Discussion Paper Auditor Scepticism - Raising the Bar21

8/3/2019 Discussion Paper Auditor Scepticism - Raising the Bar21

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Discussion Paper

AUDITOR SCEPTICISM: RAISING THE BAR

August 2010

Auditing PracticesTheBoard


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Auditor scepticism: Raising the bar

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Contents Page

Introduction 3

Nature of auditor scepticism 5

Growing importance of auditor scepticism 8

Importance of scepticism in practice 9

Development and promotion of auditor scepticism within audit

firms

10

Can more be done to promote auditor scepticism? 13

Questions 18

Appendices1. Academic research on auditor scepticism 19

2. References to scepticism in ISAs (UK and Ireland) 28


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AUDITOR SCEPTICISM: RAISING THE BAR

Introduction

Audit is essential to public and investor confidence in companies. It is far from easyto do well, requiring judgement and technical competence, often in complex

circumstances. This paper discusses the degree of scepticism that auditors need to

apply to conduct an audit to a high standard. This issue is particularly timely as, in the

wake of the banking crisis, regulators have challenged audit firms on whether

sufficient scepticism was demonstrated and the need for audit firms to exercise

greater professional scepticism was a key message in the Audit Inspection Unit (AIU)

2009/10 Annual Report1.

The application of an appropriate degree of professional scepticism is a crucial skill

for auditors. Unless auditors are prepared to challenge managements assertions they

will not act as a deterrence to fraud nor be able to confirm, with confidence, that acompanys financial statements give a true and fair view. However, scepticism can be

taken too far; challenging everything in a well run company will slow down the

publication of its financial statements and risks unnecessary costs.

The challenge for audit firms is to identify, develop and retain people with the

necessary skills and to deploy them appropriately. This paper shows the importance

of choosing and investing in the right people and developing the right processes to

drive quality, through nurturing appropriate sceptical behaviour. Audit firms need to

be vigilant about such matters and ensure that they foster the right level of scepticism

in their people, despite possible incentives to do otherwise.

The role of regulation is also important. Auditors work to technical and ethical

standards, including requirements on rotation of partners. These seek to achieve a

balance between scepticism, knowledge and over familiarity. Furthermore, audits of

listed companies are inspected by the AIU which looks for evidence that the right

questions have been asked and the right judgements made. The challenge for

regulators is to protect investors in ways that enable audit skills and judgement to

flourish.

Corporate behaviour also plays a significant role. Audit firms and audit partners

should not fear removal from their role if they challenge management strongly.

Management and Audit Committees also have a responsibility for ensuring that the

corporate culture and environment is one which encourages open dialogue with their

auditors at all levels.

This paper goes to the heart of some important issues and the views we hope it will

elicit will be of great interest to both the Auditing Practices Board (APB), which

issues Auditing Standards and guidance, and the Professional Oversight Board (POB),

which (through the AIU) monitors the conduct of audits of larger entities. Because of

its importance to audit quality, both Boards have worked together to develop this

Discussion Paper.

1 The AIUs Annual Report, which was published on 21 July 2010, can be found at

www.frc.org.uk/pob/audit/reports.cfm.


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The APB and POB welcome the views of those stakeholders and other parties

interested in audit quality. In particular we would welcome views on the following:

1. Do you agree with the emphasis that this paper places on the importance ofauditor scepticism? Are there aspects of the analysis, including the summary of

academic research in Appendix 1, with which you particularly agree, or disagree?

If so, what are they?

2. Regulators have recently challenged audit firms on whether sufficient scepticismwas demonstrated on some audits:

Do you think that this problem is widespread or limited to certain types of auditsor circumstances?

What factors do you believe do, or could, in practice create disincentives forauditors to apply an appropriate degree of professional scepticism and what

should be done about them?

In what areas do you think auditors should be more (or less) sceptical in theirapproach?

3. How do you think audit firms should promote and develop professional scepticismin their partners and staff? Do they need to do more and, if so, what?

4. Do you think that others, including companies, should be doing more to promote,develop and support professional scepticism in auditors? If so, what?

Commentators should not feel constrained by these questions, or required to answer

all of them. However, it will assist collation of views, if the questions are used to

structure responses on this topic.

The APB and POB would prefer to receive responses in electronic form. These may

be sent by e-mail [email protected]. If this is not possible, please send letters

of comment to:

JEC Grant

Financial Reporting Council5th Floor Aldwych House

71 91 Aldwych

London WC2B 4HN

In either case, letters of comment should be sent so as to be received no later than 31

October 2010.

All responses will be regarded as being on the public record unless confidentiality is

expressly requested and will be posted to the APBs website soon after receipt.

The Financial Reporting Council Limited 2010. The Financial Reporting Council Limited is a company limited by guarantee.Registered in England number 2486368. Registered Office: 5th Floor, Aldwych House, 71-91 Aldwych, London WC2B 4HN.


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Nature of auditor scepticism

1. Auditing Standards2 define professional scepticism as3An attitude that includes aquestioning mind, being alert to conditions which may indicate possible

misstatement due to error or fraud, and a critical assessment of audit evidence.

This definition suggests that scepticism influences the scope of the work, helpsthe auditor evaluate audit findings and ultimately conclude whether sufficient

appropriate audit evidence has been obtained to enable a true and fair view

opinion to be expressed on an entitys financial statements4.

2. It is widely acknowledged that a sceptical attitude of mind is essential if an auditis to be rigorous and performed with due professional care5; however, auditing

literature is less forthcoming about the degree of scepticism to be applied in

practice. The degree of scepticism to be applied is important because it influences

both the effectiveness and the efficiency of an audit. Too little scepticism

endangers audit effectiveness; too much risks unnecessary cost. Achieving the

right balance is vital. Unless audit inquiries are to be pursued without regard to

cost or time, in practice there must be a limit on the degree to which auditors

inquire about particular issues and the extent of audit procedures performed. This

thinking probably underlies the famous judicial view that an auditor should be a

watchdog not a bloodhound.6

3. In understanding how scepticism influences the conduct of audit in practice it isworth exploring both the auditors initial mindset and how the auditor reacts to

evidence obtained during the audit process. Initially, auditors approach an audit

without a strong predisposition to believe that either the financial information is

misstated or that management are other than honest and candid. Through theprocess of gathering audit evidence, auditors may obtain information that

suggests that the financial information could be misstated. In this situation

auditors become more intense in their enquiries and seek to obtain more audit

evidence to resolve issues, especially if they develop concerns about the veracity

of the evidence or the integrity of those providing it. To understand the practical

application of scepticism it may therefore be helpful to view it as being applied by

auditors on a sliding scale where the intensity of their scrutiny and challenge

reflects both the auditors initial mindset and their response to audit findings.

2References to Auditing Standards in this paper are to the Clarified ISAs (UK and Ireland) that are

effective for audits of accounting periods ending on or after 15 December 2010.3 ISA (UK and Ireland) 200, paragraph 13.4 Auditing Standards require the auditor to obtain sufficient appropriate audit evidence. They provideguidance that this comprises information that both supports and contradicts managements assertions.However, how the auditor addresses conflicts in evidence obtained and what comprises sufficient

appropriate audit evidence are essentially matters for the audit teams judgement.5

Many of the responses to the FRCs Promoting Audit Quality confirmed the view that sound auditorjudgement is a critical element of audit quality and that this is highly dependent on the personalqualities of audit partners and staff, including the degree of scepticism exhibited. The importance ofauditor scepticism was also a theme of many responses to the APBs 1998 Consultation Paper Fraudand audit: Choices for society.6 In Re: Kingston Cotton Mills Co. (1896), Lord Justice Lopes stated that an auditor is not bound to bea detective - he is a watchdog, not a bloodhound. In the later case of Fomento (Sterling Area) Ltd. v

Selsdon Fountain Pen Co. Ltd. (1958), Lord Denning stated to perform his task properly he must cometo it with an enquiring mind - not suspicious of dishonesty - but suspecting that someone may have

made a mistake somewhere and that a check must be made to ensure that there has been none.


