Auditors recognise the importance of exercising an appropriate level of professional scepticism during the performance of an audit but get stuck on how to practically demonstrate that this has been achieved. This article provides an overview of the provisions included in ISA 540 (Revised) relating to the practical application of professional scepticism when auditing accounting estimates.
Words: Juané Schreuder and Hayley Barker Hoogwerf
ISA 540 (Revised), Auditing Accounting Estimates and Related Disclosures, becomes effective for audits of financial statements for periods beginning on or after 15 December 2019. In outlining the objectives of this project, the International Auditing and Assurance Standards Board (IAASB) indicated that the revisions to ISA 540 (Revised) seek to emphasise the importance of the appropriate application of professional scepticism. In addressing this objective, ISA 540 (Revised) contains several provisions designed to enhance the auditor’s application of professional scepticism in auditing accounting estimates.
Before the auditor is able to apply these provisions in auditing accounting estimates, it is important to first understand what professional scepticism is.
Professional scepticism explained
Professional scepticism is defined as an ‘attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence’.1
ISA 540 (Revised) makes it clear that the exercise of professional scepticism is influenced by the auditor’s consideration of the inherent risk factors and resulting assessment of risks of material misstatement (RoMM).2 The auditor is therefore required to exercise a higher level of professional scepticism when there is a greater degree of uncertainty, complexity, and subjectivity, or a greater susceptibility to misstatement due to management bias or fraud. Similarly, a greater need for documented audit evidence of this heightened level of professional scepticism applied in the audit file can be seen.
While most auditors would agree that a greater level of professional scepticism is necessary, they often get stuck when asked how they practically demonstrate this heightened level of professional scepticism.
Exercising professional scepticism
Experience has proven that the involvement of senior members of the audit team is fundamental to exercising an appropriate level of professional scepticism. An engagement quality control review (EQCR) can also make a valuable contribution towards ensuring that professional scepticism has been appropriately applied throughout the audit.
Audit procedures performed in obtaining audit evidence should be performed by members of the engagement team that have the necessary skills, competencies and experience, perhaps even the senior manager or the engagement partner him- or herself. The involvement of less experienced team members when performing audit procedures or in observing discussions held with the client by the engagement partner or other more experienced members of the engagement team represents an ideal opportunity for training on exercising professional scepticism.
A further response to evidence a heightened level of professional scepticism is for the audit team to consider different sources of information, such as asking relevant questions of persons outside the finance department.
ISA 540 (Revised) also contains guidance for auditors in the application of professional scepticism in that it provides specific examples of instances where professional scepticism can be demonstrated. These examples are discussed below.
Review of previous accounting estimates
As part of the risk assessment process, ISA 540 (Revised) requires the auditor to review the outcome of the previous estimate, or where applicable, their subsequent re-estimation to assist in identifying and assessing RoMM.
This requirement may seem misfit, but the intention behind this is to provide the auditor with an upfront opportunity to objectively assess the entity’s process for making the estimate. It is important to highlight that a mere difference between the previous estimate and the actual outcome thereof does not necessarily indicate a misstatement in the previous estimate. Rather, a consideration of the reasons for the different outcome provides the auditor with insight into the appropriateness of management’s assumptions and data and/or the process for obtaining these, which is valuable information for the auditor to use during the risk assessment process.
Change in methods, significant assumptions and the data from prior periods
ISA 540 (Revised) indicates that where changes to methods, significant assumptions or data are not based on new circumstances or information, there may be cause for concern about the appropriateness of the change. The same goes for significant assumptions that are inconsistent with each other, inconsistent with those assumptions used in calculating other estimates or even inconsistent with related assumptions used in other parts or activities of the entity’s business.
When the changes are identified, the standard suggests that the auditor may need to hold further discussions with management and, if necessary, challenge management about whether the use of that method, assumption or data is appropriate.
This process requires a higher-level overview of, not only the audit evidence obtained over the financial statements as a whole but also other client data, such as cash flow and other forecasts, to compare assumptions and other data to each other.
Indicators of management bias
ISA 540 (Revised) lists indicators of possible management bias and suggests that the auditor should have discussions with management about the appropriateness of the assumptions and data used.5 The auditor should also consider if sufficient appropriate audit evidence has been obtained to support the estimate in light of the identified biases.
