The COVID-19 pandemic has caused a worldwide health and humanitarian crisis. Not only has the pandemic impacted all facets of life, it also has a significant impact on financial reporting and the manner in which audits are performed. With the potentially increased audit risk and restrictions in terms of performing physical site visits, auditors need to be innovative in adjusting the audit approach and designing alternate procedures to gather sufficient, appropriate audit evidence to support audit opinion. Hayley Barker Hoogwerf, SAICA Project Director: Assurance, outlines the challenges encountered by auditors and their approach to overcoming these in expressing the audit opinion.
Are there specific audit risks related to the operation of the entity or otherwise that the auditor should consider?
In the past, we have seen a shift in the accounting standards from a historical cost model, which as the name suggests, requires that items are measured at the price actually paid, to a fair value model, which is heavily reliant on future orientated information. With the fluid situation that we currently find ourselves in, with changes occurring on a daily basis, it is difficult to develop future expectations or estimates that are required in measuring these items. And in the current economic environment, it is possible that assets have lost value and will therefore need to be impaired to some extent. The higher the level of uncertainty, the more difficult it is for the preparer to establish a fair value and for the auditor to verify that this value fairly presents.
It is not business as usual. Businesses that are not able to continue operating are faced with increasing concerns around the ability of the entity to continue operating when they are eventually able to reopen, a concept referred to as going concern. Businesses that are able to continue operating remotely are doing so but this does mean changes to the internal control environment. This may result in perceived opportunities to commit fraud as a result of a different working environment. Increased economic pressure also heightens the risk of the occurrence of fraud.
What impact does COVID-19 have on the auditor’s determination of materiality?
In determining materiality, the auditor assesses what is important to users in terms of influencing the economic decisions taken on the basis of the financial statements. Materiality can also be described as a measure of user’s tolerance for misstatement. In calculating materiality, the auditor applies a percentage to a benchmark. Typical benchmarks that auditors use include total revenue or net profit before tax, or even total assets. The important point to note here in relation to COVID-19 is that the benchmark must be stable. The auditor may therefore need to rethink, firstly, whether the benchmark that was historically used in calculating materiality is still appropriate and, secondly, whether this benchmark needs to be adjusted for “abnormal” expenditure, such as retrenchment costs, restructuring costs or impairments losses.
How is the auditor’s evaluation of the design of the controls and the determination of whether they have been implemented impacted by COVID-19, and does this affect the identification and assessment of risks of material misstatement?
Here, there are two scenarios that need to be considered;
COVID-19 did not impact the ability of the entity to implement internal controls during the period under review
In this scenario, the financial period under review ended before the start of the national lockdown and therefore the entity was able to continue implementing the internal controls designed for normal operation of the business throughout the financial period being reported upon. It is therefore unlikely that the control risk will be heightened as a result of COVID-19 and as such, will have minimal impact on the auditor’s identification and assessment of risks of material misstatement. The following financial period may however result in an increased risk of material misstatement, due to the lockdown having taken place in that following period.
COVID-19 did impact the ability of the entity to implement internal controls during the period under review.
As a result of the lockdown, where possible, employees are working remotely, which is not part of the usual routine and may result in changes to both the design and implementation of the internal controls. Although this will only possibly impact a portion of the financial year, the auditor should ensure that a thorough understanding of the entity and its environment, including the internal controls implemented during the lockdown period, be obtained and documented. It is possible, depending on the extent of changes in the system of internal control, that the entity will have two systems of internal controls during the financial reporting period.
It is also highly likely that auditor will encounter a third scenario after lockdown in that entities will not return to business as it was prior to the global pandemic. There may, for example, be less staff due to retrenchment or even illness that are able to implement the traditional internal controls.
What is the impact of the inability of the auditor to obtain sufficient appropriate audit evidence through attendance at physical inventory counts?
Due to the lockdown under alert level 5 and 4, auditors were not able to obtain physical access to clients’ premises to physical observe the inventory count for March, April and even May 2020 financial year ends. Inventory is unique in that the auditing standards contain a specific requirement for the auditor to attend a physical inventory count when inventory is material to the financial statements, unless impracticable to with COVID-19 and the related lockdown, this was a particularly difficult requirement to comply with. The standard does allow the auditor to observe an inventory count on a date other than at the date of the financial year end and perform audit procedures on intervening transactions if the auditor is not able to attend the year-end inventory count.
The ability of the auditor to physically attend an inventory count is dependent on whether the client is considered to be an essential service and therefore able to perform the inventory count themselves.
If attendance at the inventory count is just not possible, the auditor must perform alternative procedures to obtain the required audit evidence. If the auditor has exhausted all options to obtain audit evidence and is still not able to obtain the required evidence, the auditor must consider the impact of this on the auditor’s report.
How are the auditor’s considerations of the appropriateness of management’s use of the going concern assumption impacted by COVID-19?
COVID-19 has had and will continue to have a significant impact on many entities, which may result in an increased number of entities being placed under business rescue, or in other cases, liquidation. The auditor’s evaluation of the appropriateness of management’s use of the going concern basis of accounting in the preparation of the financial statements has suddenly become an even more difficult yet pertinent issue for the auditor to consider.
Those responsible for preparing the financial statements are required to make a specific assessment of the entity’s ability to continue as a going concern. The auditor is then responsible for evaluating management’s assessment. If the auditor does identify events or conditions that cast doubt on the continued existence of the entity, the auditor is required to perform further procedures.
The going concern assessment is based on forward looking information and those preparing the financial statements will be faced with significant challenges in making such assessments in these fluid and uncertain times. It also makes the auditor’s job that much more challenging. This situation is further aggravated by the fact that some entities may still not operate for the foreseeable future.
From the early onset of the pandemic, entities that sourced stock from China found themselves in a predicament when China went into lockdown, as exports from China were limited, and the entities started running short on stock to sell.
Other companies that import goods and did not take out forward cover also experienced a financial knock with the devaluing of the ZAR. The end result: stock that has cost the company significantly more, which will eat into the profit margins. Other matters, such as expiring inventory or slow moving stock may also be indicators of events of conditions that require the auditor to look deeper in assessing whether management’s use of the going concern basis of accounting in preparing the financial statements remains appropriate.
As the country moved to lockdown Alert Level 3, auditors experienced some relief in terms of the challenges encountered. There are however, instances were opportunities to obtain audit evidence have been lost, which may result in an increase in the number of modified audit opinions issued. Audit firms are proceeding with caution in easing into the new alert level by, in most cases, continuing to work remotely and only performing physical site visits where there is no realistic alternative but to do so.