The auditor and professional scepticism

An auditor is required under the ISAs (UK and Ireland) to carry out their work with professional scepticism. Professional bodies and regulators frequently criticise audit firms for failing to evidence that they have exercised professional scepticism during the audit. Essentially, a high-quality audit features the exercising of professional judgement by the auditor and a mindset which includes professional scepticism being applied at both the planning stage and during the execution of the audit fieldwork.

Adopting an approach of professional scepticism will also involve a critical assessment of audit evidence and being alert for audit evidence which may contradict other audit evidence or may call into question the reliability of the information gathered from management and those charged with governance (TCWG).

While the ISAs (UK and Ireland) recognise the importance of professional scepticism being applied by the auditor, it is nevertheless a personal and professional trait to be adopted by the auditor. The auditor must recognise that professional scepticism is an integral part of their work and is closely interrelated to the fundamental concepts of independence and objectivity.

Training audit staff to be professionally sceptical is an important issue. Audit work needs to be undertaken to satisfy the relevant audit assertions and therefore creating an internal culture that recognises the importance of professional scepticism on all audits, regardless of past experiences with the audit client, is a pivotal activity that needs to be promoted within all firms so that it can be demonstrated that professional scepticism has been applied.

The global financial crisis in 2008-2009 highlighted a weak approach to professional scepticism in areas of the financial statements which are particularly subjective, such as fair values, related party transactions and going concern assessments. Professional bodies and regulators believe that it is in the public’s interest to re-emphasise to both auditors and others which play an important role in an audit of financial statements of the need to adopt and maintain a degree of professional scepticism during the course of an audit.

Professional scepticism enables the auditor to exercise professional judgement – especially concerning decisions relating to:

• The nature, timing and extent of audit procedures to be performed;
• Whether sufficient appropriate audit evidence has been obtained and whether more needs to be done to achieve the objectives of the ISAs (UK and Ireland);
• The evaluation of management’s judgements in applying the entity’s applicable financial reporting framework; and
• The drawing of conclusions based on the audit evidence obtained, for example, assessing the reasonableness of estimates made by management in preparing the financial statements.

What is professional scepticism?

Professional scepticism is 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. The ISAs (UK and Ireland) explicitly require that the auditor plan and performs the audit with professional scepticism and keeping in mind that circumstances may be present which cause the financial statements to be materially misstated.

The problem that many auditors have with the concept of professional scepticism is that there is no single way of demonstrating that the auditor has exercised scepticism when conducting an audit in accordance with ISAs (UK and Ireland). Notwithstanding this problem, professional scepticism is a mindset and a sceptical mindset will enable the auditor to question aspects of the entity and the financial statements that are being audited rather than merely accepting information at face value. This questioning mindset will then enable the auditor to form conclusions on the information at hand. The concept of professional scepticism is very closely related to the concepts of independence and objectivity – two traits which are fundamental ethical principles. The auditor’s independence enhances the auditor’s ability to act with integrity, be objective and maintain an attitude of professional scepticism.

Professional scepticism can also be exercised by being alert to audit evidence which may contradict other audit evidence obtained. It can also be exercised by calling into question the reliability of documents or responses to inquiries and it also includes being alert to conditions that may indicate a potential fraud risk and thus developing audit procedures that adequately respond to the circumstances.

Applying professional scepticism when reviewing audit evidence is a critical aspect. Audit evidence has to be both sufficient and appropriate as well as covering the relevant audit assertions. An auditor can demonstrate professional scepticism by questioning and considering both the sufficiency and appropriateness of the audit evidence gathered in light of the circumstances. Where the auditor has doubt concerning the reliability of information or where evidence points to potential fraud risk, the ISAs (UK and Ireland) require the auditor to investigate further and determine what additional procedures are necessary to resolve the issue.

Firms often run into difficulty with regulators and professional bodies during audit file reviews because they believe that management and TCWG are honest and their integrity is intact. While this may be the case in the majority of audits, a belief that a client is honest and has integrity does not relieve the auditor of their responsibility under the ISAs (UK and Ireland) to maintain professional scepticism or be satisfied with less than persuasive audit evidence when obtaining reasonable assurance.

