the company until the same was not completely repaid. The
auditors failed to disclose all the facts all KAMs in their audit reports chose to do otherwise.
The auditors and the company took undue advantage of the fact that FAS 140 reflects nothing
about the individual obligation of disclosures in this regard (KMPG, 2010).
• No disclosure of improper transaction in the Auditor report
The auditors of the company chose not to reflect in the balance sheet of the same about the
consequences of the Repo 105. This was done in order to disallow the users of the financial
statements of the company from becoming aware of the fact that the leverage ratio of the
company was unfavorable and that the same was already suffering from huge debts. These
disclosures were necessary on the auditors’ part so as to allow the users of the statements of
the company to learn about the actual well being of the same.
• Lehman’s Repo 105 Policy was approved that mislead the investors
Repo 105 and Reverse Repo were selected by the company and upon receiving approval from
the auditors treated these repo transactions in its balance sheet as repurchase and sale of
investments. The auditors should have not given their consent on this policy. They could have
withheld the company from practicing this policy by making them aware of the impacts
arising out of the same in the coming time (Eilifsen & Messier, 2014). Lehman Brothers
opted for Repo 108 transactions in order to employ equities as collateral instead of securities
of fixed income.
• Failed to disclose Non-Approval of True Sale Opinion in United States
The company needs to procure a true sales opinion in order to treat the Repo 105
transactions. The company must confirm that all its transactions are in full compliance as
what is needed with respect to transfers and sales so as to treat Repo 105 transactions as
Sales. However, it was noticed that the Lehman Brothers did not procure true sales opinion.
The company later procured a true sales opinion by collaborating with finances of UK so as
to opt for Repo transactions. Lehman Brothers were put through a condition that the
securities of the company shall be sited in the UK and the investment securities of the same

Audit ASA 701
shall be traded with the boundaries of UK. The company continued to go as per the pre-
requisite condition for some time but later chose to transfer billions of dollars of US fixed
income generating securities without taking acknowledgment from UK financers (Cappelleto,
2010). This information too was known to the auditors of the Lehman Brothers yet they chose
to not disclose the same in their audit reports.
MINING Industry
1. BHP BILLITON
Asset valuation and taxation are the areas that reflected the presence of a significant amount
of KAMs for the company.
Asset valuation
An auditor must necessarily learn about the assets of an entity so as to detect the KAMs
present in the same. The valuation of assets must be necessarily done by an auditor as assets
are highly prone to misstatements. The management of the organization too believed that the
impairment of its assets carries the risks pertaining to material misstatements. The
management of the organization preferred to conduct a thorough analysis by means of
reviewing and monitoring the valuation of the assets so as to detect the presence of material
misstatements pertaining to impairment of assets (BHP Billiton, 2018). The management also
assessed the commodity prices that were supposed to be forecasted along with various other
factors that may have an adverse effect on the asset valuation of the company.
Taxation
BHP Billiton is a company that operates worldwide and is also engaged in cross-border sales.
As the company operates globally, it has to undergo a lot of hardships pertaining to various
tax structures. The auditors of the company regarded KAMs pertaining to the taxation,
expenses and contingent liabilities of the same. The auditors also evaluated the presence of
proper disclosures made by the company in its financials pertaining to it taxation mechanism
so as to help the users to gather an understanding of tax structure the company has to deal
with (BHP Billiton, 2018). The auditors of the company were also keen on learning about the
consistency with respect to the prevalence of various structures in different borders. The
auditors incorporated various mechanisms such as tested key controls and took suggestions

Audit ASA 701
from certain tax experts from the countries in which BHP operated so as to understand the tax
mechanisms the company has to go through.
2. RIO TINTO
Provisions for uncertain tax positions
Rio Tinto is an organization that operates globally and it is why the company faces a lot of
hardships pertaining to the contrast in tax structures, laws, and regulations, policies, etc. Also,
matters related to transfer pricing, taxes, and other tax matters also affect the operations of
the organization. Rio was entitled to pay an amount of $US2190 million with respect to its
current and non-current taxes on 31 December 2018. In order to tackle the uncertainty with
respect to tax payable amount, the organization has adopted multiple provisions which are
completely on the basis of the best estimate that is closest to the tax payable amount as
derived by the top-level executives (Rio Tinto, 2018). The disputes that the company has
been dealing with were also assessed by various tax experts. The tax experts affirmed that the
organization has adhered to all the necessary regulations pertaining to taxation and has also
been in accordance with the tax provisions.
Provisions relating to close-down, restoration, and environmental obligations
Rio Tinto has provisions that pertain to close-down, restoration as well as obligations of
environment amounting to the US $9975 million as at 31 December 2018 (Rio Tinto, 2018).
In order to calculate these provisions, the management of the company must assess a proper
rate so as to discount future costs to their net present value. In order to perform a thorough
analysis of the cost estimates, the management formulated legal obligations that applies to
provision of closure. This is why the company chose to focus on the method of rehabilitation
and restoration and associated cost estimate.
3. Alumina Limited
The KAM for Alumina Limited are discussed below-
Assessment of impairment indicator for investment in AWAC
Alumina Limited has invested $2.3 billion as reflected in the annual report of the same. This
amount was cross-verified by the auditors and they suggested that the amount could be

