FRC's Professional Judgement Guidance

The application of professional judgement in the conduct of audits (and other assurance engagements) is a requirement of the auditing standards. It can be difficult to describe and even harder to define, but it’s an area where auditors strive to enhance their skills and those scrutinising audit quality find room for improvement. On 23 June 2022 the Financial Reporting Council (FRC) published Professional Judgement Guidance, which aims to help auditors improve their practice in this key component of audit quality.

The guidance introduces a Professional Judgement Framework, offers illustrative examples and outlines regulatory expectations around how the guidance – in particular the ‘framework’ – will be used to enhance professional judgement and audit quality.  Auditors can access the full report, ‘outtake’ documents and a separate paper on the regulator’s expectations.

The FRC intends the guidance to be ‘persuasive’ rather than ‘prescriptive’, but it is consistent with a range of other FRC guidance, such as Practice Notes, for example, so all UK firms need to consider the new Professional Judgement Guidance. “Practitioners who choose not to use or consider the guidance will need to be prepared to explain how they have complied with relevant engagement standards,” notes Katharine Bagshaw, Senior Manager, Auditing Standards, ICAEW.

Comply or explain

Practitioners who choose not to apply or consider FRC Practice Notes already need to be prepared to explain how they have complied with the requirements of the engagement standards. The FRC expects firms that choose not to adopt its Professional Judgement Framework to at least analyse and understand it, and identify and remediate areas within their own framework that could be enhanced.

The FRC will not require firms that already have their own professional judgement framework to instead adopt the FRC’s, but it is encouraging such firms to assess how and in what circumstances they apply their framework. Although there is no explicit requirement for firms to use a professional judgement framework, the FRC is also encouraging firms that do not yet have one to consider the merits of developing their own or applying that of the FRC.

Practice and resourcing

The need for professional judgement may appear to be most obvious in areas such as risk assessment, fair values, going concern, interpretations of standards, design of procedures or assessing the sufficiency and appropriateness of evidence. In addition, it shapes decisions about matters such as how an audit is resourced, the allocation of tasks, the need for specialist skills or knowledge, and the time needed to complete an audit.

Professional judgement is also called upon in the design, implementation and operation of a system of quality management (SoQM) at the firm level. As many firms are currently implementing the quality management standards ISQM (UK) 1, ISQM (UK) 2 and ISA (UK) 220, this presents a timely opportunity for firms to ensure they have a robust professional judgement framework in place.

Responding to circumstances

The guidance is a response to poor professional judgement being noted as a ‘significant contributor’ to recent audit failings. It goes some way to pull together guidance on an intuitive subject. For some firms and individual auditors, aspects of the guidance may serve to highlight opportunities to improve their professional judgement and strengthen associated procedures and structures.

As the FRC’s guidance states: “Understanding the nature of a more structured approach can help individuals and teams improve their more intuitive judgement-making, for example by deepening their understanding of areas where they may be most susceptible to biases and other judgement traps.” Where a more structured approach is appropriate, the framework may assist auditors to better take account of all relevant considerations and achieve a high quality of judgement.

Finely balanced judgements

There is significant evidence that auditors regularly exercise high-quality professional judgement, as the FRC notes in the panel on the right. Audit quality reviews conducted by the FRC and by reviewers in ICAEW’s quality assurance department do, however, find instances in which the auditor’s professional judgement does not appear to have been exercised effectively and could be more consistent.

Trevor Smith, Director, Quality Assurance, ICAEW, says: “Application of professional judgement with scepticism and appropriate challenge of management is critical to high-quality audits. Lack of these skills is a factor in many weaker audits and we also see good practice, where auditors have applied robust challenges of an audited entity’s management to explain and justify key judgements underlying the information in their financial statements.”

Application matters

Instances where professional judgement has not been exercised effectively and consistently have been seen by the FRC in firms that already have a professional judgement framework. In its Expectations Paper, the FRC notes the significance of how such a framework is applied. “It is not simply the existence of a framework which is important, but how effectively it is utilised in the specific circumstances of a firm, or of an engagement.”

The same could be said of other aspects of the FRC’s Professional Judgement Guidance. Some firms may, for example, want to utilise the fictional illustrative examples as an education aid or consider the regulator’s Expectations Paper as they finesse their SoQM. Determining how the guidance can best be utilised in the particular circumstances of each firm and engagement will, as with other aspects of audit, require professional judgement.

The quality of judgement

Ramana McConnon, Audit Policy Project Associate at the FRC, introduces its new Professional Judgement Guidance

In June 2022, the Financial Reporting Council (FRC) published its comprehensive Professional Judgement Guidance for auditors. Professional judgement is key to high quality audit; many significant quality failings identified by the FRC’s Audit Quality Review (AQR) team involve the poor, or inconsistent, exercise of auditor professional judgement.

In Sir Donald Brydon’s 2019 review on the quality and effectiveness of audit, he recommended that the FRC (or its successor, the Audit, Reporting and Governance Authority) “should revisit the existing definition of professional judgement with a view to strengthening, and demonstrating better, the use of judgement in audit.

The FRC felt it could best achieve this aim by producing non-prescriptive guidance. The FRC convened an expert working group comprising members from various FRC teams, audit firms and academia, including Professor Sir Andrew Likierman, Professor of Management Practice in Accounting at London Business School and its former Dean.

The FRC’s guidance includes a framework for making professional judgements, followed by a series of illustrative examples.

The framework has four elements:

• Mindset – an appropriate mindset for auditors exercising professional judgement;
• Professional Judgement Trigger and Process – a suggested professional judgement process, together with a reminder to remain alert to situations that may require professional judgement;
• Consultation – effective communication with a range of relevant parties; and
• Environmental factors – factors that may be present in the environment of those making a judgement, which can impact on how challenging it is to exercise professional judgement in an appropriate manner.

This framework is supported by a series of three illustrative examples, showing auditors exercising professional judgement in hypothetical scenarios. These are not intended to show best practice, or even good practice. The examples intentionally show judgement processes that contain flaws and they include commentary on these areas and on areas where something has been done well.

Alongside this guidance, the FRC has published a paper concerning regulatory expectations around how it might be used to enhance audit quality.

This guidance is non-prescriptive, consistent with a range of other FRC guidance (Practice Notes, for example). However, this does not mean that audit practitioners in the UK can disregard it; auditors are expected to be aware of, and take into account, such guidance where relevant.

This guidance can be used by auditors making professional judgements directly, as a stand-alone guide to the application of professional judgement. Central teams in audit firms may find it useful in the context of the firm’s training, resourcing, methodology and other intellectual resources.

Additionally, those elsewhere in the financial reporting chain (for example, personnel in finance functions or members of audit committees) may find this guidance useful in making their own judgements, or in better understanding how auditors make decisions.

Firms do not have to use a professional judgement framework and those with an existing framework are not required to use the FRC’s instead (although they are expected to assess whether there are any areas where theirs could be enhanced). The implementation of ISQM (UK) 1 represents a significant opportunity to ensure that any professional judgement framework that is being applied helps address risks to audit quality within the firm.

There is significant evidence that auditors regularly exercise high-quality professional judgement. However, there can be a lack of consistency here, which can affect audit quality. The FRC’s intent is that this guidance can facilitate consistent, quality professional judgements and therefore enhance audit quality.The FRC Professional Judgement Guidance and associated documents are available.