AU 336: Using the Work of a Specialist

AU-C 620: Using the Work of an Auditor’s Specialist

AU EFFECTIVE DATE AND APPLICABILITY

AU-C EFFECTIVE DATE AND SUMMARY OF CHANGES

SAS No. 122, Codification of Auditing Standards and Procedures, is effective for audits of financial statements with periods ending on or after December 15, 2012.

AU-C 620 supersedes AU Section 336 and makes the following changes.

Because audit evidence produced by management’s experts (internal or external) needs to be evaluated by the auditor for relevance and reliability like any other audit evidence, AU-C Section 500, Audit Evidence, now includes the requirements and guidance addressing the use of management’s specialist. This does not change extant requirements.

AU Section 336 specifically scopes out from the standard use of specialists employed by the firm who participate in the audit. However, the clarified SAS encompasses in-firm specialists. This change in the scope of the standard will affect current practice, because it will create incremental documentation requirements.

AU DEFINITIONS OF TERMS

Specialist. A person (or firm) possessing special skill or knowledge in a particular field other than accounting or auditing. Specialists include, but are not limited to actuaries, appraisers, engineers, environmental consultants, and geologists.

AU-C DEFINITIONS OF TERMS

Source: AU-C 620.06

Auditor’s specialist. An individual or organization possessing expertise in a field other than accounting or auditing, whose work in that field is used by the auditor to assist the auditor in obtaining sufficient appropriate audit evidence. An auditor’s specialist may be either an auditor’s internal specialist (who is a partner or staff, including temporary staff, of the auditor’s firm or a network firm) or an auditor’s external specialist.

Expertise. Skills, knowledge, and experience in a particular field.

Management’s specialist. An individual or organization possessing expertise in a field other than accounting or auditing, whose work in that field is used by the entity to assist the entity in preparing the financial statements.

OBJECTIVES OF AU SECTION 336

This section provides a basis for more detailed guidance to be provided in industry audit guides on the use of particular types of specialists in various specialized industries. For example, audit guides related to insurance companies provide guidance on the use of the work of actuaries who determine loss reserves.

Section 336 takes the position that the auditor should obtain an understanding of the specialist’s methods and assumptions but would ordinarily be able to use the work of the specialist unless the auditor believes the specialist’s findings are unreasonable. In other words, the auditor does not have to substantiate the reasonableness of the specialist’s findings but is expected to have done enough to recognize clearly unreasonable findings. It also prohibits reference to the specialist in the auditor’s report unless the auditor is qualifying the opinion based at least in part on the specialist’s findings.

This section clarifies the circumstances when the guidance concerning use of the work of a specialist would have to be applied. Essentially, the guidance applies when an auditor uses a specialist’s work as evidential matter in performing substantive tests to evaluate material financial statement assertions. The applicability of the guidance is not influenced by who engaged the specialist. The section notes that an auditor may encounter complex or subjective matters potentially material to the financial statements that may require special skill or knowledge, and that in the auditor’s judgment require using the work of a specialist to obtain competent evidential matter. In those cases, such as insurance loss reserves, in which a material financial statement amount or disclosure is developed by a specialist, use of the work of a specialist would be essential unless the audit team includes an auditor with the knowledge, training, and experience of such a specialist.

OBJECTIVES OF AU-C SECTION 620

AU-C 620 states that:

. . . the objectives of the auditor are

FUNDAMENTAL REQUIREMENTS

Qualifications of a Specialist

The auditor should consider the following to evaluate whether the specialist has the necessary qualifications:

Work of a Specialist

The auditor should obtain an understanding of the nature of the specialist’s work that covers the following:

Relationship to Client

The auditor should evaluate whether the specialist’s relationship to the client, if any, might impair the specialist’s objectivity; if so, the auditor should perform additional procedures to determine whether the specialist’s assumptions, methods, or findings are not unreasonable, or engage another specialist for that purpose.

Using Findings

The auditor should perform procedures to:

Effect on Audit Report

If there is a material difference between the specialist’s findings and the assertions in the financial statements, the auditor should do the following:

Report Reference to Specialist

The auditor should not refer to the work or findings of, or identify the specialist in the audit report, unless the findings of the specialist cause the auditor to depart from an unqualified opinion or add explanatory language to the standard report.