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Initial mindset

4. When considering the auditors initial mindset a distinction can be made betweena neutral position (where the auditor does not assume either that the financial

statements are misstated or that management is dishonest) and a more questioning

approach that is sometimes referred to as presumptive doubt.

5. The recently updated Auditing Standards can be characterised as reflecting apresumptive doubt approach. In particular ISA (UK and Ireland) 200 states The

auditor shall plan and perform an audit with professional scepticism recognising

that circumstances may exist that cause the financial statements to be materially

misstated7. An attitude of presumptive doubt is reinforced by ISA (UK and

Ireland) 240 which states the auditor shall maintain professional scepticism

throughout the audit, recognising the possibility that a material misstatement due

to fraud could exist, notwithstanding the auditors past experience of the honesty

and integrity of the entitys management and those charged with governance8.

Whilst the auditor does not disregard past experience of the competence, honestyand integrity of the entitys management and those charged with governance when

making risk assessments, this does not detract from the initial mindset of the

auditor.

6. Recognising that the initial mindset is largely a personal attribute, questions ariseabout whether all individuals are likely to have the same attitude of mind and, if

not, what causes differences.

7. As more fully described in Appendix 1 academics have identified a number ofcharacter traits that underlie auditor scepticism, including:

Curiosity / having a questioning mind, Deferral of judgement / not jumping to premature conclusions, Understanding management behaviour and motivations, Self-confidence, and Freedom of action.

8. However, there are a number of important questions yet to be answered, forexample:

- is scepticism an innate or an acquired condition?

- does scepticism vary between cultures?

9. While it is possible that some individuals are innately more curious than others, itseems likely that a sceptical mindset can be influenced by experience, by direct

and indirect forms of training and by the cultural environment within the audit

firm, including the formal and informal incentive mechanisms that apply within it.

Indeed, the notion of professional scepticism suggests that it is through

professional development and experience that an auditor learns the right level of

scepticism to be applied in different circumstances. This seems consistent with

anecdotal evidence that auditors become more sceptical after they have been

7 ISA (UK and Ireland) 200 Paragraph 158

ISA (UK and Ireland) 240 Paragraph 12


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personally involved in an investigation of an audit failure.

10.In contrast, if success at university requires curiosity and an enquiring mind it islikely that new recruits will commence their career with this trait. Indeed some

academic research suggests that new staff level auditors demonstrate significantly

higher levels of sceptical thought and action than their superiors.

11.If, at least to a degree, a sceptical mindset can be either acquired, or subdued,there are some important questions about how it is acquired or maintained and the

degree to which audit firms actively encourage and foster it.

Reaction to audit findings

12.Auditing Standards establish requirements in relation to the need to performadditional work in reaction to negative findings9. However, judgement is required

when determining what findings are negative and what additional work needs to

be performed in the context of the particular circumstances encountered. Whilethe personal traits of individual auditors are also likely to influence judgements

and the actions taken to respond to concerns identified, subsequent behaviour is

also likely to be influenced by auditors working collectively as a team and by the

audit firms policies and procedures.

13.Auditors usually work in hierarchical teams. The work of junior auditors will besupervised by more senior staff and the more important decisions will be taken by

managers and, ultimately, partners. In the event of negative audit findings there is

likely to be communication between team members about what has been

discovered and what should next be done. While the importance of team

behaviour is acknowledged by academics, little research has been undertaken in

this area as much of this communication is informal and it is often difficult to

reconstruct the audit teams thought process after the event. Audit regulators face

the same challenge (see paragraph 58).

14.Audit firm policies and procedures, normally embodied in audit methodologies,will also often address how audit teams should respond to particular issues

including the possible detection of frauds or illegal activity within the audited

entity.

9 For example ISA (UK and Ireland) 500 paragraph 11 states that If: (a) audit evidence obtained fromone source is inconsistent with that obtained from another, or (b) the auditor has doubts over the

reliability of information to be used as audit evidence, the auditor shall determine what modificationsor additions to audit procedures are necessary to resolve the matter, and shall consider the effect of the

matter, if any, on other aspects of the audit.


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Growing importance of auditor scepticism

15.Towards the end of the 1990s the APB published two Discussion Papers both ofwhich attached considerable importance to professional scepticism:

Fraud and audit: Choices for society10 Aggressive Earnings Management11

16.In the case of Fraud and audit: Choices for society, professional scepticism wasidentified as being especially important for junior staff who, because of their

contact with client management and their direct involvement in inspecting and

testing transactions, had the best opportunity of identifying suspicious

circumstances.

17.In Aggressive Earnings Management the APB described the opportunities thatexist for companies to mislead the capital markets about their performance and

profitability by biasing accounting estimates. While recognising the difficulties

that auditors face in identifying and responding to such situations, the APB

encouraged auditors to be more sceptical in their audit of accounting estimates. As

a result of APBs work in this area requirements relating to the application of

scepticism have been embedded in Auditing Standards and the relevant standard12

relating to the audit of estimates has been extended to cover the audit of fair

values.

18.Changes in accounting requirements, especially the increase in estimationinvolved in preparing financial statements in accordance with IFRS, means that

scepticism throughout the audit team has become even more important for audit

quality. Scepticism is needed by auditors both to challenge management aboutwhether accounting estimates are appropriate and to challenge themselves as to

whether sufficient appropriate audit evidence has been obtained to support those

estimates. This often involves auditors assessing whether the assumptions

underlying estimates seem plausible. Assessing the plausibility of assumptions can

not be performed without an appropriate degree of scepticism and challenge.

19.The AIU has raised concerns over insufficient auditor scepticism with theleadership of the major global audit firms and has sought action plans setting out

how these firms intend to address the root causes.

10 November 1998. www.frc.org.uk/apb/publications/other11

June 2001. www.frc.org.uk/apb/publications/other12 ISA (UK and Ireland) 540 Audit of Accounting Estimates, Including Fair Value Accounting

Estimates, and Related Disclosures


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Importance of scepticism in practice

20.Over the years, disciplinary investigations into Equitable Life Assurance Society,London International Group, Independent Insurance, TransTec, Wickes and ERF

Holdings have identified audit failings. These include instances of over reliance

on management representations, failure to investigate conflicting explanations andfailure to obtain appropriate third party confirmations - which may suggest that

the auditors in these cases were not sufficiently sceptical.

21.A lack of scepticism has also been reported by the AIU. One of the findingsdescribed in their 2009/10 Annual Report13 was that audit firms are not always

applying sufficient professional scepticism in relation to key audit judgements. In

particular, audit firms sometimes approach the audit of highly judgmental

balances by seeking to obtain evidence that corroborates, rather than challenges,

the judgments made by their clients.

22.The AIU also reported that auditors should exercise greater professionalscepticism when reviewing managements judgements relating to fair values and

the impairment of goodwill and other intangibles and future cash flows relevant to

the consideration of going concern.

23.In the US, research has shown that the failure to demonstrate an appropriate levelof scepticism was a deficiency found in 60% of the cases where the SEC brought

fraud related actions against auditors14.

24.This is consistent with the findings of the US Panel on Audit Effectiveness. ThePanel, which was set up by the Securities and Exchange Commission (SEC) in1998, conducted a very thorough review of the effectiveness of large audits by the

large audit firms15. The Panel reasserted the importance of professional scepticism

and observed that:

auditing standards needed to provide better guidance on how to implement theconcept,

audit firms should more effectively teach the concept of professionalscepticism, and

audit firms should develop or expand training for auditors at all levels orientedtoward responsibilities and procedures for fraud detection. These programs

should emphasise interviewing skills and the exercise of professionalscepticism, as well as testing techniques.