What audit firms can do to ensure professional scepticism is achieved

The firm’s leadership and the examples that it sets will essentially drive the internal culture of the audit firm. Therefore audit engagement partners need to ensure that audit staff understand the importance of professional scepticism and the need to have a questioning mind. Audit firms should have policies and procedures in place that accord with the requirements of ISQC (UK and Ireland) 1, Quality Control for Firms that Perform Audits and Reviews of Financial Statements, and Other Assurance and Related Engagements. Such policies and procedures should contain specific emphasis on the importance of exercising professional scepticism throughout the course of an audit. In addition, the firm should consider documenting the importance of exercising professional scepticism when:

• Establishing policies and procedures which are designed to promote an internal culture recognising that quality is essential when performing engagements.
• Promoting a quality-oriented internal culture through clear, consistent and frequent actions and messages from all levels of the firm’s management.
• Ensuring that the firm has sufficient personnel with the necessary competence, capabilities and commitment to ethical principles.
• Developing and implementing internal training and continuing professional development for all levels of the firm’s personnel.

Audit planning is an integral aspect of an audit and the audit team planning meeting is an ideal opportunity to re-affirm the importance of professional scepticism. An important part of the team meeting is for the team to discuss the susceptibility of the financial statements to material misstatement. This could be due to fraud and/or error and in the meeting it is the opportunity to discuss not only the susceptibility of the financial statements to material misstatement, but also HOW the financial statements could be materially misstated due to fraud or error. Many audit firms fall into the trap of relying on past experience concerning the honesty and integrity of clients and hence document that there are no issues relating to fraud/error on the grounds that no fraud/error was noted in prior year audits. This is clear evidence of failing to maintain professional scepticism. So how can this be overcome?

As well as fraud issues, the team should also discuss how the financial COULD be materially misstated because of error. The word ‘could’ is capitalised to emphasise that it might not necessarily be the case that fraud has taken place once the audit has been completed or the financial statements may not contain any errors, but a sceptical mindset will approach the audit with an awareness that such misstatements due to fraud or error COULD have happened during the period under audit.

The audit engagement partner should also demonstrate the application of professional scepticism when taking responsibility for:

• The direction, supervision and performance of the audit;
• Reviews of work performed; and
• The engagement team undertaking appropriate consultation on difficult or contentious matters and considering the conclusions reached from such consultations.

Professional scepticism needs to be applied throughout the entire audit, even at the stage of accepting the engagement (for example when considering the integrity of the principal owners and management). In addition, professional scepticism should be applied:

• In identifying and assessing risks of material misstatement;
• Designing the nature, timing and extent of further audit procedures which are responsive to the assessed levels of risk;
• Evaluating audit evidence – such as recognising the need to increase the quantity of audit evidence or obtain evidence which is more relevant and reliable for areas which have a higher assessed risk;
• Designing and performing substantive analytical procedures;
• Addressing situations when management refuse to allow the auditor to send a confirmation request; and
• Forming an opinion on whether the financial statements are prepared, in all material respects, in accordance with the applicable financial reporting framework.

It is also particularly important to apply professional scepticism when addressing areas of the financial statements that are complex, significant or contain a high degree of judgement on the part of the client and challenge management’s assumptions, for example:

