Discussion Paper Auditor Scepticism - Raising The Bar21

Discussion Paper
AUDITOR SCEPTICISM: RAISING THE BAR
August 2010
The
Auditing Practices Board
Auditor scepticism: Raising the bar
Contents Introduction Nature of auditor scepticism Growing importance of auditor scepticism Importance of scepticism in practice Development and promotion of auditor scepticism within audit firms Can more be done to promote auditor scepticism? Questions Appendices 1. Academic research on auditor scepticism 2. References to scepticism in ISAs (UK and Ireland)
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AUDITOR SCEPTICISM: RAISING THE BAR

Introduction
Audit is essential to public and investor confidence in companies. It is far from easy to do well, requiring judgement and technical competence, often in complex circumstances. This paper discusses the degree of scepticism that auditors need to apply to conduct an audit to a high standard. This issue is particularly timely as, in the wake of the banking crisis, regulators have challenged audit firms on whether sufficient scepticism was demonstrated and the need for audit firms to exercise greater professional scepticism was a key message in the Audit Inspection Unit (AIU) 2009/10 Annual Report1. The application of an appropriate degree of professional scepticism is a crucial skill for auditors. Unless auditors are prepared to challenge managements assertions they will not act as a deterrence to fraud nor be able to confirm, with confidence, that a companys financial statements give a true and fair view. However, scepticism can be taken too far; challenging everything in a well run company will slow down the publication of its financial statements and risks unnecessary costs. The challenge for audit firms is to identify, develop and retain people with the necessary skills and to deploy them appropriately. This paper shows the importance of choosing and investing in the right people and developing the right processes to drive quality, through nurturing appropriate sceptical behaviour. Audit firms need to be vigilant about such matters and ensure that they foster the right level of scepticism in their people, despite possible incentives to do otherwise. The role of regulation is also important. Auditors work to technical and ethical standards, including requirements on rotation of partners. These seek to achieve a balance between scepticism, knowledge and over familiarity. Furthermore, audits of listed companies are inspected by the AIU which looks for evidence that the right questions have been asked and the right judgements made. The challenge for regulators is to protect investors in ways that enable audit skills and judgement to flourish. Corporate behaviour also plays a significant role. Audit firms and audit partners should not fear removal from their role if they challenge management strongly. Management and Audit Committees also have a responsibility for ensuring that the corporate culture and environment is one which encourages open dialogue with their auditors at all levels. This paper goes to the heart of some important issues and the views we hope it will elicit will be of great interest to both the Auditing Practices Board (APB), which issues Auditing Standards and guidance, and the Professional Oversight Board (POB), which (through the AIU) monitors the conduct of audits of larger entities. Because of its importance to audit quality, both Boards have worked together to develop this Discussion Paper.
The AIUs Annual Report, which was published on 21 July 2010, can be found at www.frc.org.uk/pob/audit/reports.cfm.
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The APB and POB welcome the views of those stakeholders and other parties interested in audit quality. In particular we would welcome views on the following: 1. Do you agree with the emphasis that this paper places on the importance of auditor scepticism? Are there aspects of the analysis, including the summary of academic research in Appendix 1, with which you particularly agree, or disagree? If so, what are they? 2. Regulators have recently challenged audit firms on whether sufficient scepticism was demonstrated on some audits: Do you think that this problem is widespread or limited to certain types of audits or circumstances? What factors do you believe do, or could, in practice create disincentives for auditors to apply an appropriate degree of professional scepticism and what should be done about them? In what areas do you think auditors should be more (or less) sceptical in their approach?
3. How do you think audit firms should promote and develop professional scepticism in their partners and staff? Do they need to do more and, if so, what? 4. Do you think that others, including companies, should be doing more to promote, develop and support professional scepticism in auditors? If so, what? Commentators should not feel constrained by these questions, or required to answer all of them. However, it will assist collation of views, if the questions are used to structure responses on this topic. The APB and POB would prefer to receive responses in electronic form. These may be sent by e-mail to j.grant@frc-apb.org.uk. If this is not possible, please send letters of comment to: JEC Grant Financial Reporting Council 5th Floor Aldwych House 71 91 Aldwych London WC2B 4HN In either case, letters of comment should be sent so as to be received no later than 31 October 2010. All responses will be regarded as being on the public record unless confidentiality is expressly requested and will be posted to the APBs website soon after receipt.
The Financial Reporting Council Limited 2010. The Financial Reporting Council Limited is a company limited by guarantee. Registered in England number 2486368. Registered Office: 5th Floor, Aldwych House, 71-91 Aldwych, London WC2B 4HN.
Auditor scepticism: Raising the bar Nature of auditor scepticism

1. Auditing Standards2 define professional scepticism as3 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. This definition suggests that scepticism influences the scope of the work, helps the auditor evaluate audit findings and ultimately conclude whether sufficient appropriate audit evidence has been obtained to enable a true and fair view opinion to be expressed on an entitys financial statements4. 2. It is widely acknowledged that a sceptical attitude of mind is essential if an audit is to be rigorous and performed with due professional care5; however, auditing literature is less forthcoming about the degree of scepticism to be applied in practice. The degree of scepticism to be applied is important because it influences both the effectiveness and the efficiency of an audit. Too little scepticism endangers audit effectiveness; too much risks unnecessary cost. Achieving the right balance is vital. Unless audit inquiries are to be pursued without regard to cost or time, in practice there must be a limit on the degree to which auditors inquire about particular issues and the extent of audit procedures performed. This thinking probably underlies the famous judicial view that an auditor should be a watchdog not a bloodhound.6 3. In understanding how scepticism influences the conduct of audit in practice it is worth exploring both the auditors initial mindset and how the auditor reacts to evidence obtained during the audit process. Initially, auditors approach an audit without a strong predisposition to believe that either the financial information is misstated or that management are other than honest and candid. Through the process of gathering audit evidence, auditors may obtain information that suggests that the financial information could be misstated. In this situation auditors become more intense in their enquiries and seek to obtain more audit evidence to resolve issues, especially if they develop concerns about the veracity of the evidence or the integrity of those providing it. To understand the practical application of scepticism it may therefore be helpful to view it as being applied by auditors on a sliding scale where the intensity of their scrutiny and challenge reflects both the auditors initial mindset and their response to audit findings.
References to Auditing Standards in this paper are to the Clarified ISAs (UK and Ireland) that are effective for audits of accounting periods ending on or after 15 December 2010. 3 ISA (UK and Ireland) 200, paragraph 13. 4 Auditing Standards require the auditor to obtain sufficient appropriate audit evidence. They provide guidance that this comprises information that both supports and contradicts managements assertions. However, how the auditor addresses conflicts in evidence obtained and what comprises sufficient appropriate audit evidence are essentially matters for the audit teams judgement. 5 Many of the responses to the FRCs Promoting Audit Quality confirmed the view that sound auditor judgement is a critical element of audit quality and that this is highly dependent on the personal qualities of audit partners and staff, including the degree of scepticism exhibited. The importance of auditor scepticism was also a theme of many responses to the APBs 1998 Consultation Paper Fraud and audit: Choices for society. 6 In Re: Kingston Cotton Mills Co. (1896), Lord Justice Lopes stated that an auditor is not bound to be a detective - he is a watchdog, not a bloodhound. In the later case of Fomento (Sterling Area) Ltd. v Selsdon Fountain Pen Co. Ltd. (1958), Lord Denning stated to perform his task properly he must come to it with an enquiring mind - not suspicious of dishonesty - but suspecting that someone may have made a mistake somewhere and that a check must be made to ensure that there has been none.
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Initial mindset 4. When considering the auditors initial mindset a distinction can be made between a neutral position (where the auditor does not assume either that the financial statements are misstated or that management is dishonest) and a more questioning approach that is sometimes referred to as presumptive doubt. 5. The recently updated Auditing Standards can be characterised as reflecting a presumptive doubt approach. In particular ISA (UK and Ireland) 200 states The auditor shall plan and perform an audit with professional scepticism recognising that circumstances may exist that cause the financial statements to be materially misstated7. An attitude of presumptive doubt is reinforced by ISA (UK and Ireland) 240 which states the auditor shall maintain professional scepticism throughout the audit, recognising the possibility that a material misstatement due to fraud could exist, notwithstanding the auditors past experience of the honesty and integrity of the entitys management and those charged with governance8. Whilst the auditor does not disregard past experience of the competence, honesty and integrity of the entitys management and those charged with governance when making risk assessments, this does not detract from the initial mindset of the auditor. 6. Recognising that the initial mindset is largely a personal attribute, questions arise about whether all individuals are likely to have the same attitude of mind and, if not, what causes differences. 7. As more fully described in Appendix 1 academics have identified a number of character traits that underlie auditor scepticism, including: Curiosity / having a questioning mind, Deferral of judgement / not jumping to premature conclusions, Understanding management behaviour and motivations, Self-confidence, and Freedom of action. 8. However, there are a number of important questions yet to be answered, for example: - is scepticism an innate or an acquired condition? - does scepticism vary between cultures? 9. While it is possible that some individuals are innately more curious than others, it seems likely that a sceptical mindset can be influenced by experience, by direct and indirect forms of training and by the cultural environment within the audit firm, including the formal and informal incentive mechanisms that apply within it. Indeed, the notion of professional scepticism suggests that it is through professional development and experience that an auditor learns the right level of scepticism to be applied in different circumstances. This seems consistent with anecdotal evidence that auditors become more sceptical after they have been
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ISA (UK and Ireland) 200 Paragraph 15 ISA (UK and Ireland) 240 Paragraph 12

