Carillion and Patisserie Valerie are the most notorious, while Galliford Try and Keir are the most recent firms where the audit, one way or another, has gone wrong. The government, regulators, professional firms and the auditors themselves have pledged to make things better and much is in the pipeline. But action has now been taken that will help to improve quality in sensitive areas and give greater assurance for those relying on financial statements.
New guidelines on professional judgment published last month by the Financial Reporting Council (FRC) provides an important way to help auditors, analysts and the audited companies.
Traditionally, one of the main safeguards of audit quality has been professional scepticism. This rightly encourages rigorous questioning of information provided by management. There’s no doubt that professional scepticism is important in checking management claims, whether it is that money due from customers will be paid or that firms taken over are still worth what was paid for them. But many key judgments in audit are not about questioning the quality of information. They are about interpreting complex circumstances and applying professional judgment deciding how the relevant accounting rules apply.
Crucial professional judgments
Financial statements rely on many such crucial professional judgments. This is both in the balance sheet (Can we treat that IT spending as capital? Will we have to pay to get out of our lease?) and the profit and loss account (How many customers will return their purchases? How do we treat currency fluctuations for this sale?).
And these are only the “normal” transactions. Once we are into long-term contracts, complex financial instruments and economic turbulence, the judgments become much more complex and problematic.
The guidance is path-breaking in defining the elements of professional judgment – something that until now has often come into the category of “I can’t define it, but I know what it is when I see it”. The professional framework sets out the following elements: remaining alert to the issues needing judgment; finding the right person to make it; framing the issue appropriately; marshalling information; and drawing conclusions.
There is then the documentation and communication of results. Recognising the increasing emphasis on the human side of the process, the framework includes an emphasis on the personal biases that can get in the way of good judgment.
Conflicting principles
All this will be good news to an auditor struggling to know how to balance conflicting principles or different viewpoints or to make a tough choice without a sense of what a good process looks like.
The guidance puts the elements of judgment in the context of the other components of audit – auditors’ mindset, the need to consult and “environmental” factors. This includes not just environmental, social and governance (ESG) but the environment of the audit – the way the auditor organises the audit, the information available and the nature of the firm being audited.
Down to earth
The guidance is supplemented by cases to bring it down to earth, dealing not only with issues faced by the auditor such as asset valuation but the way the audit itself is organised, such as who to consult.
These guidelines will not just be useful to auditors. Chief financial officers who want to know how their auditors think should take a look. Other professions without such a framework would be well-advised to consider it for their own membership.
So will anything change? The new guidance has the flavour of President Theodore Roosevelt’s view that the United States should speak softly but carry a big stick. “Practitioners who chose not to consider this guidance will need to be prepared to explain how they complied with the relevant engagement standards,” it says.
Auditors should welcome this guidance. It will help them track down what has hitherto been that elusive animal – good professional judgment – as a result keep them out of the wrong kind of headlines.