AU INTERPRETATIONS

The Use of Legal Interpretations as Evidential Matter to Support Management’s Assertion That a Transfer of Financial Assets Has Met the Isolation Criterion in Paragraph 9(A) of Financial Accounting Standards Board Statement 140 (December 2001); Revised March 2006, June 2009, October 2011; Effective for Audits of Financial Statements for Periods Ending on or After December 15, 2012

Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 860, Transfers and Servicing, requires that a transferor of financial assets must surrender control over the financial assets to account for the transfer as a sale. Paragraph 9(a) states several conditions that must be met to provide evidence of surrender of control. One of these conditions is that the transferred assets must have been isolated from the transferor and its creditors. The determination of whether this isolation criterion has been met depends on facts and circumstances and should be assessed primarily from a legal perspective.

Decision to Use a Specialist

The auditor should first consider whether to use the work of a legal specialist to support management’s assertion that the isolation criterion has been met. The specialist can be the client’s internal or external attorney who is knowledgeable about applicable law. While the use of a legal specialist will not be necessary for routine transfers of assets, a legal specialist is necessary for transfers involving complex legal structures, continuing involvement by the transferor, or other legal issues.

If the auditor uses a legal opinion to support the accounting conclusion, the auditor may need, in certain circumstances, to obtain updates of the opinion to confirm that there have been no subsequent changes in relevant law or applicable regulations or in the pertinent facts of the transaction that would change the previous opinion. Updates may be necessary when:

• The legal opinion relates to multiple transfers under a single structure, and such transfers occur over an extended period of time under that structure.
• Management asserts that a new transaction has a structure that is the same as a prior structure for which a legal opinion that complies with this interpretation was used as evidence to support an assertion that the transfer of assets met the isolation criterion.

The auditor should also consider whether management needs to obtain period updates to confirm that there have been no subsequent changes in relevant law or applicable regulations that may affect the conclusions in the previous opinion in the case of other transfers.

Assessing the Adequacy of the Legal Opinion

In assessing the adequacy of the legal opinion, the auditor should:

• Consider whether the legal specialist has experience with relevant matters, including knowledge of the U.S. Bankruptcy Code and other federal, state, and foreign law.
• Consider whether the legal specialist has knowledge of the transaction on which management’s assertion is based.
• For transactions that may be affected by provisions of the Federal Deposit Insurance Act, consider whether the legal specialist has experience with the rights and powers of receivers, conservators, and liquidating agents under that Act.
• Obtain an understanding of the assumptions used by the legal specialist and make appropriate tests of information.
• Consider the form and content of the document provided by the legal specialist.
• Evaluate whether the legal specialist’s findings support management’s assertions about the isolation criterion.

A legal opinion that includes any of the following would not be persuasive evidence that a transfer of assets has met the isolation criterion:

• An inadequate opinion, inappropriate opinion, or a disclaimer of opinion
• A limit on the scope of the opinion to facts and circumstances that are not applicable to the transaction
• Language that does not provide persuasive evidence, such as the following examples provided in the interpretation:
  • “We are unable to express an opinion . . .”
  • “It is our opinion, based upon limited facts . . .”
  • “We are of the view . . .” or “it appears . . .”
  • “There is a reasonable basis to conclude that . . .”
  • “In our opinion, the transfer would be either a sale or a grant of a perfected security interest . . .”
  • “In our opinion, there is a reasonable possibility . . .”
  • “In our opinion, the transfer should be considered a sale . . .”
  • “It is our opinion that the entity will be able to assert meritorious arguments . . .”
  • “In our opinion, it is more likely than not . . .”
  • “In our opinion, the transfer would presumptively be . . .”
  • “In our opinion, it is probable that . . .”
• Conclusions about hypothetical transactions if they are not relevant to management’s assertions or do not contemplate all the facts and circumstances of the transaction

If a legal specialist’s response does not provide persuasive evidence that a transfer of assets has met the isolation criterion, and no other relevant evidential matter exists, derecognition of the transferred assets is not in conformity with GAAP, and the auditor should consider expressing a qualified or adverse opinion (see Section 508, Reports on Audited Financial Statements).

Restricted Use Legal Opinions

Legal opinions that restrict the use of the opinion to the client, or to third parties other than the auditor, would not be acceptable audit evidence. In this case, the auditor should ask the client to obtain the legal specialist’s written permission for the auditor to use the opinion for the purpose of evaluating management’s assertion that the isolation criterion has been met.

If the legal specialist does not grant permission for the auditor to use a legal opinion that is restricted to the client or to third parties other than the auditor, a scope limitation exists, and the auditor should consider qualifying or disclaiming an opinion (see Section 508).

