Business Report

Report

PROFESSIONAL SCEPTICISMAUDIT & CORPORATE GOVERNANCE

STUDENT NUMBER

12015699

Word Count: 1,492

Professional Scepticism is defined by the ISA (2007) as ‘an attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence.’

A questioning mind can be interpreted as the auditor’s duty to not be wholly trusting and accepting of any information or resources provided to them by the auditee. Questioning documents, processes, staff and other evidence maintains integrity and reliability of the auditor’s report.

Being alert to conditions that may indicate misstatement due to error or fraud includes the auditor being aware of any circumstances that would suggest error/fraud has been committed, utilising knowledge and experience to locate and identify them efficiently.

An auditor must provide a critical assessment of audit evidence, including information both supporting and contradicting any assertions made by management (IAASB, 2012). To be critical means to be analytical from all perspectives, both in favour and against and not keeping a broadened view on the situation.

The Financial Reporting Council (2012) identifies professional scepticism (PS) as the ‘cornerstone of audit quality’ and so is an essential aspect of any great auditor.

Definition

Recent reports from the Audit Quality Review Team (AQRT) and the Audit Inspection Unit (AIU) have found that many auditors are failing to utilise professional scepticism throughout the audit process.

An Annual Report by the AIU (2009/10) found that firms were bias in their approach of PS, in the sense that they would put more effort into finding evidence that ‘corroborates rather than challenges’ their clients judgements. The report also found that there was a lack of consistency in the accepted judgements made by auditing firms with regards to clients in similar industries – which by nature should have similar, not ‘conflicting’ accepted judgments.

Research conducted in the United States into the Top 10 Audit Deficiencies (2001) identified PS deficiencies in 60% of cases were auditors were brought up on fraud charges by the Securities Exchange Commission (SEC).

The AIU also found that greater PS should be exercised when reviewing judgements related to fair values and goodwill impairments and other intangibles – especially since the economic crisis where management may be more likely to misstate intentionally.

A Lack of Scepticism

Firms often provide many incentives for achieving certain targets or time frames, but there are also numerous disincentives that encourage auditors to slack of professional scepticism.

Large auditing firms often have to compete to win/retain clients, so it is easy to see why auditors may not want to ‘upset’ their clients by being professional sceptical. The very essence of PS is to question everything and not trust something simply because management/evidence has told you.

However, if an auditor is too afraid to and challenge managers’ assertions for fear of losing a client, they become unable to confidently confirm that a company’s financial statements present a true and fair view (FRC, 2012).

Also, strong professional scepticism can prolong the audit process if the auditor chooses to investigate something they are sceptical about. As many audits have pre-agreed timetables, any delays that prove to be unfounded will negatively impact the auditing firm’s reputation and client relationship. This can also be problematic for stakeholders if they company have agreed a date that they will announce the results of an audit (Raising the Bar, 2010).

Hackenbrack & Nelson (1995) and many others supported this through research that found auditors will alter their judgement behaviour to client-preferred alternatives in to maintain client relations.

Professional Scepticism can also have a monetary impact on an audit, either to the client or the firm themselves. Building on the previous statements, if an audit exceeds its deadline then there may be additional fees to pay.

Monetary incentives such as compensation for retaining profitable clients will also act as disincentive to auditors, who will want to retain clients as best they can (DeZoort, 1997) for the financial benefit to the firm – as at the end of the day, an auditing firm, is still aiming for profit.

Disincentives

In this section we will investigate ways to promote and develop PS, contrasting the previous section, ‘incentives’ may play a key role in the promotion of professional scepticism.

There are many different types of incentives which could apply to audit scepticism; immediate versus probabilistic, financial versus social – both of which can affect PS in either a conscious or unconscious way (Nelson, 2009).

A way to strengthen PS in the general pool of auditors is to screen for PS traits by implementing the Hurtt (2007) scale, which measures an individual’s PS traits. Similarly, firms could stress the importance of PS during the hiring process with hopes of discouraging applicants with low PS traits (Salop and Salop, 1976) as is the norm with various other desirable traits during the recruitment process.

Equally, professional scepticism could be screened for during promotions and performance evaluations (Nelson, 2009), ensuring staff are aware that PS is emphasised during the evaluation process will act as an additional incentive encouraging PS. However, this could encounter problems as a very common aspect of performance evaluations is likely to be efficiency, which could potentially contradict the effort of promoting PS.

Also, the quality of the performance evaluations will affect the reliability of these PS assessments, as auditors with more evaluation experience are better able to predict the judgement of other auditors regarding highly judgemental accounting treatments (Jamal and Tan, 2001).

Additionally, Messier and Tubbs (1994) found that anticipation of a review would prompt auditors to focus more strongly on PS, as it encouraged more solid investigations and strengthened reliability so not to miss anything and get a negative review.

Further, errors due to lack of PS can be reduced by implementing a stronger sense of accountability (Kennedy, 1993) as an auditor becomes personally accountable for any errors that go unnoticed due to their lack of PS and thus putting their individual professional reputation at risk, rather than their firm accepting all accountability.

Promote & Develop

Utilising a questioning mind, I was able to look beyond the off the record remarks by management and looked further into particular financials, particularly revenue as it was verbally stated to have ‘doubled’ by some staff, by going through the financial statements for 2014-2015 (9months AND 12months).

