1. Critically assess what you understand by the audit concept of professional scepticism and why professional scepticism is important in the audits of financial statements?
2. Identify, research and evaluate any one recent example of your choice of a UK business failure where there was an apparent lack of professional scepticism?
Auditors look after the accounts of a company to determine whether they are representing the affairs of the company exactly and accurately on the accounts date or not, by the process of auditing. On the other hand, this auditing provides ‘assurance’ or comfort to the accounts users that the auditor, who is the independent third party, has checked the accounts and agrees with the management of the company. Thus, both the term audit and assurance are interconnected and interrelated to each other (Vallance-Jones, 2012). Again to perform auditing accurately, professional skepticism is the compulsory factor, as without professional skepticism, the auditors might not understand the fraudulent activities of a particular activity. Thus, professional skepticism should be developed within the auditors to avoid misinterpretation of audit results. As professional skepticism is an attitude, thus it has to be developed within the auditors, and cannot be readily integrated into them. Thus audit is related to professional skepticism and vice versa. Therefore, professional skepticism plays a vital role in the procedure of audit of the financial statements of a company.
Generally, audit means an evaluation and an unbiased examination of all the financial statements of a particular financial year of any organization by the help of the internal employees of the firm who deals with the financial department of the company or chattered accountants or employees of financial department of other organization (Whittington, 2012). Audit is generally done to verify the accuracy of the financial filings, such that an organization could pay proper amount of tax to the government of the country.
Professional skepticism may be defined as an attitude which involves questioning mind and a critical assessment of evidence of audit (Turri, 2011). On other hand, it can be said that, the external or internal auditors should not consider the management of the specified organization to be either dishonest or honest, during the process of financial auditing.
According to the annual report of Audit Inspection Unit (AIU), of the year 2011 – 2012, there is basic importance of professional skepticism in various key audit issues (Pickett, 2011). Thus, the concept of audit is related to the professional skepticism.
Auditors are required by any organization or a company for auditing the financial statements. Thus, the auditors of a specified company have to perform the audits with an attitude of professional skepticism, that is, they should possess the questioning mind and should not consider the management of the company to be either dishonest or honest, during the process of auditing (Nolder, 2012). Financial researchers have stated that presently, many auditors have failed to perform the act of auditing correctly, due to lack of professional skepticism, and thus, they are planning for improvement of this attitude within this profession.
Fraud is a very common act, which a company may perform for more sales revenue, profit and betterment of the company. Thus, the auditors should remain alert to the misstatement risk, though there may be the strength of the control of the client or the reports of current or prior years by the audit procedures.
To consider the type of identified misstatements is another way of implication of professional skepticism. In the past, there had been a tendency to identify any misstatement immediately as an error. But the auditors should examine the misstatements much deeply, as some of them can be fraud too or just an indication of deficiencies in the system of accounting, which could lead to more errors in future (McCoy et al., 2011).
The auditors generally apply the attitude of professional skepticism at different stages of audit process they are as follows:
Finally, it can be said that, the application of professional skepticism should reduce the risk as it enhances the efficiency and effectiveness of audit procedures. It also reduces the possibility of reaching inappropriate conclusion.
According to chairman of IAASB, large numbers of auditors are needed for application of professional skepticism. The reason for this is the enlarged use of the subjectivity and judgment in the financial reporting decisions of the management of the company. This is due to the decision of Financial Reporting Standards, for the application of principle based and often requires the financial statement preparers to perform the significant judgment during decision making on treatments of accounting.
The global financial crisis of 2009 – 2010, also aimed on professional skepticism. In many jurisdictions, the auditors were critically criticized for not applying enough professional skepticism, especially in relation to the fair values audit, transactions of related party and assessments on going concern concept. Staff Questions and Answers document is issued by IAASB, for re-emphasizing the importance of professional skepticism, especially in the field of auditing of the financial statements, which includes the high risk of misstatement of material due to financial distress (Keating, 2011).
The Financial Reporting Council of U.K. has issued a paper on professional skepticism, which advices that in audit quality, professional skepticism is the cornerstone. It also proposes that, the auditor should look for material misstatement risks. This activity is possible only when a high quality of knowledge about the business of audited entity and its environment is known to the person.
Thus from these, we can understand the increasing importance of professional skepticism. But the reasons for which professional skepticism is important in audits of financial statements are:
a. Selection of inappropriate procedures of audit.
b. Application of inappropriate procedures of audit.
c. Misinterpretation of audit results.
d. Unusual circumstances are overlooked.
a. The extent or timing or nature of the procedures of audit with the aim to reduce the high risk to an appropriate level.
b. Sufficient evidence of audit has been obtained or not, and according to that, more evidence should be obtained, to achieve the goals of assurance standards (Cascarino and Cascarino, 2012).
c. Evaluation can be done on the judgment of the management, based on the financial reporting of the entity, regarding the annual audit.
d. Conclusions can be drawn based on the evidence of the audit obtained.
