ACCOUNTING ETHICS

SESSION 1

1 Accounting ethics

1.1 What is accounting ethics?

Reliable corporate reporting, whether financial and non-financial.

Why does accounting ethics matter?

 Because it is the root cause of corporate and financial scandals. There have been huge
economic and social consequences.
Examples: big scandal in Germany, a technology firm in Belgium, VW in 2015

Leadership is really important. If they are not interested in reporting in a reliable way, it will
cause a lot of problems. Sometimes, auditors are misled. Auditors need to be skeptical. When
they select a client, they need to have a good feeling of integrity, otherwise it will lead to
troubles. The auditor needs to try to defend himself, say that he has been misled.

1.2 Who cares about accounting ethics? Who are the stakeholders?

- Investors (ex: shareholders, banks)

- Government (ex; tax authorities)
- Employees
- Customers and suppliers
- Society at large: we all suffer from this, directly or indirectly

1.3 Who are the “players”? Who has to ensure that we have reliable corporate reporting?

- CFO: draws the financial statements

- Internal auditors: make sure the internal control is functioning
- Audit committee: working oversight
- External auditors: provide assurance
 Governance mosaic

2 Corporate governance

Assurance is only one aspect of ensuring high quality financial reporting.

Governance mosaic: interaction between different players improves value of audit.

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The audit committee helps and support the auditors.
If internal controls are functioning well, the life of auditor is much easier because he can rely on
that.

3 External audit of the financial statements

3.1 What is auditing?

It is an independent assurance on the reliability of the financial statements.

3.2 What is the objective?

To obtain reasonable assurance about whether the financial statements are free from material
misstatements due to error or fraud.

3.3 What is the role of the (external) auditor?

To ensure the reliability of the financial statements.

3.4 What is the purpose?

To increase the confidence that users can place on the financial statements. Ex: increase
confidence that earnings are not inflated.

3.5 What skills and knowledge are needed by the auditor?

- Be competent - Professional skepticism

- Know how to do the audit - Leadership
- Technical knowledge on accounting and auditing - Be critical
- Knowledge on the industry - Be able to work under pressure
- Client-specific knowledge - Teamwork
- Be independent - Communication
- IT skills - (Ethical) decision-making
- Assess and respond to fraud risk - Integrity

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A license is required to become a certified auditor.

4 International Ethics Standards Board for Accountants (IESBA)

It is the code of ethics for professional accountants, to which auditors need to stick and comply.
There are 5 fundamental principles:
1. Integrity
2. Objectivity
3. Professional competence and Due Care
4. Confidentiality
5. Professional behavior

5 Importance of auditing: some quotes

“A credible and effective audit function is indispensable for an efficient and competitive EU
capital market and it plays a key role in determining investor confidence in that market”.

“The audit tradition is a professional asset of incalculable value. It derives from the market-place
for high-quality, decision-making information”.

“Our system of capital formation relies upon the confidence of millions of savers to invest in
companies. The auditor’s opinion is critical to that trust”.

6 Corporate failures

Failures mean that you were not convinced of the work of auditor, the auditor needs to defend
himself.

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7 What is audit quality?

7.1 Definition

- Joint probability that an auditor will detect a material misstatement in the financial
statements (problem) and report it.
- Meaning (and expectations) differs across the stakeholders.

7.2 Why is there value in assurance service?

Auditors are independent and must be competent (expertise).

 Independent:
Users derive value from the knowledge that the assurance provider has no interest in the
information other than for its usefulness.
 Key area of attention for regulators

 Expertise:
Assurers must have the competence to obtain sufficient relevant information to provide a
reasonable basis for their conclusions.
It requires professional judgement and professional skepticism.
 Key area of concern for regulators

7.3 Drivers of audit quality

Audit quality: 5 different dimensions

- Skills and quality and engagement
- You’re paid by clients, but you do not always please them. Tension between
Professionalism vs commercialism.

7.4 IAASB Audit quality framework

IAASB = International Auditing And Standards Board

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  Key elements that create an environment for audit quality:

The framework describes in a holistic manner the different input, process, and output factors
relevant to audit quality at the engagement, firm, and national levels. It also demonstrates the
importance of appropriate interactions among stakeholders, and how they may facilitate
improvements to audit quality, as well as perceptions of audit quality.
Further, the framework demonstrates the importance of various contextual factors, such as laws
and regulations, the litigation environment, corporate governance, and the financial reporting
framework – collectively, factors that have the potential to impact the nature and quality of
financial reporting and, directly or indirectly, audit quality.

