Professional Skepticism in Auditing: Third Eye of Auditor

Introduction: In the wake of increasing financial frauds involving senior management, auditors play a crucial role as custodians safeguarding public and stakeholder interests. Professional skepticism, often referred to as the third eye of auditors, is essential for detecting possible misstatements due to fraud. This article delves into the definition, importance, application, and documentation of professional skepticism in auditing.

In the era, where many financial frauds are being reported having involvement of senior management or owners across the corporate world. Society is seeing auditor as custodian for safeguarding the public or stake holder interest from any possible fraud, by performing his duty with utmost professional care. To detect any possible misstatement due to fraud, he has to apply professional skepticism in the audit and document the same.

It does not mean that auditor to plan audit procedures always considering existence of possible fraud in the financial statement. The auditor may accept records and documents as genuine unless the auditor has reason to believe the contrary. Also note that detection of fraud in an audit of financial statement is always affected by inherent limitations of audit.

What is Professional Skepticism

The glossary of terms contained in the IAASB’s Handbook of International Quality Control, Auditing, Review, other Assurance, and Related Services Pronouncements contains the following definition of the term ‘professional skepticism’:

“An attitude of auditor that includes a

Questioning mind,

Being alert to conditions which may indicate possible misstatement due to error or fraud

Critical assessment of audit evidence

Professional skepticism is closely related to fundamental ethical requirements of auditor as objectivity and independence. Professional skepticism is also linked to the application of professional judgment by the auditor. At its core the application of professional skepticism should help to ensure that the auditor does not:

• neglect unusual circumstances
• Oversimplify the results from audit procedures or
• Adopt inappropriate assumptions when determining the audit response required addressing identified risks all of these should improve audit quality

SA 200(R), “Overall objective of the Independent auditor and the Conduct of an Audit in Accordance with Standard on Auditing” contains requirement and guidance for professional skepticism while doing audit.

An auditor should maintain behaviour of professional skepticism throughout the period of audit.

The auditor shall plan and perform an audit with professional skepticism recognising that circumstances may exist that cause the financial statements to be materially misstated.

Why Necessary to maintain professional skepticism

• For Effective Audit
• To compliance with Reporting requirements under statutes

Professional skepticism is a cornerstone of good auditing. Effective audits should enhance confidence in the financial reporting process. For this process to work, stakeholders need to be satisfied that auditors are applying appropriate professional skepticism.

Legislation now also mandates that auditor to report fraud or suspected fraud to the   authorities. Sec. 143(12) of the Companies Act, 2013 are specifically having provision for fraud reporting by auditor. In case of failure of auditor in reporting responsibilities auditor will be liable for penal provisions.

Companies’ auditor report order, 2020 (CARO) also requires auditor to report fraud noticed or reported during the year. Although scope of CARO reporting is limited for the fraud already known to management.

In case of Bank audits, the RBI issued a circular relating to implementation of recommendation of Committee on legal  aspects of banks frauds applicable to all scheduled commercial banks (excluding RRBs). Regarding liability of accounting and auditing  profession, the said  circular provided as under:

“If an accounting professional, whether in the course of internal or external audit or in the process of institutional audit finds any susceptible to be fraud or fraudulent activity or act of excess power or smell any foul play in any transaction,  he  should refer matter to the regulator. Any deliberate failure on the  part of the auditor  should render himself liable for action.”

Apart from legislative requirement, applying professional skepticism helps auditor in various aspects, such as:

• To determine nature, timing and extent of substantive audit procedure
• To determine audit procedure for obtaining sufficient and appropriateness audit evidence
• To determine appropriateness of conclusions reached in the circumstances

By this way it enhanced the effectiveness of audit. Professional skepticism help auditor to reduce audit risk at an acceptable low level.

Requirements of Other standards on auditing

Applying professional skepticism is also required by other Standard on auditing:

SA 200, “Overall responsibility of auditor in an audit of financial statements and audit in accordance with Standard on auditing” which sets the requirement that auditor to plan and perform an audit with professional skepticism recognising that circumstances may exist that cause the financial statement to be  materially misstated.

SA 220, “ Quality control for an audit  of financial statements” requires:

• Engagement partner shall remain alert, through  observation and making inquiries as necessary, for  evidence  of non-compliance with  relevant ethical requirements by members of the engagement team.
• Engagement partner shall remain alert to identify the situations in which an engagement quality control review is necessary, even though at the start of the engagement,  such  a review  was not required.

SA 240, “The Auditor’s responsibility relating to fraud in an audit of Financial Statement” requires:

• Auditor to recognise the possibility that a material misstatement due to fraud could exist
• If any 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.
• Where response to enquiries of management or those charge with governance are inconsistent, the auditor shall investigate the inconsistencies.

SA 250, “Consideration of laws and regulations in an audit of Financial statements” requires auditor to remain alert to the possibility that other audit procedures applied may bring instances of  non-compliances or suspected non compliances with laws and regulations.