13Published on 21 July 2010

14Beasley, M.S., J.V. Carcello & D.R Hermanson, 2001. Top 10 audit deficiencies. Journal of

Accountancy 191 (4):63-6615

At the request of the SEC, the Public Oversight Board appointed the Panel on Audit Effectiveness inOctober1998 to assess whether independent audits of the financial statements of public companiesadequately serve and protect the interests of investors. The Panel reviewed and evaluated the way thataudits were performed, and assessed trends in audit practices to determine whether they were in the

public interest. It studied the audit policies, methodologies and other forms of guidance used primarilyby the large audit firms, certain aspects of auditor independence and the auditing professions self-

regulatory structure.


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25.The academic work summarised in Appendix 1 also provides some indicators thatauditors may not be sufficiently sceptical, although it is recognised that much of

this is US research and the findings may not apply to auditors working in different

environments.

Development and promotion of auditor scepticism within audit firms

26.Scepticism is an important element of audit quality and, in the medium to longterm, audit failures can expose audit firms to litigation and reputational damage.

Consequently audit firms have policies and procedures aimed at achieving audit

quality.

27.However, it is also clear that audit firms place considerable importance onretaining their client base. Emphasis on client service planning and relationship

management within the firms may act as a disincentive for auditor scepticism if

audit teams believe that by demonstrating scepticism they risk having an unhappy

client.

28.Particular problems are likely to arise if scepticism results in a delay in thecompletion of the audit. The timetable for an audit is usually agreed in advance,

especially if the entity is a listed company which has agreed a date upon which to

announce its results. Delays caused by the auditor pursuing additional inquiries

that cause the audit not to have been completed by the agreed date can be

problematic, especially if the auditors concerns prove to be unfounded.

29.Furthermore, application of scepticism can also directly threaten short termprofitability. The fees for most audits are agreed in advance on the basis of timeestimates; additional fees for variances from the plan are negotiated after the audit

is completed . Initial fee estimates are often prepared on the basis that the entitys

controls will be shown to be operating effectively and that few other problems

will be revealed. The audit market is competitive and such fee estimates do not

usually contain contingencies for dealing with the unexpected. Negotiations for

additional fees after the audit has been completed can adversely impact client

relationships. In this environment there may be an incentive for the audit team to

adhere strictly to the plan. Keeping to the plan is also a plausible strategy for

junior staff who are already working long hours and may not wish to work even

longer16

.

30.Two particular areas that are likely to be relevant to the development andpromotion of auditor scepticism are (a) recruitment, training and motivation /

reward processes and (b) audit methodologies.

16

B Pierce and B Sweeney Cost quality conflict in audit firms: an empirical investigation and M PageA survey of time budget pressure and irregular auditing practices among newly-qualified UK

chartered accountants.


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Recruitment, training and motivation/reward processes

31.If the underlying characteristics of scepticism are largely innate then initialrecruitment policies are likely to be important in helping audit firms employ staff

with the appropriate attitude.

32.While recognising that there are a number of different qualities that audit firmswill be seeking in new recruits, more could perhaps be done to extend the

electronic screening that is often currently used to seek out the character traits

underlying sceptical behaviour. Even if initial recruitment does not focus on

scepticism, subsequent promotion/retention policies could be used to promote its

importance.

33.If underlying characteristics are largely an acquired skill then training anddevelopment in the firm become more important. In this context lessons might be

learnt from how the US audit firms responded to the US Panel on Audit

Effectiveness recommendation that firms should more effectively teach theconcept of professional scepticism.

34.However, irrespective of how effective the classroom training might be, it willbe lost in the pressure of practice unless it is reinforced through the culture of the

firm and its mentoring and reward systems. Many believe that nurturing the right

professional qualities is best achieved through junior staff working closely with

more experienced partners and staff provided that such senior personnel already

have the right qualities.

35.A key stimulus to achieving an appropriate level of scepticism in junior staff islikely to be through coaching undertaken as part of the review process. Research

suggests that one way to enhance professional scepticism is for reviewees to

understand that scepticism is a priority of the reviewer. It also suggests that junior

auditors who expect a face-to-face review undertake more thorough work than

those who anticipate interacting with the reviewer electronically or who do not

anticipate being reviewed at all.

36.This is consistent with the importance given to coaching and mentoring in theFRCs publication Promoting Audit Quality.

37.It is possible that the level of innate scepticism varies between cultures. If so thisis likely to be a challenge for audit firms undertaking group audits where the work

on overseas subsidiaries is undertaken by national firms. While there is a

requirement in Auditing Standards17 for the group auditor to obtain an

understanding of the subsidiary auditors professional competence there is no

specific indication that this should include the degree of scepticism and indeed

this could be very difficult to achieve in practice. Although Auditing Standards

require the group auditor to be actively involved in the audit of significant

subsidiaries it is questionable whether this could fully compensate for a systematic

lack of scepticism in the local team. Other techniques such as staff secondments

17ISA (UK and Ireland) 600 paragraph 19


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from other countries may be a more effective approach to national variations in

scepticism if they exist.

Audit methodologies

38.Audit firms, particularly the largest, invest significant amounts in their auditmethodologies and quality control systems.

39.In recent years audit methodologies have grown both in their complexity and theirinfluence on what audit work is done in practice, especially by more junior

members of the audit team. This is, in part, influenced by developments in

Auditing Standards and other regulatory activity but also by the larger audit firms

wish to standardise parts of the audit and to take advantage of control techniques

that become available in electronic working papers.

40.The FRCs Promoting Audit Quality observed that electronic working papershad the potential to distance both partners and staff from the company being

audited and reported anecdotal evidence that the proportion of audit time spent by

staff sitting in the audit room completing electronic schedules seemed to be

increasing at the expense of time spent reviewing client records, discussing

accounting issues with client staff and otherwise obtaining audit evidence.

41.It is of course easier to imagine auditor scepticism being applied when auditorsare walking the floor, observing and inspecting the company's operations, rather

than sitting in the audit room completing electronic schedules - but there are also

wider issues associated with the integration of methodologies and electronic

working papers. Self-determination or freedom to act appears to be one of the

character traits that fosters sceptical behaviour. This involves individual auditors

having the ability to pursue their own inquiries when needed and the motivation to

do so. Rather than requiring auditors to perform predefined audit tasks and

complete checklists, professional scepticism might be better fostered by

methodologies encouraging auditors to ask management relatively open questions

and follow up on responses.

42.Academic research, albeit before the latest generation of electronic workingpapers, suggests that the firms documentation systems are reducing the amount of

detailed comments that show how thinking on a particular topic evolves and howfinal conclusions are reached. Documentation of this nature would seem to be

especially important to support judgements, for example on the acceptability of

fair values, when the work of relatively junior staff is reviewed and challenged by

more senior members of the audit team who apply their wider knowledge of the

entity and their greater experience to the judgements. An absence of a clear

thought trail is likely to reduce the opportunity for juniors to learn and inhibit the

effectiveness of review processes18.

18

A clear record of the auditors thought process is also likely to be beneficial to audit quality moregenerally as documentation often helps structure a thought process and helps the author and subsequent

reviewers identify illogicalities and inconsistencies.


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43.Active consideration of how auditors make, and document, important judgementsis likely to be a useful area of future research. In particular it may be worth

exploring how members of the team, especially the partners and managers, review

the work of the rest of the audit team in an electronic environment, how they raise

review points and how the actions taken in response to them are documented. It

would also be worth discussing why review notes are not usually retained once theaudit has been completed.

44.It is apparent that audit firms often request their clients to prepare, in advance ofthe audit, specific schedules and analyses (client co-operation arrangements). In

some cases the level of client assistance may be greater and include, for example,

extracting records from files and other work. While saving audit costs, there is a

danger that such arrangements may influence the auditors mindset and make

them over-trusting. Academic research in Ireland19 suggests that co-operation and

trust seem to be mutually reinforcing conditions and that excessive trust may

reduce auditor scepticism.