personally involved in an investigation of an audit failure. 10. In contrast, if success at university requires curiosity and an enquiring mind it is likely that new recruits will commence their career with this trait. Indeed some academic research suggests that new staff level auditors demonstrate significantly higher levels of sceptical thought and action than their superiors. 11. If, at least to a degree, a sceptical mindset can be either acquired, or subdued, there are some important questions about how it is acquired or maintained and the degree to which audit firms actively encourage and foster it. Reaction to audit findings 12. Auditing Standards establish requirements in relation to the need to perform additional work in reaction to negative findings9. However, judgement is required when determining what findings are negative and what additional work needs to be performed in the context of the particular circumstances encountered. While the personal traits of individual auditors are also likely to influence judgements and the actions taken to respond to concerns identified, subsequent behaviour is also likely to be influenced by auditors working collectively as a team and by the audit firms policies and procedures. 13. Auditors usually work in hierarchical teams. The work of junior auditors will be supervised by more senior staff and the more important decisions will be taken by managers and, ultimately, partners. In the event of negative audit findings there is likely to be communication between team members about what has been discovered and what should next be done. While the importance of team behaviour is acknowledged by academics, little research has been undertaken in this area as much of this communication is informal and it is often difficult to reconstruct the audit teams thought process after the event. Audit regulators face the same challenge (see paragraph 58). 14. Audit firm policies and procedures, normally embodied in audit methodologies, will also often address how audit teams should respond to particular issues including the possible detection of frauds or illegal activity within the audited entity.
For example ISA (UK and Ireland) 500 paragraph 11 states that If: (a) audit evidence obtained from one source is inconsistent with that obtained from another, or (b) the auditor has doubts over the reliability of information to be used as audit evidence, the auditor shall determine what modifications or additions to audit procedures are necessary to resolve the matter, and shall consider the effect of the matter, if any, on other aspects of the audit.
Auditor scepticism: Raising the bar Growing importance of auditor scepticism

15. Towards the end of the 1990s the APB published two Discussion Papers both of which attached considerable importance to professional scepticism: Fraud and audit: Choices for society10 Aggressive Earnings Management11 16. In the case of Fraud and audit: Choices for society, professional scepticism was identified as being especially important for junior staff who, because of their contact with client management and their direct involvement in inspecting and testing transactions, had the best opportunity of identifying suspicious circumstances. 17. In Aggressive Earnings Management the APB described the opportunities that exist for companies to mislead the capital markets about their performance and profitability by biasing accounting estimates. While recognising the difficulties that auditors face in identifying and responding to such situations, the APB encouraged auditors to be more sceptical in their audit of accounting estimates. As a result of APBs work in this area requirements relating to the application of scepticism have been embedded in Auditing Standards and the relevant standard12 relating to the audit of estimates has been extended to cover the audit of fair values. 18. Changes in accounting requirements, especially the increase in estimation involved in preparing financial statements in accordance with IFRS, means that scepticism throughout the audit team has become even more important for audit quality. Scepticism is needed by auditors both to challenge management about whether accounting estimates are appropriate and to challenge themselves as to whether sufficient appropriate audit evidence has been obtained to support those estimates. This often involves auditors assessing whether the assumptions underlying estimates seem plausible. Assessing the plausibility of assumptions can not be performed without an appropriate degree of scepticism and challenge. 19. The AIU has raised concerns over insufficient auditor scepticism with the leadership of the major global audit firms and has sought action plans setting out how these firms intend to address the root causes.
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November 1998. www.frc.org.uk/apb/publications/other June 2001. www.frc.org.uk/apb/publications/other 12 ISA (UK and Ireland) 540 Audit of Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures
Auditor scepticism: Raising the bar Importance of scepticism in practice

20. Over the years, disciplinary investigations into Equitable Life Assurance Society, London International Group, Independent Insurance, TransTec, Wickes and ERF Holdings have identified audit failings. These include instances of over reliance on management representations, failure to investigate conflicting explanations and failure to obtain appropriate third party confirmations - which may suggest that the auditors in these cases were not sufficiently sceptical. 21. A lack of scepticism has also been reported by the AIU. One of the findings described in their 2009/10 Annual Report13 was that audit firms are not always applying sufficient professional scepticism in relation to key audit judgements. In particular, audit firms sometimes approach the audit of highly judgmental balances by seeking to obtain evidence that corroborates, rather than challenges, the judgments made by their clients. 22. The AIU also reported that auditors should exercise greater professional scepticism when reviewing managements judgements relating to fair values and the impairment of goodwill and other intangibles and future cash flows relevant to the consideration of going concern. 23. In the US, research has shown that the failure to demonstrate an appropriate level of scepticism was a deficiency found in 60% of the cases where the SEC brought fraud related actions against auditors14. 24. This is consistent with the findings of the US Panel on Audit Effectiveness. The Panel, which was set up by the Securities and Exchange Commission (SEC) in 1998, conducted a very thorough review of the effectiveness of large audits by the large audit firms15. The Panel reasserted the importance of professional scepticism and observed that: auditing standards needed to provide better guidance on how to implement the concept, audit firms should more effectively teach the concept of professional scepticism, and audit firms should develop or expand training for auditors at all levels oriented toward responsibilities and procedures for fraud detection. These programs should emphasise interviewing skills and the exercise of professional scepticism, as well as testing techniques.
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Published on 21 July 2010 Beasley, M.S., J.V. Carcello & D.R Hermanson, 2001. Top 10 audit deficiencies. Journal of Accountancy 191 (4):63-66 15 At the request of the SEC, the Public Oversight Board appointed the Panel on Audit Effectiveness in October1998 to assess whether independent audits of the financial statements of public companies adequately serve and protect the interests of investors. The Panel reviewed and evaluated the way that audits were performed, and assessed trends in audit practices to determine whether they were in the public interest. It studied the audit policies, methodologies and other forms of guidance used primarily by the large audit firms, certain aspects of auditor independence and the auditing professions selfregulatory structure.

