What are Critical Audit Matters and Why You Need Them?

In the world of accounting, there are many things that must be considered in order to have a high-quality, successful audit. One would think that the only thing one needs to worry about is whether or not they’ve done their job well and everything else falls into place. But in reality, it is so much more complicated than just doing your job right because there are specific elements that can actually cause material misstatement if not examined thoroughly. Critical Audit Matters involve those issues that have the potential to cause significant noncompliance with laws or regulations if not detected. The importance of these issues cannot be denied because they may lead to serious consequences if not examined carefully enough.

What are critical audit matters?

What are critical audit matters?

Critical audit matters are a seemingly innocuous list of issues that can have serious consequences if not examined carefully. In finance, these mistakes are called accounting errors and the primary goal is to prevent them from happening because they make a large impact on companies as well as their investors. If an auditor misses one of these critical items, it could be disastrous for the company and its investors. Some examples include accounting errors, fraud, management overriding the system, and not using good judgment.

What are critical audit matters in accounting?

Critical audit matters are defined as those issues that have the potential to cause material misstatement or significant noncompliance with laws or regulations if not detected. As per EY’s Global Audit Quality Issue Brief”, the importance of these issues cannot be denied because they may lead to serious consequences if not examined thoroughly, or in case of an understatement, the company’s future is at risk.

Why are they important?

Critical audit matters can result in significant noncompliance with laws or regulations if not detected. Companies are required to file quarterly reports with the Securities and Exchange Commission (SEC) as well as annual reports when they have a fiscal year end that is different from June 30, so these reports are part of the critical audit matters. The Sarbanes-Oxley Act also dictates that companies have to incur an independent investigation in case they or one of their employees is accused of committing fraud, and even if this doesn’t result in any legal action, the company still has to incur the cost of hiring a law firm for the investigation. The same law also has a section that deals with how the company’s auditors should handle cases where they suspect fraud, but do not have enough evidence to link it directly to an individual or group within the company.

What are common examples of critical audit matters?

There are many types of things that auditors have to look for during their audits which can result in one of these items being missed if they aren’t looking hard enough. Some examples of critical audit matters are:

The absence or incorrect application of an accounting principle. This means that the auditing firm must make sure that they are applying an accounting method and assertions that are correct for the business in question.
Failure to identify or misidentify a material inconsistency. This means that there should be consistency between various financial statements, procedures, and any other evidence of something being recorded incorrectly.
Documentation not properly completed, reviewed, or retained. This means that it is important to make sure that all of the necessary documentation for financial events has been properly recorded and followed up on.
Failure to detect or misidentify an unrecorded liability. This means that auditors must find out if there are any expenses, fees, taxes, etc. that have not been correctly recorded formally as a liability of the business.
Failure to detect or misidentify an unrecorded asset. Similar to the last point, this means that there are opportunities for assets not being recorded at all or incorrectly, which will lead to serious losses if not noticed by the auditors during the review.
General ledger account balances do not reconcile to sub-ledger accounts which means that the financial statements reflect incorrect balances that could lead to material misstatements. This can be attributed to errors in recording, calculations, or both.
Improper valuation of inventory means that the value of inventory could be improperly recorded which would lead to a material misstatement. This can also result in inventory not being recorded at all or a difference between standard cost versus actual cost.
Failure to detect or misidentify an incorrect application of revenue recognition principles means that there might be accounting methods used for things such as sales commissions, etc. that aren’t correct and should be changed to avoid errors, or sales recorded without the proper documentation which could lead to incorrect balances on financial statements.
Failure to detect or misidentify a non-compliance with contract terms which means that there might be revenue not recorded at all or incorrectly, such as an item of income that was not properly recognized due to incorrect calculations or incorrect application of principles.
Business transactions that appear unusual refer to anything that doesn’t seem to follow appropriate business practices, unusual sales transactions, etc., which means there should be explanations for these types of things.
Quality of audit documentation refers to the quality of records kept, procedures used in an audit to put forth evidence for transaction processing and accounting systems, etc. There must be sufficient evidence provided for everything if there is a lack of documentation.
Material misstatement of internal control over financial reporting means that there might be some sort of error, omission, or mistake with internal controls that could have an effect on the overall statement. This should pay particular attention to what’s going on in a company’s finance department.
Failure to detect or misidentify a fraud. This means that auditors should be looking for anything that seems suspicious, such as unusual transactions or inconsistencies on records, etc.
Failure to make appropriate inquiries of management refers to the auditor making sure they are asking the necessary questions and checking on everything.
Financial statement presentation which means that it is important for auditors to make sure there is everything needed for the statement to be put forth accurately and effectively.
Significant deficiencies in internal control over financial reporting mean that there are some issues with controls so it’s important to fix these before they can become problems.

