Somerset Maugham once said “Money is like a sixth sense without which you cannot make use of the other five”. With audit techniques failing to pre-warn about minefields in the financial statements of some large entities, it is said that the sixth sense of the auditor could have probably done what the techniques could not.

In the United States, the Statement on Auditing Standards 99 – Consideration of Fraud in a Financial Statement Audit has coined a phrase for this: “Professional scepticism”.

Professional scepticism in auditing implies an attitude that includes a questioning mind and critical assessment of audit evidence without being obsessively suspicious or sceptical. A recent report by The Public Company Accounting Oversight Board (PCAOB) in the US has found this quality lacking in quite a few firms based on their inspections.

Deficiencies seen

PCAOB inspectors continued to find deficiencies in important audit areas, both established and emerging. These areas include critical and high-risk parts of audits, such as revenue, fair value, management's estimates, and the determination of materiality and audit scope. These deficiencies occurred in audits of issuers of all sizes, including in some of the larger audits they reviewed.

In some cases, the deficiencies appeared to have been caused, at least in part, by the failure to apply an appropriate level of professional scepticism when conducting audit procedures and evaluating audit results. The deficiencies identified by the inspection team suggest that the engagement teams may be placing too much reliance on management's responses to the teams' inquiries and not sufficiently challenging or evaluating management's assumptions, and that they may not be applying an appropriate level of professional scepticism in subjective areas susceptible to management bias.

UK experience

This phenomenon is not restricted to the United States alone. The United Kingdom's Audit Inspection Unit found that 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. In reporting on its recent inspections of major accounting firms, the Netherlands Authority for the Financial Markets stated that it found weaknesses in 29 of the 46 audits it reviewed and identified insufficient professional scepticism exercised by the external auditor as one of the causes of these weaknesses.

In Australia, the Securities and Investment Commission stated that its audit inspection programme has identified a number of instances where we have concerns about the auditors' judgement, and the level and attitude of professional scepticism. The Canadian Public Accountability Board found several examples of overreliance on management representations and noted that while some reliance on management is inherent in any audit, there is a higher risk of inappropriately reducing professional scepticism in instances where there is greater familiarity or comfort with the reporting issuer and its historical accounting policies and practice. While the specific reasons for findings like these are often complex, the Board was concerned they may reflect instances in which the auditors involved failed to put the interests of investors before those of the client's management.

Solutions

As a solution to this conundrum, many innovative solutions have been offered. Some, for example, have proposed to replace the ‘client pays' model with a system of financial statement insurance. Under such an approach, companies would insure their financial statements against losses suffered by investors. The market would set premiums, which could be made public, and insurance companies would pay for the audit. Another opinion has explored whether auditors should themselves be converted into the functional equivalent of insurers by subjecting them to stricter, but capped, liability. Still others have proposed a system of random auditor selection, with, among other things, compensation set by a third party.

These measures could take time and be delayed due to legislative ennui. In the interim, the PCAOB is proposing a rule providing that a registered public accounting firm is not independent of its audit client if it has provided an opinion on the client's financial statements for a certain number of consecutive years and hence rotation is the only solution. This approach could be similar in structure to the SEC's rule requiring audit partner rotation. Professional scepticism could turn out to be the vision and mission of accounting firms of the future.

(The author is a Bangalore-based chartered accountant.)

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