25. The academic work summarised in Appendix 1 also provides some indicators that auditors may not be sufficiently sceptical, although it is recognised that much of this is US research and the findings may not apply to auditors working in different environments.
Development and promotion of auditor scepticism within audit firms

26. Scepticism is an important element of audit quality and, in the medium to long term, audit failures can expose audit firms to litigation and reputational damage. Consequently audit firms have policies and procedures aimed at achieving audit quality. 27. However, it is also clear that audit firms place considerable importance on retaining their client base. Emphasis on client service planning and relationship management within the firms may act as a disincentive for auditor scepticism if audit teams believe that by demonstrating scepticism they risk having an unhappy client. 28. Particular problems are likely to arise if scepticism results in a delay in the completion of the audit. The timetable for an audit is usually agreed in advance, especially if the entity is a listed company which has agreed a date upon which to announce its results. Delays caused by the auditor pursuing additional inquiries that cause the audit not to have been completed by the agreed date can be problematic, especially if the auditors concerns prove to be unfounded. 29. Furthermore, application of scepticism can also directly threaten short term profitability. The fees for most audits are agreed in advance on the basis of time estimates; additional fees for variances from the plan are negotiated after the audit is completed . Initial fee estimates are often prepared on the basis that the entitys controls will be shown to be operating effectively and that few other problems will be revealed. The audit market is competitive and such fee estimates do not usually contain contingencies for dealing with the unexpected. Negotiations for additional fees after the audit has been completed can adversely impact client relationships. In this environment there may be an incentive for the audit team to adhere strictly to the plan. Keeping to the plan is also a plausible strategy for junior staff who are already working long hours and may not wish to work even longer16. 30. Two particular areas that are likely to be relevant to the development and promotion of auditor scepticism are (a) recruitment, training and motivation / reward processes and (b) audit methodologies.
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B Pierce and B Sweeney Cost quality conflict in audit firms: an empirical investigation and M Page A survey of time budget pressure and irregular auditing practices among newly-qualified UK chartered accountants.
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Recruitment, training and motivation/reward processes 31. If the underlying characteristics of scepticism are largely innate then initial recruitment policies are likely to be important in helping audit firms employ staff with the appropriate attitude. 32. While recognising that there are a number of different qualities that audit firms will be seeking in new recruits, more could perhaps be done to extend the electronic screening that is often currently used to seek out the character traits underlying sceptical behaviour. Even if initial recruitment does not focus on scepticism, subsequent promotion/retention policies could be used to promote its importance. 33. If underlying characteristics are largely an acquired skill then training and development in the firm become more important. In this context lessons might be learnt from how the US audit firms responded to the US Panel on Audit Effectiveness recommendation that firms should more effectively teach the concept of professional scepticism. 34. However, irrespective of how effective the classroom training might be, it will be lost in the pressure of practice unless it is reinforced through the culture of the firm and its mentoring and reward systems. Many believe that nurturing the right professional qualities is best achieved through junior staff working closely with more experienced partners and staff provided that such senior personnel already have the right qualities. 35. A key stimulus to achieving an appropriate level of scepticism in junior staff is likely to be through coaching undertaken as part of the review process. Research suggests that one way to enhance professional scepticism is for reviewees to understand that scepticism is a priority of the reviewer. It also suggests that junior auditors who expect a face-to-face review undertake more thorough work than those who anticipate interacting with the reviewer electronically or who do not anticipate being reviewed at all. 36. This is consistent with the importance given to coaching and mentoring in the FRCs publication Promoting Audit Quality. 37. It is possible that the level of innate scepticism varies between cultures. If so this is likely to be a challenge for audit firms undertaking group audits where the work on overseas subsidiaries is undertaken by national firms. While there is a requirement in Auditing Standards17 for the group auditor to obtain an understanding of the subsidiary auditors professional competence there is no specific indication that this should include the degree of scepticism and indeed this could be very difficult to achieve in practice. Although Auditing Standards require the group auditor to be actively involved in the audit of significant subsidiaries it is questionable whether this could fully compensate for a systematic lack of scepticism in the local team. Other techniques such as staff secondments
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ISA (UK and Ireland) 600 paragraph 19
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from other countries may be a more effective approach to national variations in scepticism if they exist.
Audit methodologies 38. Audit firms, particularly the largest, invest significant amounts in their audit methodologies and quality control systems. 39. In recent years audit methodologies have grown both in their complexity and their influence on what audit work is done in practice, especially by more junior members of the audit team. This is, in part, influenced by developments in Auditing Standards and other regulatory activity but also by the larger audit firms wish to standardise parts of the audit and to take advantage of control techniques that become available in electronic working papers. 40. The FRCs Promoting Audit Quality observed that electronic working papers had the potential to distance both partners and staff from the company being audited and reported anecdotal evidence that the proportion of audit time spent by staff sitting in the audit room completing electronic schedules seemed to be increasing at the expense of time spent reviewing client records, discussing accounting issues with client staff and otherwise obtaining audit evidence. 41. It is of course easier to imagine auditor scepticism being applied when auditors are walking the floor, observing and inspecting the company's operations, rather than sitting in the audit room completing electronic schedules - but there are also wider issues associated with the integration of methodologies and electronic working papers. Self-determination or freedom to act appears to be one of the character traits that fosters sceptical behaviour. This involves individual auditors having the ability to pursue their own inquiries when needed and the motivation to do so. Rather than requiring auditors to perform predefined audit tasks and complete checklists, professional scepticism might be better fostered by methodologies encouraging auditors to ask management relatively open questions and follow up on responses. 42. Academic research, albeit before the latest generation of electronic working papers, suggests that the firms documentation systems are reducing the amount of detailed comments that show how thinking on a particular topic evolves and how final conclusions are reached. Documentation of this nature would seem to be especially important to support judgements, for example on the acceptability of fair values, when the work of relatively junior staff is reviewed and challenged by more senior members of the audit team who apply their wider knowledge of the entity and their greater experience to the judgements. An absence of a clear thought trail is likely to reduce the opportunity for juniors to learn and inhibit the effectiveness of review processes18.
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A clear record of the auditors thought process is also likely to be beneficial to audit quality more generally as documentation often helps structure a thought process and helps the author and subsequent reviewers identify illogicalities and inconsistencies.
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43. Active consideration of how auditors make, and document, important judgements is likely to be a useful area of future research. In particular it may be worth exploring how members of the team, especially the partners and managers, review the work of the rest of the audit team in an electronic environment, how they raise review points and how the actions taken in response to them are documented. It would also be worth discussing why review notes are not usually retained once the audit has been completed. 44. It is apparent that audit firms often request their clients to prepare, in advance of the audit, specific schedules and analyses (client co-operation arrangements). In some cases the level of client assistance may be greater and include, for example, extracting records from files and other work. While saving audit costs, there is a danger that such arrangements may influence the auditors mindset and make them over-trusting. Academic research in Ireland19 suggests that co-operation and trust seem to be mutually reinforcing conditions and that excessive trust may reduce auditor scepticism. 45. Where client co-operation arrangements are established, it is important that audit teams do not allow them to reduce the level of scepticism demonstrated and that such arrangements do not allow client management to influence the extent and nature of audit work performed.
Can more be done to promote auditor scepticism?

