Professional Skepticism - Essay Example

Name: .......................................................................................................xxxxx Institution: .............................................................................................xxxxx Title: ..................……………….Professional skepticism Course: ..................................................................................................xxxxx Tutor: ...................................................................................................xxxxx @2012 Professional skepticism Introduction Professional skepticism is described by the auditing standards as the attitudes which include a questioning mind, being alert of all possible situations which may indicate the possibility of a material misstatement as a result of fraud or error and a critical assessment of the audit evidence (Grenier 2010). The auditor assesses the validity of audit evidence obtained and he is very alert to any audit evidence which may contradict the reliability of the documents and responses to inquiries or any other information obtained from the management. Therefore, professional skepticism may be defined as the propensity of an auditor to defer the conclusion of his audit until evidence provides sufficient support (Nelson 2009). A skeptical auditor therefore does not assume that the management has unquestioned honesty or has the unquestioned dishonest. Professional skepticism is the opposite of trust and this equates skepticism with distrust (Wright et.al 2011). Auditors are supposed to have professional skepticism and it should be inconsistent with the client relationships that they try to preserve to keep the money flowing. That is, they should adopt a powerful and a simple philosophy of verifying to trust. This is because most clients are dishonesty and the only way to be effective in auditing for them is to be professionally skeptical. Professional skepticism and external audit An examination by SEC in 1987-1997 found that 60% of all enforcement actions were related to lack of professional skepticism (Nelson 2009). A review by Public Company Accounting Oversight Board (PCAOB) of the first four years in the largest accounting firms found deficiencies which were attributed to lack of professional skepticism when performing audit tests and audit procedures (Wright et.al 2011). The auditing standards in US discuss the responsibility of auditors in exercising increased professional skepticism in response to the following situations: Confirmation of procedures is one of the circumstances where the auditor should exercise high degree of professional skepticism, some situational cues in auditing could indicate higher levels of risk or the need for additional fraud testing and exercise high degree of professional skepticism and higher fraud risk engagements should be audited with increased professional skepticism (Grenier 2010). Auditors should exercise due professional care in the provision of their services and this requires high level or degree of professional skepticism. Professional skepticism and internal auditors Internal auditors have the responsibility of conducting auditing reviews with the professional skepticism attitude as well as the recognition of internal auditing procedures which may provide evidence of the possibility of errors and frauds (Grenier 2010). He should also maintain the highest degree of professional skepticism in recognizing the possibility of material misstatement in the financial statement. The need for auditors to maintain professional skepticism Skeptic minds enable the auditors to recognize all the circumstances which may exist and which may cause material misstatements in the financial statements and this calls for him to be alert and to remain cautious about such events and information which indicates the existence of material misstatement in the financial statements (Grenier 2010). Skepticism suggests to the auditor that he can accept the information obtained by him not unless he obtains any other information which may contradict the old information or expectation of the auditor. Maintaining professional skepticism is very important to auditors through out the audit as it helps in the reduction of risks of over generalization when drawing conclusions from the audit observations, overlooking the unusual circumstances and the use of inappropriate assumptions in determining the nature, extent and timing of the audit procedures and results evaluation thereof (Wright et.al 2011). Culture of professional skepticism Professional skepticism has been supported by staff and audit partners with strong business understanding and the appropriate knowledge on the requirements of financial reporting (Nelson 2009). The culture of professional skepticism must be promoted and supported through consistent and strong messages from the leaders of the firms. This should then be complemented by technical support, consultation processes, training and education, firm procedures and guidance and effective engagement quality control reviews. Professional skepticism often involves changing the extent and the nature of audit procedures and it is very important that the staff and the audit partners do not compromise audit quality and professional skepticism in their efforts to meet budget and deadline pressures (Grenier 2010). Objectivity and the independence of the auditors are key elements in upholding high levels of professional skepticism. It is very important for auditors to exercise high levels of professional skepticism otherwise they will maintain or gain respect from management and directors. Accounting polices and treatment A reporting surveillance by ASIC has indicated a number of appropriate accounting treatment which auditors should have challenged. They include policies used in revenue recognition, measurement of assets, non-consolidation of controlled entities and expense deferral. A sound knowledge on the principles and the rules of accounting standards is very important in resolving the issues concerning polices and the treatment of this accounting procedures by the management (Grenier 2010). In this case, auditors should step back and apply their professional skepticism in order to determine whether the policies make sense and whether the treatment reflects the substance reflected. Estimates The ASIC’s audit inspection has identified instances in where auditors appear to have been over reliant on the managements explanations and representations. Some auditors do not explore the occurrence of contradictory evidence or do not have sufficient regard to historical