In recent years regulatory bodies including the International Auditing and Assurance Standards Board (IAASB) and the UK Financial Reporting Council (FRC) have issued documents highlighting the importance of professional scepticism in an audit of financial statements. The objective of this article is to explain the importance of professional scepticism as an essential part of the auditor’s mindset, and to consider the reasons why approaching an audit with an attitude of professional scepticism is becoming increasingly important.
WHAT IS PROFESSIONAL SCEPTICISM?
The glossary of terms contained in the IAASB’s Handbook of International Quality Control, Auditing, Review, Other Assurance, and Related Services Pronouncementscontains the following definition of the term ‘professional scepticism’:
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 evidence.
ISA 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International Standards on Auditing, contains more guidance on how and why the auditor should act with an attitude of professional scepticism. ISA 200 contains a specific requirement in relation to professional scepticism:
The auditor shall plan and perform an audit with professional scepticism recognising that circumstances may exist that cause the financial statements to be materially misstated.
This overall objective is the fundamental driver for the relevant learning outcomes within the Paper P7 syllabus, namely:
- To discuss the importance of professional scepticism in planning and performing an audit (B1e), and
- To assess whether an engagement has been planned and performed with an attitude of professional scepticism, and evaluate the implications (B1f).
The application paragraphs of ISA 200 contain more guidance on what is meant by applying professional scepticism when conducting an audit:
Professional scepticism includes being alert to, for example:
- Audit evidence that contradicts other audit evidence obtained.
- Information that brings into question the reliability of documents and responses 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. (ISA 200 A.18).
Essentially, ISA 200 requires the use of professional scepticism as a means of enhancing the auditor’s ability to identify risks of material misstatement and to respond to the risks identified. Professional scepticism is closely related to fundamental ethical considerations of auditor objectivity and independence. Professional scepticism is also linked to the application of professional judgment by the auditor. An audit performed without an attitude of professional scepticism is not likely to be a high quality audit. At its core the application of professional scepticism should help to ensure that the auditor does not neglect unusual circumstances, oversimplify the results from audit procedures or adopt inappropriate assumptions when determining the audit response required to address identified risks, all of which should improve audit quality.
HOW DOES THE AUDITOR APPLY PROFESSIONAL SCEPTICISM?
The auditor is likely to apply professional scepticism at various stages from client acceptance and at various points during the audit process, and some typical examples are given below:
- When assessing engagement acceptance – at this stage the auditor should consider whether the management of the intended audit client acts with integrity and whether there are any matters that may impact on the auditor being able to act with professional scepticism if they accept the engagement, such as ethical threats to objectivity.
- When performing risk assessment procedures – an auditor should be sceptical when performing risk assessment procedures at the planning stage of the audit. For example, when discussing the results of analytical procedures with management, the auditor should not accept management’s explanations at face value, and should obtain corroboratory evidence for the explanations offered.
- When obtaining audit evidence – the auditor should be ready to challenge management, especially on complex and subjective matters and matters that have required a degree of judgement to be exercised by management. The reliability and sufficiency of evidence should be considered, especially where there are risks of fraud. There may also be specific issues arising during an audit which impacts on professional scepticism – for example, if management refuses the auditor’s request to obtain evidence from a third party. The auditor will have to consider how much trust can be placed on evidence obtained from management – for example, evidence in the form of enquiry with management or written representations obtained from management. ISA 200 states that ‘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 scepticism or allow the auditor to be satisfied with less than persuasive audit evidence when obtaining reasonable assurance’.
- When evaluating evidence – the auditor should critically assess audit evidence and be alert for contradictory evidence that may undermine the sufficiency and appropriateness of evidence obtained.
The auditor should also apply professional scepticism when forming the auditor’s opinion, by considering the overall sufficiency of evidence to support the audit opinion, and by evaluating whether the financial statements overall are a fair presentation of underlying transactions and events.
Ultimately, the application of professional scepticism should reduce detection risk because it enhances the effectiveness of applied audit procedures and reduces the possibility that the auditor will reach an inappropriate conclusion when evaluating the results of audit procedures.
SPECIFIC APPLICATIONS OF PROFESSIONAL SCEPTICISM
ISA 240, The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements, specifically refers to professional scepticism stating that ‘when obtaining reasonable assurance, the auditor is responsible for maintaining professional scepticism throughout the audit, considering the potential for management override of controls and recognising the fact that audit procedures that are effective for detecting error may not be effective in detecting fraud’ (ISA 240.8).