45.Where client co-operation arrangements are established, it is important that auditteams do not allow them to reduce the level of scepticism demonstrated and that

such arrangements do not allow client management to influence the extent and

nature of audit work performed.

Can more be done to promote auditor scepticism?

46.Audit firms Audit firms have invested significantly in recent years in theautomation of their systems in order to obtain efficiency and effectiveness

benefits. This may be an appropriate stage for them to take stock of the progressmade and to evaluate the impact of their systems on the judgemental aspects of the

audit and in particular on the mindset of staff at all levels.

47.Further consideration of aspects of their recruitment, training, methodology, andmotivation and reward processes may provide opportunities for increased auditor

scepticism and, therefore, improve audit quality.

48.Auditing Standards - Auditing Standards applicable in the UK and Ireland20require the auditor to plan and perform an audit with professional scepticism21 and

guidance as to the importance of scepticism is provided in supporting application

material. Reference to the need for auditor scepticism is also made in a number ofother Auditing Standards (see Appendix 2) most notably ISA (UK and Ireland)

200 on the overall objectives of the auditor and ISA (UK and Ireland) 240 on

fraud.

19 Extended Clan: External Influences on Audit Team Behaviour Sweeny and Pierce20 The ISAs (UK and Ireland) are theISAs issued by the International Auditing and AssuranceStandards Board ( IAASB) supplemented, where appropriate, with additional requirements to address

specific UK and Irish regulatory requirements and additional guidance that is appropriate in the UKand Irish national legislative, cultural and business context.21

ISA (UK and Ireland) 200 paragraph 15


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49.Over recent years, the Auditing Standards, have been revised to make them morerigorous22. This has involved, in part, imposing requirements on all auditors to

perform certain procedures which, while normally undertaken by a sceptical

auditor, were not always performed in practice. Examples include:

Mandatory meetings of the audit team to discuss the susceptibility of the entityto:- misstatements (ISA 315),

- fraud (ISA 240), and

- fraud or error that could result from related party relationships (ISA 550),

Reviewing the outcome of opening provisions (ISA 540), Checking a sample of journal adjustments (ISA 240), Evaluating risks in relation to revenue transactions based on the presumption

that there are risks of fraud in revenue recognition (ISA 240), and

Investigating significant related party transactions outside the entitys normalcourse of business (ISA 550).

50.That said, experience from audit inspections would suggest that further actioncould be taken; for example consideration could be given to whether Auditing

Standards inadvertently lead auditors to place undue reliance on managements

work and whether there might be new requirements for:

Fuller documentation of the rationale for key audit judgements, perhaps bymandating Audit Completion Memoranda,

The retention of review notes as part of audit documentation, Meetings of the audit team after most of the work has been completed, but

before the audit report is signed, to discuss findings,

Ensuring that reviews are undertaken in person rather than remotely.51.However, in considering whether more should be done to make Auditing

Standards more specific, consideration needs to be given to the risk that a further

move away from principles towards rules will demotivate audit staff and add

unnecessarily to the cost of some audits. Furthermore, specification of required

procedures does not necessarily ensure that the work is performed in a sceptical

manner and that there is adequate follow up of the findings.

52.Guidance - Rather than adding more requirements to standards, APB couldperhaps develop guidance on audit scepticism to help audit firms understand its

nature and how best it might be encouraged. Such guidance might build on

research undertaken in a UK context.

53.Another possibility might by for APB, or another body, to publish summaries ofthe lessons learnt from investigations into possible audit failures. War stories of

this nature may help increase auditor scepticism and assist with fraud detection.

22 Some of these changes were introduced for UK and Irish audits of accounting periods ending on or

after 15 December 2010 when the Clarified ISAs (UK and Ireland) became effective.


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54.Ethical Standards Some academics consider that there is an inverserelationship between scepticism and trust. As one observed As the auditor-client

relationship lengthens, a behavioural bond develops between the auditor and the

auditee as they become more familiar with each other and mutual trust replaces

the auditors necessary professional scepticism. At some point, it is argued, the

degree of trust can become so great that violations will not be challenged asauditors instinctively favour evidence that confirms their prior beliefs. One of the

difficulties here is that two of the vital ingredients of a high quality audit

scepticism and knowledge of the clients business - seem to be pulling in different

directions.

55.Ways of avoiding auditors placing too much trust in their clients are traditionallyaddressed in Ethical Standards. Methods used to enhance auditor objectivity and

independence include:

Rotation (both of firms and partners and staff), Prohibition of certain non-audit services especially those that create a

mutuality of interest with management, and

Prohibition of employment, by the audited entity, of ex-audit teammembers.

56.These topics were debated during the Governments enquiry by the Co-ordinatingGroup on Audit and Accounting Issues (CGAA) into the implications of the Enron

failure for UK auditing and accounting. These areas are also addressed in APBs

Ethical Standards for Auditors which were first issued in 2004 and subsequently

reviewed in 2007. Neither the CGAA nor the APB thought that it was necessary to

introduce mandatory rotation of audit firms, but the rotation period of audit

partners on listed company audits was reduced from seven years to five.

57.Audit inspection. The AIU is responsible for monitoring the audits of all listedand other major public interest entities23. This involves, inter alia, the AIU

forming a view on the quality of the important judgements made during the audits

they inspect and evaluating whether sufficient scepticism has been demonstrated.

As noted above, the AIU has commented that audit firms are not always applying

sufficient professional scepticism in relation to key audit judgements.

58.One of the challenges faced by audit inspectors is that there are two aspects toscepticism sceptical thinking and sceptical actions. Sceptical thinking operates,

or does not operate, within an individual auditors mind. While it can probably bewitnessed on a real time basis, the transparency to others of sceptical thought

rapidly reduces over time. Audit inspectors, who review audit documentation

some time after it is performed and do who not see original client records, may see

evidence of sceptical actions but, without knowing what was in the auditors mind

at the time, it is difficult to evaluate the adequacy of these. The problem of

evaluating the degree of sceptical thinking within an audit team is exacerbated by

the removal from the audit documentation of review notes on completion of the

audit (see paragraph 13 above).

23

The AIUs scope is the audits of all UK incorporated companies with listed securities (both equityand non-equity securities) and other entities in whose financial condition there is considered to be a

major public interest. The AIU reviews a sample of audits each year.


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59.Companies Corporate culture and behaviour can impact auditor scepticism too close a relationship between management and the auditor may reduce auditor

scepticism; too hostile a relationship, whether resulting from excessive challenge

by the auditor or from a defensive attitude by the audited entitys management

and/or staff, may be intimidating to the auditor and/or may create an environmentin which there is a lack of openness in responding to auditor enquiries.

60.Periodically audit committees may wish to consider whether there is anappropriate relationship between management and the auditors and, if not what

can be done to change it. However, deciding what to do if the relationship is not

right is likely to be challenging. It is not easy to change management behaviour

and while requiring changes in the audit team, or indeed changing the audit firm,

may appear an easier solution, audit committees will be aware that such actions

were sometimes taken in the past and some audit failures have demonstrated that

this had the effect of weakening audit quality rather than strengthening it. One

possible safeguard to this concern might be the mandatory rotation of audit firmsbut there are well documented disadvantages to such a requirement.

61.The UK Corporate Governance Code anticipates that the audit committees oflisted companies will review and monitor the effectiveness of the audit process.

As well as considering the relationship between management and the audit team,

audit committees may wish to consider whether the audit partner and staff

exhibited sufficient levels of professional scepticism in their work and were robust

in dealing with issues identified during the audit24. In this context, the AIU issues

reports on the individual audits reviewed each year and the auditors are required

to provide copies to the audit committee of the audited entity these should

provide further input to their consideration of audit effectiveness, where

applicable. Direct consideration of whether the audit team was sufficiently

sceptical, and communication with the audit firm if this was not the case, is likely

to help increase the emphasis audit firms place on this.