outcomes (Nelson 2009). ASIC therefore recommends professional skepticism be practiced highly when the auditor is reviewing the judgment of the management in areas like recognition and measurement of deferred tax assets, measurement of fair value and impairment of goodwill and other intangibles. In different occasions, auditors should be highly subjective and judgmental by seeking or by obtaining audit evidence which will collaborate with the client’s judgment (Grenier 2010). Auditors need to exercise high levels of professional skepticism when considering the explanations by the management for significant variances which are noted in analytical procedures. The explanations and audit evidence which are obtained during the auditing process should confirm with the audit needs to conform to the understanding and cumulative knowledge of the operations of the client (Hurtt et.al 2010). Substantive analytical procedures require developing an estimate and corroborating reasons for variances to independent audit evidence. Enhancing professional skepticism For several decades, professional skepticism has been part of auditing standards though there have been changes in the recent past which have increased the importance of professional skepticism in conducting an effective audit (Nelson 2009). There have been criticisms of auditors failing to exercise enough professional skepticism while conducting their audit and there have been issues on the appropriate levels of professional skepticism to be held by auditors (Grenier 2010). Different techniques have been put in place to enhance the application of skepticism in auditing. Current thinking on professional skepticism in UK There has been an ongoing debate on whether professional accounts are sufficiently skeptical in applying professional judgment. Different professional bodies and legislation have expressed their opinions on the current practice of the auditing profession in the UK. For example, the Auditing Practice Board (APB) which is part of the Financial Reporting Council (FRC) has called fro more professional skepticism in the conduct of auditors in UK (Grenier 2010). FRC has been of the opinion that auditors responsibilities should be increased since auditors are not doing what they are required to do in terms of professional skepticism. According to UKSA, auditors should report to the company owners as a requirement which should be taken in all considerations. FRC has argued that this is very much unlikely to be achieved by the closer relationship between the auditor and the directors of the company and these calls for high level of professional skepticism (Nelson 2009). The Auditing Practice Board (APB) paper on 30 March 2012 on “Auditor Skepticism: Raising the bar “expressed the lack of consensus as to the role and nature of professional skepticism in auditing. According to APB, there need to be consistency in the nature of professional skepticism. They are of the opinion that auditors should demonstrate a high degree of professional skepticism in the course of their auditing (Hurtt et.al 2010). The European Commission green paper in its report of the House of Lords enquiry in the UK give its explicit criticism that auditors have failed to exercise sufficient professional skepticism. The continues importance of auditors applying professional skepticism and especially in the areas of disclosure and going concern has been emphasized in the recent communication by the International Auditing and Assurance Standards Board. The paper also was of the opinion that the conditions necessary to demonstrate the required degree of professional skepticism and the position of engagement teams, audit committees, management and auditors should be upheld in the country (Wright et.al 2011). The paper also identifies the factors which could create disincentives for auditors in order to apply the required degree of professional skepticism. The Code of Ethics for Professional Accountants which is issued by International Ethics Standards Board for Accountants say that an individual can act with integrity in order to exercise objectivity and professional skepticism only in areas where professional judgment will not be compromised (Hurtt et.al 2010). According to this paper, though many appropriate safeguards may be implemented by the auditors, there are other parties whose inactions and actions create disincentives for the auditors to apply the required degree of professional skepticism (Wright et.al 2011). The paper therefore holds opinion that the degree of auditor skepticism in UK is highly influenced by the assessment of audit risk of material misstatement by the auditor and therefore the auditor will require more persuasive evidence to challenge the judgments of the management. The Financial Reporting Council (FRC) and The UK Financial Services Authority (FSA) are of the opinion that proper examination should be conducted on the use of professional skepticism by auditors. The two bodies are of the opinion that the auditors in UK need to challenge the management of the clients more (Grenier 2010). In particular, FSA has highly questioned whether the auditors has always been sufficiently skeptical and has therefore paid more attention on the indicators of management bias. There are concerns that the auditor portrays a worrying lack of skepticism in relation to key areas. There has been questioning on whether auditors in UK exercise sufficient judgment in regard to financial statement disclosures. There has been a perception in UK that auditors do not sufficiently challenge the management as well as those charged with governance about whether all disclosures necessary are included in the financial statements (Wright et.al 2011). Other professional bodies have the perception tat auditors focus solely on completeness without ever applying judgment regarding whether all of those disclosures are necessary in the context of the specific entity. The United Kingdom Audit Inspection Unit found that firms in the country approach the audit involving highly judgmental balances by seeking or by obtaining audit evidence which will corroborate the judgments made by their clients. In it’s reporting on the recent inspections on accounting firms in Netherlands, 29 of the 46 audits reviewed indicated weaknesses and insufficient professional skepticism was the main cause of these weaknesses (Hurtt et.al 2010). Evaluation of the measures introduced to respond to criticisms of professional skepticism The professional and legislation bodies suggest the following as means of ensuring consistency in the role and nature of professional skepticism