Professional Judgment: How to Effectively Use Critical Thinking

A training course offered by the Institute of Internal Auditors (IIA) indicates that: “One of the most difficult skills associated with auditing is determining the propriety of audit evidence. Does it support the audit objective? Is it enough? Is it too much and inefficient? How does professional judgment affect the quality and quantity of audit procedures?”

The description of this course indicates it will provide internal audit staff and management with at least 2 years of experience with the techniques necessary to identify the appropriate evidence to support the audit conclusion. The instruction will also suggest approaches to guide the use of critical thinking skills to facilitate the gathering of audit evidence. Real-life examples of strong and weak evidence will further enhance the learning process.

As a complement to this course, another IIA course emphasizes that: “Auditors are expected to be open-minded and analytical thinkers. Decision making skills and professional judgment are a daily necessity in the internal audit process. Teaching auditors to utilize critical thinking skills throughout the audit process strengthens their ability to identify and assess risk, prioritize testing, align audit objectives with business objectives and identify true value-added activities.”

For more information about these 2-day interactive courses, visit the IIA training centre and obtain the course descriptions on Audit Evidence and Professional Judgment: How to Effectively Use Critical Thinking and Embedding Critical Thinking in the Internal Audit Process.

Five ways to overcome confirmation bias

According to an article in the CPA Journal of Accountancy: “Confirmation bias—one of the five commonly occurring judgment biases—has the potential to trip up auditors, particularly during the early stages of an audit. At that time, financial information is often highly aggregated and may be too ambiguous to allow the auditor to definitively identify the reason for a change in financial information. As a result, an auditor’s initial hypothesis may not actually represent the true cause of the data fluctuation.”

The deeper the auditors get into investigating a particular hypothesis, the more difficult it becomes to consider other potential hypotheses. This is because once a potential explanation has been identified, it is common to seek evidence that supports it and ignore evidence that does not support the explanation. This is the behavior psychologists refer to as confirmation bias. As such, if auditors generate an early hypothesis, they risk overlooking important contradictory evidence that may result in a flawed evaluation of the data.

What can be done? Auditors can take several simple and pragmatic steps to overcome this bias when performing analytical procedures. Learn more by reading the online article 5 ways to overcome confirmation bias by Benjamin L. Luippold, Ph.D., Stephen Perreault, CPA, Ph.D. and James Wainberg, Ph.D. dated February 1, 2015.

Auditor Judgment Under Uncertainty: Doctoral Dissertation 2013

A recent research paper investigates how experienced auditors recognize and respond to the degree of management’s evidentiary support and the level of estimate uncertainty when assessing management estimates. Drawing on information processing research, the paper predicts that auditors can be more comfortable with management estimates, and expect a lower adjustment, when there is alignment between the degree of estimate uncertainty and management’s evidentiary support (that is, high uncertainty and more support or low uncertainty and less support). The following diagram provides a graphical representation of the theoretical predictions.

This prediction is tested using an experiment where experienced auditors evaluate an uncertain warranty estimate. The level of uncertainty is manipulated by varying the range of potential costs as either two-times or eight-times materiality. The degree of management’s evidentiary support is manipulated by management either obtaining industry information, inquiring of technicians, or doing these two plus reviewing records, and performing field inspections.

The results support the prediction. In the higher uncertainty condition, auditors were more comfortable and expected a lower adjustment when management obtained more evidential support, but in the lower uncertainty condition auditors were more comfortable and expected a lower adjustment when management obtained less evidential support. In fact, the alignment between estimate uncertainty and management’s evidentiary support can make auditors more comfortable with management estimates supported by relatively less evidence.

These findings demonstrate how audit risk factors, such as the level of uncertainty and degree of management’s support can interact and cause auditors to more readily accept less supported financial statement estimates. More broadly, these findings reveal how providing more information can actually make recipients more uncomfortable with a proposition.

For more information, refer to the 93-page Dissertation, “Auditor Judgment Under Uncertainty” by Stephen P. Rowe, submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy in Accountancy in the Graduate College of the University of Illinois at Urbana-Champaign, 2013. The Doctoral Committee included: Professor Mark Peecher, Chair; Assistant Professor Bradley Pomeroy; Professor Ken Trotman, University of New South Wales; and Professor Michel Regenwetter.

Developing strategies to heighten professional skepticism and help overcome judgment biases

A current CAmagazine article observes that “There are many inherent barriers to making good judgments, but they can be overcome with some effort and proper safeguards.” It also notes that “Professional skepticism is a cornerstone of audit quality. It defines the quality of each audit judgment and, to a significant extent, is the essence of the audit. The connection between skepticism and professional judgment is complex, which research across many professional disciplines is proving. The relationship needs to be better understood to improve our audits.”