62.Audit committeescan also influence scepticism in advance of the audit. Opendiscussion with the auditors about business and accounting issues will help alert

them to risk areas. Furthermore, when discussing proposed audit fees, audit

committees may wish to challenge whether they include an appropriate

contingency for dealing with any unexpected developments (see paragraph 29).

63.Accountancy bodies There is likely to be a link between scepticism andtraining. While much of the audit related training is provided by the audit firms,

the accountancy bodies have responsibility for the curriculum leading to

qualification as an accountant and also have requirements relating to continuing

professional development (CPD).

24See the FRCs Audit Quality Framework.


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64.More could perhaps be done to enhance auditor scepticism through trainingprovided by the accountancy bodies. One possible mechanism might be through

developing training videos. It is interesting to observe that films such as The

Auditor in Court25 and Billion Dollar Bubble26 that were viewed by many older

auditors are no longer readily available to younger members of the profession.

65.Academics - One of the inevitable conclusions to academic research papers is thatmore research needs to be carried out and this is clearly the case in relation to

auditor scepticism and how it can be increased. Possible topics include:

Conceptual

To what extent are underlying characteristics of scepticism innate or acquired? If innate do these vary with cultural background? How do the different underlying factors combine (for example are they

additive or multiplicative)?

Do sceptics respond to time / client pressure in the same way as non-sceptics? What is the relationship between levels of education and scepticism?Training and development

Can scepticism be taught? If so, how? What is best practice within firms for developing and maintaining scepticism? Do firms encourage or discourage self-determination? How do firms evaluate/reward staff for scepticism?Audit methodologies

Do methodologies encourage auditors to ask questions? Do electronic working papers facilitate the making and recording of the

important audit judgements? Do they encourage sceptical behaviour?

Can improvements be made to how:o auditors make, and document, important judgements?o partners and managers review work in an electronic environment?o partners and managers raise review points and how the actions taken in

response to them documented?

66. The APB and the POB would welcome copies of any research studies undertakenin the UK and Ireland on auditor scepticism or related topics and being informed

if studies are underway or due to commence.

25 An ICAEW film that followed the cross examination of an audit practitioner accused of negligence.26

The story of the Equity Funding fraud


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Questions

1. Do you agree with the emphasis that this paper places on the importance ofauditor scepticism? Are there aspects of the analysis, including the summary of

academic research in Appendix 1, with which you particularly agree, or disagree?

If so, what are they?

2. Regulators have recently challenged audit firms on whether sufficient scepticismwas demonstrated on some audits:

Do you think that this problem is widespread or limited to certain types of auditsor circumstances?

What factors do you believe do, or could, in practice create disincentives forauditors to apply an appropriate degree of professional scepticism and what

should be done about them?

In what areas do you think auditors should be more (or less) sceptical in theirapproach?

3. How do you think audit firms should promote and develop professional scepticismin their partners and staff? Do they need to do more and, if so, what?

4. Do you think that others, including companies, should be doing more to promote,develop and support professional scepticism in auditors? If so, what?


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Appendix 1

Academic research on auditor scepticism

This appendix outlines the manner in which academic research has investigated thecharacteristics underlying auditor scepticism and the degree to which it is likely to be

exhibited in practice, and provides illustrative findings from that research.27

Studies of auditor scepticism fall within a broad field of research concerned with

judgement and decision making in auditing, looking at the manner in which individual

attributes and contextual variables are associated with the judgements auditors form

and the actions they take when conducting an audit. Much of the research in this field

has been undertaken by US academics and it should be noted that the findings may

not apply equivalently to auditors working in different countries and environments.

Furthermore, due to the difficulty of gaining research access to real life situations,

many studies have relied upon hypothetical case examples tested using surveys or in

settings outside practice rather than data drawn from actual audit engagements. While

research designs employing hypothetical cases are useful in illustrating the

significance of specific factors they cannot easily capture all the complexities that are

found in practical situations.

While some of the research is current, some dates back to the 1990s and before. To

the extent that the audit firms have changed attitudes and behaviour, for example by

responding to the recommendations of the US Panel on Audit Effectiveness, this will

not be reflected in the older research.

This summary draws attention to research findings in the following three categories:

Studies that seek to identify characteristics underlying auditor scepticism; Studies that explore the factors which may influence the degree of scepticism

reflected in auditor behaviour;

Studies that explore the scepticism in the context of the audit firm.Characteristics underlying auditor scepticism.

Some researchers have sought to identify the elements which characterise sceptical

behaviour. This approach goes beyond seeking simply to define auditor scepticism to

identify the characteristics that are associated with differing levels of scepticism

between individuals and the resulting types of behaviour which reflect the application

of professional scepticism. Distinction is often drawn between sceptical judgement

and sceptical actions. While individual judgements may be more or less sceptical, it is

only when scepticism reaches a threshold that the judgement will lead to consequent

identifiable action by the auditor, such as obtaining more evidence or seeking

adjustments.

27

An in-depth review of the literature can be found in: Nelson, M., A Model and Literature review ofProfessional Skepticism in Auditing,Auditing a Journal of Practice and Theory, Vol. 28, No. 2,

November 2009, pp. 1-34.


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Approaches to investigating professional scepticism in the research literature, and also

to applying it in practice standards, adopt differing views about what professional

scepticism means in terms of the initial mindset that the auditor should have in

undertaking an engagement. Contrast can be drawn between a neutral mindset, in

which the auditor neither accepts management figures and explanations in an

unquestioning way nor assumes that there is error or misstatement, and presumptivedoubt where the auditor exhibits a heightened awareness of the risk that the figures

could be affected by error or dishonesty28. Auditors have sometimes been criticised

for not applying sufficient professional scepticism, implying that more doubt would

have led auditors to have investigated further or look for more persuasive evidence

and to have avoided alleged failures as a result. However, greater doubt is not

unambiguously a good thing as it may lead to unnecessary procedures, over-auditing

and inefficiency.

Hurtt, Eining and Plumtree29 studied how scepticism was treated in early

philosophical writings and in other relevant disciplines (including scepticism reflected

in the work of psychologists, jury behaviour and consumer behaviour in relation toadvertising). They identified four behaviours expected of sceptics, namely:

Expanded information search sceptics always demand reasons, evidence,justification and proof ,

Increased contradiction detection sceptics seek out inconsistencies Increased alternative generation sceptics construct alternative explanations Increased security of source reliability sceptics make links with

understanding peoples motivation / behaviour. A sceptic will be concerned

about the reliability and independence of data sources.

Based on this approach they developed a model (the Hurtt Model) of auditorscepticism which involves:

Factor Underlying characteristics

1 Examination of

evidence characteristics Questioning mind a sceptic questions everything

even their own judgements.

Suspension of judgement sceptics want to seeevidence before making conclusions; they are

slow to form a judgement.

Search for knowledge / curiosity - sceptics seekknowledge for its own sake.

2 Understanding

evidence providers

Interpersonal understanding understandingpeoples motivation and behaviour is afundamental requirement in scepticism.

3 Characteristics to act

on the information Self-confidence the propensity to challenge

assumptions.

Self-determination an auditor must individuallydecide when a sufficient level of information has

been obtained.

28

Bell,T.B, M.E. Peecher, and I. Solomon. 2005. The 21st

Century Public Company Audit, New York.29 Hurtt, K., M. Eining and D. Plumtree, Professional Skepticism: A Model with Implications for

Research, Practice and Education, working paper, University of Wisconsin Madison, 2002.


