By Billy E. Brewster, Janet B. Butler, and Ann L. Watkins at Journal of Accountancy on August 1, 2019
Auditing standards state that inquiry alone does not provide sufficient evidence regarding the lack of material misstatement (AU-C §500, Audit Evidence, ¶.A2), yet regulatory inspections and laboratory findings indicate that even experienced auditors often simply accept management's explanations without further corroboration. In its staff inspection brief issued in August 2017, the PCAOB staff stated that reviews of audit inspections have continued to raise concerns about whether some auditors apply professional skepticism, particularly in areas that involve management judgment. The brief stated that inspectors observed that some auditors sought to obtain only evidence that would support judgments or representations made by management. The auditors failed to critically take into account all relevant evidence, regardless of whether it confirmed or contradicted management's assertions.
Why does this problem persist despite the authoritative guidance and its overall importance to the audit process? The PCAOB (2012) offers some insights when stating that auditor skepticism can be hindered by cognitive biases. By expanding on these insights, this article aims to show auditors of both private and public companies how they can improve their judgment and enhance their professional skepticism. We begin by briefly examining the factors likely to influence an auditor's decision to investigate management's representations. We then examine common cognitive biases that can make auditors more vulnerable to flawed decision-making, and describe how auditors can learn to apply mental modeling to combat cognitive biases (without the need for specific firm training), thus improving auditor judgment and professional skepticism.
CORROBORATING MANAGEMENT REPRESENTATIONS
AICPA Professional Standards stress that while client inquiry is an important source of evidence, typically such discussion alone does not provide evidence of the absence of a material misstatement or the effectiveness of internal controls (AU-C§500, ¶.A2). The required corroboration can include comparing the explanation to the auditor's preexisting understanding "of the entity and its environment, and other audit evidence obtained during the course of the audit" (AU-C §520, Analytical Procedures, ¶.A28).
When an unexpected material issue arises, most auditors will seek additional information from the client, but as noted in "The World Has Changed: Have Analytical Procedure Practices?" by Greg Trompeter and Arnold Wright, Contemporary Accounting Research, Vol. 27, Issue 2, page 669 (2010), as many as one-third of auditors may not always follow up to corroborate the client-provided explanations. Additionally, "Two Decades of Behavioral Research on Analytical Procedures: What Have We Learned?" by William F. Messier Jr., Chad A. Simon, and Jason L. Smith, Auditing: A Journal of Practice & Theory, Vol. 32, Issue 1, page 139 (February 2013), finds that when performing analytical procedures, even experienced auditors fail to follow through with additional evidence when a client explanation appears plausible, and are likely to overweight a client's explanation, compared to other pieces of evidence, when forming conclusions. Corroborating management estimates and fair value measurements also has been a challenge for auditors for many years, as PCAOB inspectors cited this as one of the three most common areas of audit deficiencies identified in 2016 audits.
COGNITIVE BIASES IMPACTING AUDITORS
Research in psychology suggests that factors in the audit setting create cognitive biases that can reduce the auditor's likelihood of following up on client explanations with additional evidence. Cognitive biases represent often unconscious, systemic influences affecting how individuals gather and interpret information when forming judgments and decisions. Identifying these unconscious biases can aid professionals in counteracting the potential "pitfalls" arising during the explanation-corroboration process of the audit. While auditors are susceptible to many types of unconscious bias, we specifically focus on three that regulators and researchers suggest are common influences, increasing the likelihood that the auditor accepts an explanation without additional corroborating evidence.
Many audit judgments are made with significant uncertainty, and research indicates that auditors who evaluate management explanations for "reasonableness" may be less likely to follow up and corroborate with additional information. The answers are not always in a stark black-and-white format. Psychology research finds that these types of judgments open the door for motivated reasoning bias that can sway the auditor toward accepting the client's preferred conclusions.
Motivated reasoning bias is a well-documented phenomenon describing an unconscious bias in which individuals interpret information in a manner that is consistent with their own goals. For an auditor, these goals can include improving client relations as well as trying to meet budget objectives. Suppose that an auditor is over budget in a particular area and asks a client for an explanation regarding an account fluctuation. Motivated reasoning theory suggests that in the absence of supporting evidence, auditors are more likely to convince themselves that the client's explanation is reasonable without actually finding supporting evidence. Further, the unstructured benchmark of the auditor reasonableness judgments opens the door for other factors like source credibility of the client, complex business environments, and the nature of auditors' listening activity to influence auditor judgment.