APB presents auditors with history lesson

AUDITORS HAVE been getting quite a bit of stick in the last few years over their opinion and assurance on company financial statements. Most recently, PwC is being blamed, in part, for the restating of RSM Tenon’s accounts, with concerns raised about the quality of its audit work at the listed firm. It is because of this blame, and the many that have come before it, that the accounting watchdog is urging auditors to go back to their roots and dig out their sceptical opinions.

In a paper published by the Accounting Practices Board (APB), an arm of the Financial Reporting Council (FRC), auditors are being pushed by the watchdog to be more cynical and pragmatic in their approach to audits.

The paper: ‘Professional Scepticism – establishing a common understanding and reaffirming its central role in delivering audit quality’ is broken down into seven sections.

It admits the paper is written in an unusual format, by APB standards, in a discursive tone, drawing analogies from a range of areas including the origins of words and the mind-set auditors need.

The first section explains that the paper is a guide the APB hopes all auditors will consider, and includes background information on how the paper came about.

A state of mind

The second section goes deep into philosophy, looking at the history of the word scepticism and its Greek origin ‘skepsis’- meaning examination, inquiry into, hesitation or doubt.

It goes on to say that “doubt, trust and uncertainty are passive concepts – states of mind”. The section pushes auditors to return to their roots and think of the state of mind needed to produce a sceptical, if necessary, opinion on financial statements.

A bit of history is also thrown into the mix to help auditors understand their origins. Many may be pleased to know part of their role derived from auditing servants in the manorial estates of the 14th century. The auditor was the most trusted servant in the household and all other servants reported to them.

The third section looks more deeply at developing an audit strategy and how other professions such as scientists have created a sceptical approach.

In science the natural world acts in a systematic way, while businesses do not always work like that. For example in science potential variables can be identified and controlled, whereas an audit could be subject to outside influences such as human error and fraud, the paper explains.

However, it outlines three main critical areas the auditor needs for sufficient scepticism: developing a good understanding of the business; considering that material misstatements can exist but designing tests to identify them quickly and not just relying on management information; and documenting everything to increase transparency for internal reviewers or external inspectors.

One of the most interesting chapters is the fourth. It looks at the relationship between the auditor and the business’ management. It kicks off (as is the theme with this paper) outlining the history of the auditors role and where it has ended up.

Back in 1844 when incorporated stock companies were born, auditors were paid by a company to check over a the financial books for the stakeholders with their fees set by the Treasury. They were not required to be an accountant, although many employed them for assistance.

Nowadays stakeholder expectations are managed through standard setting. However, there is a risk that an auditor will lack scepticism because they have no relationship with the stakeholder, who in turn doesn’t trust the auditor, and only with the company.

The relationship between auditor and company is one that sets alarms ringing. The APB warns that close working relationships with management and audit committees could see the auditor refrain from questioning aspects of financial statements and are unlikely to be cynical towards them.

Audit DNA

Firms’ business models now encourage strong working relationships with clients which could lead the audit firms to develop “self-interest motivations” that could compromise objectivity or willingness to challenge management should they need to.

This idea of working independently from management is carried through to chapter five, which shifts back to science, quoting DNA expert Richard Dawkins: “DNA neither cares nor knows. DNA just is. And we dance to its music.”

Professional scepticism by an auditor should operate in the same way. Auditors should work separately from management and make their own assumptions, based on their own investigations. They should: actively look for risks of material misstatement as part of their audit; make risk assessments through their own “fresh and independent eyes” rather than through the eyes of management; and each business may need a different structured audit team.

The challenges faced by auditors are showcased in section six. It outlines what audit firms, teams and individuals need to do to enhance scepticism.

Individuals need to understand the management’s motivation if a misstatement has taken place, they also need to actively consider alternative views. Teams should collectively have good business experience and ensure that partners and managers are accessible to staff.

Audit firms on the other hand should embed scepticism in training; it should employ strict quality control and provide support to auditors to help them identify issues early.

And finally section seven looks at how the APB will push this issue forward. The regulator admits auditors who follow the exact letter of the law on standards could still fall short of a sceptical audit. But, the body intends to influence the International Auditing and Assurance Standards Board to enhance standards in “due course”.

In the meantime, it hopes to stimulate debate and momentum on the topic both in the UK and internationally.

Although the 22 page document can come across as a bit airy fairy in parts, its overarching message has a serious and dark undertone that the relationship between auditor and client should not be cosy, also that auditors work for the stakeholder and should reflect their cynical sentiment on financial reports accordingly. After all if something is too good to be true it probably is… something global markets should have realised pre-credit crunch.