The following example from the interpretation illustrates a letter from a legal specialist to a client that adequately communicates permission for the auditor to use the legal specialist’s opinion for the purpose of evaluating management’s assertion that a transfer of financial assets meets the isolation criterion of FAS ASC 860:

Notwithstanding any language to the contrary in our opinions of even date with respect to certain bankruptcy issues relating to the above-referenced transaction, you are authorized to make available to your auditors such opinions solely as evidential matter in support of their evaluation of management’s assertion that the transfer of the receivables meets the isolation criterion of ASC 860, provided a copy of this letter is furnished to them in connection therewith. In authorizing you to make copies of such opinions available to your auditors for such purpose, we are not undertaking or assuming any duty or obligation to your auditors or establishing any lawyer-client relationship with them. Further, we do not undertake or assume any responsibility with respect to financial statements of you or your affiliates.

The following would not adequately communicate permission for the auditor to use:

• “Use but not rely on” language in which a letter from a legal specialist authorizes the client to make copies available to the auditor but states that the auditor is not authorized to rely thereon
• Other language that similarly restricts the auditor’s use of the legal specialist’s opinion

The auditor may wish to consult with his or her legal counsel in circumstances where it is not clear that the auditor may use the legal specialist’s opinion.

Finally, the interpretation provides:

• Two examples of the conclusions in a legal opinion for an entity that is subject to receivership or conservatorship under provisions of the Federal Deposit Insurance Act. The conclusions in the examples provide persuasive evidence, in the absence of contradictory evidence, to support management’s assertion that the transferred financial assets have been put presumptively beyond the reach of the entity and its creditors, even in conservatorship or receivership.
• Examples of additional paragraphs addressing substantive consolidation that applies when the entity to which the assets are sold or transferred is an affiliate of the selling entity. These paragraphs may also apply in other situations as noted by the legal specialist.

TECHNIQUES FOR APPLICATION

Examples of Use of a Specialist

The following are examples of common uses of specialists:

The auditor is not required to use a specialist automatically whenever the client has engaged a specialist. The distinction between the circumstances that require use and other circumstances involving use of real estate appraisers discussed by the Auditing Standards Board provides an instructive example. The key is the relation of the specialist’s work to the financial statement assertions. A financial institution normally obtains a real estate appraisal for loans collateralized by real estate as part of the loan origination process. In testing controls over the loan origination process, the auditor normally would inspect the appraisal to see that it conformed with the institution’s policies and procedures. This is not use of a specialist’s work that requires application of the guidance in Section 336. This is a test of controls, not a substantive test, and the specialist’s work is not being used to evaluate a material financial statement assertion.

In contrast, in the evaluation of the need for a reserve on a problem loan, the auditor might inspect an appraisal to consider whether the collateral value is below the loan amount. This is a substantive test involving the valuation assertion, and loss reserves are usually material to a financial institution’s financial statements. Application of the guidance in Section 336 is required.

Use of a Lawyer as a Specialist

Section 336 applies to attorneys engaged as specialists in situations other than to provide services to a client concerning litigation, claims, or assessments. Section 337, Inquiry of a Client’s Lawyer Concerning Litigation, Claims, and Assessments, applies to an attorney’s response to audit inquiries concerning litigation, claims, and assessments. Section 336 applies to other use of an attorney’s work, such as interpreting the provisions of a contractual agreement.

An auditor, however, cannot use an attorney’s work to evaluate material assertions related to income tax matters. Generally, the auditor’s education, training, and experience enable him or her to be competent to assess the presentation of income tax matters in financial statements.

Documentation of the Understanding of the Work to Be Performed by the Specialist

Section 336 indicates that in some cases, the auditor may decide it is necessary to contact the specialist to determine that the specialist is aware that his or her work will be used for evaluating the assertions in the financial statements.

Frequently, the nature and purpose of the specialist’s work is clearly understood within the industry, such as the use of a petroleum engineer to determine oil and gas reserves by an oil and gas producer. In some cases, such as for a real estate appraiser, the specialist’s report routinely documents the specialist’s qualifications and purpose of the engagement.

Thus, the auditor has considerable discretion in deciding whether it is necessary to contact the specialist and in documenting the understanding with the specialist.

For those circumstances in which documentation is appropriate, the “AU Illustrations” section provides an engagement letter form.

Specialist Related to Client

Section 336 clearly indicates that the purpose of considering the specialist’s relationship is to evaluate whether there are circumstances that might impair the specialist’s objectivity. If the client has the ability to directly or indirectly control or significantly influence the specialist, objectivity might be impaired. The influence might arise from employment, ownership, contractual right, family relationship, or otherwise.

A specialist without a relationship to the client is more likely to be objective, and that specialist’s work will provide the auditor with greater assurance of reliability.