46. Audit firms Audit firms have invested significantly in recent years in the automation of their systems in order to obtain efficiency and effectiveness benefits. This may be an appropriate stage for them to take stock of the progress made and to evaluate the impact of their systems on the judgemental aspects of the audit and in particular on the mindset of staff at all levels. 47. Further consideration of aspects of their recruitment, training, methodology, and motivation and reward processes may provide opportunities for increased auditor scepticism and, therefore, improve audit quality. 48. Auditing Standards - Auditing Standards applicable in the UK and Ireland20 require the auditor to plan and perform an audit with professional scepticism21 and guidance as to the importance of scepticism is provided in supporting application material. Reference to the need for auditor scepticism is also made in a number of other Auditing Standards (see Appendix 2) most notably ISA (UK and Ireland) 200 on the overall objectives of the auditor and ISA (UK and Ireland) 240 on fraud.
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Extended Clan: External Influences on Audit Team Behaviour Sweeny and Pierce The ISAs (UK and Ireland) are the ISAs issued by the International Auditing and Assurance Standards Board ( IAASB) supplemented, where appropriate, with additional requirements to address specific UK and Irish regulatory requirements and additional guidance that is appropriate in the UK and Irish national legislative, cultural and business context. 21 ISA (UK and Ireland) 200 paragraph 15
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49. Over recent years, the Auditing Standards, have been revised to make them more rigorous22. This has involved, in part, imposing requirements on all auditors to perform certain procedures which, while normally undertaken by a sceptical auditor, were not always performed in practice. Examples include: Mandatory meetings of the audit team to discuss the susceptibility of the entity to: - misstatements (ISA 315), - fraud (ISA 240), and - fraud or error that could result from related party relationships (ISA 550), Reviewing the outcome of opening provisions (ISA 540), Checking a sample of journal adjustments (ISA 240), Evaluating risks in relation to revenue transactions based on the presumption that there are risks of fraud in revenue recognition (ISA 240), and Investigating significant related party transactions outside the entitys normal course of business (ISA 550). 50. That said, experience from audit inspections would suggest that further action could be taken; for example consideration could be given to whether Auditing Standards inadvertently lead auditors to place undue reliance on managements work and whether there might be new requirements for: Fuller documentation of the rationale for key audit judgements, perhaps by mandating Audit Completion Memoranda, The retention of review notes as part of audit documentation, Meetings of the audit team after most of the work has been completed, but before the audit report is signed, to discuss findings, Ensuring that reviews are undertaken in person rather than remotely. 51. However, in considering whether more should be done to make Auditing Standards more specific, consideration needs to be given to the risk that a further move away from principles towards rules will demotivate audit staff and add unnecessarily to the cost of some audits. Furthermore, specification of required procedures does not necessarily ensure that the work is performed in a sceptical manner and that there is adequate follow up of the findings. 52. Guidance - Rather than adding more requirements to standards, APB could perhaps develop guidance on audit scepticism to help audit firms understand its nature and how best it might be encouraged. Such guidance might build on research undertaken in a UK context. 53. Another possibility might by for APB, or another body, to publish summaries of the lessons learnt from investigations into possible audit failures. War stories of this nature may help increase auditor scepticism and assist with fraud detection.
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Some of these changes were introduced for UK and Irish audits of accounting periods ending on or after 15 December 2010 when the Clarified ISAs (UK and Ireland) became effective.
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54. Ethical Standards Some academics consider that there is an inverse relationship between scepticism and trust. As one observed As the auditor-client relationship lengthens, a behavioural bond develops between the auditor and the auditee as they become more familiar with each other and mutual trust replaces the auditors necessary professional scepticism. At some point, it is argued, the degree of trust can become so great that violations will not be challenged as auditors instinctively favour evidence that confirms their prior beliefs. One of the difficulties here is that two of the vital ingredients of a high quality audit scepticism and knowledge of the clients business - seem to be pulling in different directions. 55. Ways of avoiding auditors placing too much trust in their clients are traditionally addressed in Ethical Standards. Methods used to enhance auditor objectivity and independence include: Rotation (both of firms and partners and staff), Prohibition of certain non-audit services especially those that create a mutuality of interest with management, and Prohibition of employment, by the audited entity, of ex-audit team members. 56. These topics were debated during the Governments enquiry by the Co-ordinating Group on Audit and Accounting Issues (CGAA) into the implications of the Enron failure for UK auditing and accounting. These areas are also addressed in APBs Ethical Standards for Auditors which were first issued in 2004 and subsequently reviewed in 2007. Neither the CGAA nor the APB thought that it was necessary to introduce mandatory rotation of audit firms, but the rotation period of audit partners on listed company audits was reduced from seven years to five. 57. Audit inspection. The AIU is responsible for monitoring the audits of all listed and other major public interest entities23. This involves, inter alia, the AIU forming a view on the quality of the important judgements made during the audits they inspect and evaluating whether sufficient scepticism has been demonstrated. As noted above, the AIU has commented that audit firms are not always applying sufficient professional scepticism in relation to key audit judgements. 58. One of the challenges faced by audit inspectors is that there are two aspects to scepticism sceptical thinking and sceptical actions. Sceptical thinking operates, or does not operate, within an individual auditors mind. While it can probably be witnessed on a real time basis, the transparency to others of sceptical thought rapidly reduces over time. Audit inspectors, who review audit documentation some time after it is performed and do who not see original client records, may see evidence of sceptical actions but, without knowing what was in the auditors mind at the time, it is difficult to evaluate the adequacy of these. The problem of evaluating the degree of sceptical thinking within an audit team is exacerbated by the removal from the audit documentation of review notes on completion of the audit (see paragraph 13 above).
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The AIUs scope is the audits of all UK incorporated companies with listed securities (both equity and non-equity securities) and other entities in whose financial condition there is considered to be a major public interest. The AIU reviews a sample of audits each year.
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59. Companies Corporate culture and behaviour can impact auditor scepticism too close a relationship between management and the auditor may reduce auditor scepticism; too hostile a relationship, whether resulting from excessive challenge by the auditor or from a defensive attitude by the audited entitys management and/or staff, may be intimidating to the auditor and/or may create an environment in which there is a lack of openness in responding to auditor enquiries. 60. Periodically audit committees may wish to consider whether there is an appropriate relationship between management and the auditors and, if not what can be done to change it. However, deciding what to do if the relationship is not right is likely to be challenging. It is not easy to change management behaviour and while requiring changes in the audit team, or indeed changing the audit firm, may appear an easier solution, audit committees will be aware that such actions were sometimes taken in the past and some audit failures have demonstrated that this had the effect of weakening audit quality rather than strengthening it. One possible safeguard to this concern might be the mandatory rotation of audit firms but there are well documented disadvantages to such a requirement. 61. The UK Corporate Governance Code anticipates that the audit committees of listed companies will review and monitor the effectiveness of the audit process. As well as considering the relationship between management and the audit team, audit committees may wish to consider whether the audit partner and staff exhibited sufficient levels of professional scepticism in their work and were robust in dealing with issues identified during the audit24. In this context, the AIU issues reports on the individual audits reviewed each year and the auditors are required to provide copies to the audit committee of the audited entity these should provide further input to their consideration of audit effectiveness, where applicable. Direct consideration of whether the audit team was sufficiently sceptical, and communication with the audit firm if this was not the case, is likely to help increase the emphasis audit firms place on this. 62. Audit committees can also influence scepticism in advance of the audit. Open discussion with the auditors about business and accounting issues will help alert them to risk areas. Furthermore, when discussing proposed audit fees, audit committees may wish to challenge whether they include an appropriate contingency for dealing with any unexpected developments (see paragraph 29). 63. Accountancy bodies There is likely to be a link between scepticism and training. While much of the audit related training is provided by the audit firms, the accountancy bodies have responsibility for the curriculum leading to qualification as an accountant and also have requirements relating to continuing professional development (CPD).
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See the FRCs Audit Quality Framework.
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64. More could perhaps be done to enhance auditor scepticism through training provided by the accountancy bodies. One possible mechanism might be through developing training videos. It is interesting to observe that films such as The Auditor in Court25 and Billion Dollar Bubble26 that were viewed by many older auditors are no longer readily available to younger members of the profession. 65. Academics - One of the inevitable conclusions to academic research papers is that more research needs to be carried out and this is clearly the case in relation to auditor scepticism and how it can be increased. Possible topics include: Conceptual To what extent are underlying characteristics of scepticism innate or acquired? If innate do these vary with cultural background? How do the different underlying factors combine (for example are they additive or multiplicative)? Do sceptics respond to time / client pressure in the same way as non-sceptics? What is the relationship between levels of education and scepticism? Training and development Can scepticism be taught? If so, how? What is best practice within firms for developing and maintaining scepticism? Do firms encourage or discourage self-determination? How do firms evaluate/reward staff for scepticism? Audit methodologies Do methodologies encourage auditors to ask questions? Do electronic working papers facilitate the making and recording of the important audit judgements? Do they encourage sceptical behaviour? Can improvements be made to how: o auditors make, and document, important judgements? o partners and managers review work in an electronic environment? o partners and managers raise review points and how the actions taken in response to them documented? 66. The APB and the POB would welcome copies of any research studies undertaken in the UK and Ireland on auditor scepticism or related topics and being informed if studies are underway or due to commence.
25 26
An ICAEW film that followed the cross examination of an audit practitioner accused of negligence. The story of the Equity Funding fraud
17
Auditor scepticism: Raising the bar Questions

