Auditor Mindsets and Audits of Complex Estimates

A recently published research paper notes that “Auditors experience significant problems auditing complex accounting estimates and this increasingly puts financial reporting quality at risk. Based on analyses of the specific errors that auditors commit, we propose that auditors need to be able to think more broadly and incorporate information from a variety of sources in order to improve audit quality for these important accounts.”

The research tries to experimentally demonstrate that a deliberative mindset intervention improves auditors’ ability to identify unreasonable estimates by improving their ability to identify and incorporate into their analyses contradictory information from diverse parts of the audit and improving their ability to think critically about the evidence. Additional analyses are performed to demonstrate that such intervention improves auditor performance by causing them to think differently, rather than simply to work harder.

The paper demonstrates that critical thinking can improve the identification of unreasonable estimates and, in doing so, provide new directions for addressing audit quality issues. For more information, refer to the article “Auditor Mindsets and Audits of Complex Estimates” by Emily E. Griffith, Jacqueline S. Hammersley, Kathryn Kadous and Donald Young in the Journal of Accounting Research (Vol. 53, No. 1, March 2015).

Professional Judgment Resources for Auditors and Audit Firms

The 1995 research report Professional Judgment and the Auditor was prepared by staff of the Canadian Institute of Chartered Accountants (CICA), Research Studies Department (J. Paul-Emile Roy, CA) under the direction of an 8-member Study Group of professionals.  That Report identified many sources of information regarding the issues surrounding professional judgment. It developed a framework for professional judgment and discussed key factors that influence the judgment process. Furthermore, it provided valuable guidance to practitioners regarding their professional obligations when exercising professional judgment.

As noted in the previous post “A Process for Professional Judgment,” the US Center for Audit Quality (CAQ) has also recently published a Professional Judgment Resource. This Professional Judgment Resource is designed to provide auditors with an example of a decision-making process to facilitate important auditing and accounting judgments in a professionally skeptical manner. This CAQ Resource is aimed at both auditors and audit firms to enhance their system of quality control. According to the Overview (on page 2): “...the exercise of professional judgment should be: (1) Based on the relevant facts and circumstances known and available at the time the judgment is made; (2) Made after the consideration of reasonable alternatives; (3) Sensitive to the degree of uncertainty that may be inherent in the judgment; and (4) In compliance with the applicable professional standards.

 Effective auditor decision making also requires the application of professional skepticism. Indeed, the appropriate exercise of professional skepticism throughout the judgment process is at the heart of effective auditor decision making. Accordingly, the CAQ Resource outlines a decision-making process grounded in five essential actions that include identifying and defining the issue, reviewing and completing the documentation, and explaining the rationale for the conclusion. In addition, the Resource identifies several of the more common judgment tendencies and traps that can potentially lead to bias and weaken professional skepticism. It also provides illustrative examples of these tendencies and strategies that can be used to avoid them.

A Process for Professional Judgment

The initial post About this Blog on June 18, 2011 states: “Judgment defines a profession! In fact, the ability to make good judgment calls is paramount to the success of any professional. For Chartered Accountants (CAs), sound “professional judgment” is based on ethical behaviour together with an appropriate foundation of technical skills and critical thought processes, sustained and enhanced by professional development.”

It also states: “Professional judgment requires a commitment to gather all the pertinent facts, the discipline to examine the fact patterns in relation to a consistently-applied framework, and the willingness to consider alternative positions. In addition, it requires the application of relevant knowledge, expertise and practical experience in selecting a rational course of action.” 

In August 2014, the US Center for Audit Quality (CAQ) published a Professional Judgment Resource that is entirely consistent with this view of professional judgment. The CAQ is an autonomous, nonpartisan public policy organization dedicated to enhancing investor confidence and public trust in the global capital markets. The CAQ fosters high quality performance by public company auditors, convenes and collaborates with other stakeholders to advance the discussion of critical issues requiring action and intervention, and advocates policies and standards that promote public company auditors’ objectivity, effectiveness and responsiveness to dynamic market conditions. Based in Washington, DC, the CAQ is affiliated with the American Institute of Certified Public Accountants (AICPA).

