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Effectively applying professional skepticism to improve audit quality: learning from past audit failures.

In planning and performing an audit, including the preparation of the audit report, an auditor is required to exercise due professional care. Implicit in this responsibility is maintaining an attitude of professional skepticism. Upholding such an attitude in practice, however, can be difficult. This discussion highlights some situations identified by the PCAOB that involve auditors' failure to maintain a skeptical attitude. These situations, together with some specific strategies, can help auditors avoid similar or comparable failures.

The Meaning of Professional Skepticism

The PCAOB auditing standards define professional skepticism as an attitude that includes a questioning mind and a critical assessment of audit evidence (see interim standard AU section 230, "Due Professional Care in the Performance of Work"; AU-C section 200.A22-A26). The AICPA's auditing standards define professional skepticism as an attitude that includes a questioning mind, an alertness to conditions that might indicate possible misstatement due to fraud or error, and a critical assessment of audit evidence (see AU-C section 200, "Overall Objectives of the Independent Audit and the Conduct of an Audit in Accordance with Generally Accepted Auditing Standards"). Auditing standards require auditors to exercise professional skepticism throughout the audit, and maintaining skepticism is critical in effectively completing any assurance engagement.

As indicated by PCAOB board member Jeanette Franzel--

Deconstructing the application of professional skepticism in auditing is complex and crosses multiple disciplines, including auditing literature, theory, and practice; corporate governance; business models; human behavior; and ethics. ("Auditor Objectivity and Skepticism--What's Next?," Aug. 5, 2013, speech at American Accounting Association Annual Meeting in Anaheim, Calif.)

Impact of Auditor Independence, Technical Proficiency, and Judgment

Auditors should exercise professional judgment and maintain professional skepticism in planning and performing an audit, recognizing that circumstances might exist that would cause the financial statements to be materially misstated (AU-C 200). Under AU section 150, "Generally Accepted Auditing Standards," auditors are required to have adequate technical proficiency in audits, be independent, and exercise due care in audits.

Before accepting an audit engagement, auditors should ensure that the professionals assigned to the engagement are (individually and collectively) technically proficient. Auditors must be able to adapt to the ever-changing environments of regulation, the economy, and technology by updating their skills on a continuous basis. Independence and technical proficiency should enable an auditor to exercise due professional care, which requires applying sound professional judgment to accomplish the audit objectives. AU-C section 200.14 defines professional judgment as "the application of relevant training, knowledge, and experience, within the context provided by auditing, accounting, and ethical standards, in making informed decisions about the courses of action that are appropriate in the circumstances of the audit engagement." To make informed decisions, an auditor should identify viable alternative courses of actions for evaluation in an unbiased manner; this requires applying sound professional judgment with a skeptical mindset.

According to International Auditing and Assurance Board (IAASB) Chairman Arnold Schilder, adopting and applying a skeptical mindset is ultimately a personal and professional responsibility that every auditor should embrace; it is an integral part of an auditor's skill set and is closely interrelated to the fundamental concepts of auditor independence and professional judgment, which contribute to audit quality (Professional Skepticism in an Audit of Financial Statements," http://www.ifac .org/sites/default/files/publications/files/ IAASB%20Professional%20Skepticism %20QandA-fmal.pdf). Auditor independence, technical proficiency, and professional judgment collectively enable an auditor to maintain a skeptical mindset in planning and executing an audit (see Exhibit 1).

In order to maintain professional skepticism, auditors should keep in mind the following strategies:

* Remain alert to conditions that might indicate the possibility of risk of material misstatement, circumstances that might cause the financial statements to be materially misstated, conditions indicating that "top management" might not recognize the need for control or might not be acting in good faith, and audit evidence that contradicts other evidence.

* Have a critical and questioning mind, and do not be satisfied with anything less than persuasive evidence.

* Neither assume that management is dishonest nor assume management's unquestioned honesty.

* Determine that proper assumptions have been used for estimates.

* Recognize the effects of pressures on management and remain aware of management bias.

* Recognize the existence of possible fraud conditions and appropriately follow up.

* Develop appropriate procedures that are responsive to assessed risk of material misstatements.

* Do not accept information or evidence without verification; in obtaining information and evidence exhibit systematic doubt, and clear that doubt by varying the nature, timing, and extent of testing in order to obtain more persuasive (e.g., including third-party) evidence.