If the specialist has a relationship with the client, the auditor should assess the risk that the specialist’s objectivity might be impaired. If the auditor believes the relationship might impair the specialist’s objectivity, the auditor should perform additional procedures.

The additional procedures involve heightened scrutiny of the specialist’s assumptions, methods, or findings to determine that the findings are not unreasonable. The auditor might decide another specialist should be engaged for this purpose.

The “Illustrations” section contains a form that can be used to document information concerning the relationship of the specialist to the client.

Specialist Employed by CPA Firm

Some CPA firms have employed specialists to provide consulting services to clients. For example, some CPA firms employ actuaries, real estate appraisers, or environmental specialists.

If the client has engaged a specialist employed by the CPA firm to determine an amount or disclosure that is material to the financial statements, the guidance in Section 336 applies to the auditor’s use of that specialist’s work. This means the auditor has to apply the same procedures that Section 336 would require to be applied to the work of a specialist unrelated to the CPA firm. For example, the auditor would have to obtain an understanding of the methods and assumptions used by the specialist and evaluate whether the specialist’s findings support the related assertions in the financial statements.

In some cases, the auditor might decide to engage a specialist. For example, a specialist might be engaged by the auditor to apply additional procedures when the client uses a related specialist. In these circumstances, a specialist employed by the CPA firm might be used. In this case, the specialist is functioning as a member of the audit team. The auditor would need to provide proper supervision of that specialist in the same manner as any other member of the audit team. On the other hand, if the auditor engages a specialist not employed by the CPA firm, then the guidance in Section 336 applies. When the CPA firm uses a firm specialist as a member of the audit team, the specialist is an assistant on the audit with all that such status implies. The specialist has to adhere to GAAS and be properly supervised. Extra supervision is required when the specialist is not knowledgeable about GAAP, GAAS, and the Code of Professional Conduct.

Tests of Data Used by the Specialist

In many cases, the client has to provide data to the specialist. For example, the management of an insurance company would provide data on insurance in force to an actuary engaged to determine loss reserves, and a financial institution might provide a real estate appraiser with income statements of a project that collateralizes a loan.

Section 336 indicates that the auditor should make appropriate tests of data provided to the specialist. In other words, the data to be tested is not limited to accounting data.

In deciding the extent of testing of data that is necessary, the auditor should consider the control risk associated with production of the data. Section 336 does not mention inherent risk. Thus, the implication is that the auditor would need to substantiate data provided to the specialist unless the data is produced by a system with a relatively low control risk. Also, the extent of testing considered necessary would depend on the nature and materiality of the related financial statement assertion.

Need to Refer to Audit Guides or Statements of Position (Sops)

If there is more specific guidance on the use of a specialist in an audit guide or Statement of Position (SOP), the auditor should refer to the more detailed guidance. An audit guide or SOP cannot reduce the procedures needed when a specialist’s work is used. However, the guidance might specify additional procedures or limit the auditor’s discretion in determining the scope of procedures. For example, SOP 92-4, Auditing Insurance Entities’ Loss Reserves, provides that an outside loss reserve specialist—that is, one who is not an officer or employee of the insurance company—should be used. When the auditor has the necessary knowledge and experience, the auditor may serve as the loss reserve specialist.

An AICPA audit guide or SOP might also provide informative guidance on the methods and assumptions of a specialist that is useful in evaluating whether a specialist’s findings support financial statement assertions. For example, there is an AICPA guide on real estate appraisals that describes the various methods used by an appraiser. Some methods might produce a value that is not suitable for supporting financial statement assertions in certain circumstances. For example, the market value determined by an appraiser based on stabilized net operating income might not be appropriate when the real estate’s fair value is the appropriate measure.

AU ILLUSTRATIONS

The following are illustrations of:

Illustration 2. Statement Of Specialist’s Independence

[Client’s letterhead]

[Addressed to specialist firm]

In connection with their audit of our financial statements for the year ended [date], please describe directly to our auditors, [name of firm], the nature and extent of any relationship noted below that you have with the Entity, exclusive of your engagement as [type of work, i.e., actuary, appraiser, etc.]. A stamped, self-addressed envelope is enclosed for your convenience.

Very truly yours,

____________________________________

[Client’s name]

By _________________________________

____________________________________

[Title]

Specialist Representation:

Except as noted below, the principals, officers, owners of our firm and members of their immediate families, and members of our staff in the office doing the work described above are not associated with [name of client], as follows:

1. By direct or indirect financial interest

2. As an officer, employee, or member of the board of directors

3. In any capacity, other than our normal business relationship, where we have a vested interest in the success of the Entity

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