According to the author, “Skepticism is a questioning attitude; exercising professional judgment is a process required in forming an opinion of value. Having a skeptical attitude is essential for auditors when analyzing evidence, looking for inconsistencies in data and considering explanations from management. That attitude shapes the actions required in forming a professional judgment. And auditors need to make every judgment count on every audit they undertake.”

The article concludes that “Unconscious cognitive errors are very real human traits. Usually we are not conscious of their effect on our day-to-day judgments. While these traits can result in efficient and reasonably accurate choices for most of our routine decisions, our unconscious bias is the enemy of skepticism in complex situations. Basing conclusions on insufficient evidence, an inappropriate starting point, and recent memories can get professionals into serious trouble.”

Nonetheless, “Judgment bias can be overcome, but not without effort. Implementation of safeguards in every audit will help guard against inherent bias. Many of the larger accounting firms have developed strategies to heighten professional skepticism and help overcome judgment bias.” Learn more by reading the article “Tougher than you think” by Phil Cowperthwaite, FCA in the March 2013 edition of CAmagazine online. In addition, review other informative research and guidance materials on professional skepticism.

Seeing What You Want to See: Perceptual Biases of Auditors

A recent research paper notes that “Auditing will always be a process of acquiring and evaluating evidence. Relevant evidence that is accurately perceived should serve as the foundation of quality audit opinions, and in turn, contribute to financial statements that correspond to economic reality. One of the largest threats to the realization of the above objective is the self-fulfilling prophecy. Auditors that have strong expectations about what they will find, tend to perceive confirmation of these expectations, even when the evidence is mixed.”

“To the extent that the self-fulfilling prophecy limits auditor ability to objectivity assess evidence, the quality of professional work may be compromised. Similar to the self-fulfilling prophecy, cognitive dissonance limits the integrity of evidence evaluation. Decision making proceeds best when multiple data points align in their importance and consequence. When data is internally inconsistent, cognitive functioning can be thought of as in disequilibrium. Auditing does not have strong and multiple cause-effect chains, but rather depends upon the totality of the evidence. When this data refuses to be properly aligned, a loss of confidence about decisions might result.”

“Although these topics have been part of a larger inquiry into audit judgment over the last quarter century, they have not been specifically considered together. The present research studies the self-fulfilling prophecy and cognitive dissonance as part of an accounts payable confirmation task. Using a broad sample of auditors from many firms, this paper reports on the extent auditors can neutrally evaluate evidence. The balance of the paper is organized into four sections. The first provides a brief literature review that grounds the statement of the hypotheses. The means by which the hypotheses were tested is described in a second section that provides ample detail about measures and design. The results of these tests and a discussion of them are contained in the third and fourth section.”

Timothy J. Fogarty, Ph.D.

According to this paper, the results show that internal control predispositions are highly consequential for accounts payable judgments. Statistical analysis of the data suggests that auditors seek to avoid cognitive dissonance. They also fall prey to the self-fulfilling prophecy. To learn more, read the 15-page research paper “Seeing What You Want to See: Perceptual Biases of Auditors” by Larry M. Parker, Ph.D. and Timothy J. Fogarty, Ph.D. (Case Western Reserve University) published in the Journal of Management Policy and Practice (Vol. 13(2) 2012).

IAASB – Guidance on Professional Skepticism in an Audit of Financial Statements

With regard to professional skepticism, a Questions & Answers (Q&A) publication developed by staff of the International Auditing and Assurance Standards Board (IAASB) was issued in February 2012. It states: “The public places value on the independent financial statement audit because it enhances the degree of confidence of intended users in the financial statements. A high-quality audit features the exercise of professional judgment by the auditor and, importantly, a mindset that includes professional skepticism throughout the planning and performance of the audit.”

The Q&A publication explains that: “The need for professional skepticism in an audit cannot be overemphasized. Professional skepticism is an essential attitude that enhances the auditor’s ability to identify and respond to conditions that may indicate possible misstatement. It includes a critical assessment of audit evidence. It also means being alert for audit evidence that contradicts other audit evidence or that brings into question the reliability of information obtained from management and those charged with governance. This critical assessment is necessary in order for the auditor to draw appropriate conclusions.”

