Enhancing Auditor Professional Skepticism: The Professional Skepticism Continuum

A 2014 academic research paper published by the American Accounting Association notes that “Due to past high-profile audit failures, reported audit deficiencies in regulator inspection reports, and the growing number and size of complex estimates in the financial statements, there is a growing need for reliability and trust in financial reports and a corresponding increased demand for enhanced audit quality. Enhancing the level of professional skepticism applied in practice is one important means of improving audit quality, but there is a lack of practical guidance around the appropriate application and documentation of professional skepticism in the professional literature.”

The following graphic offers a proposed skepticism continuum. Such a continuum enables the auditor to take the perspective that is most appropriate considering the circumstances applicable to each audit area and assertion. Applying a continuum to a specific account and assertion takes place after a careful and rigorous initial risk assessment, and a continued re-evaluation of the risk throughout the audit to ensure that appropriate skepticism is applied to the collection and evaluation of audit evidence.

According to the paper, “A shared understanding would allow audit professionals to identify, communicate, and exercise a level of professional skepticism appropriate for the risks involved, and would enable regulators to fairly evaluate, after the fact, the level of skepticism applied. The skepticism continuum we propose represents a potential step forward in understanding the nature of professional skepticism and in applying it appropriately under varying circumstances.”

The paper concludes that, “In order to make the necessary changes, the profession, academics, regulators, and standard setters should work together to better understand the nature of professional skepticism, including how skepticism is threatened at various structural levels, current measures in place to mitigate those threats and, then, finally, how skepticism can be enhanced at the various structural levels. Our hope is that this paper will provide a conceptual foundation to facilitate a productive ongoing dialogue that will lead to specific actions to enhance auditor professional skepticism and, ultimately, audit quality.”

To learn more, read the full paper by Steven M. Glover and Douglas F. Prawitt, both Professors at Brigham Young University, “Enhancing Auditor Professional Skepticism: The Professional Skepticism Continuum” in Current Issues in Auditing: December 2014, Vol. 8, No. 2, pp. P1-P10.

Mandatory audit rotation seen as a threat to skepticism

An Accountancy Age magazine article published July 2015 notes that forcing companies to change their auditors may put professional skepticism in jeopardy. That’s the conclusion of a number of US academics, who published their thoughts in the American Accounting Association’s journal The Accounting Review.

According to the study, Effects of Auditor Rotation, Professional Skepticism, and Interactions with Managers on Audit Quality, instead of elevating auditor skepticism of clients and raising audit quality, the intended “benefit disappears and even reverses when auditors rotate. Rotation and a skeptical mindset interact to the detriment of audit effort and financial reporting quality.”

Report authors, Kendall Bowlin of the University of Mississippi, Jessen Hobson of the University of Illinois at Urbana-Champaign, and David Piercey of the University of Massachusetts Amherst, said: “Rotating auditors, aware that they will not be in a long-term relationship, will... likely perceive themselves to be less competent in evaluating the honesty or dishonesty of the [corporate] manager relative to auditors who do not rotate.”

As a result, “rotating auditors would find it difficult to garner psychological support for the probability of manager dishonesty, leading them to be less likely to choose high levels of audit effort than non-rotating auditors.”

The Role of Auditors’ Emotions and Moods on Audit Judgment

CPA Vision 2011 and Beyond: Focus on the Horizon, published by the American Institute of Certified Public Accountants (AICPA), states that emotional skills are extremely important and interpersonal skills are crucial for success as professional accountants. During the audit process, auditors may experience emotional reactions, such as liking or disliking toward client personnel, or anxiety about components of tasks. Auditors also may also experience different moods while conducting audits. Research reveals that an important consequence of auditors experiencing emotions and moods is that these reactions can influence their decision making and audit judgments.

A recently-published research article summarizes the results and practice implications associated with several studies in a stream of research that has examined the role of emotions and moods in auditing. Research illustrates that auditors can experience emotional reactions toward a client (e.g., likability) or an element of a task environment (e.g., anxiety from dealing with certain types of people or about being held accountable) or general moods unrelated to the judgment context (e.g., bad mood related to the weather), which can result in judgment errors.

The research summarized in this paper reveals the potential for auditors’ judgments to be susceptible to emotional reactions toward client personnel and components of a task, as well as general negative and positive moods. Given the fact that auditors’ emotional reactions and moods are pervasive in the audit environment, such effects appear to be somewhat inevitable. There is a potential for these effects to have significant negative consequences. Therefore, a critical first step is to make auditors aware of the potential for emotions and moods to inadvertently impact their judgments, and how the reactions could impact audit effectiveness and efficiency.