1. Do you agree with the emphasis that this paper places on the importance of auditor scepticism? Are there aspects of the analysis, including the summary of academic research in Appendix 1, with which you particularly agree, or disagree? If so, what are they? 2. Regulators have recently challenged audit firms on whether sufficient scepticism was demonstrated on some audits: Do you think that this problem is widespread or limited to certain types of audits or circumstances? What factors do you believe do, or could, in practice create disincentives for auditors to apply an appropriate degree of professional scepticism and what should be done about them? In what areas do you think auditors should be more (or less) sceptical in their approach?
3. How do you think audit firms should promote and develop professional scepticism in their partners and staff? Do they need to do more and, if so, what? 4. Do you think that others, including companies, should be doing more to promote, develop and support professional scepticism in auditors? If so, what?
18

Appendix 1
Academic research on auditor scepticism

This appendix outlines the manner in which academic research has investigated the characteristics underlying auditor scepticism and the degree to which it is likely to be exhibited in practice, and provides illustrative findings from that research.27 Studies of auditor scepticism fall within a broad field of research concerned with judgement and decision making in auditing, looking at the manner in which individual attributes and contextual variables are associated with the judgements auditors form and the actions they take when conducting an audit. Much of the research in this field has been undertaken by US academics and it should be noted that the findings may not apply equivalently to auditors working in different countries and environments. Furthermore, due to the difficulty of gaining research access to real life situations, many studies have relied upon hypothetical case examples tested using surveys or in settings outside practice rather than data drawn from actual audit engagements. While research designs employing hypothetical cases are useful in illustrating the significance of specific factors they cannot easily capture all the complexities that are found in practical situations. While some of the research is current, some dates back to the 1990s and before. To the extent that the audit firms have changed attitudes and behaviour, for example by responding to the recommendations of the US Panel on Audit Effectiveness, this will not be reflected in the older research. This summary draws attention to research findings in the following three categories: Studies that seek to identify characteristics underlying auditor scepticism; Studies that explore the factors which may influence the degree of scepticism reflected in auditor behaviour; Studies that explore the scepticism in the context of the audit firm.
Characteristics underlying auditor scepticism.

Some researchers have sought to identify the elements which characterise sceptical behaviour. This approach goes beyond seeking simply to define auditor scepticism to identify the characteristics that are associated with differing levels of scepticism between individuals and the resulting types of behaviour which reflect the application of professional scepticism. Distinction is often drawn between sceptical judgement and sceptical actions. While individual judgements may be more or less sceptical, it is only when scepticism reaches a threshold that the judgement will lead to consequent identifiable action by the auditor, such as obtaining more evidence or seeking adjustments.
An in-depth review of the literature can be found in: Nelson, M., A Model and Literature review of Professional Skepticism in Auditing, Auditing a Journal of Practice and Theory, Vol. 28, No. 2, November 2009, pp. 1-34.
27
19

Approaches to investigating professional scepticism in the research literature, and also to applying it in practice standards, adopt differing views about what professional scepticism means in terms of the initial mindset that the auditor should have in undertaking an engagement. Contrast can be drawn between a neutral mindset, in which the auditor neither accepts management figures and explanations in an unquestioning way nor assumes that there is error or misstatement, and presumptive doubt where the auditor exhibits a heightened awareness of the risk that the figures could be affected by error or dishonesty28. Auditors have sometimes been criticised for not applying sufficient professional scepticism, implying that more doubt would have led auditors to have investigated further or look for more persuasive evidence and to have avoided alleged failures as a result. However, greater doubt is not unambiguously a good thing as it may lead to unnecessary procedures, over-auditing and inefficiency. Hurtt, Eining and Plumtree29 studied how scepticism was treated in early philosophical writings and in other relevant disciplines (including scepticism reflected in the work of psychologists, jury behaviour and consumer behaviour in relation to advertising). They identified four behaviours expected of sceptics, namely: Expanded information search sceptics always demand reasons, evidence, justification and proof , Increased contradiction detection sceptics seek out inconsistencies Increased alternative generation sceptics construct alternative explanations Increased security of source reliability sceptics make links with understanding peoples motivation / behaviour. A sceptic will be concerned about the reliability and independence of data sources. Based on this approach they developed a model (the Hurtt Model) of auditor scepticism which involves: Factor Underlying characteristics 1 Examination of Questioning mind a sceptic questions everything evidence characteristics even their own judgements. Suspension of judgement sceptics want to see evidence before making conclusions; they are slow to form a judgement. Search for knowledge / curiosity - sceptics seek knowledge for its own sake. 2 Understanding Interpersonal understanding understanding evidence providers peoples motivation and behaviour is a fundamental requirement in scepticism. 3 Characteristics to act Self-confidence the propensity to challenge on the information assumptions. Self-determination an auditor must individually decide when a sufficient level of information has been obtained.
28 29
Bell,T.B, M.E. Peecher, and I. Solomon. 2005. The 21st Century Public Company Audit, New York. Hurtt, K., M. Eining and D. Plumtree, Professional Skepticism: A Model with Implications for Research, Practice and Education, working paper, University of Wisconsin Madison, 2002.
20

The Hurtt Model has been applied in research undertaken with practicing auditors in the Netherlands. Quadackers, Groot and Wright30 tested the strength of the relationship between four possible determinants of auditor scepticism (trust, suspension of judgement, locus of control and the Hurtt Model). A total of 376 practitioners from the Big Four in the Netherlands responded to a case scenario where the results of an analytical procedure showed an unusual increase in sales and a fairly superficial management response. The results showed that 2 of the 4 determinants (trust and the Hurtt Model) had the highest explanatory power in predicting sceptical behaviour. Hurtt has used the Model herself31 to explore auditor behaviour and concludes that while less sceptical auditors may be better at identifying factual errors, more sceptical auditors are better at identifying situations containing contradictory information and adopting a holistic view of evidence. While acknowledging that both skills are valuable she postulates that while less sceptical auditors focus on the details more sceptical auditors are better at developing a coherent conceptualisation of evidence taken as a whole.
Factors influencing the degree of scepticism reflected in auditor behaviour

A further line of research has investigated how various factors can influence the degree of professional scepticism reflected in auditors judgements and actions. While some of this research seeks to model the potentially complex interactions between different factors, for present purposes it is sufficient to note that studies have shown that auditor knowledge, personal traits and incentives may be linked to variations in auditor scepticism32. Auditor knowledge, experience and training Increased knowledge, specialist experience and training have been shown to enhance auditors awareness of potential causes of error and the ability to recognise patterns and respond to risk factors. However, increased knowledge may not always result in increased scepticism as some studies have shown that knowledge also increases the likelihood that reasons other than error will be accepted by specialists as explanations for unusual patterns.
30
Quadackers, L.,M., T.L.C.M. Groot and A. Wright, Auditors Skeptical Characteristics and their Relationship to Skeptical Judgments and Decisions, working paper, VU Amsterdam, 2009. 31 K. Hurtt, M. Eining and D. Plumlee, Linking professional skepicism to auditor behaviours, Baylor University, working paper 2010. 32 See Nelson M., 2009, op. cit., for a more detailed review of studies on each of these factors.
21