* Recognize and effectively respond to increased risk of material misstatement arising out of economic crisis (e.g., fair value measurements, impairment of goodwill, indefinite-lived intangible assets, allowance for loan losses).

Technical proficiency. The findings of the PCAOB's recent inspection reports support the impact of auditor independence and proficiency on an auditor's ability to exercise due care and maintain a skeptical attitude (Release 2013-006, "Second Report on the Progress of the Interim Inspection Program Related to Audits of Brokers and Dealers," Aug. 19, 2013; Release 2013-001, "Report on 2007-2010 Inspections of Domestic Firms That Audit 100 or Fewer Pubic Companies," Feb. 25, 2013).

Technical proficiency is required to effectively plan and execute an audit. In some situations, audit firms accept clients without a careful and serious consideration of whether the firm possesses the necessary technical knowledge to perform the audit. For example, the PCAOB noted in its inspections situations where minimum levels of training on GAAP, PCAOB standards, or SEC reporting requirements had not been established for the foreign-affiliate personnel participating in audits of the foreign operations of U.S. issuers, thus affecting audit quality (Release 2008-008, "Report on the PCAOB 2004, 2005, 2006, and 2007 Inspections of Domestic Annually Inspected Firms," Dec. 5, 2008). Furthermore, heavy partner and professional staff workloads could result in professional skepticism not being sufficiently maintained.

Auditor independence. A lack of independence could also adversely influence an auditor's ability to remain skeptical while gathering and evaluating audit evidence. The PCAOB observed that auditors did not meet the independence requirement in some audits because they provided bookkeeping or other services related to the accounting records or financial statements of the broker/dealers, and some firms prepared a company's trial balances. Providing nonaudit services to audit clients might adversely affect the auditor's objectivity, in addition to violating the independence requirement. Some examples of a lack of independence and technical proficiency that affect audit quality include the auditor 1) accepting evidence that is not persuasive because of a belief that management is honest; 2) accepting client-prepared analyses without corroboration, including when there was known contradictory audit evidence; and 3) not adequately examining the completeness and accuracy of source documents and not documenting the completed audit work.

Professional judgment In planning and executing an audit of financial statements, applying sound professional judgment influences the following matters:

* Determining whether sufficient resources are available to effectively complete the audit and assessing engagement risk before accepting an engagement

* Assigning professionals with appropriate technical competence to the engagement

* Keeping abreast of recent changes in regulations [e.g., GAAP, AICPA, and PCAOB auditing standards]

* Considering all external (e.g., economic, environmental, regulatory) and internal (e.g., governance, internal controls, financing, investing, and operating) factors, staffing, and the timing of applying procedures during engagement planning

* Establishing planning materiality and performance (tolerable) materiality

* Assessing fraud risk and going concern-related matters

* Assessing the risk of material misstatements (combined inherent and control risk) in order to develop responsive audit procedures in light of performance/tolerable materiality

* Gathering sufficient appropriate (e.g., third-party) evidence in accordance with auditing standards

* Evaluating (quantitative and qualitative) misstatements individually and in the aggregate in order to obtain a reasonable degree of assurance that the financial statements are free of material misstatements in accordance with GAAP.

An auditor should have a skeptical mindset in order to recognize whether material (quantitative and qualitative) misstatements exist at various (transactions, account balances, and disclosures) assertion levels. Applying the concept of materiality is as elusive as practicing the concept of professional skepticism. For example, a small quantitative misstatement that changes a loss into a profit might make the financial statements misleading. After recognizing the existence of such situations, the auditor should continue to have a skeptical mindset in developing and performing appropriate procedures to seek sufficient appropriate evidence to prevent a potential audit failure.

Examples of Situations Where Auditors Failed to Apply Skepticism

Although auditors have an obligation to maintain an attitude of professional skepticism, the PCAOB has reported in its inspection reports situations where auditors did not maintain such an attitude. Several PCAOB Settled Disciplinary Orders (SDO) summarized an auditor's responsibilities as follows:

An auditor may express an unqualified opinion on an issuer's financial statements only when the auditor has formed such an opinion on the basis of an audit performed in accordance with PCAOB standards. Among other things, those standards require that an auditor exercise due professional care, exercise professional skepticism, and obtain sufficient competent evidence to afford a reasonable basis for an opinion regarding the financial statements.