Thus, the application of professional skepticism increases the effectiveness of the procedure of audit and of its application and also lowers the chance of selecting inappropriate procedure of audit.
2. The Professional Scepticism of a company means the prediction of company’s performance through audit. The future planning or strategy of a company depends on its professional scepticism. Due to the lack of professional scepticism, a company may suffer from loss or slower growth in profit. In U.K., there are some companies, which suffer from apparent lack of the professional Scepticism. Among these companies, is the Cannary Limited of U.K (Ashton, 2015).
On 1st February 2012, Canary Limited has appointed the auditor named C.S. Group of the new subsidiary. This group has planned the audit for the individual financial statement of the firm named Canary Limited and then has analyzed its significance of the audit on the consolidated financial statements. The selling process of Canary Limited is related to the online selling. Since, there is complexity related to the online selling system, the professional scepticism focus on the requirement of expert and the computed-oriented audit techniques, which is used to get the higher profit. It is necessary to understand the financial performance and position of that company, and for this, the review of preliminary analysis on a full set of Canary Ltd.’s financial statement should be done besides forecasting the revenue and profit for the year (Bland, 2015).
At that time, the management of Canary Ltd. Company was unfamiliar with the process used of financial audit and failed to provide required information to CS group in preparing the consolidated statements, as the Canary Ltd. management was involved with the group financial reporting for the first time. Therefore, there was a risk related to inaccurate and incomplete information of the company such as incomplete information related to the inter-company transactions (Frc.org.uk, 2015).
Considering the consolidated profit and revenue figure of Canary Ltd. in 2012, the group financial result was encouraged before the tax of 1-2% with a rise in revenue of eight percent and in profit.
The 2012 result of Canary Ltd. include the report of six months’ revenue and profit of that company. By comparing its result with the previous year combined financial year of the Crow Ltd and Starling Ltd. it can be said that, there was a reduction in profit of the combined companies Craw Ltd and Starling Ltd. for the year 2012, as the revenue reduced slightly. To do with the acquisition of Canary Ltd. like legal costs and diligence, the one-off costs may results the apparent rise in costs with the acquisition of Canary of Canary Ltd. As costs could be overstated or revenue may be understated, there was risk misstatement in this company (Gaaaccounting.com, 2015).
|
Forecast of Crow Ltd in 2012 (£ million) |
Forecast of Starling Ltd in 2012 (£ million) |
Forecast of Crow Ltd and Starling Ltd in 2012 (£ million) |
Actual report of Crow Ltd and Starling Ltd in 2011 (£ million) |
Change in percentage |
|
|
Revenue |
69 |
50 |
119 |
125 |
4.8% |
|
Profit before tax |
3.5 |
3 |
6.5 |
8.4 |
22.6% |
As the financial statements of Canary Ltd. have been prone to manipulation, a risk or misstatement that leads to a lack of professional scepticism. Particularly, to protect the good sale price for the company, its management may overstate the revenue and profit of the company. As the groups avoid the additional consideration, the existence of consideration of contingent related to the acquisition revenue of group post is also treated as a contributing factor for the possible manipulation (Hancox et al., 2015).
Due to the lack of Professional Scepticism, there is a risk related to the material misstatement of the company. This will leads to some changes to corporate structure of the company like moving into large business, installation of new significant IT system and large acquisitions etc. Since the CS Group was involved in all these three changes during the financial year, the audit is involved with the high risk (Hartl, 2015).
There are specific risks attached with the various components of goodwill. According to the professional scepticism, on the acquisition of Canary Ltd, the goodwill of the company will rise to £45 million, which will represent the 8.2 percent of total assets. As the measurement of the goodwill of the company, involves the judgement, which is judged based on the probability of the amount to be paid, the contingent element of consideration is inherently risky. If there is the incorrect assessment of this probability of payment, the consideration part can be overstated. In case of the individual financial statement of Craw Ltd., there are also some risk factors related to its goodwill. The value of identifiable assets is another component of assessing the goodwill of the company. Therefore, it is essential to measure the fair value at the date of acquisition. Since, the estimation of fair value involves the uncertainty, so there is a risk factor related to this estimation. Therefore, if the management fails to conduct an impairment hypothesis or Professional Scepticism, then there will arise a risk regarding the goodwill of the company (Kang, Trotman and Trotman, 2015).
The management of the company has issued £100 million loan stock, which represents the 18.2% of total assets of crow Ltd. As the loan will be paid at a significant premium of £20 million, this will recognized as a financial cost of the company over the period. There arises a risk of misstatement if the premium of the financial year, has not been included under the financial cost. Moreover, if interest payable has not been accrued, the financial cost could be understated. Besides these types of risks, regarding the loan in the financial statement, there is a risk associated to financial disclosure, as the required narrative and financial disclosure are related to financial instruments, which provide the risk exposure. Regarding the loan in the notes to the financial statement, there is also a risk of inadequate disclosure (MACHUCA, 2015).
