AUDITING LABORATORY

SUMMARY OF INTRODUCTION. SECTION 1 CASE 1

Arranged by:
Syafira Azzahra 165020307141011

INTERNATIONAL UNDERGRADUATE PROGRAM IN ACCOUNTING

FACULTY OF ECONOMICS AND BUSINESS
BRAWIJAYA UNIVERSITY
MALANG
2019
INTRODUCTION : PROFESSIONAL JUDGEMENT

Summary

THE IMPORTANCE OF PROFESSIONAL JUDGMENT IN AUDITING AND ACCOUNTING

Key that distinguished the feature of auditing is the ability to consistently make high-quality
professional judgments. Professional judgment, which is the bedrock of the accounting and
auditing professions, is referenced throughout the professional literature. There is no doubt that
ability and experience are important parts of effective professional judgment, yet it is possible to
improve your professional judgment skills through learning and applying some key concept.
Research in the areas of judgment and decision making over recent couple of decades shows that
additional knowedge about common threats to judgement, together with tools and procedures for
making good judgements, can enhance the professional judgment abbilities of both new and
professional.

A MODEL OF A GOOD JUDGMENT PROCESS

Judgment is the process of reaching a decision or drawing a conclusion where there are a number
of possible alternative solutions. Judgment occurs in a setting of uncertainty and risk. In the areas
of auditing and accounting, judgment is typically exercised in three broad areas:
 Evaluation of evidence (e.g., does the evidence obtained from confirmations, combined
with other audit evidence, provide sufficient appropriate audit evidence to determine
whether accounts receivable is fairly stated)
 Estimating probabilities (e.g., determining whether the probability-weighted cash flows
used by a company to determine the recoverability of long-lived assets are reasonable)
 Deciding between options (e.g., audit procedure choices, such as inquiry of management,
inspection, or confirmation)

KPMG’s Professional Judgment Framework is an example of a framework. A good procedures

will not make hard judgments easy or always guarantee a good outcome, but a well-grounded
procedures can improve the quality of judgments and help auditing professionals more effectively
navigate through complexity and uncertainty. While KPMG Professional Judgment Framework
provides a good representation of the procedures, we should follow when applying professional
judgment, but it is not necessarily an accurate representation of the processes people follow
consistently. At the very center of the KPMG framework is “mindset.” It is important that auditors
approach matters objectively and independently, with inquiring and incisive minds. The
Professional Judgment Framework depicts constraints, influences, and biases that threaten good
judgment with the box on the outer rim of the Framework labeled “Environment” and the triangle
at the top labeled “Influences/Biases.” Professional skepticism helps to frame our “mindset.”
wrapping around “mindset” in the Framework is “consultation.” At professional services firms
like KPMG, consultation with others, including engagement team members, specialists, or other
professionals, is a vital part of maintaining consistently high judgment quality and enhancing the
exercise of appropriate professional skepticism.

TRAPS THAT CATCH US IN THE EARLY STEPS OF THE JUDGMENT PROCESS

People in reality often do not follow a good process due to common judgment traps and
tendencies that can lead to bias. These traps and tendencies are systematic—in other words, they
are common to most people, and they are predictable. Research provides convincing evidence that
even the smartest and most experienced people similarly fall into predictable judgment traps and
biases. The “Rush to Solve.” One of the most common judgment traps is the tendency to want to
immediately solve a problem by making a quick judgment. As a result, we under-invest in the
important early steps in the judgment process and often go with the first workable alternative that
comes to mind or that is presented. Judgment Triggers: Solving the Wrong Problem. under-
investing in defining the fundamental issue. In the example above, Ax Snack Company’s
distinctive packaging functioned as what could be called a judgment trigger, or an assumed or
inherited issue that can lead the decision maker to skip the crucial early steps in the judgment
process. Often, the trigger comes from the way others have defined the issue, which is often
formulated in terms of one potential solution. Alternatively, we may create triggers ourselves
because we are in such a hurry to “solve” or to be decisive. Judgment triggers often lead to
judgments made on incomplete facts or understandings. How might you overcome the very
common trap of skipping the first couple of elements in the judgment process that comes about
through the rush to solve or through judgment triggers? The answer is to ask “what” and “why”
questions. It often does not take a lot of time to consider the first step in the judgment process, but
the more important the judgment, the more important it is to invest in clarifying the fundamental
issues and objectives. A little extra investment in clarifying the issue and objectives will almost
always pay off, sometimes in a big way

PROFESSIONAL SKEPTICISM AND “JUDGMENT FRMING”