The authors examined PCAOB inspection reports and SDOs, and identified examples of audit deficiencies resulting from the auditor's failure to maintain healthy skepticism when planning and executing audits (also see Staff Audit Practice Alert 10, "Maintaining and Applying Professional Skepticism in Audits," Dec. 4, 2012). These examples of deficiencies are included in Exhibit 2, indicating the PCAOB auditing standards (AS) and PCAOB interim standards (AU), as well as comparable AU-C sections of auditing standards issued by the AICPA for the audits of nonpublic companies.

A Suggested Approach for Applying Skepticism

The examples included in Exhibit 2 should enable auditors to recognize similar or comparable situations and encourage them to take steps to maintain a skeptical mindset. In order to further ensure that a skeptical attitude is maintained while effectively planning and executing an audit, audit programs and procedures covering a specific audit engagement should be developed by identifying the standards and regulations (e.g., related to auditing and accounting) that are relevant for the engagement. Audit procedures should be prepared in sufficient detail for the following:

* Special considerations (e.g., communicating with the predecessor auditor and opening balances) if the engagement is an initial audit

* Audit planning, properly staffing and supervising, and establishing materiality

* Assessing the types of misstatements (due to errors, fraud, illegal acts--particularly those that affect the financial statements directly) that might occur

* Understanding the client's business, including internal controls

* Determining whether accounting standards (e.g., revenue recognition) have been properly applied

* Assessing the risk of material misstatements for specific assertions at relevant transaction classes, account balances, and disclosures levels

* Addressing the assessed risk for relevant assertions

* Identifying and projecting misstatements individually and in the aggregate for evaluation

* Determining whether uncorrected and undetected (quantitative and qualitative) misstatements, individually or in the aggregate, would result in material misstatements

* Closing the audit, including subsequent events

* Reviewing completed procedures, related audit work, and documentation, and ensuring that all audit procedures and programs are completed

* Conducting an overall review at every level to ensure that quality controls and other regulatory requirements are met before communicating the audit conclusion

* Verifying representations made by management relating to recorded and reported amounts.

Audit procedures should be extended or varied when--

* evidence obtained from one source is not consistent with information obtained from other sources,

* a pattern of misstatements or inconsistencies is indicated,

* significant accounting estimates are involved,

* management estimates appear unreasonable,

* material adjustments around the yearend are recorded,

* there are transactions with related parties,

* specialists are used, or

* new accounting standards or regulations are adopted or implemented.

Any significant changes in the economy; the industry in which a company operates; and an entity's financing, investing, and operating activities should be monitored, as well as their effects on the assertions embodied in the financial statements.

Remaining Aware of Independence Issues

Auditors should be reminded about the importance of maintaining a skeptical attitude during audits. This could be accomplished by 1) ensuring that auditors assigned to the engagement are technically proficient; 2) incorporating into audit programs adequate steps to ensure that audit procedures are applied with a questioning mind; and 3) conducting reviews of audit work and documentation at every level to ensure that due audit care, including a skeptical attitude, was maintained in gathering and evaluating sufficient appropriate audit evidence in support of an audit opinion.

Richard Coppage, CPA, CMA, is a professor of accountancy, and Trimbak Shastri, CA, CMA, CIA, is an associate professor of accountancy, both at the University of Louisville, Louisville, Ky.


Examples of Situations Where an Auditor Failed to Maintain a
Skeptical Attitude

                                          How the Auditor Failed to
PCAOB Standards      Topic                Apply Skepticism

AS 5                 Audit of internal    * The auditor did not
                     control over         utilize an audit program,
                     financial            did not perform procedures
                     reporting            adequate to make a
                                          reasonable basis for the
                                          firm's internal control
                                          over financial reporting
                                          report, and did not obtain
                                          competent evidence that was
                                          sufficient to obtain
                                          reasonable assurance about
                                          whether material weaknesses

AS 9/AU section      Audit planning       * The auditor failed to
311 (AU-C section                         plan or carry out
300)                                      essentially any audit
                                          procedures relating to the
                                          client's discontinued

AS 10                Supervision          * Staff members with
(AU-C section 220)                        limited experience
                                          performed almost all of the
                                          audit work, and the
                                          engagement partner failed
                                          to review much of that

AS 11/AU section     Consideration of     * The auditor failed to
312 (AU-C sections   materiality in an    design procedures relating
320 and 450)         audit                to intangible asset account
                                          balance to obtain
                                          reasonable assurance of
                                          detecting misstatements
                                          that the auditor believed
                                          (based on judgment about
                                          materiality) could be

AS 15/AU section     Audit evidence       * The auditor determined
326 (AU-C section                         that accounts receivable
500)                                      was a significant audit
                                          area that presented the
                                          risk of material
                                          misstatement due to fraud,
                                          but failed to perform the
                                          necessary audit procedures
                                          to obtain evidence.

