The exercise of professional scepticism in relation to auditing accounting estimates under the revised ISA 540 is affected by consideration of inherent risk factors, with its importance increasing when accounting estimates are subject to a greater degree of estimation uncertainty or are affected to a greater degree by complexity, subjectivity or other inherent risk factors. It is also important when there is greater susceptibility to misstatement due to management bias or fraud. The revised ISA 540 has introduced a number of new provisions designed to enhance professional scepticism.
Corroborative and contradictory audit evidence
One such requirement is that both corroborative and contradictory audit evidence needs to be considered when evaluating audit evidence. It can be easy to design audit tests purely with the objective of supporting management’s assertions, but auditors will need to consider a more balanced approach to the design of audit procedures. This might include a differently designed test or additional procedures to obtain audit evidence that is both corroborative and/or contradictory. Auditors should not just look for supporting evidence but equally should not keep pursuing a line of questioning without reason. A balance will be required with auditors refraining from making prejudgements or overly relying on checklists.
The auditor will also need to consider how the documentation demonstrates that the audit procedures are not biased towards obtaining corroborative evidence while ignoring contradictory evidence. It may be advisable to explicitly document whether any contradictory evidence has been identified and then assess the impact on the sufficiency and appropriateness of the audit evidence.
Taking a balanced approach to the design of procedures is an effective way to incorporate scepticism into the design of audit tests. However, such audit tests could prove more difficult to design and may therefore require the involvement of a senior member of the audit team.
Stand-back requirement
Enhanced application of professional scepticism is also introduced through a stand-back requirement. Auditors are required to ask themselves whether, based on the procedures performed:
- the risk assessments at the assertion level are appropriate;
- management’s decisions relating to recognition, measurement and presentation and disclosures are in accordance with the financial reporting framework; and
- sufficient appropriate audit evidence has been obtained (including all relevant evidence whether corroborative or contradictory).
Although standing back and reviewing audit evidence obtained is not a new concept, it does help to emphasise that the audit is an iterative process. The risk assessment requirements recognise this and the stand-back requirement allows auditors to reflect on work performed, the appropriateness of the risk assessments and whether they have obtained unbiased sufficient appropriate audit evidence.
The auditor will also need to decide the best method for documenting the stand-back requirement, although this may be dictated by the audit software and methodology. One suggested approach would be to include the overall assessment of the reasonableness of accounting estimates and whether sufficient appropriate audit evidence has been obtained, in a summary memorandum included in the completion section of the file.
Management bias
The auditor needs to consider whether management’s judgements and decisions in making estimates are indicators of management bias – even where they might be individually reasonable. This means considering whether the judgements made in selecting the method, significant assumptions or data give rise to indicators of possible management bias.
Indicators of possible management bias include arbitrary changes in estimates or methods, or overly optimistic or pessimistic assumptions. This is particularly the case where these changes or assumptions help management achieve an objective such as maximising a bonus or minimising tax which, in extreme circumstances, may indicate fraud. Where there are indicators, the auditor needs to think about how these affect the audit and document both the indicators and the auditor’s evaluation of the implications.
Practical implementation
It is important that the audit documentation provides evidence that the auditor has challenged management on the selection and application of methods, data and assumptions in making accounting estimates. ISA 230 Audit Documentation does not prescribe a specific way in which professional scepticism is documented. This means the auditor will need to apply judgement in determining how they can demonstrate through the audit documentation that they have applied professional scepticism.
Auditors should record how they have obtained and then evaluated audit evidence, with a well-documented thought process. This should include how management has been challenged and how explanations provided by the client have not been taken at face value. Evaluating contradictory evidence might be a good way of evidencing this as well as performing sensitivity analysis on information such as going concern forecasts. Auditors should consider the use of finalisation memos or section-specific conclusion memos that require the auditor to stand back and evaluate all the evidence.
Demonstrating that auditors have applied professional scepticism in seeking, evaluating and documenting audit evidence will be dependent on good planning, audit team training, coaching and supervision, and effective file review. High-quality audit training is necessary to both encourage scepticism and help calibrate it, so that auditors respond consistently to audit risks. Having a sceptical mindset is the bedrock of auditing and ICAEW’s training videos False Assurance and Without Question can both be useful tools to assist with this. For more information and resources on professional scepticism, visit the ICAEW’s website.