Auditors are experts in accounting and auditing matters, but are they expected to possess competencies in fields not usually related to their profession? Quite frequently, auditors are confronted with situations which require expertise that transcends well beyond the realm of accounting and auditing. Consider for instance the following scenarios:
• For an oil exploration company, if the results of exploration and drilling indicate the presence of oil and gas reserves which are considered to be commercially viable, the expenditure incurred on exploration and drilling is capitalised and amortised (depleted) on a ‘unit of production’ basis computed based on proved reserves in the oilfield. How would an auditor estimate the quantum of oil reserves in an oil field?
• In case of a coal mining company, it is necessary to remove overburden and other barren waste materials from the land pit to access ore from which minerals can economically be extracted. Costs incurred for removal of such waste materials during the initial development phase of the mine are generally capitalised. These costs are usually amortised using a proportion of the quantity of ore extracted during a period over the estimated ore reserves. How would one estimate the ore reserve in a mine?
• How would an auditor obtain assurance over the reported liabilities of a company that has made a provision for costs arising as a consequence of an environmental disaster for which the company is culpable?
• How would an auditor obtain sufficient appropriate evidence to support the ‘true and fair’ opinion on the financial statements of a company that owns expensive jewelry, works of art or antiques, either as trading or as investment assets.
The above scenarios present situations where it is imperative to involve an expert to provide necessary information for preparation of the financial statements.
Other areas where experts may be involved are actuarial valuation of liabilities associated with insurance contracts and employee benefit plans, valuation of intangible assets such as brands, patents and trademarks, site clean-up costs, interpretation of contracts, laws and regulations, analysis or valuation of complex derivatives or financial instruments etc.
Depending on the nature, significance and complexity of the matter that requires the involvement of an expert, an auditor may determine whether he has the expertise to evaluate the work of the expert engaged by the management (known as management’s expert), or whether he needs to engage an ‘auditor’s expert’ so as to decrease the risk that material misstatement will not be detected.
An ‘auditor’s expert’ is an individual or organisation possessing expertise in a field other than accounting or auditing, whose work in that field is used by the auditor to assist him in obtaining sufficient appropriate audit evidence. An auditor’s expert may be either an auditor’s internal expert (from within his own firm) or an external expert. It is pertinent to note that an auditor’s expert is engaged by the auditor and not by the client (‘auditee’).
In the present article, we will focus on 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’.
SA 500 Audit Evidence provides guiding principles for auditors where information to be used as evidence has been prepared using the work of a management’s expert.
Having regard to the significance of the expert’s work for audit purposes, the auditor would need to evaluate the competence, capabilities and objectivity of the expert when assessing the risk of material misstatements; obtain an understanding of the work performed by him and evaluate the appropriateness of the expert’s work as audit evidence for the relevant assertion.
Let us understand the application of SA 500 with certain practical real-life scenarios.
1. Actuarial valuation of retirement benefits
Use of actuaries in valuation of retirement benefits/longterm employee benefits is one of the most common practice followed by enterprises world over. While auditors are not expected to re-work the valuation performed by the actuary, an auditor is expected to be cognisant of key factors considered in the valuation and to perform corroborative audit procedures. An illustrative inventory of procedures that need to be performed are as under:
i. Testing the assumptions and methods used by the actuary with empirical data available in public domain as well as historical data of the enterprise. The procedures that could be followed while testing some of these assumptions are listed below –
a. Salary increments – could be tested based on past history of increments given by the enterprise and the general level of increment in the industry in which the enterprise operates.
b. Mortality – could be tested by reference to the mortality tables used by insurance companies
c. Attrition – could be tested based on past history/ experience of employees exiting the enterprise. The workforce could be categorised into various age profiles and a graded attrition rate be applied to each profile.
d. Discount rate – could be tested by reference to yields on government bonds with a maturity that corresponds to the remaining service life considered by the actuary.
e. Expected return on plan assets – could be tested by reviewing the profile of investments comprised in the plan.
f. An analytical review of the various components of the actuarial valuation such as current service costs, return on plan assets, actuarial gains/losses, past service costs etc. in relation to the previous year may also provide directional insights to the auditor.
ii. T esting whether the assumptions and methods are generally accepted by the actuarial profession and are appropriate for financial reporting purposes
iii. Testing whether the source data provided by the enterprise to the actuary was relevant, complete and accurate, for e.g., employee data provided by the enterprise relating to salary, date of joining, leave policy and accumulated leave balances (in case of valuation of compensated absences) etc.
iv. Whether the actuary is a member of any statutory professional body governing the actuarial profession and is subject to ethical/accreditation standards of that body.
v. T he auditor could also consider discussing with the actuary on any aspect relating to the actuarial valuation where clarifications are needed. The personal experience with previous work of the expert could also assist the auditor in evaluating the competence of the actuary.
vi. T he auditor should also be mindful of circumstances that would impair objectivity of the actuary, for e.g. , whether the actuary has any financial interest in the enterprise, whether he provides other services and has any business/personal relationships with the enterprise (other than the engagement for actuarial services).
vii. I t may however be noted that the auditor continues to be responsible for opining on the financial statements which incorporate the retirement benefits liability accounted using the valuation provided by the actuary.