Examples:

Engagement Firm level National level

level
OUTPU PROCESSFACTORS INPUT FACTORS

Value, ethics & Professional Tone at the top Ethics requirements

attitudes skepticism Appraisal and
reward
Knowledge, skills, Audit team Training Education
experience and competence requirements
time
Audit process and Team complies Quality control Oversight of auditing
quality control with standards procedures profession
procedures

Audit reports Transparency Aggregate inspection

reports reports

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Professional skepticism: if auditors are acting skeptical, higher audit quality. People are rewarded for being
professional and skeptical.

Audit team: team has to be efficiently competent

Training: which the firm provides

Education: differs between countries, what is needed is a license that shows that you are a certified
auditor, you need to have a master’s degree. Differs across the different states in the USA. Ex: license from
Florida, you can do the audit in other states, but some states don’t allow it.

Transparency report: overview of the corporate governance practices

Aggregate inspection: gives indication of the quality of the audit

A quality audit is likely to have been achieved by an engagement team that:

- Exhibited appropriate value, ethics and attitudes ( input, independence)

- Was sufficiently knowledgeable, skilled and experienced, and had sufficient time
allocated to perform the audit work ( input, competence)
- Applied a rigorous audit process and quality control procedures that complied with law,
regulation and applicable standards (  process)
- Provided useful timely reports ( output)
- Interacted appropriately with relevant stakeholders

8 Audit firm culture

Audit firm culture is crucial. Once the top is involved in fraud, it all has to do with the culture of
the firm.

Key attributes to create a culture at audit firm level where audit quality is valued:
 Governance arrangements in place to establish appropriate “tone at the top”, and
safeguard the firm’s independence
 Necessary personal characteristics are promoted through appraisal and reward systems
supporting audit quality
 Financial considerations do not drive actions and decisions that impair audit quality
 Importance is emphasized of continuing professional development of partners and staff
and access to high-quality technical support
 A culture of consultation on difficult issues is promoted
 Robust systems exist for making client acceptance and continuance decisions

Audit firm culture is perceived as a root cause of audit quality! (PCAOB, IAASB, IFIAR, AFM).
Audit firms need to articulate the quality-oriented culture they want to realize (AFM 2015).

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9 Economics of auditing

The audit market is not a free market, more and more regulation that is comping into place. The
regulators are worried and want to protect the quality of the audit.

10 Demand

Is there an economic demand for auditing? Yes:

- Agency theory
- Information theory: want to show them that my earnings are reliable
- Insurance theory: if something goes wrong

Is there demand for quality-differentiated audits? Yes:

- Different clients have different auditor preferences (e.g., need for better monitoring)
- Different stakeholders

Empirical evidence: Certain clients are willing to pay fee premium to Big N audit firms, industry
specialists.

What do we learn from article Lennox & Pittman (TAR, 2011): voluntary versus mandatory
audit?
 “Exploiting a natural experiment in which voluntary audits replace mandatory audits for
U.K. private companies, we analyze whether imposing audits suppresses valuable
information about the types of companies that would voluntarily choose to be audited.
We control for the assurance benefits of auditing to isolate the role signaling plays by
focusing on companies that are audited under both regimes. These companies
experience no change in audit assurance, although they can now reveal for the first time
their desire to be audited. We find that these companies attract upgrades to their credit
ratings because they send a positive signal by submitting to an audit when this is no
longer legally required. In contrast, companies that dispense with being audited suffer

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 downgrades to their ratings because avoiding an audit sends a negative signal and
removes its assurance value.”
11 Supply

What is needed for an effective and efficient audit?

- Human capital (knowledge, ethics and values)
- Audit methodology (business risk approach)
- Technology

12 Impact of new IT developments

“Work is changing, but it will become

more interesting”(Head data analytics,
PwC)

“A lot of the more boring manual work

conducted by juniors can be automated”

13 Data-driven audit environment

The traditional way of auditing is fundamentally changing. There is much more data-driven
audit environment.
The audit data analytic tools are used in various stages of the audit process to perform:
- Risk assessment
- Analytical procedures
- Substantive testing

14 Functioning of the audit market

• Auditing is an economic activity: demand and supply forces shape the audit market
• Raison d’être of the audit market: audit quality
• Specific features of the audit market:
- Audit process/quality is unobservable and outcome is uncertain result even for
auditor (i.e. level of assurance obtained)
- Idiosyncratic nature of the audit service
- Auditor serves public interest which may not always align with client’s interest,
while…
- … client is paying the auditor

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 • Impact of regulation on audit market structure: Nearly 50% of small audit firms leave
audit market following SOX (DeFond and Lennox, 2011)

15 Regulation

The value of auditing depends on audit quality

- Top priority of regulators
- “A credible and effective audit function is indispensable for an efficient and competitive EU
capital market and it plays a key role in determining investor confidence in that market”
(F.Bolkestein, Former EU commissioner)

There is a dramatic increase in regulation, likely to play a more prominent role in shaping audit
quality in the future.

