4.2 Professional Skepticism and Due Diligence
3 min read•august 15, 2024
is crucial for auditors to spot potential misstatements and fraud. It involves questioning evidence, staying alert to red flags, and critically assessing information throughout the audit process.
Due diligence complements skepticism by requiring thorough research and analysis of a company's finances and operations. Together, these practices help auditors gather reliable evidence and identify risks in financial statements.
Professional Skepticism in Auditing
Definition and Role in the Audit Process
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- Professional skepticism is an attitude that includes a questioning mind, being alert to conditions that may indicate possible misstatement due to fraud or error, and a critical assessment of audit evidence
- Auditors must maintain professional skepticism throughout the audit process, recognizing the possibility that a material misstatement due to fraud or error could exist, despite the auditor's past experience with the entity and belief in management's honesty and
- The application of professional skepticism is crucial in identifying and assessing risks of material misstatement, designing and performing audit procedures to respond to those risks, and evaluating the sufficiency and appropriateness of audit evidence obtained
- Maintaining professional skepticism helps auditors avoid overlooking unusual circumstances (red flags), over-generalizing when drawing conclusions from audit observations, and using inappropriate assumptions in determining the nature, timing, and extent of audit procedures
Importance of Maintaining Professional Skepticism
- Maintaining professional skepticism is essential for auditors to fulfill their responsibility of obtaining reasonable assurance about whether the financial statements are free from material misstatement due to fraud or error
- Professional skepticism helps auditors identify and respond to red flags, unusual transactions (large, complex, or related party transactions), or other indicators of potential misstatement that may not be apparent through routine audit procedures
- By remaining skeptical, auditors are better equipped to design and perform appropriate audit procedures that address identified risks and obtain sufficient appropriate audit evidence
- Maintaining professional skepticism throughout the engagement allows auditors to continuously reassess their and adjust their audit approach as necessary, ensuring that the audit remains effective and responsive to changing circumstances
- A lack of professional skepticism can lead to an increased risk of audit failure, as auditors may fail to identify material misstatements or inappropriately rely on management's representations without sufficient corroborating evidence
- Demonstrating professional skepticism is crucial for upholding the integrity and credibility of the audit profession, as it helps to maintain public trust in the reliability of audited financial statements
Due Diligence in Auditing
Concept and Application
- Due diligence is the care that a reasonable person exercises to avoid harm to other persons or their property, often referring to the research and analysis of a company or organization done in preparation for a business transaction or audit engagement
- In auditing, due diligence involves a comprehensive appraisal of a business to establish its assets and liabilities and evaluate its commercial potential, including a detailed review of financial records, legal documents (contracts, agreements), and other relevant information
- Auditors apply due diligence by thoroughly examining the client's financial statements, internal controls, and other relevant aspects of the business (operations, industry, regulatory environment) to identify potential risks, misstatements, or areas requiring further investigation
- Due diligence helps auditors gather sufficient appropriate evidence to support their opinion on the financial statements and assess the risk of material misstatement due to fraud or error
- The extent of due diligence required may vary based on the complexity of the client's business, industry-specific factors (regulations, market conditions), and the auditor's risk assessment
Skeptical Auditor Mindset
Characteristics and Traits
- A skeptical auditor possesses a questioning mind, critically assessing audit evidence and remaining alert to conditions that may indicate possible misstatement due to fraud or error
- Skeptical auditors maintain an objective and unbiased perspective, avoiding the influence of personal beliefs, biases, or past experiences with the client that may cloud their judgment
- They exhibit professional curiosity, proactively seeking out additional information or explanations when audit evidence is inconsistent, contradictory, or otherwise raises concerns
- Skeptical auditors are willing to challenge management's assertions and representations, especially when evidence suggests that such assertions may be inaccurate or misleading
- They remain open to alternative possibilities and explanations, considering multiple viewpoints and potential scenarios when evaluating audit evidence and forming conclusions
- Skeptical auditors are diligent in their work, thoroughly documenting their thought processes, decisions, and the basis for their conclusions throughout the audit engagement
Key Terms to Review (21)
Accountability: Accountability is the obligation of individuals or organizations to accept responsibility for their actions and decisions, and to disclose the results in a transparent manner. It emphasizes the importance of ethical conduct and integrity in maintaining trust and credibility among stakeholders.
AICPA Code of Professional Conduct: The AICPA Code of Professional Conduct is a set of ethical guidelines established by the American Institute of Certified Public Accountants that outlines the principles and standards for professional behavior in the accounting profession. This code emphasizes the importance of integrity, objectivity, and professionalism, which are essential for maintaining public trust and ensuring ethical practices in various accounting activities.
Confidentiality: Confidentiality refers to the ethical principle that requires professionals to protect sensitive information obtained in the course of their work. This principle is essential for maintaining trust between clients and professionals, ensuring that personal, financial, and proprietary information remains secure and private, which is critical in fostering an environment of integrity and responsibility.
Corroboration: Corroboration refers to the process of validating or confirming information by obtaining additional evidence or support from multiple independent sources. This technique is essential in evaluating the reliability of financial information and ensuring accuracy in accounting practices, as it helps to build a stronger foundation for conclusions drawn during audits and assessments.