I read through the interview transcripts with all staff members and, noting anything of importance for later review. Much of what was discussed during the interviews was akin to gossip, but there was some key information which also appeared during the Meeting Minutes.

I felt this level of professional scepticism was particularly important to Sheridan AV as there were frequently evidential absences relating to key financial data, such as revenues, management accounts and bonus schemes.

Combining the financial data from the 12 months to 2014 and 2015, I was able to draw up a spreadsheet with a few formulae worked in to visualise annual increase/decreases. Any major change from year to year was further investigated through the use of transcripts and the notes to the financial documents.

Through the use of staff profiles I was able to identify Martin Sheridan as a potential risk due to his ‘borrowing’ of assets from the company and how this is recorded in their books. Also, it highlights a key security issue by showing how simple it would be for someone else to ‘borrow’ equipment without everybody finding out.

I tried to take into account a variety of resources, from financial statements, meeting minutes, verbal interviews, staff profiles and the initial talk with David Sheridan during the tour. However, with such a large collection of resources and further investigation still needed, it’s possible my assessment to date is not wholly accurate.

If I were to conduct the risk assessment again I would go back to key staff such as David Sheridan and Emily Winters and provide them with the actual revenue figures and try to ascertain whether they had been misinformed or whether they had deliberately told Alex Gold incorrect figures. Either way, I think it is essential to know the how and why.

Likewise I would like a sit down with the Financial Director and Rosie Hendricks to determine the processes they have in place in terms of recording and reporting financial

Reflection

data as at the moment it seems to be very informal – thus susceptible to misstatement, deliberate or erroneously. Again this implements PS by being alert to conditions that may indicate fraud/error.

Regarding the customer who had an accident, I might address it from a legal standpoint by the maximum she could sue if the case did ever go to court – simply to be confident on Sheridan’s going concern.

I was able to utilise most of the resources available to me to identify the key risks I felt affected Sheridan AV. However, next time around I would cross-reference the different sources to build a broader picture and capture everything in one document – rather than going back and forth, when I am likely to forget/misplace things.

References

Amer, T., Hackenbrack, K. and Nelson, M. (1995). Context-Dependence of Auditors' Interpretations of the SFAS No. 5 Probability Expressions. Contemporary Accounting Research, 12(1), pp.25-39.

Audit Inspection Unit, (2010). Annual Report 2009/10. [online] London: Financial Reporting Council, p.4. Available at: https://frc.org.uk/Our-Work/Publications/AIU/AIU-2009-10-Annual-Report.pdf [Accessed 20 Feb. 2015].

Auditing Practices Board, (2010). Discussion Paper. Auditor Scepticism: Raising The Bar. [online] London: Financial Reporting Council, pp.9-14. Available at: https://www.frc.org.uk/getattachment/2a1e0146-a92c-4b7e-bf33-305b3b10fcd2/Discussion-Paper-Auditor-Scepticism-Raising-the-Ba.aspx [Accessed 19 Feb. 2015].

Auditing Practices Board, (2012). Professional Scepticism. Establishing a Common Understanding and Reaffirming Its Central Role in Delivering Audit Quality. [online] London: Financial Reporting Council, p.2. Available at: https://frc.org.uk/Our-Work/Publications/APB/Briefing-Paper-Professional-Scepticism.pdf [Accessed 21 Feb. 2015].

Beasley, M., Carcello, J. and Hermanson, D. (2001). Top 10 Audit Deficiencies. Journal of Accountancy, [online] 191(4), pp.63-66. Available at: http://www.journalofaccountancy.com/Issues/2001/Apr/Top10AuditDeficiencies.htm [Accessed 20 Feb. 2015].

DeZoort, F. T., & Lord, A. T. (1997). A review and synthesis of pressure effects research in accounting. Journal of Accounting Literature, 16, 28−85

Hurtt, R. K. 2007. Professional skepticism: An audit specific model and measurement scale. Working paper, Baylor University

International Auditing and Assurance Standards Board, (2007). Proposed Revised and Redrafted International Standard on Auditing.

ISA 200, Overall Objective of the Independent Auditor, and the Conduct of an Audit in Accordance with International Standards on Auditing. [online] New York: International Federation of Accountants, p.22. Available at: http://www.ifac.org/sites/default/files/meetings/files/3393.pdf [Accessed 24 Feb. 2015].

Jamal, K., and H. T. Tan. 2001. Can auditors predict the choices made by other auditors? Journal of Accounting Research 39 (3): 583–597.

Kennedy, J. 1993. Debiasing audit judgment with accountability: A framework and experimental results. Journal of Accounting Research 31 (Autumn): 231–245.

McNair, C. J. (1991). Proper compromises: The management control dilemma in public accounting and its impact on auditor behavior. Accounting, Organizations and Society, 16(7), 635−653.

Messier, W. F., and R. M. Tubbs. 1994. Recency effects in belief revision: The impact of auditexperience and the review process. Auditing: A Journal of Practice & Theory 13 (Spring): 57–72.Nelson, M. (2009). A Model and Literature Review of Professional Skepticism in Auditing.AUDITING: A Journal of Practice & Theory, 28(2), pp.1-34.

Salop, J., and S. Salop. 1976. Self-selection and turnover in labor-market. The Quarterly Journal of Economics 90 (4): 619–627.