The definition of framing follows: Frames are mental structures that we use, usually
subconsciously,to simplify, organize, and guide our Introduction: Professional Judgment
understanding of a situation. They shape our perspectives and determine the information that we
will see as relevant or irrelevant, important or unimportant. Frames are a necessary aspect of
judgment, but it is important to realize that our judgment frames provide only one particular
perspective. Frames are necessary and helpful, but the problem is that we often are not aware of
the perspective or frame we are using. our frame can blind us to the fact that there are other valid
perspectives A key characteristic of those who make high-quality judgments is that they are
frameware. They know how to seek and consider different frames to get a fuller picture of the
situation.
JUDGMENT TENDENCIES THAT CAN RESULT IN BIAS
The availability tendency is defined as the tendency for decision makers to consider information
that is easily retrievable from memory as being more likely, more relevant, and more important
for a judgment. The confirmation tendency is defined as the tendency for decision makers to seek
for and put more weight on information that is consistent with their initial beliefs or preferences.
The overconfidence tendency is defined as the tendency for decision makers to overestimate their
own abilities to perform tasks or to make accurate diagnoses or other judgments and decisions.
The anchoring tendency is defined as the tendency of decision makers to make assessments by
starting from an initial numerical value and then to adjust insufficiently away from that initial
value in forming a final judgment.
MITIGATING THE EFFECTS OF JUDGMENT BIASES
The most important step in avoiding judgment traps and reducing bias caused by subconscious
mental shortcuts or self-interest is “awareness.” By better understanding traps and biass, and
recognizing common situations where they are likely to present themselves, we can identify
potential problems and often formulate logical steps to improve our judgment. While a thorough
discussion of potential ways to mitigate biases is beyond the scope of this professional judgment
introduction. The bottom line is that we need to realize where and how we may be biased in order
to develop simple approaches for mitigating the effects of those biases. And the good news is that
once you are aware of traps and biases, the mitigation approach often is a matter of applying logic
and common sense.
CASE 1 : OCEAN MANFUACTURING, INC.
Required

1. The client acceptance process can be quite complex. Identify five procedures an
auditor should perform in determining whether to accept a client. Which of these five
are required by auditing standards?

 Take various steps to obtain an understanding of the client and its industry (e.g., on-site
tour, reviewing industry publications), and determine if your firm has or can reasonably
expect to obtain the technical skills and industry knowledge needed to perform the audit
properly
 Consider whether the client has any unusual or special circumstances that will require
special attention by your firm. Also consider whether issues such as litigation or
goingconcern problems exist for the client.
 Perform preliminary analytical procedures to obtain an understanding of the prospective
client and its industry.
 Determine if management is going to impose a limitation on the scope of the auditor’s
work.
 Obtain an agreement from management that it acknowledges and understands its
responsibility for selecting the appropriate financial reporting framework, establishing and
maintaining internal control, and providing access and information to the auditor.

2. What nonfinancial matters should be considered before accepting Ocean as a client?

How important are these issues to the client acceptance decision? Why?
 Recent management turnover. This matter may or may not pose a potential problem to the
audit but may be a sign of other problems that should be investigated. The controller is
very new and has little relevant experience, which may make audit work slower and more
difficult
 High auditor turnover rate. This should be a red flag to the auditors. The auditors should
look into why Ocean has employed so many different auditors in so few years.
 Complicated new computer system. The complicated system poses a couple of problems
for the auditors. First, the auditors may have difficulty getting the information they need
from the system, and a question arises regarding auditability. Second, inadequate controls
over the new system may increase the amount of substantive testing required.
 Initial public offering. Ocean has plans to go public and aggressively expand into the
national market. If successful, these plans will make Ocean a more attractive client for
Barnes and Fischer, but they also serve to increase the auditor’s business risk (increased
reliance on the statements, increased litigation risk, etc.) and should be considered.
 Management’s aggressiveness. There are some indications in the case that management is
willing to manipulate the financial statements via year-end accruals and revenue
recognition to achieve relatively low interest rates from creditors. This raises a potential
management integrity issue, and should be heavily weighted in view of the fact that the
upcoming IPO may give management even greater incentive to manipulate the financial
statements

3. Using Ocean’s financial information, calculate relevant preliminary analytical

procedures to obtain a better understanding of the prospective client and to
determine how Ocean is doing financially. Compare Ocean’s ratios to the industry
ratios provided. Identify any major differences and briefly list any concerns that arise
from this analysis.
Major Differences to be noted:

 Ocean has a low return on equity relative to the industry.

 Ocean has a low return on assets relative to the industry.
 Ocean’s accounts receivable turnover is high relative to the industry.
 Ocean’s inventory turnover is low relative to the industry.

4. [a] Ocean wants Barnes and Fischer to aid in developing and improving its IT system.
What are the advantages and disadvantages of having the same CPA firm provide
both auditing and consulting services? Given current auditor independence rules, will
Barnes and Fischer be able to help Ocean with its IT system and still provide a
financial statement audit? Support your conclusion with appropriate citations to
authoritative standards if your instructor indicates that you should do so.
The issue of providing both systems (consulting and auditing services) to the same client
is actually debatable in profession. Some parties argue that providing both consulting and
auditing services to the same client may ruin the objectivity of the auditor. But on the other
hand, by providing both consulting and auditing services the audit firm can gain a great
deal of efficiency because the firm can influence the auditor’s deep understanding of the
client and its information system in providing additional services. For the public
companies, which are subject to the Sarbanes-Oxley Act of 2002, the auditor is not
permitted to provide certain types of consulting services for clients. Financial information
system design and implementation is not an approved consulting service under Sarbanes-
Oxley. Until it performs its planned Initial Public Offering (IPO), Ocean is a privately-held
company and is thus subject to AICPA independence requirements. The AICPA Code of
Professional Conduct indicates that systems implementation is an acceptable nonattest
service to provide to audit clients under certain conditions. For example, while a CPA firm
 may assist an audit client in implementing a computer software package, it may not design
the financial information system by creating or changing the computer source code
underlying the system.