Audit ASA 701
nothing other than impairment. In this regards, the auditors took the required processes by
means of assuming the future price of alumina (Alummina Limited, 2018). The auditors also
draw a comparison between the overall value of the company and the overall value of its
rivalries so as to trace the impaired values. Even after so much of hard work, the auditors
were unable to locate impairment evidence from the investment affairs of the entity.
Equity accounting for AWAC investment
The auditors checked whether the company has adhered to the principles of US GAAP by
determining its appropriateness. The auditors have also conducted a comparison so as to
determine the contrast between US GAAP and AAS. The auditors mentioned the
methodology incorporated by them in the annual report of the Alumina Limited so as to
assess the organization’s investment of 40% in AWAC (Alummina Limited, 2018).
4. Evolution Mining
Identification of deferred tax assets
Evolution mining has reported its deferred tax assets at $57.74 million. The number of
deferred tax assets was affirmed by the auditors of the company as the same was evaluated as
per AAS. The auditors confirmed this amount after taking all the necessary measures by
means of determining the firm’s ability and re-evaluating a number of deferred tax assets.
The auditors also determined the appropriateness of the firm’s taxable amount (Evolution
mining, 2018).

Audit ASA 701
Conclusion
The failure of Lehman Brothers is an example for all the entities. A company must always
adhere to independent statutory requirements and must have sound corporate governance in
its system no matter what the size of the same is. The auditors and the management of an
organization must function ethically for the well-being of the same. All the accounting
policies and auditing standards must be adhered strictly by the organization. The management
and the auditors must be aware of the consequences that the company might have to face if
there is no adherence to accounting policies and auditing standards. The auditors must
disclose all the key audit matters in their auditors’ report so as to project a genuine outlook of
the company’s financial well being. This will ultimately allow the users to learn about the
actual well being of the company and construct appropriate investment related decisions.

Audit ASA 701
References
Alummina Limited. (2018) Alummina Limited 2018 annual report and accounts. Available
from https://www.aluminalimited.com/latest-annual-report/[Accessed 18 May 2019]
BHP Billiton. (2018) BHP Billiton 2018 annual report and accounts. Available from:
https://www.bhp.com/-/media/documents/investors/annual-reports/2018/
bhpannualreport2018.pdf [Accessed 15 May 2019]
Cappelleto, G. (2010) Challenges Facing Accounting Education in Australia. AFAANZ,
Melbourne
Eilifsen, A., & Messier Jr, W. F. (2014). Materiality guidance of the major public accounting
firms. Auditing: A Journal of Practice & Theory, 34(2), 3-26. Available from:
https://www.researchgate.net/publication/257643150_Qualitative_audit_materiality_and_ear
nings_management [Accessed 20 May 2019]
Evolution mining. (2018) Evolution mining 2018 annual report and accounts. Available
from: https://evolutionmining.com.au/wp-content/uploads/2018/10/1858627.pdf [Accessed
20 May 2019]
KMPG. (2010) An overview of Risk and disclosure. Available from
https://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/
KPMG-pharmaceuticals-disclosures-summary.pdf [Accessed 20 May 2019]
Malkiel, B. G. (2013). Asset management fees and the growth of finance. Journal of
Economic Perspectives, 27(2), 97-108. Available from: https://www.umass.edu/preferen/You
%20Must%20Read%20This/MalkielJEP2013.pdf [Accessed 20 May 2019]
Niemi, L. and Sundgren, S. (2012) Are modified audit opinions related to the availability of
credit? Evidence from Finnish SMEs. European Accounting Review. [online]. 21(4), p. 767-
796. Available from: https://doi.org/10.1080/09638180.2012.671465 [Accessed 15 MAy
2019]
Rio Tinto. (2018) Rio Tinto annual report 2018. Available from
http://www.riotinto.com/documents/RT_2018_annual_report.pdf [Accessed 18 May 2019]

Audit ASA 701
Venanci, D. (2012). Financial Performance Measures and Value Creation. State of art .
New York: Springer.
Wiggins, R.Z, Piontek, T & Metrick, A. (2014) The Lehman Brothers Bankruptcy. Available
from: http://som.yale.edu/sites/default/files/files/001-2014-3A-V1-LehmanBrothers-A-
REVA.pdf [Accessed 20 May 2019]