SA 300, “Planning an Audit of Financial Statements”requires auditor to emphasizes to engagement team members to maintain questioning mind and to exercise professional skepticism in gathering and evaluating audit evidence.

SA 540, “Auditing accounting estimates, including fair value estimates and related disclosures”states that professional skepticism assist auditor in identifying such circumstances or conditions which indicates possible management bias in accounting estimates and in determining the nature, timing and extent of audit procedures for such conditions.

SA 550, “Related Parties” requires to  perform audit  with professional  skepticism to identify undisclosed related party relationships  and transactions.

SA 570, “Going Concern” requires auditor to remain alert throughout the audit for audit evidence or events or conditions that may cast significant doubt on the entity’s ability to continue as a going concern.

SA 700, Independent auditor’s report, also requires auditor to mention that he has conducted audit with professional scepticism in the auditor’s responsibility para in the Auditor’s report.

Other Examples where professional skepticism needs to be apply:

• Reliability of management’s representation
• Reliability of external confirmation
• Accepting the engagement- consideration of integrity of owners and  management
• Changes in terms of engagement after acceptance of audit
• Contradictory evidence from two sources
• Transactions recorded by book entries
• Conditions indicate possible fraud
• Extensive efforts required to obtain general information required for audit evidence
• Continuous failure to correct weakness of internal control
• Restriction imposed by management
• Shorter time to conclude the audit
• Consistent excessive bank or cash balance maintained by entity, despite borrowing or cash credit maintained
• Inconsistent relationship between two financial item as compare to industry/trend
• Transactions outside the normal course of business
• Evaluating work of an management’s expert
• Using work of an Internal auditor as direct assistance
• Excessive cash transactions
• Transactions with tax heaven countries
• Utilisation of long terms loans or proceeds of IPO/FPO
• Transactions outside  the normal course  of business

Apart from specific instances mentioned in SAs, skepticism is an attitude that entire audit team to apply while conducting audit.

An important part of skepticism is challenging management’s assumptions which often given to auditor in many areas like provision for pending litigations, impairment of assets, warranty provision etc.

Documenting Professional Skepticism- “Not Documented- Not done”

Considering that professional skepticism is a state of mind, a behavioural aspect, it’s difficult to document. Although it is necessary to document that professional skepticism has been applied throughout the audit.

The Auditing Standards require auditor to document discussions of significant matters, significant difficulties and also to communicate to those charge with Governance. Such documentation helps to demonstrate how significant judgements and key audit issues were addressed and how the auditor has evaluated whether sufficient appropriate audit evidence has been obtained.

Demonstrating Professional Judgement

The auditor’s documentation of audit judgements and evidenced obtained sets out not only the auditor’s conclusion but also the rational for the conclusion.

Examples of events where audit documentation should demonstrate application of professional skepticism:

• Communication to Those charge with governance as per SA 260
• Discussion among engagement team
• Basis of conclusion about client’s estimate/provisions and any indicator of possible biasness
• How auditor addressed conflict in audit evidence
• Regarding pending litigations
• Regarding undisclosed related parties in previous year
• Inconsistency between other information and financial statement
• Subsequent events
• Reason for refusal to send external confirmation request to a particular party
• Communication of a matter identified by any joint  auditor and communicated  to all joint  auditors and they all agree on the same
• Identified or suspected non compliance of law or regulation
• Material uncertainty exist regarding going concern assumption
• Significant, unusual or highly complex  Transactions, especially those close to period end  that pose difficult “substance over form question”
• Significant judgement of management or those charge with  governance
• Fraud  reported or identified by  management
• Action taken for identified or reported fraud
• Instances of management override of an internal control established
• Use  of business intermediaries for which there appears to be no clear business justification
• Management biasness in correcting misstatement
• Management biasness in making accounting estimates
• Minutes of meeting  with legal  counsel of company for a material litigation

Effective documentation of skepticism should include, but not limited to below aspects:

• Document thought process, alternative views in the situation considered and changes in audit approach
• Circumstances where auditor changed nature, time and extent of audit procedure during the audit
• Basis for adequacy of disclosure in case of fair presentation framework
• Result of surprise check
• Change in overall materiality level or performance materiality level
• Communication of any  restriction or  limitation imposed by  management to those charge with governance

Conclusion

In short, the quantum of professional skecpticism to be applied is the key, because it influences both effectiveness and efficiency of an audit.

Too little scepticism endangers audit effectiveness and results in higher audit risk.

Same time auditor need not to over emphasised the professional skepticism but it is essential to adopt and applying a skeptical mindset throughout the audit while auditing and document as well. Given the increasingly complex and subjective nature of assumptions, varied types of commercial transactions and complexity, auditor must challenge management on a range of matters relevant to the preparation of the financial statements.

“An audit performed without an attitude of professional skepticism is not likely to be a high quality audit”

Documentation of application of professional scepticism will serves to explain the auditor’s conclusions and to reinforce the quality of the conclusions.