in auditing: The process of risk assessment by the auditor should involve critical appraisal of the assertions by the management as a way of looking for material misstatements, the auditor should develop intense knowledge on the entity business and the environment in which it operates in order to enable it make its risk assessment through its own fresh and independent eyes rather than through the eyes of the management (Wright et.al 2011). This will enable the auditor to make informed challenge of consensus view as well as to consider any possible incidence of low probability of high impact events. The auditor should approach and document audit judgments and the processes of audit review in a manner which will facilitate challenge and demonstrate the rigor of that challenge. Firms should develop and promote professional skepticism in their staff and partners (Grenier 2010). It is important to use the audit methodologies which will allow appropriate scope for use of informed professional judgment and audit skepticism like increase in the reliance of audit software and the proliferation of detailed requirements in the auditing standards. For auditors to become professionally skeptical, the following should be done: Do not reject any violated trust rather recons true or refute it, If the trust is experience and knowledge based the auditor should not quickly or readily accept an “adequate explanation”. The auditor should not succumb to cognitive inertia of seeking evidence to confirm rather than disconfirm a belief (Wright et.al 2011). The auditor should not fall a victim of self deception of believing something to be true if you want it to be. The auditor should not attribute untrustworthy behavior too easily to the situation Evaluation of the incentive which make auditors to act in a manner other than professional skepticism There are several incentives which have made auditors to act in a manner other than with professional skepticism. Several incentive factors may have an influence on the likelihood that auditors will behave in a manner that reflects professional skepticism or in a manner other than professional skepticism (Grenier 2010). Relationship with the client company Any close relationship between the auditor and the client company will be a threat to the auditor’s independence. In this situation, the auditor is likely not to practice professional skepticism in their auditing course. Opportunities for additional services and revenue generation This will make the auditor to act in any other ways other than with professional skepticism. When the auditor’s independence is under threat, the auditor will always act in a manner other than with professional skepticism (Nelson 2009). Regulatory inspection and threats to reputation Where there is no regulatory inspection, the auditor may fail to practice professional skepticism in his judgments (Nelson 2009). The auditor is also likely to exhibit less professional skepticism in his or her judgments if the concern for reputation and exposure to litigation is less than the concern for the firm revenue or the potential loss of the client. Client risk and the use of the internal auditors work by the external auditor Client risk may have a negative impact on professional skepticism of the auditor’s judgments. In high risk situations, auditor’s skeptical judgment and decisions is expected to be high. This is very important as such situations expose the auditor and the firm as well to an increased reputation. Therefore, professional standards dictate the engagements with a higher risk of material misstatement due to fraud and should therefore be audited with increased professional skepticism. However, some clients have risk prone and due to the weaknesses in their internal control system, the auditor is in one way or the other unable to detect the possibility of material misstatement (Hurtt et.al 2010). That is, the internal control may in way that everything is presented as if no fraud or error has been committed. In this case, the auditor may be forced to use the work of an internal auditor and this makes the auditor to behave in a manner different from the use of professional skepticism. Conclusion The accounting profession has been under assault for the past years because of a seeming inability of the auditors to detect frauds prior to the issuance of company financial statements. The current focus on professional skepticism in terms of the elevated responsibility for the detection and prevention of errors and frauds calls for the investigation on how to enhance professional skepticism (Nelson 2009). It has been found that audit novices with practice and feedback in fraud detection indicated greater skepticism than the experienced auditors by assigning a higher initial likelihood that a material misstatement was due to fraud rather than error. References Durtschi, C. 2002. Teaching auditors to detect fraud: A problem-based learning approach. Working paper, Florida State University. Hackenbrack, K. 1992. Implications of seemingly irrelevant evidence in audit judgment. Journal of Accounting Research 30(1): 126-136 Lindberg, D. 1999. Lakeview Lumber Inc.: A study of auditing issues related to fraud materiality and professional judgment. Issues in Accounting Education 14(3): 497-515 American Institute of Certified Public Accountants (AICPA). 2002. Consideration of Fraud in a Financial Statement Audit, Statement on Auditing Standards No. 99. New York, NY: AICPA. Audit Inspection Unit of the UK’s Professional Oversight Board (AIU). 2010. Public Report on the 2009/10 Inspection of PKF (UK) LLP. (accessed April 2012) Carpenter, T. D. 2007. Audit team brainstorming, fraud risk identification, and fraud risk assessment: Implications of SAS No. 99. The Accounting Review 82 (5): 1119-1140 Grenier, J. H. 2010. Encouraging professional skepticism in the industry specialization Era: A model and an experimental test. Paper presented at the 19th Symposium on Auditing Research, Champaign Illinois Hurtt, R. K. 2010. Development of a scale to measure professional skepticism. Auditing: A Journal of Practice & Theory 29 (1): 149-171 Hurtt, R. K., M. Eining, and R. D. Plumlee. 2008. An experimental examination of professional skepticism. Working Paper. Available at SSRN:http://ssrn.com/abstract=1140267 Nelson, M. W. 2009. A model and literature review of professional skepticism in auditing. Auditing: Journal of Practice & Theory 28 (2): 1-34 Quadackers, L., T. Groot, and A. Wright. 2011. Auditors’ professional skepticism: Neutrality versus presumptive doubt. Paper presented at the 34th EAA Annual Congress, Rome Read More