How Audit Skepticism Has Fallen Short

Skepticism among auditors has been on the wane and needs to return in a big way, according to a panel of experts at a PCAOB small business forum.
Kathy HoffelderJuly 19, 2013

Skepticism is one of the key attributes auditors bring to the table when auditing any size company, and for the most part, it’s what made many enter the field in the first place. But many auditors of small businesses have forgotten what it takes to be truly skeptical, said Public Company Accounting Oversight Board (PCAOB) officials at their small business forum on Thursday.

Greg Scates, deputy chief auditor at the PCAOB, posed the key question at the forum: “Why do [auditors] not exercise skepticism when there are red flags and when there is significant [corporate] judgment involved?” Scates says skepticism should start immediately, from the time an audit firm takes on a new client and assigns the engagement partner. “Do you want this audit client? Do you want this company to be part of your portfolio? Do you trust management?” 

Even if audit firms have the same clients for years, they should set guidelines to help maintain their skepticism, according to Scates. “The firm needs to set the appropriate tone,” he said, noting that a firm needs to communicate to its auditors how important it is to conduct quality audits on a regular basis.

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Auditors of all sizes, he notes, have become too complacent and not contradictory enough when reviewing a client’s financial reports. “If you find contradictory evidence [to what management has said in their financial statements], you need to pursue that evidence. At the end of the day, you may find some very serious problems — where you question the integrity of management,” Scates said.

Similarly, George Botic, deputy director of small-firm inspections at the PCAOB, said auditors need to be reminded that there can be equally verifiable arguments for a position that is opposite to what the company presents, so it’s best not to take the company’s position at face value.

Too often Botic  has found audits of small firms include mistakes related to impairment analysis (an evaluation of how much a firm’s capital is reduced due to declining value in intangible assets or goodwill). In one audit misstep, a company determined that impairment analysis was not required for a certain segment of its business, and the auditor deemed that acceptable. But, Botic notes, the auditor missed several signs that the company’s judgment was wrong. The signs included that the company was reporting impairments in other areas of the business and was experiencing declining profitability and sales. The auditor, in this example, did “minimal work,” according to Botic.

In other examples, auditors rely too much on a client’s judgment about “Level 2” investments — those that do not have regular market pricing. Though Level 2 assets can be hard to value, auditors still need to be skeptical where appropriate, said Botic. Too often an auditor ends up using outdated assumptions from a previous quarter to value an asset or the auditor doesn’t listen when management says they expect declines in Level 2 asset values in the future, he added.

And once a question is raised about Level 2 asset values or any other problem, “inquiry alone isn’t enough,” Botic noted. He suggested that having an open dialogue with the company’s management team should help produce a successful audit.

Small-business audits, in particular, have come under intense scrutiny at the PCAOB. A study the oversight board initiated in February found that about 44 percent of the firms that audit 100 or fewer public companies had at least one significant audit performance deficiency between 2007 and 2010. The causes were a lack of skepticism, a lack of technical competence or ineffective supervision. Though deficiencies have decreased by more than 60 percent since 2007, they are still too high for the PCAOB’s liking

Last December, the accounting oversight board also published a Staff Audit Practice Alert (No. 10) to remind auditors to exert professional skepticism, saying that it continued to see instances where is it not appropriately applied in audits.