What is a CAM audit?

Critical Audit Matters (CAM) are defined as those issues that have the potential to cause material misstatement or significant noncompliance with laws or regulations if not detected. The importance of these issues cannot be denied because they may lead to serious consequences if not examined thoroughly.

Who decides what is a cam?

CAMs are identified in the planning phase, and an appropriate risk-audit approach is adopted to examine the CAMs and provide evidence that one may need in order to minimize risks.

19 examples of CAMs

Unrecorded adjustments to accounts that could materially affect financial statement balances if not detected (i.e., an unrecorded inventory write-down)
Undocumented assets and liabilities (i.e., If you knew there was a $100,000 transaction with an undocumented vendor five years ago, what would you do?)
Failure to record an item of revenue because the proper documentation wasn’t there (i.e., If a sale was made but no invoice or bill was received by the customer, what will you do?)
Material misstatement or noncompliance with contract terms (i.e., There is software support fee revenue recorded in the sales journal but there is no signed contract to support that revenue.)
Failure to detect or misidentify noncompliance with contract terms (i.e., When examining inventory, how would you know if it doesn’t match up to what’s on the contract?)
Business transactions that appear unusual (i.e., What would you do when you find a large amount of inventory where the sales journal only reflects one sale made in the last quarter?)
Quality of audit documentation (i.e., How can you determine if you have all the information required to make an informed decision regarding an issue?)
Material misstatement due to weakness in internal control over financial reporting (i.e., If a control isn’t effective, what would you do?)
Failure to make appropriate inquiries of management (i.e., What is important about this? Why is it here?)
Significant deficiency in internal control over financial reporting (i.e., If there are weaknesses, where would they be? Are there a few of them or a lot?)
Failure to obtain sufficient competent evidential matter to support a conclusion reached (i.e., How would you know if you don’t have everything needed?)
Inadequately evaluated deficiencies in internal control over financial reporting (i.e., If you didn’t look at enough, how do you know it’s a problem?)
Failure to obtain an understanding of internal control over financial reporting (i.e., What would you do if you don’t understand everything?)
Inadequate professional skepticism (i.e., If you aren’t skeptical enough, what will happen? How can this be fixed?)
Significant issues identified by an engagement team (i.e., What do you think about this? Why is it important?)
Insufficient professional skepticism in evaluating the results of procedures (i.e., If you aren’t skeptical enough, what can happen? Why isn’t this good?)
Failure to obtain sufficient competent evidential matter on which to base an audit conclusion (i.e., How would you know if you don’t have enough?)
Inadequate understanding of fraud risk areas (i.e., What about fraud makes this risky?)
Failure to test fraud controls (i.e., If there isn’t a fraud control, how do you think this will go down?)

Critical Audit Matters can be classified into two dimensions:

(1) Their characteristics and (2) The environment they exist in.

i. Characteristics: These are significant issues that may result in a material misstatement or a significant noncompliance with laws or regulations. Some of the examples of these matters include fraud, compliance and disclosure-related matters, and accuracy-related matters.

ii. Environment: Critical Audit Matters exist in all kinds of environments i.e. internal environments as well as external ones. For example, Critical Audit Matters in an internal environment exist in offices and departments such as the finance department, while those in an external environment can be observed within industries and marketplaces such as stock markets (Top 10 Stock Exchanges).