In our research of the topic, we came across other types of biases that are not specifically mentioned in ISA 540 (Revised). In many instances, the bias identified is unintended. Auditors may wish to start creating awareness of these biases, both internally, amongst the audit team members, and externally, with preparers of financial statements, including management and those charged with their governance.
In creating awareness around and educating auditors on how to effectively exercise professional scepticism, it is important for firms to highlight the different types of biases that exist. As a starting point, the International Ethics Standards Board for Accountants (IESBA) has already identified biases such as anchoring bias, availability bias, confirmation bias and groupthink.
Overall evaluation based on procedures performed
ISA 540 (Revised) includes a new requirement for the auditor to ‘stand back’ and consider all evidence obtained, whether corroborative or contradictory when evaluating whether the accounting estimates and related disclosures are reasonable in the context of the applicable financial reporting framework.
In complying with this provision, professional scepticism can be demonstrated by confirming the assessed RoMM remains appropriate after performing further audit procedures, whether the financial statements, as prepared by management are in accordance with the applicable financial reporting framework and that sufficient appropriate audit evidence has been obtained.
This ‘stand back’ step takes into account what the auditor has learnt about the complexity, subjectivity or another inherent risk factor which the auditor may not have known when initially assessing RoMM. If the assessed RoMM is amended, the auditor will have to consider whether the design and performance of the further procedures remain appropriate.
Performing a final analytical review of the financial statements by a member of the engagement team with the necessary skills, knowledge and experience can further assist the auditor in demonstrating the application of professional scepticism in performing this ‘stand back’ step.
In ‘standing back’, documented evidence of the auditor considering both corroborative and contradictory audit evidence gathered during the performance of the audit evidences the auditor’s exercise of professional scepticism.
Determining whether the accounting estimates are reasonable or misstated
Careful consideration of differences between management’s estimate and the evidence obtained from audit procedures assists the auditor in identifying misstatements in the accounting estimates. Paragraph A139 of ISA 540 (Revised) provides the guidance needed to demonstrate the critical assessment of audit evidence.
Although there is no single way in which the auditor’s exercise of professional scepticism can be documented, audit documentation provides evidence of the auditor’s exercise of professional scepticism.10 Examples of areas where the auditor exercises professional scepticism that can be evidenced through documentation include how the auditor
Applied an understanding of the estimate in developing the auditor’s own estimate
Obtained audit evidence through performing procedures that is not biased towards corroborative evidence and does not exclude contradictory evidence
Addressed indicators of possible management bias
Concluded on the sufficiency and appropriateness of audit evidence obtained
There are numerous steps that the auditor can take and procedures that can be performed for an audit team to demonstrate exercising an appropriate level of professional scepticism when auditing accounting estimates.
Most of the actions are not new, nor are they difficult to apply.
More awareness of these possible actions that can be taken in applying professional scepticism and a concerted effort to make the actions taken more observable through documentation of what has been done can only make a positive contribution to maintaining and enhancing audit quality.
AUTHORS l Juané Schreuder CA(SA), RA is the Quality Control Manager at Moore Cape Town and chairperson of the SAICA Assurance Guidance Committee and Hayley Barker Hoogwerf is the Project Director for Assurance at SAICA
ISA 540 (Revised), Auditing Accounting Estimates and Related Disclosures.
Basis for conclusions: ISA 540 (Revised), Auditing Accounting Estimates and Related Disclosures, Including Confirming and Consequential Amendments to Other International Standards.
IAASB video: Gateway Panel Discussion, ISA 540 (Revised), Auditing Accounting Estimates and Related Disclosures – Video 4: Professional Skepticism, available on https://www.ifac.org/knowledge-gateway/audit-assurance/discussion/implementation-support-isa-540-revised-accounting.
Also refer to the key concepts ‘ISA 540 (Revised), concepts and changes’ for an overview of the most significant changes and key concepts.
1 Glossary of Terms contained in the International Auditing and Assurance Standards Board’s Handbook of International Pronouncements.
2 ISA 540 (Revised), para 8.
3 ISA 540 (Revised), para 14.
4 ISA 540 (Revised), para A95.
5 ISA 540 (Revised), para A134.
6 ISA 540 (Revised), para A96.
7 As part of the IESBA project to amend the International Code of Ethics for Professional Accountants (including International Independence Standards) to promote the role and mindset expected of professional accountants.
8 ISA 540 (Revised), para 34.
9 ISA 540 (Revised), para A137.
10 ISA 540 (Revised), para A152.