Are checklists killing the CA profession?

A recent article in CAmagazine notes that, when faced with the 570-plus requirements in the Canadian auditing and quality control standards, generic checklists may be a great way to start an audit, but they can lead to a lessened focus on judgment. It states that “...ours is a thinking profession, not one that relies on a mechanical approach to deliver a product. Every audit is unique so reliance on a common set of checklists is unlikely to be efficient, nor will it result in an effective audit.”

The relatively new Canadian auditing standards (CAS) clock in at 800-plus pages. Many experienced auditors rely on generic checklists developed in-house or by third parties to cope with the volume, with reliance on generic checklists appearing easier than crafting their own. However, “Research shows that reliance on systems designed to do your thinking for you can reduce your ability to make good judgments. Professional judgment is the crux of our profession. It is what the public expects and what clients pay for.”

“Systems with built-in decision-making capabilities may be easy to use, but they don’t encourage the thought required for difficult decision-making. A point-and-click operation is not the same as thinking through a process. In an effort to make application software easy, designers often bury the underlying logic in the application so users can focus on moving or clicking through the program to reach their goal quickly. While this is an admirable design goal for many computer applications, it is the antithesis of a quality audit process. Removing the decision-making process could impair a user’s ability to think deeply — and deep thinking is essential in making sound judgments.”

“This situation is more than relevant to the audit profession. Auditors must think their way through every aspect of an audit to decide what evidence needs to be obtained, evaluate the quality of that evidence and then use this information to make a myriad of professional judgments. Just because an auditor understands the individual steps suggested by the expert system does not mean he or she grasps the bigger picture of how the steps fit together. Bottom line: a successful audit is not built on a system that encourages superficial thought.”

“Generic checklists can lead to a lessened focus on professional judgment, which is the antithesis of the intent of CAS. However, customizing checklists for each audit can heighten professional judgment. Once customized, audit automation provides the ability to carry your unique approach forward annually — tailoring changes as appropriate, improving recoveries and reducing engagement risk.”

To learn more, read the article “Are checklists killing our profession?” by Phil Cowperthwaite, FCA in the September 2012 issue of CAmagazine online.

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.

Professional scepticism and other key audit issues

There is an ongoing debate about whether professional accountants are sufficiently sceptical in applying professional judgment. For example, the concerns of regulators and others have been highlighted in the media and form part of the discussions on the future of the accounting profession. In this regard, the Institute of Chartered Accountants in England and Wales (ICAEW) (Audit and Assurance Faculty) is exploring the possibility of conveying key messages on the issues and has discussed this possibility with the UK Professional Oversight Board (POB).

The result is a new set of videos Professional scepticism and other key audit issues now available on the ICAEW website. The purpose of the videos is to highlight some of the concerns of the POB (and other regulators around the world) and to be constructive about how audit firms respond to the issues. In total, there are ten videos with one compilation video (about 40 minutes long). It is hoped that, in addition to individual auditors watching them, some firms will play the videos as part of training activities and team meetings.

The longest video (about 17 minutes) highlights the fundamental importance of professional scepticism. The video provides key messages on the issues that will be of interest to firms at the current time. Martyn Jones (ICAEW Vice-President) speaks about how auditors should be dealing with the challenges and the need to understand that scepticism is a behavioural issue for the entire audit team. John Kellas (POB Chairman) talks about what the Audit Inspection Unit (AIU) has been looking at in the current climate and describes the ways a lack of scepticism can be apparent. Myles Thompson (Chairman of the faculty’s Technical and Practical Auditing Committee) outlines the personality traits that auditors need to have and gives tips on how to produce documentation that demonstrates scepticism.

The messages are relevant to auditors from firms of all sizes and the personal qualities that are spoken about are needed for all types and sizes of audit. The key points also apply internationally, not just in the UK. Other subjects covered in the videos are group audits, quality control, audit committee reporting, audit documentation, ethical matters and concluding remarks.