For more information, read the 17-page research paper “The Role of Auditors’ Emotions and Moods on Audit Judgment: A Research Summary with Suggested Practice Implications” by Sudip Bhattacharjee (Virginia Tech) and Kimberly K. Moreno (Northeastern University). A manuscript has been accepted for publication in an American Accounting Association (AAA) journal. This preliminary version of the manuscript was posted in the interest of making the information available for distribution and citation as quickly as possible following acceptance.

Elevating Professional Judgment in Auditing and Accounting: The KPMG Professional Judgment Framework

 

The KPMG University Connection website states: “With the move toward a more principles-based financial reporting framework and increased emphasis on fair value measurement, the ability to consistently make high quality professional judgments is increasingly important. KPMG has produced a monograph intended for use as a supplement in college-level auditing and accounting courses to help students understand the components of and threats to good professional judgment.”

“Elevating Professional Judgment in Auditing and Accounting: The KPMG Professional Judgment Framework will help students understand what professional judgment is and how to develop and practice it. This Framework and training are intended to elevate judgment quality and professional skepticism, and to provide a common vocabulary that facilitates implementation and mentoring on professional judgment.”

It is noteworthy that the KPMG Framework monograph is the recipient of the 2013 AAA/Deloitte Wildman Medal Award. The Wildman award, first presented in 1979, recognizes a work published within the most recent five years that the judges view as the most significant contribution to the advancement of the practice of public accountancy including audit, tax and management services.

To learn more about the KPMG Framework monograph, refer to the three-part article titled “Can you really teach good judgment?” (Part 1, Part 2 and Part 3). In addition, read the related article on “Enhancing Board Oversight by Challenging Traps and Biases in Professional Judgment” (Part 1, Part 2 and Part 3).

Do Auditing Standards Matter?

Understanding the economic role of auditing standards is essential for improving audit effectiveness and efficiency. In fact, auditing standards are most important when an auditor may have an incentive to under-audit. However, the conditions under which standards may, or may not, have a desirable effect on audit quality are less obvious.

 

A recently-completed research paper discusses what standards can do: (1) compensate for the lack of observability of the audit outcome by focusing on the audit process; (2) partially mitigate the information advantage possessed by the auditor as a professional expert that might motivate the auditor to under-audit; (3) counterbalance the diversity of demand across multiple stakeholders that might drive the audit to the lowest common denominator and create a market based on adverse selection; and (4) provide a benchmark that facilitates the calibration of an auditor’s legal liability in the event of a substandard audit.

 

The paper also presents a number of observations about what standards should not do: (1) discourage the use of judgment by auditors; (2) limit the potential demand for economically valuable alternative levels of assurance; (3) lead to excessive procedural routine or standardization in the conduct of the audit; and (4) be based on an enforcement agenda. In the end, standards overreach may undermine the economic value of the audit to many stakeholders and lead to fee pressure for audit firms.

 

Hopefully, these insights can inform future debates about the level and types of standards that are appropriate for the auditing profession. For more information, read the article “Do Auditing Standards Matter?” by W. Robert Knechel, PhD, University of Florida. This manuscript has been accepted for publication in an American Accounting Association (AAA) journal. The author has posted this preliminary version of the manuscript in the interest of making the information available for distribution and citation on a timely basis.

Ethics of Relationships between Accounting Academics and External Sponsors

They challenge and shape the accounting world, and support the standard-setters and regulators. For leading academic accountants, research informs not only accounting and the financial world in general, but also their work with aspiring accountants. The very best in academe are those scholars who challenge their students as well as established thought while shaping novel and inventive ways of looking at the accounting world. The need for rigorous research to support the decisions that have to be made by standard-setters and regulators is only going to increase (see the article “Inquiring minds” by Robert Colapinto in the April 2013 edition of CAmagazine online).

 A variety of relationships can develop between accounting academics and external sponsors that raise issues of ethical propriety. External donors may seek to influence academic decisions by applying pressure on recipients to gain favored treatment. These types of situations are on the rise because of increased commercialization of universities. A recently-completed study examined relationships between accounting academics and external sponsors that challenge academic independence because of conflicts of interest when donors seek to impose conditions on financial support.

 

The authors solicit the opinions of academic accountants about how likely they are to go along with the conditions. They link these activities to the following ethical issues: fair-mindedness, objectivity and integrity. They conclude that the more experienced accounting academics (i.e., full professors, current chairs, holders of endowed chairs and designated faculty fellows) are less likely to engage in ethically questionable relationships with external sponsors than academics who are less experienced.