• Accounting estimates, including fair value accounting estimates and related disclosure – particularly:
  • Evaluating the reasonableness of the significant assumptions used by management for accounting estimates that give rise to significant risks;
  • Determining whether changes in accounting estimates or in the method for making them from the prior period are appropriate in the circumstances; and
  • Reviewing the judgements and decisions made by management in the making of accounting estimates to identify whether there are indicators of possible management bias.
• Related party transactions and relationships and remaining alert during the audit for information which may indicate previously unidentified or undisclosed related party relationships or transactions.
• Significant transactions outside the ordinary course of business and evaluating whether the business rationale (or lack thereof) of the transactions suggests that they may have been entered into so as to engage in fraudulent financial reporting or to conceal misappropriation of assets or the reliability of external confirmation requests.
• Consideration of laws and regulations and remaining alert when performing the audit for instances of non-compliance with laws and regulations (or suspected non-compliance) which may have a material effect on the financial statements or that could have a fundamental effect on the operations of the client causing the business to cease trading or bring into question the entity’s ability to continue as a going concern.
• Considering whether the going concern presumption is appropriate in the company’s circumstances such as evaluating management’s plans for future actions and whether the outcome of these plans is likely to improve the situation and whether such plans are feasible.
• If the auditor is auditing significantly unusual or highly complex transactions, they must apply professional scepticism because the nature of such transactions may give rise to material misstatement of the financial statements and hence will merit heightened attention by the auditor.

Evidencing professional scepticism

One of the main reasons that audit firms get criticised by professional bodies and regulators where professional scepticism is concerned is the lack of evidence proving that the auditor has applied professional scepticism when it comes to the file review. Where audit firms have documented certain points it is often clear that the auditor is relying on past experience where the client’s honesty and integrity is concerned and merely saying that because fraud/error was not noted in previous audits then it can be assumed that the current year’s audit will also not contain material misstatement due to fraud and/or error.

Care must also be taken by audit firms when they rebut the presumption that fraud in relation to revenue recognition is not applicable to the client. The presumption itself may be rebutted in cases where there may be a single type of simple revenue transaction (for example leasehold revenue from a single unit rental property). Management override of internal controls is also recognised as a significant risk in paragraph 31 to ISA (UK and Ireland) 240, The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements and therefore the auditor must undertake the required procedures laid down in paragraph 31 to ISA (UK and Ireland) 240 and not simply overlook this requirement of the ISA (UK and Ireland) because of past beliefs concerning the client’s integrity and honesty.

An auditor can evidence professional scepticism in conversations that they hold with TCWG. For example it might be the case that the audit client has applied a certain accounting practice which might be permitted under GAAP but which the auditor does not consider to be appropriate in the company’s circumstances. Challenging such practices and making sure that the notes of any discussions are documented are key in demonstrating that professional scepticism has been applied.

Audit documentation is critical because it demonstrates that the requirements of the ISAs (UK and Ireland) and legislation have been applied. ISA (UK and Ireland) 230, Audit Documentation requires the auditor to prepare sufficient audit documentation to enable an experienced auditor, having no previous connection with the audit, to understand, among other things, the significant decisions made regarding significant matters arising during the audit, the conclusions reached thereon, and significant judgements made in reaching those conclusions. Discussions of significant matters discussed with management and TCWG should also be documented including the nature of the significant matters discussed and when and with whom the discussions took place. By ensuring such matters are properly documented this will help the auditor demonstrate how significant judgements and key audit issues were addressed and how the auditor has evaluated whether sufficient and appropriate audit evidence has been obtained.

The following are examples of where appropriate audit documentation should be on file and where the maters and judgements are significant (note the list below is not exhaustive):

• The decisions reached during the audit team discussion concerning the susceptibility of the financial statements to material misstatement due to fraud.
• The decisions reached during the audit team discussion concerning the susceptibility of the financial statements to material misstatement due to fraud with related parties.
• Communication with management and TCWG, regulators and others in respect of fraud.
• Identified or suspected non-compliance with laws and regulations and the results of discussions with management and, where applicable, TCWG and other parties external to the entity.
• The basis for the auditor’s conclusions concerning the reasonableness of accounting estimates and their disclosure which give rise to significant risks and any indicators of possible management bias.
• Identified information which is inconsistent with the auditor’s conclusions concerning a significant matter and how that inconsistency was addressed.
• The basis for the auditor’s conclusions concerning the reasonableness of areas of subjective judgements.
• The basis for the auditor’s conclusion about the authenticity of a document when the procedures applied by the auditor caused them to believe that the document may not be authentic.

Category: Audit