KAM helps us understand companies and environmental changes

Mandatory KAM in auditor’s reports

Certified public accountants, who are experts in accounting and auditing, audit financial statements disclosed by companies and prepare auditor’s reports based on the results. If the financial statements are free of material errors due to mistakes or fraud and are accurate as a whole, the financial statements are expressed as “appropriate” in the auditor’s report. In other words, the opinion expressed in the auditor’s report provides assurance that the financial statements are reliable. For example, the auditor’s report is very important because it endorses the information in the financial statements, which is one of the key factors in investment decisions.

Although the designation may vary depending on the type of organization, most public companies have company auditors, who are responsible for the audit of business operations and accounting. However, company auditors are internal members of the company and they are not necessarily accounting experts. In Japan, after World War II, following the model of the U.S. system, a system was introduced where a certified public accountant performs accounting audits as an independent specialist outside the company. The auditor’s report, the conclusion of the certified public accountant’s work, was generally a short document that briefly described the audit work and the resulting opinion, and used standardized language. Many investors and financial institutions thought that as long as the report was endorsed by an expert, it was sufficient.

However, since the beginning of the 2000s, there has been a series of accounting fraud scandals involving large companies. In particular, the 2001 scandal of Enron, a major U.S. energy company, is said to be one of the largest accounting fraud cases in the U.S. Moreover, since Arthur Andersen, a large auditing firm, was involved in the case, accounting and auditing were discredited. Furthermore, the 2008 collapse of Lehman Brothers, the fourth largest securities firm in the U.S., triggered a global financial crisis. Also in Japan, a number of cases of accounting fraud by companies occurred during the same period, and in 2015, the accounting fraud of Toshiba, one of Japan’s leading companies, came to light.

In today’s globalized economy, the effects of giant corporate scandals span the globe, as was the case with the 2008 financial crisis. How to prevent the recurrence of such scandals was actively discussed, but the focus of attention was on the role of certified public accountants (hereafter simply referred to as “auditors”) who are in charge of auditing financial statements. In the face of repeated revelations of corporate accounting irregularities, people questioned what exactly auditors, who are experts in accounting, were doing. The auditor is the only outsider who has access to the process of preparing a company’s financial statements. Of course, this is not to say that the auditor did nothing, but short and cliched statements such as the above do not tell us what kind of audit work was done on the financial statements. To those interested in the financial statements of companies, the audit work seemed very unclear.

Discussions in response to this situation became active, especially in European countries, and in 2013 the U.K. introduced a mechanism to include particularly important matters in the auditor’s report. This was the beginning of KAM. Even if the auditor expresses an opinion that the information in the financial statements as a whole is reliable and appropriate, if there are significant events or areas of risk that could lead to fraud in the future that are of particular interest to the auditor, they are to be included as information. It is characterized by the fact that auditors express their opinions in their own words and in an easy-to-understand manner. The EU then unified the system in 2017, and the U.S. adopted the system as well. It was decided Japan also introduced KAM mainly in auditor’s reports for financial statements of listed companies starting from the fiscal year ended March 31, 2021.

KAM is created in cooperation between a company and its auditors

Financial statements summarize the activities of a company by using accounts and figures; they consolidate the results of one year’s activities. However, modern financial statements are said to contain considerable forward-looking elements. An easy-to-understand example is an allowance for doubtful accounts, which is a provision based on an estimate of the amount that will not be collected in the future. Another example that often attracts attention is the accounting for intangible assets called goodwill. When a company is acquired or merged, it arises from the difference between the valuation of the company’s net assets and the purchase price. If management determines that no revenue is being generated from it, it is then devalued. This is called impairment. These amounts are estimated based on future projections. In other words, they are highly likely to fluctuate depending on the projected values used and management’s judgment. It is in these areas that auditors pay particular attention to. Other areas include sales recognition and tax issues.

KAM is considered to be useful information because it allows investors, financiers, and others to know exactly what points to focus on in the company’s financial statements and the process by which the auditor has determined that the figures are appropriate. In addition, visualizing the auditor’s activities leads to better understanding and trust in the audit work and is expected to dispel the distrust mentioned above.

An audit of financial statements is different from a criminal investigation or an investigation of tax evasion and it is based on a cooperative relationship with the company being audited. Therefore, when deciding on KAM, the auditor informs the company of the matters that caught the auditor’s attention during the audit process, communicates with the company auditor and management, and holds repeated discussions to reach a decision. In the process, the company may take actions based on the knowledge of the auditor’s points of interest. In other words, management’s motivation is to proactively include information in the notes to the financial statements before KAM is included. The expectation is that the financial statements will be richer in content as a result of increased disclosure. A company auditor may even encourage management to disclose the information. Through KAM, the role of the company auditor has also received a lot of attention. Of course, KAM is not about exposing corporate secrets. Rather, there is a great deal of information that, when disclosed, will facilitate understanding of the company’s activities.

KAM can be learning material

Are there any disadvantages to KAM? Before KAM was introduced, there was concern on the part of companies that having their information reviewed and disclosed by auditors might damage their corporate image. However, once KAM became effective, many companies became more aware of how they were viewed by the securities market and society, which motivated them to disclose information. The survey revealed that the introduction of KAM was good for companies. The change in corporate awareness of disclosure is expected to contribute to the deterrence of fraud. KAM is also expected to discipline management behavior and contribute to corporate governance. Being regarded by the securities market, and by society at large, as a company with good corporate governance is expected to enhance the company’s image and positively affect its growth. In this sense, I believe that KAM is a major reform not only in the fields of accounting and auditing but also in corporate activities themselves.

On the other hand, the challenge with KAM is that it will result in standardized and cliched statements, as has been the case with auditor’s reports themselves. This is called boilerplate. It means that they all have the same notation. If this happens, again, the auditor’s raison d’etre may be called into question. This must be avoided at all costs. In fact, France started a system similar to KAM in the early 2000s, but in the end, the descriptions were all the same side by side, and it did not function effectively. Certainly, in the current KAM, given the business model of each company, the points that auditors focus on are expected to be the same every year. If this is the case, the auditor’s report simply becomes longer, which loses the significance of KAM, eventually leading to a mere facade.

However, perhaps because of the example in France, auditors in European countries are working on very creative descriptions. Moreover, the environment surrounding companies is currently undergoing drastic changes. These include COVID-19, the energy and food crises caused by war, and the rapid depreciation of the yen. These are reflected in the financial statements as business performance. Recently, there has also been a great deal of interest in corporate efforts to address climate change and environmental issues. We could say that KAM provides an explanation of the situation in which companies find themselves, through the eyes of an auditor who is an expert in accounting and auditing, and in turn explains the changes in the environment that surrounds us.

For those who are not interested in investment, financial statements and auditor’s reports may not be very relevant. However, KAM may also provide clues for the general public to increase their awareness of the real economy and business management. KAM is a unique and very effective tool for accounting students to understand corporate activities and the work of real auditors. The auditor’s reports that contain KAM are available on each company’s website, such as in IR information, and can be easily viewed by anyone. I encourage you to take a look at KAM.

* The information contained herein is current as of August 2022.
* The contents of articles on Meiji.net are based on the personal ideas and opinions of the author and do not indicate the official opinion of Meiji University.
* I work to achieve SDGs related to the educational and research themes that I am currently engaged in.

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