Incentives Several incentive factors may influence the likelihood that auditors will behave in a manner that reflects increased scepticism and studies have shown that incentives do affect auditors behaviour. These incentive factors include the relationship with the client company and opportunities for additional services and revenue generation, the nature of review and performance appraisal within the firm and related recognition and reward, and regulatory inspection and threats to reputation. It is the overall balance which is likely to affect judgements and actions in an audit engagement. Overall, the evidence suggests that auditors judgements will exhibit more scepticism where concern for reputation and exposure to litigation is greater rather than concern for firm revenue or the potential loss of a client. Less is known about how performance evaluation and reward systems within audit firms can be used to promote appropriate levels of professional scepticism in auditors behaviour. Traits An important question that has been investigated by a number of researchers is whether underlying personal attributes are influential on the degree of scepticism exhibited by auditors. For example, problem solving ability has been shown to be relevant to the ability to identify potential errors. Ethical and moral development also appears to be related to auditors ability to identify potentially inappropriate actions by a client. The characteristics included in the earlier table describing the Hurtt model, such as self-confidence, self-determination and interpersonal understanding also relate to the personal attributes, or traits, possessed by the individual auditor. Several studies have examined how interpersonal trust affects sceptical judgements and actions. Rennie, Kopp and Lemon 33 explored the tension between trust and professional scepticism. They note that trust is a practical necessity for the efficient conduct of an audit but over time trust accumulates and that at some point too much trust destroys audit quality. Research in this area suggests that co-operation and trust are mutually reinforcing. What is important, it is suggested, is how the auditors respond to evidence of a trust violation. In the US, Lewicki and Bunker34 use an existing model of trust to explore at what point the auditor might place too much trust on management:
33
Rennie, M.D., L.S. Kopp and W.M. Lemon, "Exploring Trust and the Auditor-Client Relationship: Factors Influencing the Auditor's Trust of a Client Representative", Auditing a Journal of Practice and Theory, 2010. 34 Lewicki, R.J. and B.B. Bunker. 1996. Developing and maintaining trust in work relationships- in Trust in Organizations: Frontiers in Theory and Research edited by Kramer R and T .Tyler: Newbury Park, CA.
22
Category of trust Calculus-based
Characteristics Fragile. An early stage of a relationship where trust is based on a rational assessment of the relative costs and benefits giving or withholding trust. More robust. A higher level of trust based primarily on the history of interaction between individuals. Highly robust. The highest level where an individual identifies with the others desires and intentions
Response to evidence of a trust violation. Trust likely to be terminated
Knowledge based Identification based
Relationship more forgiving if an adequate explanation can be found for the violation it will often be accepted. Sense-making process likely to apply auditors will favour evidence that confirms their beliefs. Ambiguous or incomplete information will be interpreted in a way not to change the belief.
Lewicki and Bunker suggest that the optimal level is calculus-based trust. They indicate that trust can be strongly influenced by members of management previously being employed by the audit firms especially if that individual is personally known to the audit team. In such cases past-trust is often not re-evaluated in the new context. The authors also note the influence that the provision of advice / non- audit services can have on trust35. Also in the US, Shaub and Lawrence36 noted that the Independence Standards Board37 had identified inappropriate trust as one of the five biggest threats to auditor independence and explored the auditor-client relationship. They identified two types of trust: (a) rational (emotional) trust and (b) deep auditor-client interdependence and postulated that deep auditor-client interdependence is likely to be troublesome for auditor independence / scepticism (especially where there is information asymmetry).
The authors cite the Panel on Audit Effectiveness 2000 report which noted that some services can subvert neutrality, impartiality and scepticism and create a mutuality of interest with management. 36 Shaub, M.K. Trust as a Threat to Independence : Emotional Trust, Auditor-client Interdependence, and their impact on Professional Skepticism, 2004 37 The Independence Standards Board (ISB) was established in May 1997 as a result of discussions between the American Institute of Certified Public Accountants (AICPA) and the U.S. Securities and Exchange Commission (SEC). The operating policies of the ISB were designed to permit timely, thorough, and open study of issues involving auditor independence and to encourage broad public participation in the process of establishing and improving independence standards. The ISB ceased its operations in 2001.
35
23

Work in Ireland by Sweeney and Pierce38 provides an insight into the relationship between trust and auditor scepticism. This study involved interviews with 18 client staff39 to assess the extent to which client staff can influence audit team behaviour, recognising that there needs to be a balance between professional scepticism and the need for client co-operation. The conclusion was that client staff can, and do, influence behaviour, for example by imposing over-demanding deadlines, late delivery of information, selecting samples and providing misleading answers to questions. The suggestion is that this manipulation is easier when audit staff are young and have no real business experience. The study also gives some interesting insights into what auditor scepticism is and how it can be achieved. The main aspects of scepticism identified are: Character of the auditor Audit firms systems positive factors Audit firms systems negative factors Confidence and knowledge junior staff find it difficult to say I dont understand that Probing skills / persistence. This may be impacted by culture Not shying away from confrontation, and Strength of character in dealing with challenging or confrontational situations Strong manager / partner reviews especially if they are knowledgeable about the clients business Strong contact between manager / partner and junior staff Increasing documentation requirements Too many check lists in methodology lack of emphasis on understanding the clients business Over aggressive budgets / timetables
Professional scepticism in the context of the audit firm

While much of the research on sceptical behaviour has focused on the behaviour of the individual auditor, the context of the professional firm and the audit team are also relevant to the exercise of professional scepticism. For example, in his review of the literature in this area, Nelson40 cites several ways in which professional firms can enhance professional scepticism: Recruitment processes that include assessment of relevant attributes; Training in error recognition and in negotiation; Performance evaluation and promotion systems that reward appropriate professional scepticism; Review processes that are structured to favour professional scepticism; Decision aids such as checklists and procedural or documentation requirements; Incentives that promote challenge in the audit process.
38
Sweeney, B. and B. Pierce, The Extended Clan: External Influences on Audit Team Behaviour, working paper. 39 The clients were listed companies audited by the Big Four, generally out of their Dublin offices. 40 Nelson, M., 2009, op. cit.
24

