By Alex Malley
The English Court of Appeal once stated that the auditor “is a watchdog, but not a bloodhound.” Since that famous judgment by Lord Justice Lopes in favour of the auditor in the Kingston Cotton Mills case 120 years ago expectations of auditors have evolved significantly.
Being a ‘watchdog’ may no longer be enough. It is now generally accepted that to be an effective auditor, you need to be able to exhibit a healthy dose of ‘professional scepticism.’ In fact, regulators and standard setters have been calling for an increased level of professional scepticism from auditors to improve audit quality.
Auditing standards describe professional scepticism as “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.”
Defining a concept is always fraught but it is reasonable to question the broad spectrum of behaviours that could fit within this definition.
A questioning mind could range from the “watchdog” approach: posing the question but accepting reasonable answers at face value; to the “bloodhound” approach: pursuing every avenue of enquiry exhaustively.
If professional scepticism is to be a useful characteristic of auditors, the lack of clarity as to what scepticism is, how it interacts with the ethical principles of the profession and why it is necessary needs to be addressed.
The International Auditing and Assurance Standards Board (IAASB) has been concerned about professional scepticism, fuelled by regulators querying whether auditors too readily accept management’s position.
The IAASB recently invited comment on audit quality and asked how professional scepticism could be enhanced. This was a positive step and now the IAASB is working with other standard setters on joint initiatives to address stakeholder feedback.
Our organisation suggested numerous avenues for improvement including the need for the audit team to have the competence and industry knowledge required for it to have an effective understanding of the client, and the confidence to challenge the client appropriately.
Recent synthesis research on professional scepticism commissioned by CPA Australia identifies that professional scepticism can be heightened by increased distrust in management representations and sources of evidence. Identifying deficiencies in a company’s governance, management oversight, ethical culture or controls in place to prevent or detect fraud or error may well be triggers for further inquiry.
The research suggests that the most productive means of increasing auditors’ distrust is to provide perceived rewards or positive consequences for the auditor in displaying professional scepticism. This could be encouraged within the audit team through inclusion of professional scepticism in performance reviews, positive mentoring, encouragement of questioning, challenging the evidence and escalating concerns.
Conversely, if rewards for the audit team are weighted too heavily towards managing the budget or meeting a deadline, it can discourage the auditor from applying an appropriate level of professional scepticism, as this may necessitate further enquiries and gathering further evidence.
Encouraging and training future audit professionals to challenge and question while they are at university is an important component of instilling a culture of professional scepticism. Auditors would also benefit from insights from liquidators after they have examined a corporate collapse and forensic accountants once they have identified how a fraud has been perpetrated. There is certainly scope to better systemise usage of these experiences to heighten professional scepticism.
Current audit practice involves selective testing based on a risk assessment and application of materiality. As a consequence, regardless of the auditor’s professional scepticism, material misstatements or fraud can still be missed.
If a company fails without any warning signs, the spotlight often turns on the auditor, with questions posed about what the auditor was doing and why they didn’t identify the underlying problem. Moves for enhancing documentation requirements to demonstrate professional scepticism need to be assessed carefully. Specifying in too much detail what should be documented risks a negative effect on audit quality by promoting a ‘tick box’ or compliance mentality at the expense of the exercise of effective professional judgement.
The answer may not only lie in whether an appropriate level of professional scepticism was exercised and the audit quality was sufficient, but whether the scope of the audit meets users’ needs.
Maybe we need to be asking if auditors should shift focus from historical information to forward-looking information, such as the appropriateness of the business model or on how operational and business risks facing the company are managed.
All things considered, Lord Justice Lopes in that historic judgement from 1896 was firmly of the view that “Auditors must not be made liable for not tracking out ingenious and carefully laid schemes of fraud, when there is nothing to arouse their suspicion.”
While this view may still resonate to some extent today, expectations of auditors have certainly shifted. Advances in technology, the evolution of online trading and the 24-hour news cycle are all realities of the growing complexity of the capital markets in which auditors operate. Bringing a questioning mind to an audit has never been more critical. And with ongoing efforts to improve audit quality – from the profession and regulators – we’re making strides in informing the evolving needs of investors and building confidence in the capital markets.
Alex Malley is chief executive of CPA Australia