Wondering whether to use experts on an audit? Peter Herbert and Rhodri Whitlock highlight some key considerations, using four example scenarios.
The need to consider and, if necessary, involve experts in the audit of specialist areas is increasing for firms of all shapes and sizes. New and innovative business models increase the complexity of transactions, balances and disclosures that fall within the scope of audit. With post-pandemic uncertainties, what were once regarded as moderately straightforward areas of judgement now have higher risk aspects.
Nonetheless, public reporting and recent regulatory enforcement notices reveal instances of insufficient evidence of the audit team having the required knowledge and/or experience of a particular specialist area. Without this, they were unable to properly challenge and evaluate whether they had sufficient, reliable and appropriate evidence from which to form an opinion. Better use of (either internal or external) experts might have improved outcomes.
Keep an open mind
It is the nature of risky and complex audit areas that the exercise of judgement is often required not only when evaluating audit evidence, but in deciding whether an expert is required.
The ICAEW qualification and audit training has provided us with rounded experience and perspective, but this does not mean that we are qualified valuers, actuaries, experts on all aspects of information technology (IT), or financial modellers. We need to ensure that our great training does not make us believe that we are audit superheroes.
Typically, we know when we are uncomfortable with a high risk or technical area, but International Standards on Auditing (ISAs) (UK) are well placed to support auditors. Specifically, ISAs (UK) 315, 330, 500 and 620 together are the auditors’ friend and really help the team to identify those areas of risk where specialist knowledge and expertise is required.
Once identified, the team should be able to establish if the required specialist knowledge and expertise genuinely and demonstrably exists within the audit team. If not, the auditor will either need to add to the team to bring in the required internal expertise or involve an external expert. If neither of these options will work, hard questions will need to be asked about whether the firm can even act.
The evaluation of whether specialist expertise is needed and whether this is available internally will differ for each firm and each engagement. ISA (UK) 620 requires the auditor to consider the interaction of complexity, judgements, the impact of an area on the financial statements, the interests of key stakeholders, and the knowledge and expertise of the firm and the audit team, in coming to a conclusion.
What does it mean in practice?
Let’s use some examples to explore this.
An audit firm is engaged to audit an owner-managed business that, in addition to its core operating assets, has a small portfolio of residential properties that represent less than 2% of gross assets. There is no external debt and there are no financial covenants.
The valuation of residential properties could require specialist knowledge, but there is a wealth of observable data from a range of data sources to help evaluate management’s assessment of the carrying value of those properties (both for fair value and for impairment purposes). The error risk in the valuation of the property portfolio in this scenario is unlikely to have a material impact on the true and fair view of the financial statements. For that reason, it is unlikely that an expert would need to be involved.
The conclusion could be different where banking covenants are under pressure, where there have been very few transactions in properties of that type in that location, or where local environmental or planning factors could impact property values, as might be the case with a new high speed rail project, new by-pass, or installation of a new mobile phone mast, for example.
As above, except that the property is commercial property and represents in the region of 5% of the company’s gross assets.
There is a wide range of freely available regional (national and global) and stratified commercial property indices, as well as more precise data that can be purchased. This data can be useful in setting audit expectations, but commercial property is far more specialised than residential property. It may well be that management’s evaluation is in line with industry data, which may reduce risk, but other factors may need to be considered that only an expert would know, especially since the commercial property is material.
If the property is in a local market in which there is a reasonable volume of observable comparable data, a desktop valuation may suffice. However, if these criteria cannot be met or if there is weak correlation with market data or conflicting evidence, a formal third-party valuation may need to be performed. The application guidance in ISA (UK) 500 is very helpful in explaining how information produced by third-party organisations for a broad range of users can be used to inform an auditor’s opinion.
A medium-sized owner-managed business has a legacy defined benefit pension scheme that is closed to new members and future accrual. A full valuation pack is available from management’s actuary (a leading firm), which also publishes a range of data, including mortality tables. The defined benefit assets, liabilities and movements thereon are material, but represent less than 5% of gross assets and gross liabilities.
The audit of pension scheme assets and liabilities and the movements thereon do require an understanding of specialist valuation techniques and of the nature of the assets and liabilities. More often than not, an auditor would or should involve somebody with specialist expertise. However, there are narrow circumstances where the risk may be low, permitting the audit team to evaluate the data provided by the actuary.
In this situation, the audit team should be clear in their expectations and in their application of scepticism and challenge. If necessary, they should speak directly with the actuary to resolve queries. If there are large and unusual variances that could impact the truth and fairness of the financial statements, the audit team will have to revise their approach and involve their own expert.
A small but fast-growing mass-market fashion retailer, backed by private equity, is audited by a long-established small firm with four Responsible Individuals. The retailer has hundreds of stock lines sold online and in many concessions across the UK. Stock records are updated by daily sales data and the audit of provisions is challenging.
This is a situation increasingly encountered by firms grounded in substantive audit procedures, as well as a scenario envisaged by ISA (UK) 315 where “substantive testing alone” may not be “sufficient”. It will be crucial to understand and possibly test the IT processes that the client has in place to manage stock movements and support the estimation of the stock provision.
Much of the messaging around ISA (UK) 315 and IT for smaller firms has focused on the fact that IT systems are often simple and unlikely to create particular misstatement risks. This may not be the case here and, in the absence of the necessary in-house IT expertise, the firm may need to engage an external IT expert.
The elephant in the room
The key message is to keep an open mind and be willing to use an expert (either internal or external to the firm) where required.
It is understandable that, if experts have not previously been used, firms and clients alike may baulk at the time and cost. So, if clients genuinely won’t pay, is it right to stick to the old ways?
Absolutely not. Experts are not always required, but being closed to the idea of using them in the right way when auditing specialist areas can expose auditors to regulatory sanction and the risk of litigation.
In an increasingly litigious and regulated world, it is more and more common for the quality of an audit to come under scrutiny. Involving an expert or specialist may cost a few hundred or even several thousand pounds. However, this is small change compared with the direct and indirect financial and reputational cost of trying to defend and possibly settle a claim or enforcement notice.
The focus should not just be on the negatives. The expert or specialist should be used as needed to attain the high audit quality and sufficient appropriate audit evidence, which then leads to lower risk of negative outcomes. Having the added perspective of an expert fundamentally improves the quality of the assurance. This may make it less likely the client will encounter a challenge during a business sale or refinancing, and it will provide them with an objective alternative perspective.
In summary, involving an internal or external expert appropriately, when necessary, should be beneficial to audit quality, the audit firm and to the entity being audited.
Peter Herbert is Director at Insight Training and Rhodri Whitlock is an Assurance and Advisory Consultant at HPL Associates.
This is the first of two articles on auditing specialist areas. The second, available in November, explores how to use the work of experts, when to use external as opposed to internal experts and how to document the approach in a way that adds value to the audit and ensures documentation is of the appropriate quality.