In case of online sale of Canary Ltd., when the revenue recognition criteria of IAS 18 Revenue have been met it is difficult to establish with the online selling process. As a result, there will arise a risk that the revenue can be recognised at the correct time. As 30% of Canary Ltd’s sales are made online, which is amounting to sales of £4.8 million or 3.6% of consolidated revenue of the year, this will treated as a significant issue and it is predicted that when a full year revenue of the Canary Ltd sales is consolidated, there will be a higher percentage of total sales in the next year. This refers to the fact that the revenue and profit are underestimated over the period.
Here will be the Professional Scepticism in this case, as the CG group had no experience of online sales, for online revenue recognition, there will be no group accounting policy. The risks arising from the system may not operate effectively and there is a deficient control, which leads to inaccurate recording of the sales (Orcpa.org, 2013).
There is a risk related to the recognition of the needs and types of grant received by the company. The company has not been yet spent £10 million, which results for the further risks and represents 1.8% of the consolidated assets.
The IT system is related to the financial reporting. Therefore, a risk of material misstatement is related to this system (Sweeney and McGarry, 2011).
Conclusion:-
Hence, from the above analysis it can be said that for every company, there is a need for proper Professional Scepticism, which help the company to take the appropriate business policy for future. A company may suffer from indecision, due to the lack of proper Professional Scepticism as this wrongly predict (either overestimate or underestimate) the performance of the company in future.
References
Cascarino, R. and Cascarino, R. (2012). Auditor’s guide to IT auditing. Hoboken, N.J.: Wiley.
Glover, S. and Prawitt, D. (2014). Enhancing Auditor Professional Skepticism: The Professional Skepticism Continuum. Current Issues in Auditing, 8(2), pp.P1-P10.
Keating, L. (2011). Performance auditing of public sector property contracts. Burlington, Vt.: Gower.
Lee, C., Welker, R. and Wang, T. (2012). An Experimental Investigation of Professional Skepticism in Audit Interviews. International Journal of Auditing, 17(2), pp.213-226.
McCoy, N., Burnett, R., Friedman, M. and Morris, M. (2011). Internal audit: How to develop professional skepticism. J. Corp. Acct. Fin., 22(4), pp.3-14.
Nolder, C. (2012). The role of professional skepticism, attitudes and emotions on auditor’s judgments.
Pickett, K. (2011). The essential guide to internal auditing. Chichester, West Sussex: Wiley.
Turri, J. (2011). Knowledge and Skepticism. International Journal for the Study of Skepticism, 1(2), pp.155-157.
Vallance-Jones, F. (2012). National freedom of information audit 2012. Toronto, Ont.: Newspapers Canada.
Whittington, R. (2012). Auditing and attestation 2012. Hoboken, N.J.: Wiley.
Ashton, N. (2015). Undercutting Underdetermination-Based Scepticism. Theoria, p.n/a-n/a.
Bland, S. (2015). Circularity, Scepticism and Epistemic Relativism. Social Epistemology, pp.1-13.
Frc.org.uk, (2015). [online] Available at: https://www.frc.org.uk/getattachment/2a1e0146-a92c-4b7e-bf33-305b3b10fcd2/Discussion-Paper-Auditor-Scepticism-Raising-the-Ba.aspx [Accessed 14 Jul. 2015].
Gaaaccounting.com, (2015). The Pros and Cons of Professional Scepticism | GAA Accounting. [online] Available at: https://www.gaaaccounting.com/the-pros-and-cons-of-professional-scepticism/ [Accessed 14 Jul. 2015].
Hancox, D., Hancox, D., Hancox, D. and Hancox, D. (2015). Professional Skepticism is Still Lacking in Audits. [online] LinkedIn Pulse. Available at: https://www.linkedin.com/pulse/professional-skepticism-still-lacking-audits-dave-hancox [Accessed 14 Jul. 2015].
Hartl, P. (2015). Modal scepticism, Yablo-style conceivability, and analogical reasoning. Synthese.
Kang, Y., Trotman, A. and Trotman, K. (2015). The effect of an Audit Judgment Rule on audit committee members’ professional skepticism: The case of accounting estimates. Accounting, Organizations and Society.
MACHUCA, D. (2015). Conciliationism and the Menace of Scepticism. Dialogue, pp.1-20.
Orcpa.org, (2013). PCAOB Finds Lack of Professional Skepticism Main Cause of Audit Deficiencies » News. [online] Available at: https://www.orcpa.org/about/news/12/1662-pcaob_finds_lack_of_professional_skepticism_main_cause_of_audit_deficiencies [Accessed 14 Jul. 2015].
Sweeney, B. and McGarry, C. (2011). Commercial and Professional Audit Goals: Inculcation of Audit Seniors. International Journal of Auditing, 15(3), pp.316-332.
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