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The Hurtt Model has been applied in research undertaken with practicing auditors in

the Netherlands.Quadackers, Groot and Wright30 tested the strength of the

relationship between four possible determinants of auditor scepticism (trust,

suspension of judgement, locus of control and the Hurtt Model). A total of 376

practitioners from the Big Four in the Netherlands responded to a case scenario where

the results of an analytical procedure showed an unusual increase in sales and a fairlysuperficial management response. The results showed that 2 of the 4 determinants

(trust and the Hurtt Model) had the highest explanatory power in predicting sceptical

behaviour.

Hurtt has used the Model herself31 to explore auditor behaviour and concludes that

while less sceptical auditors may be better at identifying factual errors, more sceptical

auditors are better at identifying situations containing contradictory information and

adopting a holistic view of evidence. While acknowledging that both skills are

valuable she postulates that while less sceptical auditors focus on the details more

sceptical auditors are better at developing a coherent conceptualisation of evidence

taken as a whole.

Factors influencing the degree of scepticism reflected in auditor

behaviour

A further line of research has investigated how various factors can influence the

degree of professional scepticism reflected in auditors judgements and actions. While

some of this research seeks to model the potentially complex interactions between

different factors, for present purposes it is sufficient to note that studies have shown

that auditor knowledge, personal traits and incentives may be linked to variations inauditor scepticism32.

Auditor knowledge, experience and training

Increased knowledge, specialist experience and training have been shown to enhance

auditors awareness of potential causes of error and the ability to recognise patterns

and respond to risk factors. However, increased knowledge may not always result in

increased scepticism as some studies have shown that knowledge also increases the

likelihood that reasons other than error will be accepted by specialists as explanations

for unusual patterns.

30 Quadackers, L.,M., T.L.C.M. Groot and A. Wright, Auditors Skeptical Characteristics and theirRelationship to Skeptical Judgments and Decisions, working paper, VU Amsterdam, 2009.31

K. Hurtt, M. Eining and D. Plumlee, Linking professional skepicism to auditor behaviours, BaylorUniversity, working paper 2010.32

See Nelson M., 2009, op. cit., for a more detailed review of studies on each of these factors.


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Incentives

Several incentive factors may influence the likelihood that auditors will behave in a

manner that reflects increased scepticism and studies have shown that incentives do

affect auditors behaviour. These incentive factors include the relationship with the

client company and opportunities for additional services and revenue generation, thenature of review and performance appraisal within the firm and related recognition

and reward, and regulatory inspection and threats to reputation. It is the overall

balance which is likely to affect judgements and actions in an audit engagement.

Overall, the evidence suggests that auditors judgements will exhibit more scepticism

where concern for reputation and exposure to litigation is greater rather than concern

for firm revenue or the potential loss of a client. Less is known about how

performance evaluation and reward systems within audit firms can be used to promote

appropriate levels of professional scepticism in auditors behaviour.

Traits

An important question that has been investigated by a number of researchers is

whether underlying personal attributes are influential on the degree of scepticism

exhibited by auditors. For example, problem solving ability has been shown to be

relevant to the ability to identify potential errors. Ethical and moral development also

appears to be related to auditors ability to identify potentially inappropriate actions

by a client. The characteristics included in the earlier table describing the Hurtt

model, such as self-confidence, self-determination and interpersonal understanding

also relate to the personal attributes, or traits, possessed by the individual auditor.

Several studies have examined how interpersonal trust affects sceptical judgements

and actions.

Rennie, Kopp and Lemon 33explored the tension between trust and professional

scepticism.They note that trust is a practical necessity for the efficient conduct of an

audit but over time trust accumulates and that at some point too much trust destroys

audit quality. Research in this area suggests that co-operation and trust are mutually

reinforcing. What is important, it is suggested, is how the auditors respond to

evidence of a trust violation. In the US, Lewicki and Bunker34 use an existing model

of trust to explore at what point the auditor might place too much trust on

management:

33 Rennie, M.D., L.S. Kopp and W.M. Lemon, "Exploring Trust and the Auditor-Client Relationship:Factors Influencing the Auditor's Trust of a Client Representative", Auditing a Journal of Practice andTheory, 2010.34

Lewicki, R.J. and B.B. Bunker. 1996. Developing and maintaining trust in work relationships- inTrust in Organizations: Frontiers in Theory and Research edited by Kramer R and T .Tyler: Newbury

Park, CA.


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Category of

trust

Characteristics Response to evidence of a trust

violation.

Calculus-based Fragile. An early stage of a

relationship where trust is based

on a rational assessment of therelative costs and benefits giving

or withholding trust.

Trust likely to be terminated

Knowledge

based

More robust. A higher level of

trust based primarily on the

history of interaction between

individuals.

Relationship more forgiving if

an adequate explanation can be

found for the violation it will

often be accepted.

Identification

based

Highly robust. The highest level

where an individual identifies

with the others desires and

intentions

Sense-making process likely to

apply auditors will favour

evidence that confirms their

beliefs. Ambiguous or

incomplete information will be

interpreted in a way not to

change the belief.

Lewicki and Bunker suggest that the optimal level is calculus-based trust. They

indicate that trust can be strongly influenced by members of management previously

being employed by the audit firms especially if that individual is personally known

to the audit team. In such cases past-trust is often not re-evaluated in the new context.

The authors also note the influence that the provision of advice / non- audit services

can have on trust35.

Also in the US, Shaub and Lawrence36 noted that the Independence Standards Board37

had identified inappropriate trust as one of the five biggest threats to auditor

independence and explored the auditor-client relationship. They identified two types

of trust: (a) rational (emotional) trust and (b) deep auditor-client interdependence and

postulated that deep auditor-client interdependence is likely to be troublesome for

auditor independence / scepticism (especially where there is information asymmetry).

35The authors cite the Panel on Audit Effectiveness 2000 report which noted that some services can

subvert neutrality, impartiality and scepticism and create a mutuality of interest with management.36

Shaub, M.K. Trust as a Threat to Independence : Emotional Trust, Auditor-client Interdependence,and their impact on Professional Skepticism, 200437 The Independence Standards Board (ISB) was established in May 1997 as a result of discussionsbetween the American Institute of Certified Public Accountants (AICPA) and the U.S. Securities andExchange Commission (SEC). The operating policies of the ISB were designed to permit timely,

thorough, and open study of issues involving auditor independence and to encourage broad publicparticipation in the process of establishing and improving independence standards. The ISB ceased its

operations in 2001.


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Work in Ireland by Sweeney and Pierce38 provides an insight into the relationship

between trust and auditor scepticism. This study involved interviews with 18 client

staff39 to assess the extent to which client staff can influence audit team behaviour,

recognising that there needs to be a balance between professional scepticism and the

need for client co-operation. The conclusion was that client staff can, and do,

influence behaviour, for example by imposing over-demanding deadlines, latedelivery of information, selecting samples and providing misleading answers to

questions. The suggestion is that this manipulation is easier when audit staff are

young and have no real business experience. The study also gives some interesting

insights into what auditor scepticism is and how it can be achieved. The main aspects

of scepticism identified are:

Character of the

auditor Confidence and knowledge junior staff find it

difficult to say I dont understand that

Probing skills / persistence. This may be impacted byculture

Not shying away from confrontation, and Strength of character in dealing with challenging or

confrontational situations

Audit firms systems

positive factors Strong manager / partner reviews especially if they are

knowledgeable about the clients business

Strong contact between manager / partner and juniorstaff

Increasing documentation requirementsAudit firms systems

negative factors Too many check lists in methodology lack of

emphasis on understanding the clients business

Over aggressive budgets / timetablesProfessional scepticism in the context of the audit firm

While much of the research on sceptical behaviour has focused on the behaviour of

the individual auditor, the context of the professional firm and the audit team are also

relevant to the exercise of professional scepticism. For example, in his review of the

literature in this area, Nelson40 cites several ways in which professional firms can

enhance professional scepticism:

Recruitment processes that include assessment of relevant attributes; Training in error recognition and in negotiation; Performance evaluation and promotion systems that reward appropriate

professional scepticism;

Review processes that are structured to favour professional scepticism; Decision aids such as checklists and procedural or documentation

requirements;

Incentives that promote challenge in the audit process.