What are audit opinions?

Audit opinions are used to express the true and fair view of a company’s financial position and financial performance based on requirements set by management, or as applicable law. The audit opinion is provided only after the auditor has conducted the audit in accordance with relevant auditing standards and professional standards. An audit can be expressed as unqualified (also called unconditional), qualified, adverse, or disclaimed.

What are the 4 types of audit opinions?

Qualified opinion: A qualified opinion is written if there are potential issues with the financial statements that need to be looked at more carefully or resolved before an unqualified opinion can be issued.
Unqualified opinion: An unqualified opinion is issued when the financial statements fairly present, in all material respects, the financial condition of the company.
Adverse opinion: An adverse audit opinion is issued when it is believed that there is substantial doubt about an entity’s ability to continue as a going concern.
Disclaimed opinion: The auditor does not believe that they have been given sufficient information to provide an audit opinion, and the auditors state this in a disclaimer.

When should auditors disclose critical audit matters?

Auditors are required to disclose critical audit matters in the auditor’s report, and they should do so as soon as they become aware of them.

Because private companies are not subject to the same reporting laws as their counterparts, does that mean they are exempted from critical audit matters?

Are critical audit matters required for private companies?

Critical audit matters are only required for public companies; the reason is that they must abide by strict standards. But, the question raises an interesting point. Because private companies are not subject to the same reporting laws as their counterparts, does that mean they are exempted from critical audit matters? Although there is no explicit answer to this question, it seems logical that small businesses might also require careful attention to these issues. Large institutions, which are largely made up of smaller entities, also need to focus on the subject matter of critical audit matters. And with the advent of ESG and sustainability factors becoming more important than ever, there is no doubt that the importance of audit matters has increased.

Can auditors be held liable for failure to detect critical audit matters?

This question raises another interesting point because it seems logical that an auditor could face litigation for missing critical audit matters. For example, if a company fails, and its insider trading scandal is traced back to material noncompliance that an auditor should have found, then there could be a case for litigation. But proving negligence is critical because auditors are not expected to catch everything. If the issue is detected long after the fact, it may be impossible to prove why the specific issue was missed. However, if it can be shown that an auditor had ample time to conduct proper research and chose not to, then the act of negligence is undeniable.

How do you audit critical audit matters?

This is a difficult question for professionals working in the industry because there are several factors that go into deciding how best to approach this matter. There are multiple steps involved with auditing critical audit matters, and each one needs to be examined carefully. For example, understanding who the person is that will have a significant impact on the issue being examined is key. In addition, seeking outside expertise can also help direct what steps should be taken next. Even though there are no defined rules for auditing critical audit matters, it is important to use common sense in order to prevent the potential for error.

How do investors use CAMs?

Investors can use CAMs in several different ways. For example, they can examine the auditor’s report to see if there are any critical audit matters listed that need to be further investigated. Or, investors can talk directly with auditors about CAMs in order to get a better idea of what an unqualified opinion really means. Auditors should be able to give investors insight into whether or not there are any critical audit matters that need to be looked at, and they can provide insight into possible effects.

Critical audit matters are an important subject matter for investors because this is what auditors focus on in their review process. Investors have a right to know if there is any issue that might potentially become a problem. Auditors are the only ones that can legally disclose this information, so investors should ask for insight directly. Although investors need to be aware of these issues, auditors must exercise caution in disclosing critical audit matters because any mistake could lead to potential litigation. Whether an investor decides to invest or not is their choice upon receiving information about CAMs. However it is important to remember that the information an auditor gives about CAMs should be used as a starting point, not the end-all. It is up to each individual investor to do their own research and come to their own conclusion.