 

The results are driven primarily by two cases: allowing a Big Four CPA firm to interview students before other firms as a condition of continued recruiting and allowing a firm to decide on the recipient of a named faculty fellowship. Read more in the forthcoming research article “Ethics of Relationships between Accounting Academics and External Sponsors,” by Steven M. Mintz, Li Dang and Arline Savage in Issues in Accounting Education (2013) published by the American Accounting Association.

Pathways Commission Report (July 2012)

The Pathways Commission Report (July 2012) summarizes two years of collective effort by over 50 individuals representing stakeholders in a broadly defined accounting profession – encompassing public and corporate accounting, education, and government. The impetus for this project came from the US Department of the Treasury’s Advisory Committee on the Auditing Profession (ACAP) report recommending that the American Accounting Association (AAA) and American Institute of Certified Public Accountants (AICPA) study the possible future structure of higher education for the accounting profession.

With a mission to consider accounting education and the accounting profession in the broadest sense, the Commission’s recommendations are expansive in scope; they demonstrate the need to address difficult and persistent issues and impediments so that the discipline and profession of accounting can better meet the challenges and opportunities of the future.

The Future Outlook section of the Report (on page 133) concludes that “As accounting and business evolve, the required knowledge and skills will also change. Adoption of more principle-based standards will require more judgment. More judgment may lead to a wider variability in decisions and, possibly, increase the risk of litigation. At the same time, pressures to conform to economic forces may increase. Measurement issues and fair value calculations may enhance financial reporting, but they are also more subject to manipulation. Therefore, responsible judgment becomes even more important as does ethical behavior consistent with the accounting profession’s responsibilities.”

For more information, visit the Pathways Commission Homepage on the website of the American Accounting Association and read the highlights in the Indiana CPA Society blog posting “It Won’t Be Easy, But It’s Worth Doing” dated December 13, 2012.

One View on Using Professional Judgment

The meaning of professional judgment and its application in an audit environment continue to be subjects of interest and discussion by auditing and accounting faculty, students, standard setters, regulators and auditing professionals alike. As accounting frameworks continue to call for increased judgment by preparers of financial statements, the auditor assessing those judgments will, in turn, need to apply professional judgment.  An article published in 2009 offers one “view from the profession” about the meaning and importance of professional judgment, as well as one approach that may be employed when applying professional judgment.

The phrase “professional judgment” is not new to the accounting and auditing profession. Recently, there has been an increased emphasis on the importance of professional judgment as a result of regulation, standard setting, inspections and a move toward more principles-based accounting and auditing standards. In its August 1, 2008 report, the Advisory Committee on Improvements to Financial Reporting recognized the “need for a cultural shift towards the acceptance of more judgment” and recommended that both the SEC and PCAOB issue statements of policy articulating how the reasonableness of accounting and auditing judgments is evaluated. So, while professional judgment may not be a new concept, its use is becoming increasingly more vital to the appropriate application of accounting and auditing standards.

For details, read the American Accounting Association (AAA) article “Using Professional Judgment” by Guy Moore, Senior Advisory Partner for Professional Practice, Deloitte & Touche LLP in The Auditor’s Report publication online (Volume 33, No. 1, Fall 2009). Also, refer to the August 2011 postings on SEC Views on a Framework for Professional Judgment – Part 1, Part 2 and Part 3.

Enhancing Board Oversight by Challenging Traps and Biases in Professional Judgment - Part 3 of 3

As previously mentioned (see Part 1 and Part 2), the Committee of Sponsoring Organizations of the Treadway Commission (COSO) has released a thought paper called Enhancing Board Oversight: Avoiding Judgment Traps and Biases. COSO recognizes the vital role of consistent, high-quality professional judgment as management and boards of directors execute and oversee an entity’s enterprise risk management, internal control and fraud deterrence efforts.

COSO stresses that “Professional judgment is increasingly important as board members fulfill their responsibilities related to effective oversight of management’s strategic planning, execution, fraud prevention and risk management processes. Even seasoned board members can improve the consistency and soundness of their judgment by being aware of common judgment traps and by following a good judgment process.” Such a process can help avoid threats to good judgment and mitigate the biases associated with common judgment tendencies (see Exhibit 3 below, drawn from page 16 of the COSO Paper).

Exhibit 2 (on page 14 of the Paper) summarizes the traps and tendencies. Exhibit 4 (on page 18 of the Paper) outlines actions that boards can consider at each of the five steps of the judgment process presented in Exhibit 1 (see Part 2).

Many board-level judgments are made in group settings and, although group judgments are often better than individual judgment, group judgments can fall victim to narrow thinking; suppression of divergent views; and, consequently, shallow judgment processes. Some common tendencies in individual judgment that can lead to bias in board-level decisions are the overconfidence tendency, the confirmation tendency, the anchoring tendency and the availability tendency.

