The Auditing Practices Board on what auditors can learn from scepticism in ancient Greece, fourteenth century manor houses and the Companies Acts of the nineteenth century
Auditors did not have a great financial crisis – having signed off on the audits of all the UK’s subsequently failed or part-nationalised banks – and have been heavily criticised as a result.
The most damning review of their failings was by the House of Lords Economic Affairs Committee in March 2011, which concluded, as we reported in this post at the time, that the large-firm audit market is:
“clearly an oligopoly with all the attendant concerns about competition, choice, quality, and conflict of interest. It gave no warning of the banking crisis. The narrowness of the assurance it offers is much criticised. Its regulatory structure…is complex and unclear”.
Since then the large-firm audit market (i.e. Deloitte, Ernst & Young, KPMG and PricewaterhouseCoopers) has been referred to the Competition Commission in the UK, and the European Commission has made radical proposals which if implemented would result in the break-up of the Big Four auditors.
One strand of criticism of the auditors has been that they were insufficiently sceptical in their work before the crisis. Indeed, that they have lost the ability to exercise sufficient professional scepticism. The Auditing Practices Board started to look at this problem in 2010, and in March 2011 published a feedback paper on “Auditor scepticism: raising the bar”, as we discussed in this post.
APB paper on reaffirming the role of professional scepticism
The APB has now followed up this work with an interesting paper published on 30 March 2012 titled “Professional scepticism: establishing a common understanding and reaffirming its central role in delivering audit quality” (accompanying press release here).
The paper takes an unusual approach (for a regulator) to its subject by examining the intellectual history of scepticism, discussing its philosophical origins in ancient Greece and the later development of scepticism in the scientific method in the seventeenth century.
The paper then traces the rise of the earliest auditing traditions in manorial households of the fourteenth century, through to the nineteenth century legislation that led to the creation of the modern audit function – in both cases looking at how the central issue of the agency problem in running both manor houses and limited companies was approached by the use of an auditor.
How to demonstrate scepticism
The APB’s paper sets out how auditors can demonstrate the appropriate degree of professional scepticism, listing the qualities required by:
- Individual auditors
- Engagement teams
- Audit firms
- Audit Committees and management.
Buried in the paper is a telling critique of the conflicts of interest involved in the modern audit and which, the APB strongly implies, are not currently well dealt with:
- “There is potential for auditors not to be sceptical or thought not to be sceptical because they are engaged and paid by the company in a way that is relatively detached from shareholders. In addition, they have little, if any, direct contact with shareholders throughout the audit process; as a result, shareholders have no way of observing, and thereby gaining trust in, the audit process. This emphasises the need for strong governance generally and, in particular, the importance of the responsibility that audit committees have in both assessing and communicating to investors whether the auditors have executed a high quality, sceptical audit;
- Auditors necessarily have strong working relationships with management and audit committees, which may lead them to develop trust that may lead to either a lack of, or reduced, scepticism; and
- The audit firms’ business models encourage a culture of building strong relationships with audited entities. This introduces the moral hazard of the auditor putting his or her interests ahead of those of shareholders and could lead the audit firm and the auditor to develop trust or self-interest motivations that may compromise either their objectivity or willingness to challenge management to the extent required.
It is perhaps not surprising that auditors often refer to the audited entity as the ‘client’, given the strength of these relationships and the all but formal appointment of the auditor by the directors and not by the shareholders.”
The APB hopes that by publishing the paper it will stimulate debate amongst “stakeholders”, the auditing profession, Audit Committee members and internationally.
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