Decision-making framework: A decision-making framework is a structured approach that guides individuals and organizations in making informed choices by systematically evaluating options and outcomes. This framework often incorporates critical thinking, ethical considerations, and the assessment of risks, leading to decisions that are more aligned with goals and values.
Ethical reasoning: Ethical reasoning is the process of systematically evaluating moral principles and values to make informed decisions regarding right and wrong. This involves critical thinking and reflection on ethical standards, particularly in professional settings, where the implications of decisions can significantly impact stakeholders. In accounting, ethical reasoning is essential for maintaining integrity, ensuring transparency, and fostering trust in financial reporting and practices.
Evidence gathering: Evidence gathering is the systematic process of collecting, analyzing, and evaluating information to support conclusions in accounting and auditing practices. This process is crucial for establishing the credibility of financial reports, ensuring compliance with regulations, and forming the basis for sound decision-making. It relies heavily on professional skepticism and due diligence to assess the quality and reliability of the information obtained.
Familiarity Threat: A familiarity threat occurs when an auditor becomes too familiar with a client or its management, potentially compromising their objectivity and independence. This situation can arise from long-standing relationships, personal friendships, or close professional ties, leading to biased judgments in the auditing process. The integrity of financial reporting can be at risk if auditors do not maintain a level of professional skepticism and due diligence when evaluating the client's financial statements.
Financial due diligence: Financial due diligence is the process of systematically reviewing and analyzing a company’s financial information to ensure accuracy, integrity, and compliance before making investment decisions or business transactions. This critical examination helps identify potential risks and opportunities, ensuring that stakeholders make informed choices based on a clear understanding of the company's financial health.
IFAC Code of Ethics: The IFAC Code of Ethics is a set of principles and standards that guide the ethical behavior of accountants and auditors worldwide. It emphasizes the importance of integrity, objectivity, professional competence, confidentiality, and professional behavior, serving as a foundational framework to promote ethical decision-making within the profession.
Inquiry: Inquiry refers to the process of seeking information, clarification, or understanding through questioning and investigation. In the realm of professional skepticism and due diligence, inquiry plays a vital role in evaluating the reliability of information, ensuring that auditors and accountants actively seek evidence and challenge assumptions to provide an accurate financial portrayal.
Integrity: Integrity in accounting refers to the adherence to moral and ethical principles, ensuring honesty and fairness in all professional actions. It involves maintaining consistency of actions, values, methods, measures, and principles, which builds trust with stakeholders and promotes a culture of ethical decision-making.
International Standards on Auditing: International Standards on Auditing (ISAs) are professional standards for the auditing of financial statements, established by the International Auditing and Assurance Standards Board (IAASB). They provide a framework for auditors to ensure the quality, consistency, and transparency of audits across different jurisdictions, helping to maintain trust in financial reporting. ISAs emphasize the importance of applying professional skepticism and due diligence throughout the audit process.
Legal Due Diligence: Legal due diligence refers to the comprehensive appraisal of a potential investment or acquisition to confirm all material facts related to it, including legal liabilities and obligations. This process ensures that all relevant legal issues are identified and assessed, providing stakeholders with critical information to make informed decisions. It is closely linked to the concept of professional skepticism, which emphasizes the need for accountants and auditors to critically evaluate evidence and question assumptions during this thorough investigation.
Materiality: Materiality refers to the significance of financial information in influencing the decisions of users. It's a concept that helps determine which information should be included in financial statements and reports, based on whether its omission or misstatement could affect the economic decisions made by those who rely on that information. This concept is essential for ensuring transparency and trust in financial reporting.
Objectivity: Objectivity refers to the principle of maintaining impartiality and neutrality in decision-making and reporting, especially in the context of the accounting profession. It emphasizes the need for accountants to present information fairly and without bias, ensuring that their judgments are based on factual data and not influenced by personal feelings or interests.
Professional Skepticism: Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence, which is essential in evaluating the truthfulness and fairness of financial information. It plays a crucial role in maintaining integrity, objectivity, and ethical standards in accounting and auditing practices, helping professionals avoid complacency or bias in their evaluations.
Risk Assessment: Risk assessment is the process of identifying, analyzing, and evaluating risks that could potentially impact an organization's ability to achieve its objectives. It involves understanding the nature of potential threats, their likelihood of occurrence, and the consequences of those threats, which is crucial for informed decision-making and resource allocation.
Sarbanes-Oxley Act: The Sarbanes-Oxley Act (SOX) is a U.S. federal law enacted in 2002 to protect investors from fraudulent financial reporting by corporations. It was created in response to major financial scandals and aimed to improve the accuracy and reliability of corporate disclosures, thereby enhancing accountability in accounting practices.
Self-interest threat: A self-interest threat occurs when an accountant's personal interests or relationships could influence their judgment and objectivity in professional decision-making. This threat can compromise the integrity of financial reporting and auditing, as it may lead to biased conclusions that favor the accountant's own financial or personal benefits. The presence of such threats underscores the importance of independence and ethical conduct in accounting.
Transparency: Transparency refers to the openness and clarity with which information is shared, particularly in financial reporting and decision-making processes. It promotes accountability and trust among stakeholders by ensuring that relevant data is accessible and understandable, reducing the potential for misunderstandings or manipulation.