2. Valuation of employee stock option plans
Generally, listed companies in india which issue employee stock options (ESOP) are required to obtain a valuation of the ESOP using an appropriate valuation model for the purpose of determining the fair value of the options for accounting/disclosure purposes. Such valuations are performed by a valuation expert using an appropriate model such as Black Scholes or Binomial models. Usually, in such cases, an auditor does not engage an ‘auditor’s expert’ for evaluating the work performed by the management expert. though the valuation may be performed by the management expert, the auditor can validate the same by independently testing some of the assumptions/data used by the management expert in valuing the options such as –
i. dividend yield – by reviewing the past dividend history to validate this assumption
ii. Volatility – by reviewing the fluctuation in the share prices of the Company over the valuation period
iii. testing the number of options granted, exercised and lapsed during the qualifying period
Even in this case, the auditor continues to be responsible while opining on the financial statements which include the ESOP charge accounted based on the valuation provided by the management’s expert.
3. Estimation of reserves in an oilfield
Enterprises engaged in such industries would have their own internal team of professional engineers and geologists or may seek the services of external experts to deduce the expected reserves in an oil field. Such a team of experts may evaluate data to determine whether oil can be economically produced from the well, whether infrastructure exists to enable the marketing of production to be obtained from the field, findings from prior years, their own knowledge of relevant formations and drilling, completion and production techniques applied by the Company etc.
Some of the significant points of focus for oil reserve valuation by an expert could be –
i. The nature, scope and objectives of the expert’s report – whether the report is prepared solely for the exclusive use of the enterprise and forms the basis for the assessment of impairment of property, plant and equipment.
ii. Whether the expert acknowledges the fact that the auditors use the report for the purposes of the year end audit?
iii. Whether the evaluation of reserves is a routine part of the expert’s business?
iv. Are these experts employed by other oil and gas development and exploration companies to perform such evaluations and thus have established procedures and guidelines that are followed as part of the reserve evaluation process?
v. Whether the expert compares the data provided by the management with public information before incorporating the data in to the model used for computing the reserve. Whether assumptions are reviewed and tested by management to ensure the reliability and consistency of the output with expectations and actual results?
vi. Whether the expert is required to comply with the ethical standards of any governing body and whether the report issued has under any statutory sanction?
vii. Whether the expert has any direct or indirect interest in the enterprise which could impair his objectivity?
viii. Based on the complexity involved, the auditors could consider incorporating a ‘matter of emphasis’ in the audit report clearly expressing his reliance on the technical evaluation done by the expert of the expected oil reserves which has formed basis of providing for amortization of the exploratory and drilling costs of the oil well.
4. Valuation of Artworks
Where an enterprise is engaged in trading of artworks/ antiques, one would need the involvement of a valuation expert to test whether the net realisable value of such items exceeds the cost so as to comply with the requirements of AS 2 – Valuation of inventories.
The valuation of artworks is influenced by factors such as the identity of artist, the art style deployed (such as contemporary, modern etc.), the age of the artwork, the medium used i.e., whether the artwork is on canvas or paper, at what price have the paintings of the artist concerned been sold in the recent past, recognition of the artist by art galleries/auctioneers, demand and supply of the artworks of the concerned artist etc. In addition to the generic audit procedures discussed in the preceding cases, the auditor would need to be aware of these nuances while verifying the valuation performed by the expert.
5. Physical verification of stock pile of minerals
For enterprises that transact in/consume minerals such as natural gypsum (usually found in rock form) or coal, it may not be practical to conduct a physical verification of the entire stock by weighment, where the quantum of stock at the year-end is substantial. In such cases, the enterprise may engage a surveyor to certify the quantum of stock based on volumetric measurement. The auditors in such cases should not merely rely on the report furnished by the surveyor but perform alternative procedures such as an overall reconciliation of quantity of materials purchased, expected material consumption (relative to finished goods produced) and derived closing inventory.
Concluding Remarks
Where enterprises involve experts to provide information necessary for preparation of the financial statements, auditors would need to decide whether they have the requisite knowledge and experience to evaluate the work performed by the experts and not merely rely on their reports. ultimately, the audit opinion is the sole responsibility of the auditor, and that this responsibility is not reduced by reliance on the work performed by the expert.