38 Sweeney, B. and B. Pierce, The Extended Clan: External Influences on Audit Team Behaviour,

working paper.39 The clients were listed companies audited by the Big Four, generally out of their Dublin offices.40

Nelson, M., 2009, op. cit.


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A number of studies have looked at how the firm context impacts on the exercise of

professional scepticism. In the US Shaub and Lawrence41 explored how socialisation

within the firm can affect professional scepticism and tested this using a case study

involving 710 auditors from a single large US firm. The study distinguished between

sceptical thinking (judgement) and sceptical behaviour (action). In general the work

demonstrated that there is a significant degree of professional scepticism in auditors atall levels. However, they found that new staff level auditors demonstrate significantly

higher levels of sceptical thought and action than their superiors (seniors, managers

and partners). While overall the scepticism of seniors is similar to those of managers

and partners there is some evidence that the level of sceptical thinking of seniors is

greater than managers and partners.

Shaub and Lawrence suggest that the relationship between sceptical thinking and

sceptical behaviour is rather inelastic, in other words that an auditors scepticism must

reach a certain threshold before an auditor is willing to take action. They postulate

that a possible reason why this threshold is higher for partners and managers are

market factors ie the commercial pressure that they are under. The researchsuggested that staff are more prepared than partners and managers to be sceptical on

those clients which are important to the firm for referrals and that partners are much

less sceptical than others when dealing with the offices single biggest audit client.

A number of studies have demonstrated the importance of selection and socialisation

in developing and maintaining a firms culture of shared values and practices42.

Selection involves both recruitment and promotion. One study has shown that auditors

are more likely to be promoted if their level of moral reasoning is similar to that of

their superiors and that principled moral reasoning falls away in the manager and

partner ranks43. Other research44 shows that the high turnover of public accounting

firms helps to establish cultural stability those who disagree with the firms value

leave it.

The suggestion that there is a tendency towards harmonising levels of scepticism

within an audit firm may be challenged by other work undertaken by Shaub and

Lawrence in the US45. They developed four categories reflecting individuals

tendency to think sceptically and to act sceptically and, using a sample of 37546

auditors explored the relationship between those categories and (1) age/experience

and (2) ethical disposition.

41 Shaub, M.K. and J.E. Lawrence, Differences in Auditors Professional Skepticism Across Career

Levels in the FirmAdvances in Behavioural Accounting Research, 2: 61-83, 1999.42

For example, see: Pratt, J., and P. Beaulieu, Organizational Culture in Public Accounting: Size,Technology, Rank, and Functional Area.Accounting, Organizations & Society, 17(7):.667-684..43

Ponemon, L., Ethical reasoning and selection-socialization in accounting,Accounting,Organizations andSociety, 17(3-4): 171-189, 199244 Harrison, J.R. and G.R. Carroll.. Keeping the Faith: A Model of Cultural Transmission in FormalOrganizations,Administrative Science Quarterly,36: 552-582, 1991.45 Shaub, M.K. and J.E. Lawrence, A Taxonomy of Auditors Professional Skepticism ,Research on

Accounting Ethics, 8: 167 -194, 2002.46 The original sample was 710 but pre-screening eliminated those that did not consistently fit the

categorisation system.


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Their categorisation system was:

Characteristics (tendency to think sceptically/ to act sceptically

Measured sceptics Low thought / high action. Not overly suspicious of routine

behaviour but very alert when something out of the ordinary

happens activated professional scepticism.

Aggressive sceptics High thought / high action. These auditors are generally moresuspicious than others and are sensitive to harmful motives.

They take action even in low risk situations likely to result

in inefficient auditing and client dissatisfaction.

Reluctant sceptics Low thought / low action. A rational approach but one that

likely to result in poor audit quality unlikely to detect

management fraud.

Conflicted sceptics High thought / low action. These auditors demonstrate risk

recognition skills but they are not acted upon. Possible that

they are influenced by client reaction / cost issues. Tendency

to become cynical.

The results of the test, undertaken within a single large US firm, were:

Measured sceptics 12% of sample. These have the highest concern for

professional ethics.

Aggressive sceptics 26% of sample. Generally the youngest / least experienced.

Reluctant sceptics 36% of sample. Significantly more experience/age than the

other categories.

Conflicted sceptics 26% of sample the least idealistic auditors.

The authors emphasise the superiority of the measured sceptic category and note that

it is troubling that 36% of the sample, are in the reluctant sceptic category. They alsofind it troubling that 80% of partners and managers are either reluctant sceptics or

conflicted sceptics (in both cases the tendency to act is low). This may be because

repetitive experiences may leave them less susceptible to the surprise/shock that leads

to increased scepticism. The number of conflicted sceptics suggests cynicism,

disillusionment and low career satisfaction.

The authors draw out a number of implications for the profession including:

If the goal is to develop more measured sceptics training and reinforcementare necessary.

It will be necessary to teach new auditors recognition skills and feedback sothat they are not continually over-reacting.

Conflicted auditors need to be rewarded not punished for their recognitionskills. A mentoring programme has the opportunity to assist in this

development.

Additional training on recognition may not be helpful for the reluctant scepticswho are generally the older auditors. They may need peers and supervisors to

challenge their thinking.


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Further work by Shaub and Lawrence47 explored auditors propensity to confront

client across experience levels and gender within the firm. Based on responses from

700 auditors from a single large US firm to questions in a case study scenario, they

found that the willingness to question a client in detail declines based on experience

although for men there is some evidence of a pick-up at partner / manager level (the

number of partners included in the sample was however small). Partners appeared lessconfrontational however in situations where the client is very large or is an active

purchaser of non-audit services. For women there is no sign of a pick up at manager

level (there were no female partners in the sample).

Summary

This brief review has illustrated how academic research has investigated the

characteristics underlying auditor scepticism, the manner in which factors such as

knowledge, personal attributes and incentives influence the degree of scepticism

reflected in the judgements and actions of auditors and the behaviour of individuals in

the context of the audit firm. The results provide insights into the nature of scepticism

in auditing, variations between the likely judgements and actions between different

auditors and the manner on which different elements can be used to enhance

professional scepticism. There remains considerable scope for research into the

culture of scepticism in UK auditing and how this is realised in actual audit practice.

47 Shaub, M.K. and J.E. Lawrence, Exercising Professional Skepticism Through Client

Confrontation, 2004


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Appendix 2

References in scepticism in ISAs (UK and Ireland)

Para

Ref

Text from ISA

200. Overall Objectives of the Independent Auditor and the Conduct of an Audit

in Accordance with International Standards on Auditing (UK and Ireland)

7. The ISAs (UK and Ireland) contain objectives, requirements and application

and other explanatory material that are designed to support the auditor in

obtaining reasonable assurance. The ISAs (UK and Ireland) require that the

auditor exercise professional judgment and maintain professional skepticism

throughout the planning and performance of the audit and, among otherthings: .

13(l)

Professional skepticism 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.

15.

The auditor shall plan and perform an audit with professional scepticism

recognizing that circumstances may exist that cause the financial statements to

be materially misstated. (Ref: Para. A18-A22)

A16.

In the case of an audit engagement it is in the public interest and, therefore,required by the IFAC Code, that the auditor be independent of the entity

subject to the audit. The IFAC Code describes independence as comprising

both independence of mind and independence in appearance. The auditors

independence from the entity safeguards the auditors ability to form an audit

opinion without being affected by influences that might compromise that

opinion. Independence enhances the auditors ability to act with integrity, to

be objective and to maintain an attitude of professional scepticism.

A18.

Professional skepticism includes being alert to, for example:

Audit evidence that contradicts other audit evidence obtained.

Information that brings into question the reliability of documents andresponses to inquiries to be used as audit evidence.

