Two important questions asked by management in today’s economic climate are, “How do we know if our Internal Audit (IA) department is functioning effectively?  Is it providing the most possible value?”

A good place to start is a review of the Internal Audit department infrastructure.  The infrastructure includes the department’s roles and responsibilities and its authority.  IA should be independent from management with direct access to the audit committee.  Typically, the Chief Audit Executive (CAE) reports administratively to the CFO and formally to the audit committee chairman.   The IA charter provides formal clarity regarding the department’s authority to access company records, execute the annual audit plan, and the department’s vision.  The charter should be reviewed and approved by the audit committee and the CFO at least annually.

Other key questions to evaluate IA include:

• Are audits conducted in compliance with the International Standards for the Professional Practice of Internal Audit?
• Does IA have a quality assurance program and are the results reported?
• Has an external quality assessment been performed in the past five years?
• Is there an audit client feedback process?
• Does IA have the tools and resources it needs to complete the annual audit plan?
• Has the IA team acquired professional designations to demonstrate competency?

If the answer is yes to all of the questions, chances are the IA department is on the path to create value.  Nos identify areas for potential improvement that could lead to positive change for both the department and the organization.

As an investment banker, I was never subject to external review of my work other than the public’s response to the value of an M&A deal or IPO pricing.  However, as a fundamental valuation expert, external review is an important and respected part of the process, specifically when an opinion of value is used for financial reporting purposes.  Over the past few weeks, I have had the unique opportunity of being on both sides of an audit review and found the experience both interesting and challenging.

The process of audit review of valuation reports is one of identifying and reconciling “red flags” in terms of both inputs and outputs.  Is a subjective input supported by quantitative analysis and management discussion?  Does the conclusion make sense relative to prior valuations, company growth, increased market concern or the decline in public markets?  The ASA’s culminating Business Valuation course (BV204) focuses on the reconciliation of methods and making sense of an answer.

In support of our audit team, I recently reviewed two reports that opined to values of common stock and found myself asking the same questions I ask during an internal review of our own valuations.  My recent experience in creating and responding to these questions left me with the following takeaways;

1. Tone defines the question.  Reviews go much easier when the reviewer doesn’t go into a review discussion with a strong opinion of what the value “should” be.  Once that feeling of “this is what I think you should have done” comes across, I start to become defensive and the conversation starts to get terse with “yes” and “no” answers.
2. Stay away from asking too many questions.  The most frustrating reviews for me have been when the auditors ask every question from their template without reviewing the report and answering and eliminating these questions prior to a discussion.  For me, the most frustrating response to a review question is “see page xx of the report.”  That response leads me to believe that the auditors have not read the report and just reviewed the exhibits.
3. The wording of the questions means everything.  My worst experiences with review from the valuation expert side occurred when I felt like the word “dummy” should have been at the end of every question.  I have always used the term that valuation is a “grey science;” not black and white.  I also believe that if you put 10 valuation experts in a room with the same information, they will come up with 10 different but defendable answers.  If a question is worded in a way that makes the assumption that the conclusion or input is wrong, the eventual conversation will more often than not head south from the start.
4. The goal on the audit side is comfort.  I believe that in order to get comfortable with a report, you need to ask quantitative AND qualitative questions.  You should ask about a cost of debt but also ask how the conversations went with management and if the expert talked to other groups within their firm or colleagues about key inputs.  I also believe that the goal on the audit side is not to run up fees, ever.  I may do some quantitative testing if my comfort level is low about a certain input but I will never default to recreating a valuation and testing for materiality or how different my valuation is from the one I am reviewing.  That process just reinforces the “dummy” experience above when I feel that the audit review team needs to recreate a valuation in order to get comfortable.
5. Leave on good terms.  I know that I will never be on the other side of a review with an independent valuation firm that is not part of an accounting firm.  Still, a simple thank you for walking me through your report and “I appreciate your time” goes a long way in creating a strong on-going relationship.
6.  Picking up the phone does wonders.  I find that calls, not emails, work the best in communicating with each other.  Context and tone are left for interpretation in email and phone calls break through any mysterious intent that may be hidden in emails.
7. Preventative maintenance does wonders.  Knowing that a report will be reviewed and having a call between the two parties PRIOR to a valuation makes for a much smoother process that eventually will benefit the client in terms of speed of process and “all-in” fees for the valuation or the cost for the valuation plus the review.  Strong relationships within the industry have a way of negating all of the negative possibilities above.

In the end, reviews benefit everyone involved and they don’t need to be painful.  But when they get painful, it can be the worst part of the day.  I try to keep an open mind to review and find that this “high road” works the best for everyone involved.