Revised 8th EU Directive (2006, Directive 2006/43/EC)

- Stricter regulations to safeguard auditor independence including partner rotation, ban
on many non-audit services for public interest entitities
- Independent public oversight
- Audit firm transparency reports
Revised 8th EU Directive (2014, Directive 2014/56/EU)
- Further restrictions to safeguard auditor independence including audit firm rotation and
nearly complete ban on non-audit services

Audit quality remains continuous area of concern to regulators. The six largest audit firm
networks have agreed with international audit regulators on a new initiative to achieve a
measureable reduction in audit deficiency findings by 2019 (see point 17).

16 Public oversight

There are some root causes for structural audit failure, such as professional skepticism and the
audit firm culture/tone at the top.

The effectiveness of public oversight is based on research relating to PCAOB inspections in the
U.S. and internationally for audit firms with clients cross-listed in the U.S.:
- Greater investor confidence
- Higher audit quality and greater value relevance of accounting numbers

17 IFIAR Survey Inspection Findings 2019

17.1 Individual audit engagements

Overall, 33% of the listed PIE audits inspected had at least one finding. Down from a high point
of 47% in 2014.

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17.2 Firm-wide systems of quality control

17.3 Examples

Inspection Theme Theme sub-category examples

Engagement performance
Independence and ethical requirements
• Failure to establish and/or implement
policies and procedures for sufficient,
timely engagement supervision and
review
• Audit methodology and guidance
• Failure to maintain independence due
to existence of financial relationships

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 • Failure to appropriately consider
applicable firm or partner rotation rules
Human resources • Compliance with the firm training and
learning plan
Monitoring • Failure to identify audit performance
issues when performing internal
inspections

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 SESSION 2: ETHICAL DECISION-MAKING

What is ethics not?

 A matter of following one’s feeling

 A matter of religious beliefs
 Doing what the law requires
 Standards of behavior in society 

What is ethics?

Ethics, derived from the Greek word ethikos (character), deals with the concepts of right and
wrong. It is about well-based standards of how people ought to act.
We need to examine and develop one’s ethical standards to ensure that they are reasonable and
well-founded since feelings, laws and social norms can deviate from what is ethical.
Strive to make the right decision in all circumstances, which requires evaluating the effects of
actions on stakeholders.

1 Ethical Reasoning: Implications for Accounting

Modern moral philosophies: Teleology, deontology, justice, virtue ethics

1.1 Teleology

An act is considered morally right if it produces results. You always assess the moral word of
behavior by looking to the consequences. 

There are 2 important philosophies in teleology: Utilitarianism and egoism. 

Utilitarianism is about bringing the greatest good for the greatest number of people. The end
goal is to maximize the well-being for all concerned.

Ethical judgement: evaluates consequences of actions (harms and benefits) on stakeholders.

 Act utilitarian and rule utilitarian. 
 Act-utilitarian: focus on their actions, what is best for everyone even if that means you
have to set aside on a rule. Examines the specific action itself vs. rule. It sets aside the
rule only if there is an increase in net utility to all stakeholders.
 Rule-utilitarian: the behavior is based on rules designed to promote the greatest
utility. Actions that conform the general rules.

Problem with the implementation: it can be difficult to assign values to harms and benefits.

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1.2 Deontology – Rights theory

Deontology is derived from Greek “deon” meaning duty. Believe the moral norms should
establish the basis for actions.

Ethical judgement: they focus on the rights of individuals. It considers rights of stakeholders and
related duties to them rather than consequences.

Deontology differs from the rule, based on reason and not outcome. That implies that
deontologists believe there are things we shouldn't do even if it maximizes utility. 

The idea is that equal respect must be given to all persons.

Problems with implementation: The rights theory has problems as it relies on moral rules. Ex:
lying is unethical, ok but sometimes not lying can have devastating consequences. 

1.3 Justice

Ethical judgment: Emphasizes rights, fairness, and equality

- A just act respects your rights and treats your fairly.
- “Original Position” – behind the “veil of ignorance”

There are 2 leading rules: 

 Each person has the maximum amount of liberty Each permitted the maximum amount
of basic liberty compatible with others.
 Social and economic inequalities are allowed only if they benefit everyone. Treat equals
(i.e. those with equal claims) equally and unequals (i.e. those with differing claims)
unequally.