                                          * The auditor failed to
                                          perform any audit
                                          procedures covering
                                          reported revenue and failed
                                          to obtain
                                          evidence covering a
                                          contract receivable'
                                          representing about 60% of
                                          total assets.

AU section 316       Consideration of     * Despite the audit
(AU-C section 240)   fraud in a           committee's concern that
                     financial            the allowance for doubtful
                     statement audit      accounts presented a fraud
                                          risk, the auditor did not
                                          perform adequate procedures
                                          to examine whether the
                                          provision for bad debts (at
                                          a lower amount) was
                                          influenced by management

                                          * A last-minute adjustment
                                          to offset a substantial
                                          write-off should have
                                          alerted the auditor to
                                          revise the risk of material
                                          misstatement due to fraud
                                          and to extend audit
                                          procedures, but the auditor
                                          failed to recognize or
                                          examine the situation.

AU section 328       Auditing fair        * The auditor initially
(AU-C section 501)   value measurements   determined that goodwill
                     and disclosures      should be impaired by 50%.
                                          Without any apparent basis
                                          or audit evidence, the
                                          auditor compromised with
                                          management that goodwill
                                          should be impaired by only

                                          * The auditor failed to
                                          consider decline in fair
                                          value of equity securities
                                          held for sale; the decline
                                          was not temporary.

AU section 333       Management's         * In some instances, the
(AU-C section 580)   representations      auditors did not
                                          sufficiently test or
                                          challenge management's
                                          forecasts, views, or
                                          representations that
                                          constituted critical
                                          support for amounts
                                          recorded in the financial

                                          * The auditor failed to
                                          review and reconcile
                                          disclosures in the
                                          financial state- ments with
                                          the contradictory
                                          information per
                                          confirmations relating to
                                          promissory note obligations
                                          included in workpapers.

AU section 334       Related parties      * Although the financial
(AU-C section 550)                        statements reported a
                                          related-party payable
                                          (about 40% of total
                                          liabilities), the auditor
                                          failed to perform adequate
                                          procedures to obtain
                                          sufficient appropriate

AU section 336       Using the work of    * When there is a material
(AU-C section 620)   a specialist         difference between the
                                          specialist's findings and
                                          the assertions in the
                                          financial statements, the
                                          auditor should extend audit
                                          procedures to resolve the
                                          difference; however, the
                                          auditor failed to perform
                                          additional procedures.
                                          (Continued on page 28)

AU section 342       Auditing             * Although the risk related
(AU-C section 540)   accounting           to estimates for sales
                     estimates            returns was assessed as
                                          relatively high, the audit
                                          personnel either failed to
                                          perform certain of the
                                          planned procedures or
                                          performed them without
                                          adequately evaluating the
                                          reasonableness of

AU section 410       Adherence to GAAP    * When products were
(AU-C section 700)                        returned due to expiration,
                                          the auditor accepted the
                                          analogy to warranty
                                          accounting without
                                          adequately considering
                                          whether such a rationale
                                          was appropriate. As a
                                          result, the auditor
                                          inappropriately allowed the
                                          client to make a provision
                                          for most of estimated
                                          returns at replacement
                                          cost, rather than at gross
                                          sales price, in violation
                                          of GAAP, which resulted in
                                          a material understatement
                                          of sales returns reserve.

AU section 560       Subsequent events    * The audit plan provided
(AU-C section 560)                        for the evaluation of
                                          subsequent events before
                                          the audit report was
                                          issued; however, the audit
                                          personnel failed to perform
                                          procedures through the
                                          completion of the audit.
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Title Annotation:Accounting & Auditing: auditing
Author:Coppage, Richard; Shastri, Trimbak
Publication:The CPA Journal
Date:Aug 1, 2014
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