Key Audit Matters are the matters that, in the auditor’s professional judgment, were of most significance in the audit of the current period’s financial statements. They are selected from matters communicated with those charged with governance (the audit committee) and represent the areas where the auditor spent the most time, applied the most judgment and assessed the greatest risk.
SA 701 introduced KAM reporting to increase the communicative value of the audit report. Before SA 701, every unmodified audit report looked essentially the same: the opinion paragraph, the basis for opinion, the management’s responsibilities and the auditor’s responsibilities. A user reading the audit report of a bank could not distinguish it from the audit report of a steel manufacturer. The report communicated the conclusion (the financial statements are fairly presented) but nothing about the audit process that produced the conclusion.
KAM reporting changes this by requiring the auditor to describe: which matters required the most significant auditor attention, why these matters were considered significant and how the auditor addressed them. The user now learns not just the conclusion but the areas where the conclusion was hardest to reach.
How KAMs are selected
The selection process has three stages.
Stage 1: Start with matters communicated to those charged with governance. SA 260 requires the auditor to communicate with the audit committee on: planned scope and timing of the audit, significant findings from the audit, significant difficulties encountered, uncorrected misstatements, circumstances affecting the auditor’s opinion, disagreements with management and any other matters the auditor considers significant. These communications form the initial population from which KAMs are selected.
Stage 2: Identify the matters of most significance. From the population of matters communicated, the auditor identifies those that required the most attention. SA 701 provides guidance on what “most significant” means:
Areas of higher assessed risk of material misstatement (including significant risks identified under SA 315): if the auditor assessed a significant risk of material misstatement in revenue recognition due to complex contractual arrangements, and the risk required extensive audit procedures, revenue recognition is a KAM candidate.
Areas involving significant management judgment, including accounting estimates with high estimation uncertainty: if the company has Rs 50 crore of goodwill on the balance sheet and the impairment assessment requires projections of future cash flows, discount rate selection and terminal value assumptions, the goodwill impairment assessment is a KAM candidate. Management’s judgment is significant. The estimation uncertainty is high. The auditor’s response required specialist involvement and independent modelling.
Areas where the auditor had to significantly adapt the audit approach due to events or transactions during the period: if the company completed a major acquisition during the year and the purchase price allocation involved complex valuations of intangible assets, the acquisition is a KAM candidate because it required the auditor to deploy resources and expertise beyond the normal audit scope.
Stage 3: Apply judgment to select the final KAMs. Not every matter that required significant attention becomes a KAM. The auditor exercises judgment to select the matters that were most significant relative to all other matters. A typical audit report contains 2 to 5 KAMs. An audit report with 12 KAMs would dilute the communicative value by listing everything rather than highlighting what matters most.
What a KAM description should contain
For each KAM, the audit report describes three things:
Why the matter is a KAM. What made this matter one of the most significant in the audit? The revenue recognition arrangements are complex because the company has multiple performance obligations in its contracts, the timing of recognition depends on management’s assessment of the percentage of completion, and the assessment involves significant estimation. This explains to the user why the matter warranted significant auditor attention.
How the auditor addressed the matter. What procedures did the auditor perform? The auditor tested a sample of contracts to verify the identification of performance obligations, re-performed the percentage-of-completion calculation using independently obtained cost data, assessed the reasonableness of management’s total cost estimates by comparing prior-period estimates to actual outcomes, and engaged a valuation specialist to assess the discount rate used in the revenue allocation.
This disclosure is powerful because it shows the user the rigour applied. A KAM description that says “we tested management’s estimates and found them reasonable” tells the user nothing. A KAM description that lists the specific procedures (contract review, independent re-performance, prior-period back-testing, specialist engagement) tells the user that the auditor invested significant effort in reaching its conclusion.
The result (implied, not stated as a separate opinion). The KAM description does not express a separate opinion on the matter. The auditor does not say “we conclude that revenue recognition is correct.” The overall opinion covers all matters, including the KAMs. But the description of the procedures and the absence of a modification implicitly communicates that the auditor was satisfied with the outcome.
What KAMs tell the reader
A sophisticated reader of financial statements uses the KAMs as a map of the financial statements’ most vulnerable areas. The auditor is telling the reader: “These are the areas where the numbers depend most on management judgment, where the estimation uncertainty is highest and where the audit risk was greatest. We addressed these areas and we are satisfied, but you should know that these are the areas most sensitive to changes in assumptions, market conditions or management’s future decisions.”
A lender reading the KAMs learns where the financial statements might change most if conditions deteriorate. If “goodwill impairment assessment” is a KAM, the lender knows that the Rs 50 crore of goodwill on the balance sheet depends on management’s projections, and if those projections do not materialise, the goodwill will be impaired, equity will decline and covenants may be breached.
An investor reading the KAMs learns where the financial statements involve the most judgment. If “revenue recognition” is a KAM because of percentage-of-completion estimates, the investor knows that the reported revenue is an estimate, not a certainty, and the estimate could change materially in subsequent periods.
What the audit committee should do with KAMs
The committee should require the auditor to present the proposed KAMs before the audit report is finalised: which matters are proposed, why each is considered one of the most significant, how each was addressed and whether any matters were considered as KAM candidates but ultimately excluded (and why).
The committee should also assess: do the proposed KAMs align with the committee’s own assessment of the most significant audit risks? If the committee believes that related-party transactions are a significant risk but the auditor has not proposed a KAM on related-party transactions, the committee should ask why.
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