Peeling away financial reporting issues one layer at a time

A Perspective on “Professional Skepticism” (Part 1 of 2)

I was recently invited to make a presentation to a conference of auditors. The leadership asked me to address “professional skepticism,” one of those difficult-to-nail-down ideas, yet a recent point of emphasis in PCAOB inspections.

The person who invited me knew that my perspectives on financial reporting were not mainstream, that I had served on the Standing Advisory Group of the PCAOB, but that financial reporting and analysis — as opposed to auditing — has been my primary focus.  I thought I might be able to provide a fresh perspective on professional skepticism (PS), but I wasn’t sure how to begin.  Luckily for me, PCAOB member Jeanette Franzel had given a presentation to the American Accounting Association entitled “Auditor Objectivity and Skepticism” in 2013.    Her detailed slides bootstrapped my own thinking.  (Jeanette, if you are reading this, thank you very much!)  My presentation was well-received, and by looking at the topic with a fresh perspective, it seems I was able to influence the thinking of a considerable number of the attendees.

An Historical Perspective

As with many accounting/auditing topics, it is helpful to understand how PS became controversial, leading to detailed guidance from the PCAOB. We all know that the Securities Act of 1933 laid the foundation for the rules of engagement between auditors and management:  the accounting profession persuaded Congress that the public could rely on auditor skepticism of as a matter of “conscience.”  But that presumption was challenged almost immediately by exposure of the McKesson & Robbins accounting fraud.  In it’s aftermath, the SEC was compelled to explain to McKesson’s auditors (and the rest of the world) that it is not appropriate to issue an audit report without having examined inventory and receivables.

McKesson was a flagrant case, yet the audit firms were strongly resistant to criticism by government regulators.  The principle, as the auditors saw it, was that they were in the best position to determine what to test, and how much they could trust management.  Second-guessing by the government was a calamity to hear them tell it.

In protesting as much as they did, perhaps the audit industry had achieved a partial victory out of what should have been total humiliation.  For five decades, direct SEC oversight of the auditing profession was essentially limited to the prohibition of scope restrictions and independence rules.  Then along came Enron, Worldcom, etc. in the early 2000’s.  That led to the Sarbanes-Oxley Act and the establishment of the PCAOB.

There is no need here to discuss the PCAOB’s spectrum of activities, except to point out that PCAOB inspections have pointed the way for much of its rule making.  Inadequate skepticism has been a recurring theme of the inspection findings.

The Challenge to be Skeptical

A few days after I was asked to present on PS, NPR happened to broadcast their first installment in a series about learning from failures: NASA and the tragic destruction of the space shuttle Columbia upon re-entry due to loss of heat-shielding tiles.  The story was largely told in the first person by the  NASA administrator who felt a level of responsibility for the failure, and was ultimately given the authority to fix it. You can download the audio recording here and listen for yourself.

Since skepticism is a challenge to many fields, I thought it would be useful to have my audience hear the podcast and to provide, as auditors, their reactions. Some of the observations that came out of the discussion that you may find useful were these:

  • The NASA engineers were technically capable, to say the least; yet, each of the numerous times the insulation incidents were addressed, they were dismissed as insignificant.  There were “100” opportunities for line engineers to tell management what they surely would not have been happy to hear — that this could be a big problem.   Obviously, no one ever did.
  • Management performance is measured by an organization’s short-term progress toward achieving certain goals.  Expressing skepticism in the kind of culture that standard incentive systems create can be like stepping in front of a moving train.
  • An audit, like a space launch, involves lots of details.  Over the life of an auditor/client relationship, there are hundreds of decision points when an auditor could stand up to management to say that their accounting treatment is not of the highest quality.  For each, the probability is low that mission (audit) failure could occur as a result. Given low probabilities of “craps” at each decision point, it is easy to decide to roll the dice by doing nothing.
  • Not every capable professional is also a good communicator, assertive, or inclined to be skeptical.
  • Highly technical issues that require detailed explanation tend not to receive adequate scrutiny for lots of bad reasons.

NASA looked inward.  They decided that they needed to change both their procedures and their culture.  Among other things, management needed to be better listeners, to take the time to fully understand complex issues, and to encourage expressions of doubt/concern.

Unpacking Professional Skepticism

Again, in an effort to provide a fresh perspective, I decided that I should think about what PS should mean in principle before looking to the PCAOB’s authoritative guidance.

Skepticism is to have doubt as to the truth of something.  But how much doubt?

The PCAOB’s standards state that the auditor should be “assuming neither honesty or dishonesty.”  Perhaps this means that the auditor should behave as if each statement from management comes from a person that they don’t know at all.  But, even if I am correct, it seems like an impossible standard to hew to given human nature and the economic constraints that auditors operate under.

Perhaps, that is where “professional” comes into play.  In all walks of life, professionalism is defined as conforming to standards of behavior that are a cut above non-professionals.  An informed public should expect a certain elevated level of behavior from auditors.  This is still somewhat of a vague thing to regulate, so that could explain why the PCAOB decided to provide detailed guidance (Staff Audit Practice Alert No. 10), which at some level could be seen to be a checklist approach to PS.

But is a checklist approach sufficient?  What else could/should auditors and policymakers do?  These are the questions that I will cover in my next post to follow in a couple of days.

1 Comment

  1. Reply Jeanette Franzel July 26, 2017

    Glad you found my presentation and slides useful and that you are helping to get the word out on Professional Skepticism! Best regards, Jeanette

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