A number of studies have looked at how the firm context impacts on the exercise of professional scepticism. In the US Shaub and Lawrence41 explored how socialisation within the firm can affect professional scepticism and tested this using a case study involving 710 auditors from a single large US firm. The study distinguished between sceptical thinking (judgement) and sceptical behaviour (action). In general the work demonstrated that there is a significant degree of professional scepticism in auditors at all levels. However, they found that new staff level auditors demonstrate significantly higher levels of sceptical thought and action than their superiors (seniors, managers and partners). While overall the scepticism of seniors is similar to those of managers and partners there is some evidence that the level of sceptical thinking of seniors is greater than managers and partners. Shaub and Lawrence suggest that the relationship between sceptical thinking and sceptical behaviour is rather inelastic, in other words that an auditors scepticism must reach a certain threshold before an auditor is willing to take action. They postulate that a possible reason why this threshold is higher for partners and managers are market factors ie the commercial pressure that they are under. The research suggested that staff are more prepared than partners and managers to be sceptical on those clients which are important to the firm for referrals and that partners are much less sceptical than others when dealing with the offices single biggest audit client. A number of studies have demonstrated the importance of selection and socialisation in developing and maintaining a firms culture of shared values and practices42. Selection involves both recruitment and promotion. One study has shown that auditors are more likely to be promoted if their level of moral reasoning is similar to that of their superiors and that principled moral reasoning falls away in the manager and partner ranks43. Other research44 shows that the high turnover of public accounting firms helps to establish cultural stability those who disagree with the firms value leave it. The suggestion that there is a tendency towards harmonising levels of scepticism within an audit firm may be challenged by other work undertaken by Shaub and Lawrence in the US45. They developed four categories reflecting individuals tendency to think sceptically and to act sceptically and, using a sample of 37546 auditors explored the relationship between those categories and (1) age/experience and (2) ethical disposition.
41
Shaub, M.K. and J.E. Lawrence, Differences in Auditors Professional Skepticism Across Career Levels in the Firm Advances in Behavioural Accounting Research, 2: 61-83, 1999. 42 For example, see: Pratt, J., and P. Beaulieu, Organizational Culture in Public Accounting: Size, Technology, Rank, and Functional Area. Accounting, Organizations & Society, 17(7):.667-684.. 43 Ponemon, L., Ethical reasoning and selection-socialization in accounting, Accounting, Organizations and Society, 17(3-4): 171-189, 1992 44 Harrison, J.R. and G.R. Carroll.. Keeping the Faith: A Model of Cultural Transmission in Formal Organizations, Administrative Science Quarterly, 36: 552-582, 1991. 45 Shaub, M.K. and J.E. Lawrence, A Taxonomy of Auditors Professional Skepticism , Research on Accounting Ethics, 8: 167 -194, 2002. 46 The original sample was 710 but pre-screening eliminated those that did not consistently fit the categorisation system.
25

Their categorisation system was: Characteristics (tendency to think sceptically/ to act sceptically Measured sceptics Low thought / high action. Not overly suspicious of routine behaviour but very alert when something out of the ordinary happens activated professional scepticism. Aggressive sceptics High thought / high action. These auditors are generally more suspicious than others and are sensitive to harmful motives. They take action even in low risk situations likely to result in inefficient auditing and client dissatisfaction. Reluctant sceptics Low thought / low action. A rational approach but one that likely to result in poor audit quality unlikely to detect management fraud. Conflicted sceptics High thought / low action. These auditors demonstrate risk recognition skills but they are not acted upon. Possible that they are influenced by client reaction / cost issues. Tendency to become cynical. The results of the test, undertaken within a single large US firm, were: Measured sceptics 12% of sample. These have the highest concern for professional ethics. Aggressive sceptics 26% of sample. Generally the youngest / least experienced. Reluctant sceptics 36% of sample. Significantly more experience/age than the other categories. Conflicted sceptics 26% of sample the least idealistic auditors. The authors emphasise the superiority of the measured sceptic category and note that it is troubling that 36% of the sample, are in the reluctant sceptic category. They also find it troubling that 80% of partners and managers are either reluctant sceptics or conflicted sceptics (in both cases the tendency to act is low). This may be because repetitive experiences may leave them less susceptible to the surprise/shock that leads to increased scepticism. The number of conflicted sceptics suggests cynicism, disillusionment and low career satisfaction. The authors draw out a number of implications for the profession including: If the goal is to develop more measured sceptics training and reinforcement are necessary. It will be necessary to teach new auditors recognition skills and feedback so that they are not continually over-reacting. Conflicted auditors need to be rewarded not punished for their recognition skills. A mentoring programme has the opportunity to assist in this development. Additional training on recognition may not be helpful for the reluctant sceptics who are generally the older auditors. They may need peers and supervisors to challenge their thinking.
26

Further work by Shaub and Lawrence47 explored auditors propensity to confront client across experience levels and gender within the firm. Based on responses from 700 auditors from a single large US firm to questions in a case study scenario, they found that the willingness to question a client in detail declines based on experience although for men there is some evidence of a pick-up at partner / manager level (the number of partners included in the sample was however small). Partners appeared less confrontational however in situations where the client is very large or is an active purchaser of non-audit services. For women there is no sign of a pick up at manager level (there were no female partners in the sample).
Summary
This brief review has illustrated how academic research has investigated the characteristics underlying auditor scepticism, the manner in which factors such as knowledge, personal attributes and incentives influence the degree of scepticism reflected in the judgements and actions of auditors and the behaviour of individuals in the context of the audit firm. The results provide insights into the nature of scepticism in auditing, variations between the likely judgements and actions between different auditors and the manner on which different elements can be used to enhance professional scepticism. There remains considerable scope for research into the culture of scepticism in UK auditing and how this is realised in actual audit practice.
47
Shaub, M.K. and J.E. Lawrence, Exercising Professional Skepticism Through Client Confrontation, 2004
27

Appendix 2
References in scepticism in ISAs (UK and Ireland)