ISA 240 goes on to state a specific requirement for the auditor: ‘The auditor shall maintain professional scepticism throughout the audit, recognising the possibility that a material misstatement due to fraud could exist, notwithstanding the auditor’s past experience of the honesty and integrity of the entity’s management and those charged with governance’ (ISA240.12).
The application paragraphs of ISA 240 emphasise the importance of assessing the reliability of the information to be used as audit evidence and the controls over its preparation and maintenance. In addition, ISA 240 states that ‘management is often in the best position to perpetrate fraud. Accordingly, when evaluating management’s responses to inquiries with an attitude of professional scepticism, the auditor may judge it necessary to corroborate responses to inquiries with other information’ (ISA 240.A17). This is significant in that ISA 240 reminds the auditor that when management provides the auditor with audit evidence – be that in the form of answers to enquiries, written representations or other forms of documentary evidence – the auditor should carefully consider the integrity of that evidence and whether additional corroboratory evidence should be obtained from a more reliable source.
Other aspects of an audit where professional scepticism may be important
The IAASB has issued a Staff Questions and Answers document entitled Professional Scepticism in an Audit of Financial Statements, which outlines some of the areas of the audit where the use of professional scepticism may be important. These are outlined below and largely relate to areas of the audit that are complex, subjective or highly judgmental.
- Accounting estimates – this can include fair value accounting estimates, the use of significant assumptions by management in developing accounting estimates, and reviewing the judgements and decisions used by management for management bias in developing accounting estimates.
- Going concern – the auditor should review management’s assessment of going concern and whether management’s plans are feasible, this being particularly important where there is a significant doubt over the entity’s ability to continue as a going concern.
- Related party relationships and disclosures – it can be difficult to obtain information on related parties, as knowledge may be confined to management meaning that the auditor may have to rely on management to identify all related parties The auditor should also be sceptical when assessing the business rationale behind related party transactions.
- Consideration of laws and regulations – the auditor should be alert throughout the audit for indications that there may have been a suspected non-compliance with laws and regulations.
THE INCREASING IMPORTANCE OF PROFESSIONAL SCEPTICISM
The IAASB Staff Questions and Answers document contains a foreword by Arnold Schilder, IAASB chairman, which emphasises the increasing need for auditors to apply professional scepticism. One reason for this is the increased use of judgment and subjectivity in management’s financial reporting decisions. This is due to the application of International Financial Reporting Standards (IFRS), which are largely principle-based, and often require the preparers of financial statements to exercise significant judgment when making decisions on accounting treatments.
The global financial crisis of 2008–2009 also focused attention on professional scepticism. Auditors in many jurisdictions were criticised for not applying sufficient professional scepticism at that time, particularly in relation to the audit of fair values, related party transactions and going concern assessments. One of the reasons for the IAASB issuing the Staff Questions and Answers document was to re-emphasise the importance of professional scepticism especially in the audit of financial statements where there is a high risk of material misstatement due to financial distress.
The UK’s Financial Reporting Council (FRC) has issued a Briefing Paper on professional scepticism which suggests that professional scepticism is the cornerstone of audit quality. It proposes that the auditor should actively look for risks of material misstatement, and that this is only possible when a high degree of knowledge of the audited entity’s business and the environment in which it operates is obtained. The document contains proposals for how audit firms can encourage audit teams to approach audits with a sceptical mindset, and it considers that some audit firms may need to change their culture to allow this to happen.
The IAASB’s Work Plan for 2015–16, Enhancing Audit Quality and Preparing for the Future – issued in December 2014 – prioritises the issues that impact on audit quality, including group audits, quality control, and professional scepticism. It is clear the professional scepticism is to stay on the agenda of the regulatory authorities for some time to come, as it is so intrinsically linked to other key audit issues such as audit quality, ethics and independence and, ultimately, the confidence that the public has in the auditing profession.
The IAASB states that ‘the need for professional scepticism cannot be overemphasised’ and that ‘adopting and applying a sceptical mindset is ultimately a personal and professional responsibility to be embraced by every auditor’. Given the increasingly complex and subjective nature of IFRS requirements, auditors must be confident to challenge management on a range of matters relevant to the preparation of the financial statements and the IAASB and national bodies such as the FRC are keen to support auditors in the application of professional scepticism. This, they believe, is an essential element of quality control, and in safeguarding the credibility of the audit opinion.
Written by a member of the Paper P7 examining team