The executive director of supervision at the Financial Reporting Council (FRC) (David Rule) completed a year-end review of the audit quality reviews conducted from 2018 to 2020 and found that the culture and methodology of audit, primarily at the Big Four firms, had improved measurably. ‘We have been encouraged by the initiatives that some firms are taking to develop and embed a culture of challenge’ to management, FRC concluded in their summary letter from Rule.

Of note to the business valuation profession in the UK, the FRC found that auditors ‘often struggle to challenge the management of audited entities effectively,’ citing judgements related to familiar business valuation analyses: ‘long-term contracts, goodwill impairment or the valuation of financial instruments.’

The FRC’s analysis reports that ineffective challenge of management was a driver in more than 80% of the audit files reviewed from 2018 to 2020 that had a less-than-satisfactory result.

‘Effective challenge of management is one of the most critical responses for the auditor in order to demonstrate that it has exercised appropriate professional scepticism, as required under a number of International Standards on Auditing (ISAs), particularly ISAs 200 and 540,’ the FRC states.

The FRC has stated that its AQR team will continue to focus on carrying out a thematic review on how firms support effective challenge of management and encourage a culture of challenge and robust professional scepticism.

The FRC’s conclusions about why valuation assumptions can go wrong during the audit process won’t surprise BVWire—UK readers. The report mentions three familiar problems:

1. Insufficient use of internal specialists or experts;
2. Issues relating to completeness of evidence, including too much focus on gathering corroborative evidence and not being sufficiently alert to contradictory evidence; and
3. Overreliance on management inquiry.

These initiatives are consistent with a renewed focus by the FRC on audit quality. In 2019, the FRC revised its ethical standard and its auditing standards in order to support the delivery of high-quality audits in the UK, with the stated intention of strengthening auditor independence and reducing the risk of conflicts of interest.

The FRC’s analysis targets the big audit firms, but it clearly states that valuation expertise is being underused as a necessary step to improve audit quality and judgements.

One independent UK business valuer commented that auditors often overlook the professional standards for the valuation profession as they try to comply with changing audit standards. ‘I don’t do valuations to follow audit policy. I do them to follow finance and economic principles, and I’m not sure the auditors remember this fact when I’m hired to provide an outside analysis,’ she told BVWire—UK.