Where an enterprise involves an expert to provide information necessary for the preparation of the financial statements, the auditor would need to decide whether he has the requisite knowledge and experience to evaluate on his own, the work performed by the expert or whether he needs to engage an ‘auditor’s expert’ so as to decrease the risk that material misstatement will not be detected.
In the previous article, we explained aspects that an auditor would need to consider where he himself chooses to evaluate the work of the expert rather than employing an ‘auditor’s expert’. We will now focus on audit considerations where an auditor elects to engage his own expert. SA 620 provides the requisite guidance in this regard.
An auditor’s expert refers to a person or organisation possessing expertise in a field other than accounting or auditing, employed or engaged by the auditor to assist him to obtain sufficient appropriate audit evidence for the purpose of the audit. SA 620 accentuates the need for the auditor to evaluate the expert’s objectivity and to establish a proper understanding with the expert of the expert’s responsibilities for the purposes of the audit.
An auditor’s expert could be an internal expert or an external expert. An auditor’s internal expert may be a partner or staff of the auditor’s firm or of a network firm. The internal expert could therefore be subject to quality control policies and procedures of the auditor’s firm. The auditor would be in a better position to exercise oversight over the functioning of the expert where he engages an internal expert.
Whereas an auditor’s external expert is not a member of the engagement team and may not be subject to quality control policies and procedures instituted by the audit firm. Where the auditor engages an external expert, he would need to exercise greater diligence in evaluating the objectivity of the external expert. Some of the factors that the auditor should be cognisant of while engaging an external expert are:
i. Enquire from the client of any interest or relationship that the client has with the auditor’s external expert that may affect the expert’s objectivity.
ii. Discuss with the expert whether he has any other interest in the client other than the present engagement for which he is being engaged by the auditor. Interests and relationships that may be relevant to discuss with the auditor’s expert include financial interests, business and personal relationships and provision of other services.
iii. Discuss whether there are any safeguards to prevent his objectivity from being impaired. Such safeguards could be in terms of code of conduct/independence requirements as prescribed by the professional body of which the expert is a member.
iv. The auditor should consider obtaining a written representation from the auditor’s external expert about any interests or relationships with the entity of which that expert is aware.
Other aspects that the auditor needs to consider while engaging internal or external experts are:
i. Whether the work of the auditor’s expert relates to a significant matter that involves subjective and complex judgments.
ii. Whether the auditor’s expert is performing procedures that are integral to the audit, rather than being consulted to provide advice on an individual matter.
iii. The competence, capabilities and objectivity of the auditor’s expert.
iv. Obtaining an understanding of the auditor’s expert’s field of expertise.
v. The nature, scope and objectives of the auditor’s expert’s work are agreed between the auditor and the auditor’s expert, regardless of whether the expert is an auditor’s external expert or an auditor’s internal expert.
vi. Whether the auditor’s expert will have access to sensitive or confidential entity information.
Application of SA 620 in practice
• Engagement of auditor’s internal expert
Due to complexities involved in various matters, which in turn leads to specialisation, many firms have separate departments which offer direct tax, indirect tax, transfer pricing and other advisory services. These departments employ professionals other than qualified accountants as well like lawyers, engineers, management graduates, corporate finance professionals etc., for rendering tax and advisory services.
It is a usual practice for auditors to refer client’s matters involving direct and indirect taxes having implications on financial reporting to tax specialists within their firm. These specialists need not necessarily be qualified accountants (could be tax lawyers). An illustrative list of factors that need to be borne in mind are:
a) Such specialists would be subject to relevant ethical requirements including those pertaining to independence.
b) Where an auditor engages such internal experts, it is important that such experts understand the interrelationship of their expertise with the audit process.
c) The fact that the auditor would be involving an internal expert from a different service line should be clearly articulated and agreed to in the terms of engagement agreed with the client.
d) T here should be a clear agreement between the auditor and the internal expert covering aspects such as, who would test the source data, consent of the expert to discuss his findings or conclusions with the client, whether the auditor would get access to and could retain the work papers of the expert and the manner and form of the report/findings that would be communicated by the expert.
For example, the auditor may seek assistance from an internal tax expert to evaluate the likelihood of pending cases involving tax demands raised by tax authorities being decided against the client. In such cases, there needs to be a clear agreement as to whether the internal expert would evaluate only the likelihood of the demands fructifying in favour or against the client or would the tax expert also comment on the adequacy of the tax provisions carried in the books. Likewise, in order to obtain comfort on the adequacy of tax expense/provision, the auditor may seek clearance from his internal tax expert on whether the transactions with related parties are at the arms’ from a transfer pricing perspective.
Similarly, the auditor may seek clearance from indirect tax experts on disputed indirect tax cases involving service tax, customs duty, excise etc. from the perspective of recording a provision or disclosure as contingent liability or otherwise.