[b] As indicated in the case, one of the partners in another office has invested in a
venture capital fund that owns shares of Ocean common stock. Would this situation
constitute a violation of independence according to the AICPA Code of Professional
Conduct? Why or why not? Ocean’s profit margin is low relative to the industry.
According to Rule 101 of the AICPA Code of Professional Conduct, materiality is not to
be considered in the case of a direct financial interest. No direct financial interests on the
part of the auditor are tolerated. However, if the financial interest is indirect, as in the case
of a mutual fund or venture capital fund investment, materiality is considered. It is fairly
clear from the case that the partner’s indirect financial interest is immaterial and thus does
not constitute a violation of Rule 101.

5. [a] Prepare a memo to the partner making a recommendation as to whether Barnes

and Fischer should or should not accept Ocean Manufacturing, Inc. as an audit client.
Carefully justify your position in light of the information in the case. Include
consideration of reasons both for and against acceptance and be sure to address both
financial and nonfinancial issues to justify your recommendation.

[b] Prepare a separate memo to the partner briefly listing and discussing the five or
six most important factors or risk areas that will likely affect how the audit is
conducted if the Ocean engagement is accepted. Be sure to indicate specific ways in
which the audit firm should tailor its approach based on the factors you identify

6. [a] How might the confirmation tendency affect the client acceptance decision?
The confirmation tendency may affect the client acceptance decision if the individual who
is making the decision has a strong belief against or for the client. This tendency affect the
client acceptance decision in manner that this will help the auditor to make each and every
required statement to be confirmed by asking multiple questions which in turn help the
service provider to take a decision whether to accept particular firm and audit client.
However, due to the confirmation bias, the auditor likely will tend to seek and place
emphasis on evidence that supports his or her beliefs about Ocean. The confirmation bias
is the tendency for decision makers to seek for and put more weight on information that is
consistent with their initial beliefs or preferences. Confirmation biases could impact how
the auditors gather information, and this bias also influences how the auditors interpret and
recall information. For example, people who support or oppose a particular issue will not
only seek information to support it, they will also interpret news stories in a way that
upholds their existing ideas. People tend to seek confirmatory evidence, rather than looking
for something inconsistent with their opinions or preferences. After receiving this
confirmatory evidence, decision makers often are confident that they have adequate
evidence to support their belief. The more confirmatory evidence they are able to
accumulate, the more confident they become. However, in many instances, we cannot
know something to be true unless we explicitly consider how and why it may be false.

[b] How might the overconfidence tendency come into play in the client acceptance
decision?
The overconfidence tendency is defined as the tendency for decision makers to
overestimate their own abilities to perform tasks or to make accurate diagnoses or other
judgments and decisions. Overconfidence is a subconscious tendency that results from
personal motivations or self-interest. Importantly, this tendency to be more confident than
is justified is likely to affect the auditors even when they are doing their best to be objective.
Studies involving practicing auditors demonstrate that auditors may be overconfident in
their technical knowledge and their competence in auditing risky areas. Such
overconfidence can lead to a variety of suboptimal outcomes in auditing, including
neglecting to ask for needed help or guidance, failing to acquire needed knowledge, poor
task performance, budget overruns, assignment of audit tasks to underqualified
subordinates, and underreview of subordinates’ working papers. Thus, due to the
overconfidence tendency, Barnes and Fischer may overestimate the firm's ability to take
on this client in an industry that the firm has little experience in.

[c] How might an auditor mitigate the possible effects of the confirmation and
overconfidence tendencies in a client acceptance situation?
There is no single best approach that the auditors can use to mitigate the effects of the
confirmation and overconfidence tendencies. The first step is always awareness. There
is no hope of mitigating biases if the auditor is not aware of these tendencies. With
awareness, common sense approaches might be available to help guard against possible
bias. However, there are some approaches that could mitigate the possible negative effects
of these tendencies. For example, to mitigate the effects of the confirmation tendency,
the auditor might refer to a robust checklist of important considerations for client
acceptance. By performing a complete evaluation of the prospective client, the auditor will
be required to consider information that does not confirm the auditor's initial belief
or opinion. Also, the auditor responsible for making the acceptance decision could
consider seeking a second opinion from another auditor about the prospective client and
could even ask that second auditor to play the role of "devil's advocate" and make the case
for the negative factors. To mitigate the effects of the overconfidence tendency, Barnes and
Fischer could get input from another auditor with experience and expertise in Ocean's
industry in order to better identify the firm's gap in skills in taking on the new client. The
firm could explicitly consider factors that could result in undetected misstatements and the
impact of possible lawsuits. The firm could also consider specific factors that might result
in budget over-runs in estimating the hours that would be needed to complete the audit
of the client. One way to do this is to identify what has gone wrong in the past and
consider the likelihood that similar things might go wrong with the prospective client.