Monday, March 21, 2011

Big Four See UK Auditing Practices Board Proposals on Professional Skepticism in Broader Corporate Governance Framework

Professional skepticism by auditors of financial statements has taken on more importance as the move to principles-based global accounting standards accelerates. Indeed, Deloitte, in comments to UK Auditing Practices Board proposals to reinforce skepticism in the audit culture, said that auditor skepticism is at the root of a financial statement audit. Ernst & Young said skepticism is fundamental to an auditor’s work and should be reflected in all parts of an audit. In practice, noted PwC, the application of skepticism is broad ranging and pervades the whole audit process.

Professional skepticism is defined in auditing standards 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 audit evidence. Skepticism is applied in real time and is a cultural and behavioral issue, said PwC.

The Big Four believe that auditor professional skepticism cannot be delinked from effective corporate governance. In the view of Ernst & Young, enhancing auditor skepticism must be seen in the context of the overall corporate governance framework, including a thoroughly engaged audit committee. The board must welcome the application of auditor skepticism and encourage it. Corporate governance must create an environment where auditor challenges are welcome and seen as constructive to the quality of the financial statements. In this regard, the tone set by the audit committee is very important. If the auditor raises challenges, the audit committee should ask management to provide demonstrable evidence rebutting the auditor’s challenge and in the absence of such, the auditor’s challenge should be accepted.

KPMG agrees that audit committees should engage in the challenge to management. PwC: believes there is a role for audit committees to promote open debate between management and the external auditor

Deloitte said that the quality of auditor skepticism could be raised if oversight bodies provided more guidance to auditors on the need for reports to those charged with governance and the audit documentation to give more information of the history of challenge to management’s assumptions by auditors where there were significant audit issues and professional judgment applied and how any issues were resolved. There should also be more emphasis on earlier consideration of significant risks and disclosures so that sufficient time is spent on them and any issues arising can be resolved on a timely basis.

The Big Four are concerned with the Board’s assertion that the clarified international auditing standards can be characterized as reflecting a presumptive doubt approach in terms of the initial mindset of the auditor. The Board describes presumptive doubt as an awareness of the risk that the figures could be affected by error or dishonesty and contrasts it with a neutral mindset in which the auditor neither accepts management’s figures and explanations in a neutral way nor assumes that there is an error or misstatement.

Noting that the term presumptive doubt is not used in the international auditing standards, PwC believes that having an initial mindset of presumptive doubt reflects an approach that assumes management is dishonest. Starting with a presumptive doubt mindset would result in procedures far beyond a questioning mind and the established concept of an enquiring mind. More broadly, it would go against the grain of risk-based standards for an auditor to take a presumptive doubt approach in all circumstances

According to PwC, the auditor starts from a neutral mindset and, based on a robust understanding of the company and its environment, performs a risk assessment to the level of evidence needed to respond to the assessed risk of material misstatement. For significant risks of material misstatement the international auditing standards require the auditor to perform additional procedures.

In its comments, Deloitte also challenged the use of the term presumptive doubt, which the firm believes goes much further than the established concept of an enquiring mind. A change to presumptive doubt would significantly increase business costs and runs contrary to a risk-based approach, which emphasizes the need for the application of further procedures only where significant risks are identified.

KPMG is concerned that the term presumptive doubt will upset the balance between auditors and company management, potentially triggering a defensive reaction and a lack of openness with the auditor to the detriment of the overall audit. It would be inappropriate to start the audit with the presumption that the judgments of management are likely to be wrong or even biased, said KPMG, since this would entail obtaining evidence to disprove the presumption. Having an inquiring mindset is more neutral than that. At its most basic, noted KPMG, professional skepticism is as described by Lord Denning in that auditors must come to their task with an enquiring mind, not suspicious of dishonesty, but suspecting that someone may have made a mistake somewhere and a check must be made to ensure that there has been none. Fomento (Sterling Area) Ltd. v Selsdon Fountain Pen Co. Ltd. (1958)

In its feedback statement, the Board said that the reaction to what was meant by presumptive doubt was a misunderstanding. The Board said that it had used the term as it had been used in academic research, as meaning the auditor exhibiting a heightened awareness of the risk that the figures could be affected by error or dishonesty rather than making the assumption that there was a misstatement.

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