Awareness of the common threats to good judgment is the key initial step in improving judgment. Board members can use the insights summarized in this thought paper to test and improve the consistency and quality of management’s judgment processes and outcomes by rigorously challenging perspectives and assumptions via open and frank discussions. Such discussions can include consideration of judgment traps, simplifying tendencies and alternative viewpoints. Board members who are aware of traps and tendencies that limit the quality of judgment can use these insights to challenge management’s judgments and more effectively fulfill their oversight role.

Enhancing Board Oversight by Challenging Traps and Biases in Professional Judgment - Part 2 of 3

As previously mentioned (see Part 1), COSO has released a thought paper called Enhancing Board Oversight: Avoiding Judgment Traps and Biases. According to this thought paper, “judgment is the process of reaching a decision or drawing a conclusion when there are a number of possible alternative solutions. An effective judgment process will be logical, flexible, unbiased, objective and consistent. It will utilize an appropriate amount of relevant information, and it will properly balance experience, knowledge, intuition and emotion.”

The paper notes that: “we often do not follow a sound process due to common judgment traps and tendencies that can lead to bias. Some of these tendencies are judgment shortcuts that help simplify a complex world and facilitate more efficient judgments. However, these shortcuts sometimes can lead to suboptimal judgments. The judgment traps and tendencies are systematic—in other words, they are common to most people, and they are predictable.”

It also points out that: “By consistently following a sound judgment process, understanding where directors and management are vulnerable to predictable traps, and appropriately challenging their own judgments and the judgments of those they are charged with overseeing, directors can improve their oversight and monitoring of the organization’s strategies and risks, including the risk of fraud. Following a better judgment process translates to improved risk management and better business outcomes.”

Exhibit 1 (on page 3 of the Paper) illustrates a model of a good judgment process. The steps in this process are simple to understand. Although the steps are a representation of the process to follow, the Exhibit does not depict how people actually make judgments. It provides a helpful context to illustrate where judgments can go wrong. The reality is that in a world of high-stake decisions, deadlines and limited capacity, the judgments of even highly educated, capable people are vulnerable to common, systematic traps and predictable biases.

This thought paper highlights some of the common pitfalls and biases in judgments to which decision makers are vulnerable and provides an overview of actions and steps that boards can take to avoid falling prey to them. For additional insight, read the COSO Paper and the article “COSO explores common judgement traps, lays out five-step decision-making process”at CGMA Magazine online.

Enhancing Board Oversight by Challenging Traps and Biases in Professional Judgment - Part 1 of 3

Recently, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) commissioned a paper on Enhancing Board Oversight: Avoiding Judgment Traps and Biases. Originally formed in 1985, COSO is a joint initiative of five private sector organizations and is dedicated to providing thought leadership through the development of frameworks and guidance on enterprise risk management (ERM), internal control and fraud deterrence. COSO’s supporting organizations are the Institute of Internal Auditors (IIA), the American Accounting Association (AAA), the American Institute of Certified Public Accountants (AICPA), Financial Executives International (FEI) and the Institute of Management Accountants (IMA).

The paper was authored by Steven M. Glover, CPA, Ph.D., and Douglas F. Prawitt, CPA, Ph.D., as well as contributing authors from KPMG LLP including Sam Ranzilla, National Managing Partner, Audit Quality and Professional Practice; George Herrmann, National Office Partner; and Rob Chevalier, National Office Partner. It provides a five-step judgment process that board members and others can use to overcome common pitfalls and mitigate the effects of judgment bias. The judgment process is based on KPMG’s Professional Judgment Framework, which enables individuals to identify where and when the quality of judgments tends to be threatened by predictable, systematic judgment traps and biases.

The authors note that: “Consistently making high-quality professional judgments in a constantly changing environment has never been more important or challenging. The growing complexities of the global business environment and demands for effective corporate governance and oversight have placed a premium on sound judgment and decision making by all key players in the marketplace: management, boards of directors, auditors, and others. Our hope is that this collaboration—incorporating insights from academic research and reflecting KPMG’s commitment to consistent and incisive professional judgment in all aspects of its work—will be useful to board members in appropriately evaluating and challenging judgments and in encouraging sound decision making and solid performance.”

To learn more, view the COSO press release “COSO Releases Thought Paper on Enhancing Board Oversight by Avoiding and Challenging Traps and Biases in Professional Judgment” and read the paper Enhancing Board Oversight: Avoiding Judgment Traps and Biases.