The adoption of IFRS will also have an impact on external audits, especially for those countries that have not converged to IFRS in their local accounting standards. Not only are accounting firms going through the same learning curve as corporate clients with respect to using and interpreting IFRS, but those firms need to be able to assist their clients through the transition while maintaining their objectivity and independence. At the same time, accounting firms will need to be alert to the risk of material misstatement in the financial statements. When carrying out an audit with a client reporting using IFRS, external auditors need to be aware of opportunities for manipulation of results.
Areas to watch
First, IFRS 1: First Time Adoption of IFRS. Management may deliberately understate provisions in the local GAAP accounts by making ‘errors’, the corrections of which will subsequently go to retained earnings on transition, resulting in expenses that are never recognised in the statement of comprehensive income. Management may also be exploiting the flexibility of the Statement of Comprehensive Income format to give undue prominence to certain measures of profit under IAS 1: Presentation of Financial Statements. One of the areas entities can take advantage of is IAS 8: Accounting Policies, Changes in Accounting Estimates and Errors. Management may correct deliberate misstatements impacting profit in the subsequent period by insisting on retrospective adjustments (in a subsequent period, restatement impacts comparatives, not reported results).
What is the potential for abuse on adoption of IAS 16: Property, Plant and Equipment? Entities can maximise gross revaluation reserve debits transferred to retained earnings to maximise remaining credits available to offset future impairments, or allocate revaluation reserve credits to assets most likely to decrease in value (or otherwise be unspecific in allocation). From experience, there are entities that overstate provision for decommissioning/restoration of assets at cost at transition date with subsequent corrections taken through the statement of comprehensive income.
More complex standards
Take the more complex accounting standard, IAS 39: Financial Instruments: Recognition and Measurement. Here, entities may classify unprofitable traded instruments as either held to maturity or available for sale, or retain the general component in the allowance for doubtful debts (which is generally not permitted under IAS 39). Entities may also re-allocate instruments between trading, available for sale and held to maturity to achieve their desired outcome.
In terms of hedging, management may backdate hedge accounting documents so that they can be prepared with the benefit of hindsight and allow hedge accounting from an earlier date. For those companies which adopt IFRS 9: Financial Instruments (effective 1 January 2013) directly, care should also be taken in reviewing the classification and measurement of these financial instruments. IFRS 13: Fair Value Measurement, which was recently issued by the International Accounting Standards Board (IASB) establishes a single source of guidance for measuring fair values under IFRS. External auditors must obtain the involvement of valuation specialists to assist in these audits to ensure valuation models are appropriate and management inputs as well as assumptions used in those models are reasonable, while the audit team can review the requirements for disclosures on fair value measurements for consistency. In applying another related standard IAS 32: Financial Instruments: Presentation, entities may restate compound financial instruments between debt and equity in order to achieve the desired outcome (debt to maximise deductible interest, equity to maximise profits), depending what management is pressured to present in the financial statements.
Impairment and goodwill
Under IAS 36: Impairment of Assets, management may allocate goodwill to the most profitable cash generating units (CGUs) to improve valuations of less profitable units. Alternatively, management could aggressively impair assets that have previously passed the recoverable amount test (write-down to retained earnings on transition). Auditors will also need to be careful in reviewing management’s definition of CGUs as they may be at a sufficiently high level to enable offsetting of impaired assets. Management could also modify valuation assumptions (eg discount rate, useful life, cash flows) to achieve the desired outcome.
Forex and related parties
On adoption of IAS 21: The Effects of Changes in Foreign Exchange Rates, entities may have the opportunity to eliminate a translation reserve in net debit for the sole purpose of improving results from subsequent disposal of foreign subsidiaries, and could also selectively allocate translation reserve balance to a disposal of foreign subsidiary to improve results. Watch out for related party transactions as there might be deliberate concealment. The external audit team should understand the requirements of IAS 24: Related Party Disclosures and identify this as a significant risk in any audits.
On the tax front
On adoption of IAS 12: Income Taxes, there have been instances where deferred tax assets are booked on transition by management using a simple comparison of accounting and tax bases but ignoring the detail of assets where the “initial recognition” exception should apply. Deferred tax liabilities, on the other hand, are not booked by arguing the initial recognition exception when they are actually acquired in a business combination.
In conclusion
Auditors need to be alert to the risks of fraudulent financial reporting, and the audit team should discuss the risk of fraud and fraudulent financial reporting more robustly during the planning process. Because IFRS is a significant change, it presents some opportunities for the manipulation of the first set of accounts on transition to IFRS. Auditors should therefore focus on aggressive earnings management, which is more likely to be a material risk of misstatement in the financial statements, than misappropriation of assets.
