Environment in the financial audit

The International Federation of Accountants (IFAC) through the International Auditing Practices Committee has released an Exposure Draft of a proposed International Auditing Practice Statement entitled The consideration of environmental matters in the audit of financial statements. The guidance is a response to the considerable interest shown in IFAC’s 1995 discussion paper on the audit profession and the environment.

The environment clearly represents an area of both significant operational risk and expenditure for many companies. Being able to understand and to apply a standard and recognised approach for addressing the environment in an audit of financial statements is a benefit to all auditors. This draft should be welcomed by the financial audit community for the assistance it provides in addressing environmental matters in the audit of financial statements.

It aims to give practical assistance to auditors in identifying and addressing environmental matters which may have a material effect on the financial accounts: they may affect the accruals, impairment of assets, disclosures or the basis of preparation. The draft outlines some examples, such as:

– when soil pollution on the entity’s premises requires soil restoration it may be necessary to accrue for remediation costs or to make appropriate disclosures

– entities that have transported hazardous waste to illegal waste disposal sites may be held responsible for contamination that may occur at those sites

The statement concentrates on seven issues most relevant to identifying and addressing environmental matters in the audit of financial statements.

The consideration of relevant environmental laws and regulations

The auditor is not and cannot be held responsible for preventing a client’s non-compliance with environmental laws and regulations. However, the audit must be planned and performed with an attitude of professional scepticism.

As part of the planning process the auditor must obtain a general understanding of environmental laws and regulations applicable to the client, and the policies and procedures used to comply.

Knowledge of the business

The auditor must be able to understand the possible impact of environmental matters on the financial statements, the audit process and the audit report respectively. The auditor’s required level of knowledge is less than that of management or of environmental experts, but needs to be sufficient to enable an understanding of environmental matters.

Risk assessments and internal control

The draft provides examples of what an auditor should do to assess the level of environmental risk and the adequacy of the entity’s controls.

Examples are given of what to look for both in assessing the inherent risk of material misstatement due to environmental matters and for when the auditor is assessing the accounting and internal control systems.

The control environment can be judged on a list of factors provided in the draft: for example, board responsibility for the environment. An understanding of control procedures should be acquired.

Detection risk/substantive procedures

In determining appropriate substantive audit procedures, the auditor is expected to consider the level of risk so as to reduce it to an acceptable level. In certain situations the auditor may need to consider using the work of environmental experts.

Using the work of others

Environmental experts may be required to provide assistance in developing accounting estimates and disclosures. The internal audit department may have information on the environmental aspects of the entity’s operations.

The auditor may also consider using the findings of environmental audits as appropriate evidence.

Management representations

Because much of the evidence in respect to the impact of environmental matters on the financial statements will be persuasive rather than conclusive, the auditor may wish to obtain specific representation from management that they:

– are not aware of any material liabilities or contingencies arising from environmental matters, including those resulting from illegal or possibly illegal acts

– are not aware of environmental matters that may result in a material impairment of assets or

– if aware of such matters, have disclosed to the auditor all facts related to them

Reporting

The auditor should assess the need for disclosure of the effects of environmental matters on the financial statements. If it is required, the auditor should assess the adequacy of such disclosure including management conclusions regarding the expected outcomes of contingencies.

The auditor may conclude that there are significant uncertainties, or inappropriate disclosures, due to environmental matters and issue a modified auditor’s report.

Jodie Lewis is an environmental consultant for KPMG’s Environment Unit.