Conditions that may indicate possible fraud. Circumstances that suggest the need for audit procedures in addition to

those required by the ISAs (UK and Ireland).


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A19.

Maintaining professional skepticism throughout the audit is necessary if the

auditor is, for example, to reduce the risks of:

Overlooking unusual circumstances. Over generalizing when drawing conclusions from audit observations. Using inappropriate assumptions in determining the nature, timing, and

extent of the audit procedures and evaluating the results thereof.

A20.

Professional skepticism is necessary to the critical assessment of audit

evidence. This includes questioning contradictory audit evidence and the

reliability of documents and responses to inquiries and other information

obtained from management and those charged with governance. It also

includes consideration of the sufficiency and appropriateness of audit

evidence obtained in the light of the circumstances, for example in the case

where fraud risk factors exist and a single document, of a nature that issusceptible to fraud, is the sole supporting evidence for a material financial

statement amount.

A21.

The auditor may accept records and documents as genuine unless the auditor

has reason to believe the contrary. Nevertheless, the auditor is required to

consider the reliability of information to be used as audit evidence.48 In cases

of doubt about the reliability of information or indications of possible fraud

(for example, if conditions identified during the audit cause the auditor to

believe that a document may not be authentic or that terms in a document may

have been falsified), the ISAs (UK and Ireland) require that the auditor

investigate further and determine what modifications or additions to auditprocedures are necessary to resolve the matter.49

A22.

The auditor cannot be expected to disregard past experience of the honesty

and integrity of the entitys management and those charged with governance.

Nevertheless, a belief that management and those charged with governance

are honest and have integrity does not relieve the auditor of the need to

maintain professional skepticism or allow the auditor to be satisfied with less-

than-persuasive audit evidence when obtaining reasonable assurance.

48 ISA (UK and Ireland) 500, Audit Evidence, paragraphs 7-9.49

ISA (UK and Ireland) 240, paragraph 13; ISA (UK and Ireland) 500, paragraph 11; ISA (UK andIreland) 505, External Confirmations, paragraphs 10-11, and 16.


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A43.

Detection risk relates to the nature, timing, and extent of the auditors

procedures that are determined by the auditor to reduce audit risk to an

acceptably low level. It is therefore a function of the effectiveness of an audit

procedure and of its application by the auditor. Matters such as:

. the application of professional scepticism; and .assist to enhance the effectiveness of an audit procedure and of its application

and reduce the possibility that an auditor might select an inappropriate audit

procedure, misapply an appropriate audit procedure, or misinterpret the audit

results.

A69.

In using the objectives, the auditor is required to have regard to the

interrelationships among the ISAs (UK and Ireland). This is because, as

indicated in paragraph A53, the ISAs (UK and Ireland) deal in some cases

with general responsibilities and in others with the application of those

responsibilities to specific topics. For example, this ISA (UK and Ireland)

requires the auditor to adopt an attitude of professional skepticism; this is

necessary in all aspects of planning and performing an audit but is not

repeated as a requirement of each ISA (UK and Ireland). .

220 Quality Control for an Audit of Financial Statements

A13. Direction of the engagement team involves informing the members of theengagement team of matters such as:

Their responsibilities, including the need to comply with relevant ethicalrequirements, and to plan and perform an audit with professional

skepticism as required by ISA (UK and Ireland) 200.50

..

50ISA (UK and Ireland) 200, Overall Objectives of the Independent Auditor and the Conduct of anAudit in Accordance with International Standards on Auditing (UK and Ireland), paragraph 15.


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230 Audit Documentation

A7

In relation to requirements that apply generally throughout theaudit, there may be a number of ways in which compliance withthem may be demonstrated within the audit file:

o For example, there may be no single way in which the auditors professional skepticism is documented. But the audit

documentation may nevertheless provide evidence of the

auditors exercise of professional skepticism in accordance with

the ISAs (UK and Ireland). Such evidence may include specific

procedures performed to corroborate managements responses

to the auditors inquiries.

240 The Auditors Responsibilities Relating to Fraud in an Audit of Financial

Statements

8. When obtaining reasonable assurance, the auditor is responsible for

maintaining professional skepticism throughout the audit, considering the

potential for management override of controls and recognizing the fact that

audit procedures that are effective for detecting error may not be effective in

detecting fraud. The requirements in this ISA (UK and Ireland) are designed to

assist the auditor in identifying and assessing the risks of material

misstatement due to fraud and in designing procedures to detect such

misstatement.

12.

In accordance with ISA (UK and Ireland) 200, the auditor shall maintain

professional skepticism throughout the audit, recognizing the possibility that a

material misstatement due to fraud could exist, notwithstanding the auditors

past experience of the honesty and integrity of the entitys management and

those charged with governance. (Ref: Para. A7- A8)

13.

Unless the auditor has reason to believe the contrary, the auditor may accept

records and documents as genuine. If conditions identified during the audit

cause the auditor to believe that a document may not be authentic or that terms

in a document have been modified but not disclosed to the auditor, the auditorshall investigate further. (Ref: Para. A9)

A7.

Maintaining professional skepticism requires an ongoing questioning of

whether the information and audit evidence obtained suggests that a material

misstatement due to fraud may exist. It includes considering the reliability of

the information to be used as audit evidence and the controls over its

preparation and maintenance where relevant. Due to the characteristics of

fraud, the auditors professional skepticism is particularly important when

considering the risks of material misstatement due to fraud.


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A8.

Although the auditor cannot be expected to disregard past experience of the

honesty and integrity of the entitys management and those charged with

governance, the auditors professional skepticism is particularly important in

considering the risks of material misstatement due to fraud because there may

have been changes in circumstances.

A9.

An audit performed in accordance with ISAs (UK and Ireland) rarely involves

the authentication of documents, nor is the auditor trained as or expected to be

an expert in such authentication.51 However, when the auditor identifies

conditions that cause the auditor to believe that a document may not be

authentic or that terms in a document have been modified but not disclosed to

the auditor, possible procedures to investigate further may include:

Confirming directly with the third party. Using the work of an expert to assess the documents authenticity.

A17.

Management is often in the best position to perpetrate fraud. Accordingly,

when evaluating managements responses to inquiries with an attitude of

professional skepticism, the auditor may judge it necessary to corroborate

responses to inquiries with other information.

A33.

Determining overall responses to address the assessed risks of material

misstatement due to fraud generally includes the consideration of how the

overall conduct of the audit can reflect increased professional skepticism, for

example, through:

Increased sensitivity in the selection of the nature and extent ofdocumentation to be examined in support of material transactions.

Increased recognition of the need to corroborate managementexplanations or representations concerning material matters.

It also involves more general considerations apart from the specific

procedures otherwise planned; these considerations include the matters listed

in paragraph 29, which are discussed below.

250 A Consideration of Laws and Regulations in an Audit of Financial

Statements

8. The auditor is required by this ISA (UK and Ireland) to remain alert to the

possibility that other audit procedures applied for the purpose of forming an

opinion on financial statements may bring instances of identified or suspected

non-compliance to the auditors attention. Maintaining professional

skepticism throughout the audit, as required by ISA (UK and Ireland) 200,52

is important in this context, given the extent of laws and regulations that affect

the entity.

51 ISA (UK and Ireland) 200, paragraph A47.52 ISA (UK and Ireland) 200, paragraph 15.


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300 Planning an Audit of Financial Statements

Appendix - Considerations in Establishing the Overall Audit Strategy

Significant Factors, Preliminary Engagement Activities, and Knowledge

Gained on Other Engagements .

The manner in which the auditor emphasizes to engagement team

members the need to maintain a questioning mind and to exercise

professional skepticism in gathering and evalu

Discussion Paper Auditor Scepticism - Raising the Bar21

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Transcript of Discussion Paper Auditor Scepticism - Raising the Bar21