The Q&A, published by the International Federation of Accountants (IFAC), contains 16 pages of guidance, including eight questions and answers about professional skepticism. It is not meant to be exhaustive and reference to the standards themselves should always be made. The IAASB’s International Standards on Auditing (ISAs) explicitly recognize the fundamental importance of professional skepticism. Nevertheless, adopting and applying a skeptical mindset is ultimately a personal and professional responsibility to be embraced by every auditor. It is an integral part of the auditor’s skill set and is closely interrelated to the fundamental concepts of auditor independence and professional judgment and contributes to audit quality.

Learning about Professional Skepticism – Part 3 of 3

What does it mean to be sceptical? What does it mean to cast doubt on something you feel is not right, despite popular consensus? Scepticism may be generally defined as a personal disposition toward doubt or incredulity of facts, persons, or institutions.

For a general overview of sketicism, watch the YouTube video "What is Skepticism? A primer for understanding reality."

For an indepth analysis, refer to the research paper "A Model and Literature Review of Professional Skepticism in Auditing" by Mark W. Nelson, Auditing: A Journal of Practice & Theory, Vol. 28, No. 2, November 2009, pp. 1–34. This paper reviews research that examines professional skepticism in auditing. Consistent with much research and with recent regulatory concerns, the paper defines professional skepticism as "indicated by auditor judgments and decisions that reflect a heightened assessment of the risk that an assertion is incorrect, conditional on the information available to the auditor."

In many circumstances the assertion in question will be a client’s assertion that the financial statements are free of material misstatement, but the definition could apply to other assertions as well (e.g., attesting to the effectiveness of a client’s internal controls). This definition reflects more of a "presumptive doubt" than a "neutral" view of professional skepticism, implying that auditors who exhibit high professional skepticism are auditors who need relatively more persuasive evidence (in terms of quality and/or quantity) to be convinced that an assertion is correct. Depending on how an auditor's decisions are evaluated, it is possible under this definition for an auditor to exhibit too much professional skepticism, in that they could design overly inefficient and expensive audits.

The paper provides a model that describes how audit evidence combines with auditor knowledge, traits, and incentives to produce judgments that reflect professional skepticism. The model also describes how, given a judgment that reflects some level of professional skepticism, the judgment combines with auditor knowledge, traits and incentives to produce actions that reflect relatively more or less professional skepticism. The model highlights that auditors’ pre-existing knowledge, traits and incentives all combine (and potentially trade off or interact) to affect the amount of professional skepticism in audit judgment and audit actions. This perspective also facilitates understanding how audit firms can influence professional skepticism in practice via hiring, training, performance appraisal, review, decision aids, incentives and changes in tasks and institutions.

Professional Judgment: Are Auditors Being Held to a Higher Standard Than Other Professionals?

This discussion paper on Professional Judgment was commissioned by the Institute of Chartered Accountants in Australia and written by Professor Ken Trotman, PhD, FCA, Centre for Accounting and Assurance Services Research, University of New South Wales. The September 2006 paper forms part of the Institute’s objective to deliver effective and visionary thought leadership initiatives that profoundly and positively impact business and the accounting profession.

According to the Executive Summary of this paper, “Auditors today are subject to increased expectations from regulators and the investing public. At the same time, corporations are expanding, transactions have become more complex and there are requirements on auditors to provide much greater levels of assurance related to financial fraud.”

The paper further notes that “judgment is the ‘cornerstone’ of auditing and describes some of the 40 years of research that has considered judgment and expertise. While the literature recognises that ‘of course experts make mistakes’, there appears to be a growing presumption that this should not be the case for auditors.”

“In many professions, the difficulty of making judgments is recognised. This paper discusses the role of judgment in medicine, the legal system, police investigations and marketing. It is recognised that errors of judgment do sometimes occur in these professions. The question that arises is whether auditors are being held to a higher level of accountability than other professions. This is particularly important where the scope of audits is constrained by the price society is willing to pay for such services. It is suggested that even a well-conducted audit, following all appropriate audit standards, can fail to detect a material fraud in the financial statements, particularly where management has gone to great lengths to cover up the fraud. These considerations are important in an environment where audit standards have the force of law.”

“The concept of cumulative evidence is discussed by reference to the Public Company Accounting Oversight Board (PCAOB) reviews of the Big 4 in the US. It is concluded that any inspection process should be concerned with whether sufficient cumulative evidence has been obtained rather than specific aspects of particular audit tests. The paper suggests that Australian inspection agencies have an opportunity to more fully inform investors than has been the case with the PCAOB, by providing a more even-handed assessment that describes both the good and the bad. The market needs to be aware of not only problems but also enhancements in independence procedures and quality controls and whether the enhanced policies are continuing to work effectively.”

(Read the discussion paper Professional judgment: are auditors being held to a higher standard than other professionals?)