A vital factor that the auditor should be cognisant of is whether the tax specialist (auditor’s internal expert) is rendering tax advisory services to the client. In such cases, the auditor needs to assure himself that the position advocated by the tax specialist in respect of tax matters that the audit team has requested for evaluation is not in any manner influenced by the existing relationship that the tax specialist has with the client. The auditor should be mindful of whether the quantum of fees billed by the tax specialist would in any manner impair the objectivity of the tax specialist in providing his clearance.
Another area where an auditor may seek assistance from an internal expert is testing of automated IT controls surrounding an accounting system to the extent that such controls have a bearing on financial reporting. Where clients deploy sophisticated IT systems to process large amounts of data for financial reporting, it may not be possible for the auditor to perform substantive testing manually. Take for instance, testing of revenue for a telecom client involving millions of subscribers or testing of interest on deposits accepted by bank having thousands of deposit accounts. In such cases, the Company would need to deploy high end ERP systems to initiate, record, process and report transactions. Given the IT environment in these enterprises, one would need to engage IT experts to test the general IT controls and application controls. The auditor may engage his internal expert having expertise in information technology to assist him in testing the controls. This would entail sharing of sensitive client data with the internal expert. Here again, the auditor would need to ensure that adequate safeguards are in place to maintain confidentiality of client information that is shared with the IT expert. Further, the auditor would need to verify the origin of the data, obtain an understanding of the internal controls over the data and review the data for completeness and internal consistency.
Another practical example of involvement of auditor’s internal expert relates to the involvement of specialists in corporate finance/financial risk management for testing the valuation of complex derivatives, business purchase, brand valuation etc. In these cases, management would have obtained the valuation of the derivatives/business purchase from a management expert and the auditors would need to obtain assurance that the valuation is appropriate. Given the highly technical nature of the valuation, an auditor may engage an internal expert to evaluate the underlying assumptions and methods for arriving at the valuation.
Engagement of auditor’s external expert
Typically, general insurers need to make an estimate on the ultimate cost of claims to know the full cost of paying claims in order to set future premium rates. Further, they also need to set up reserves in their accounts to ensure that they have sufficient assets to cover their liabilities. Such reserves are in the form of Incurred But Not Reported (IBNR) and Incurred But Not Enough Reported (IBNER).
Assuming a year end of 31st March, IBNR claim reserve is required in respect of claims that have occurred before 31st March, but the claim has not yet been reported to the insurer whereas IBNER is required in respect of claims that have been reported, but not yet closed.
In other words, IBNR is the liability for future payments on losses which have already occurred but have not yet been reported in the insurer’s records whereas IBNER refers to expected future development on claims already reported (i.e., claims which have not yet been recorded in full to its ultimate loss value).
Reserve for IBNR/IBNER is recorded by management based on actuarial valuation carried out by a management appointed actuary. In such determination, the appointed actuary follows the guidance issued by the professional body governing the actuarial profession in concurrence with the directions issued in this regard by the statutory authority regulating insurance business. The quantum of such reserves would be material to the financial statements of the insurance company.
In India, auditors usually include in their report a comment to the effect that they have placed reliance on the management appointed actuary for valuation of liabilities for IBNR and IBNER claims.
Auditors in certain jurisdictions overseas may appoint their own actuary(external expert)to assess the appropriateness of management’s judgments and assumptions used in the calculation of the reserves for reported claims. The actuary would review the methodology and assumptions used for calculating the reserve and comment whether they are in line with the related regulations and also comment on the reasonableness.
The auditors would nevertheless need to have discussions with the client and the actuaries and would need to perform the following with the assistance of its own expert:
Determine the client’s overall methodology for generating the reserves for reported claims including changes compared to the previous period.
Assess whether the auditor appointed actuary has adequately reviewed the appropriateness of managements judgments and assumptions used in the calculation of the reserves.
Assess whether the overall reasonableness of the reserves for reported claims is appropriate given the consideration of historical evidence of the reasonableness of the previous periods level of the reserves for reported claims.
Perform reconciliation of net earned premium, net claims paid together with net claims outstanding as appearing in the financial statements and the actuarial data inputs used by the actuary for the IBNR/IBNER computation.
Closing remarks
The decision of auditors of whether to employ their own experts or otherwise, should be taken only after very careful consideration of the risk of material misstatement in the relevant area of the financial statements and scrutiny of the status and the work of the management’s expert. Any decision in this regard should be influenced by the knowledge that, ultimately, the audit opinion is the sole responsibility of the auditor, and that this responsibility is not reduced by reliance on the work of a management’s expert or an auditor’s expert.
In terms of requirements of Indian GAAS, the auditor is not permitted to refer to the work of the auditor’s expert in the audit report containing an unmodified opinion, unless required by law or regulation. Further, even if any local law were to permit inclusion of such reference in the audit report, SA 620 mandates the auditor to state that such reference does not in any manner reduce his responsibility for the opinion issued.