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What is the most common CAM?

The most common CAM is a Lack of a Separate Entity (LSE). If the company fails to meet this criterion, it may mislead its users.

What are examples of LSE in financial statements?

A lack of separate entity occurs when an entity does not have any existence or substance outside its sole proprietor or members, regardless of whether its operations or activities are separate from its member’s other businesses and organizations. This may include:

A co-mingled investment account.
Accounts that use a single bank account, credit card, debit card, or brokerage account for personal business activities.
Joint investments between an entity holder and spouse/family members.

Another example is the Lack of Adequate Procedures (LAP). It refers to the lack of documented procedures that need to be followed in order to reduce risks of material misstatements.

Finally, one more example is the Lack of Proper Authorization (LPA) . This issue exists when an individual’s actions are not recognized by the company’s governing body.

What are KAMs in an auditor’s report?

A KAM is an acronym for Key Audit Matters which refers to the important issues in the audit field. These Key Audit Matters are also often called critical audit matters because they have the potential to cause material misstatement or significant noncompliance with laws or regulations if not detected.

There is no set rule on what exactly constitutes a KAM, but areas like financial statements and valuation policies are widely included in the scope. The importance of these issues cannot be denied because they may lead to serious consequences if not examined thoroughly.

KAMs are identified when performing a risk assessment in order to determine which factors may potentially cause material misstatement in reported financial data. Risk assessment is the process of identifying and assessing potential threats to the achievement of business objectives.

KAMs don’t include normal business risks such as fluctuations in sales, expenses, or working capital requirements. These matters are better addressed by good management and internal controls. A KAM is a matter that if not detected, would result in incorrect application of accounting principles and/or misstated financial data. Essentially, it would lead to material misstatements.

10 examples of KAMs

The following are common KAMs:

1) Inventory valuation methods used by the company do not conform with GAAP or other criteria as prescribed by regulatory authorities.

2) Complex or questionable transactions are not properly authorized.

3) Transactions are improperly recorded, including the use of cutoff errors in applying journal entries.

4) Ending cash is materially misstated.

5) Assets are overstated or understated relative to critical accounting assumptions that have been made by management in valuing assets and recording their depreciation.

6) Debt is not properly authorized and documented, including the use of cutoffs.

7) Revenue and expense accounts are not always classified correctly.

8) Factored invoices or other credit extensions contain terms that may lead to an overstatement of assets because unearned interest income has not been considered in collateral valuations.

9) Accounting estimates are not properly applied, including the use of cutoff errors.

10) Problems with compliance with company policies, procedures, and other regulatory requirements that may lead to material misstatements in the (Comptroller) financial records.

Caveats, disclaimers, complex auditor judgment & audit procedures

We have covered many topics in this article and want to be clear that any reference to, or mention of critical audit committees, statement users, applicable reporting framework, challenging subjective or complex, reporting, significant unusual transactions, auditor’s opinion, financial reporting, auditor judgment related, audit process, large accelerated filers, principal considerations, matter arising, public accounting firms, financial statement disclosures, especially challenging subjective, significant measurement uncertainty, substantial doubt, current period audit, obtain reasonable assurance, related party transactions, entity’s ability, accounts or disclosures, separate opinion, significant risks, internal control, opinion paragraph or critical accounting estimates in the context of this article is purely for informational purposes and not to be misconstrued with investment advice or personal opinion. Thank you for reading, We hope that you found this article useful in your quest to understand ESG.

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Dean Emerick is a curator on sustainability issues with ESG The Report, an online resource for SMEs and Investment professionals focusing on ESG principles. Their primary goal is to help middle-market companies automate Impact Reporting with ESG Software. Leveraging the power of AI, machine learning, and AWS to transition to a sustainable business model. Serving clients in the United States, Canada, UK, Europe, and the global community. If you want to get started, don’t forget to Get the Checklist! ✅

What are Critical Audit Matters & Why You Need Them