Para Ref Text from ISA
200. Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International Standards on Auditing (UK and Ireland) 7. The ISAs (UK and Ireland) contain objectives, requirements and application and other explanatory material that are designed to support the auditor in obtaining reasonable assurance. The ISAs (UK and Ireland) require that the auditor exercise professional judgment and maintain professional skepticism throughout the planning and performance of the audit and, among other things: . Professional skepticism 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. The auditor shall plan and perform an audit with professional scepticism recognizing that circumstances may exist that cause the financial statements to be materially misstated. (Ref: Para. A18-A22) In the case of an audit engagement it is in the public interest and, therefore, required by the IFAC Code, that the auditor be independent of the entity subject to the audit. The IFAC Code describes independence as comprising both independence of mind and independence in appearance. The auditors independence from the entity safeguards the auditors ability to form an audit opinion without being affected by influences that might compromise that opinion. Independence enhances the auditors ability to act with integrity, to be objective and to maintain an attitude of professional scepticism.
13(l)
15.
A16.
A18. Professional skepticism includes being alert to, for example: Audit evidence that contradicts other audit evidence obtained. Information that brings into question the reliability of documents and responses to inquiries to be used as audit evidence. Conditions that may indicate possible fraud. Circumstances that suggest the need for audit procedures in addition to those required by the ISAs (UK and Ireland).
28
A19.
Maintaining professional skepticism throughout the audit is necessary if the auditor is, for example, to reduce the risks of: Overlooking unusual circumstances. Over generalizing when drawing conclusions from audit observations. Using inappropriate assumptions in determining the nature, timing, and extent of the audit procedures and evaluating the results thereof.
A20.
Professional skepticism is necessary to the critical assessment of audit evidence. This includes questioning contradictory audit evidence and the reliability of documents and responses to inquiries and other information obtained from management and those charged with governance. It also includes consideration of the sufficiency and appropriateness of audit evidence obtained in the light of the circumstances, for example in the case where fraud risk factors exist and a single document, of a nature that is susceptible to fraud, is the sole supporting evidence for a material financial statement amount. The auditor may accept records and documents as genuine unless the auditor has reason to believe the contrary. Nevertheless, the auditor is required to consider the reliability of information to be used as audit evidence.48 In cases of doubt about the reliability of information or indications of possible fraud (for example, if conditions identified during the audit cause the auditor to believe that a document may not be authentic or that terms in a document may have been falsified), the ISAs (UK and Ireland) require that the auditor investigate further and determine what modifications or additions to audit procedures are necessary to resolve the matter.49 The auditor cannot be expected to disregard past experience of the honesty and integrity of the entitys management and those charged with governance. Nevertheless, a belief that management and those charged with governance are honest and have integrity does not relieve the auditor of the need to maintain professional skepticism or allow the auditor to be satisfied with lessthan-persuasive audit evidence when obtaining reasonable assurance.
A21.
A22.
48 49
ISA (UK and Ireland) 500, Audit Evidence, paragraphs 7-9. ISA (UK and Ireland) 240, paragraph 13; ISA (UK and Ireland) 500, paragraph 11; ISA (UK and Ireland) 505, External Confirmations, paragraphs 10-11, and 16.
29
A43.
Detection risk relates to the nature, timing, and extent of the auditors procedures that are determined by the auditor to reduce audit risk to an acceptably low level. It is therefore a function of the effectiveness of an audit procedure and of its application by the auditor. Matters such as: . the application of professional scepticism; and .
assist to enhance the effectiveness of an audit procedure and of its application and reduce the possibility that an auditor might select an inappropriate audit procedure, misapply an appropriate audit procedure, or misinterpret the audit results. A69. In using the objectives, the auditor is required to have regard to the interrelationships among the ISAs (UK and Ireland). This is because, as indicated in paragraph A53, the ISAs (UK and Ireland) deal in some cases with general responsibilities and in others with the application of those responsibilities to specific topics. For example, this ISA (UK and Ireland) requires the auditor to adopt an attitude of professional skepticism; this is necessary in all aspects of planning and performing an audit but is not repeated as a requirement of each ISA (UK and Ireland). . Quality Control for an Audit of Financial Statements Direction of the engagement team involves informing the members of the engagement team of matters such as: Their responsibilities, including the need to comply with relevant ethical requirements, and to plan and perform an audit with professional skepticism as required by ISA (UK and Ireland) 200.50 ..
220 A13.
50
ISA (UK and Ireland) 200, Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with International Standards on Auditing (UK and Ireland), paragraph 15.
30
230 A7
Audit Documentation In relation to requirements that apply generally throughout the audit, there may be a number of ways in which compliance with them may be demonstrated within the audit file: o For example, there may be no single way in which the auditors professional skepticism is documented. But the audit documentation may nevertheless provide evidence of the auditors exercise of professional skepticism in accordance with the ISAs (UK and Ireland). Such evidence may include specific procedures performed to corroborate managements responses to the auditors inquiries.
240 8.
The Auditors Responsibilities Relating to Fraud in an Audit of Financial Statements When obtaining reasonable assurance, the auditor is responsible for maintaining professional skepticism throughout the audit, considering the potential for management override of controls and recognizing the fact that audit procedures that are effective for detecting error may not be effective in detecting fraud. The requirements in this ISA (UK and Ireland) are designed to assist the auditor in identifying and assessing the risks of material misstatement due to fraud and in designing procedures to detect such misstatement. In accordance with ISA (UK and Ireland) 200, the auditor shall maintain professional skepticism throughout the audit, recognizing the possibility that a material misstatement due to fraud could exist, notwithstanding the auditors past experience of the honesty and integrity of the entitys management and those charged with governance. (Ref: Para. A7- A8) Unless the auditor has reason to believe the contrary, the auditor may accept records and documents as genuine. If conditions identified during the audit cause the auditor to believe that a document may not be authentic or that terms in a document have been modified but not disclosed to the auditor, the auditor shall investigate further. (Ref: Para. A9) Maintaining professional skepticism requires an ongoing questioning of whether the information and audit evidence obtained suggests that a material misstatement due to fraud may exist. It includes considering the reliability of the information to be used as audit evidence and the controls over its preparation and maintenance where relevant. Due to the characteristics of fraud, the auditors professional skepticism is particularly important when considering the risks of material misstatement due to fraud.
12.
13.
A7.
31
A8.
Although the auditor cannot be expected to disregard past experience of the honesty and integrity of the entitys management and those charged with governance, the auditors professional skepticism is particularly important in considering the risks of material misstatement due to fraud because there may have been changes in circumstances. An audit performed in accordance with ISAs (UK and Ireland) rarely involves the authentication of documents, nor is the auditor trained as or expected to be an expert in such authentication.51 However, when the auditor identifies conditions that cause the auditor to believe that a document may not be authentic or that terms in a document have been modified but not disclosed to the auditor, possible procedures to investigate further may include:

A9.
Confirming directly with the third party. Using the work of an expert to assess the documents authenticity.
A17.
Management is often in the best position to perpetrate fraud. Accordingly, when evaluating managements responses to inquiries with an attitude of professional skepticism, the auditor may judge it necessary to corroborate responses to inquiries with other information. Determining overall responses to address the assessed risks of material misstatement due to fraud generally includes the consideration of how the overall conduct of the audit can reflect increased professional skepticism, for example, through:

A33.
Increased sensitivity in the selection of the nature and extent of documentation to be examined in support of material transactions. Increased recognition of the need to corroborate management explanations or representations concerning material matters.
It also involves more general considerations apart from the specific procedures otherwise planned; these considerations include the matters listed in paragraph 29, which are discussed below. 250 A Consideration of Laws and Regulations in an Audit of Financial Statements 8. The auditor is required by this ISA (UK and Ireland) to remain alert to the possibility that other audit procedures applied for the purpose of forming an opinion on financial statements may bring instances of identified or suspected non-compliance to the auditors attention. Maintaining professional skepticism throughout the audit, as required by ISA (UK and Ireland) 200,52 is important in this context, given the extent of laws and regulations that affect the entity.
51 52
ISA (UK and Ireland) 200, paragraph A47. ISA (UK and Ireland) 200, paragraph 15.
32

300 Planning an Audit of Financial Statements Appendix - Considerations in Establishing the Overall Audit Strategy Significant Factors, Preliminary Engagement Activities, and Knowledge Gained on Other Engagements

. The manner in which the auditor emphasizes to engagement team members the need to maintain a questioning mind and to exercise professional skepticism in gathering and evaluating audit evidence. .
330 A1.
The Auditors Responses to Assessed Risks Overall responses to address the assessed risks of material misstatement at the financial statement level may include:
Emphasizing to the audit team the need to maintain professional skepticism. .
540 A40.
Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures The review of prior period accounting estimates may also assist the auditor, in the current period, in identifying circumstances or conditions that increase the susceptibility of accounting estimates to, or indicate the presence of, possible management bias. The auditors professional skepticism assists in identifying such circumstances or conditions and in determining the nature, timing and extent of further audit procedures. Related Parties Planning and performing the audit with professional scepticism as required by ISA (UK and Ireland) 20053 is therefore particularly important in this context, given the potential for undisclosed related party relationships and transactions. The requirements in this ISA (UK and Ireland) are designed to assist the auditor in identifying and assessing the risks of material misstatement associated with related party relationships and transactions, and in designing audit procedures to respond to the assessed risks.
550 7.
53
ISA (UK and Ireland) 200, paragraph 15.
33
A9.
Matters that may be addressed in the discussion among the engagement team include:

. An emphasis on the importance of maintaining professional scepticism throughout the audit regarding the potential for material misstatement associated with related party relationships and transactions. .
34

Discussion Paper Auditor Scepticism - Raising The Bar21

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AUDITOR SCEPTICISM: RAISING THE BAR

Auditing Practices Board

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar

AUDITOR SCEPTICISM: RAISING THE BAR

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar Nature of auditor scepticism

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar Growing importance of auditor scepticism

Auditor scepticism: Raising the bar Importance of scepticism in practice

Auditor scepticism: Raising the bar

Development and promotion of auditor scepticism within audit firms

Auditor scepticism: Raising the bar

ISA (UK and Ireland) 600 paragraph 19

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar

Can more be done to promote auditor scepticism?

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar

See the FRCs Audit Quality Framework.

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar Questions

Auditor scepticism: Raising the bar

Academic research on auditor scepticism

Characteristics underlying auditor scepticism.

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar

Factors influencing the degree of scepticism reflected in auditor behaviour

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar

Category of trust Calculus-based

Response to evidence of a trust violation. Trust likely to be terminated

Knowledge based Identification based

Auditor scepticism: Raising the bar

Professional scepticism in the context of the audit firm

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar

References in scepticism in ISAs (UK and Ireland)

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar

Auditor scepticism: Raising the bar

Emphasizing to the audit team the need to maintain professional skepticism. .

ISA (UK and Ireland) 200, paragraph 15.

Auditor scepticism: Raising the bar

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