Problem with implementation: can be difficult to determine a criteria to distinguish equal from
unequal claims.

1.4 Virtue ethics

Ethical judgement: ethical reasoning methods – virtues (internal traits of character) – apply both
to the decisionmaker and the decision.

It is both on the person engaging in the act and the act itself. The judgments are made not by
applying the rules, but by possessing those traits that enable the decision maker to act for the
good of others.

Problems with implementation: virtues may conflict, requiring choices to be made.

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2 Cognitive Processes and Ethical Decision Making in Accounting

2.1 Case: Heinz and the drug

(p.72 of the book)

Heinz’s wife has a rare cancer. A radium drug could help. The druggist charged 10 times what
drug cost ($200 cost; $2,000 for small dose of drug). Heinz could only get together $1,000. The
druggist would make no exceptions to price of drug. What should Heinz do?

Sample responses to the Heinz dilemma:

 Egoism: Steal the drug, depending on how much Heinz likes his wife and how much risk
to stealing
 Ends justify the means: Steal the drug, due to loving the wife so much and cannot watch
her die
 Act Utilitarianism: Weigh the costs and benefits of alternative actions
 Rule Utilitarianism; justice: Do not steal the drug, since stealing is against the law
 Rights: Right to life above all else (Constitutionally: life, liberty, and the pursuit of
happiness)

2.2 Kohlberg's stages of moral development

Apply it to Heinz dilemma:

1. Obedience to rules: avoidance of punishment: not steal the drug because he will be afraid
of the consequences and might end up in prison.
2. Satisfying one’s own needs: he will steal it because he wants his wife to live, HE wants
her to be with HIM, it’s about him and not so much about her.
3. Fairness to others: steals the drug because it’s fair to his wife.
4. Law and order: he will not steal because the law prohibits stealing. He’s taking his duty
5. Social contract: in our society we have the right to live. That right to live is dominant,
that is why he would steal the drug.
6. Universal ethical principles: evaluates what is the most fundamental value. Saving a
person’s life is more than protecting the ownership of someone else. 

First thing you need to know is what is right or wrong. Then you need to act. 

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2.3 Rest: component model of ethical decision-making

Rest’s model of ethical action is based upon the presumption that individual’s behavior is related
to his/her moral development. He assumes once you are in that specific stage of moral
development, that will lead to a specific action. 

He breaks down the ethical decision-making process into four major components:
1. Moral sensitivity: ability to identify what is moral and amoral.
2. Moral judgement: ability to reason through several courses of actions and making the
right decision when you’re faced with an ethical dilemma. 
3. Moral motivation: Once you have decided on what course of action is best, you focus on
the ethical moral action. Your moral values may conflict with other values. Motivation
reflects your willingness to place ethical values ahead of non-ethical values.
4. Moral character: an individual is going to take the action that matches the ethical
intention he had in mind. Having one’s ethical intentions match actions taken.

2.4 Integrated ethical decision-making process

1. Identify the ethical and professional issues (ethical sensitivity)

2. Identify and evaluate alternative courses of actions (ethical judgement)
3. Reflect on the moral intensity of the situation and virtues that enable ethical action to
occur (ethical intent)  your ethical intention to act in correspondence with ethical
judgment. 
4. Take action (ethical behavior)

2.5 Case: Milton Manufacturing Company

See slides on Google Slides.

2.5.1 Giving voice to values (GVV)

- Behavioral ethics approach with an emphasis on developing the capacity to effectively

express one’s values in a way that positively influences others. Finding levers to
effectively voice and enact one’s values.

- Ask to think about the arguments others might make that create barriers to expressing
one’s values in workplace.

- Ask to think how best to counteract these “reasons and rationalizations”

- Used post-decision making (already decided what to do).

4-step GVV process:

1. What are the main arguments you are trying to counter? That is, what are the reasons
and rationalization you need to address?
2. What’s at stake for the key parties, including those with whom you disagree?
3. What levers can you use to influences those with whom you disagree?

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 4. What is your most powerful and persuasive response to the reasons and rationalizations
you need to address?

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 SESSION 3: ORGANIZATIONAL ETHICS AND CORPORATE
GOVERNANCE

We are going to focus a lot more on ethical decision making.

1 Framework for understanding ethical decision making in business

Ethical Issue Intensity: importance of the decisions, based on one’s values, beliefs, morals. If
you’re not very sensitive to it, you won’t realize there is actually a problem. It is important to me
or the organization, based on my values, beliefs, morals.

Individual factors: values of individuals

Organizational factors: values of the organization. Those will influence the person’s own
values. Sometimes they can conflict. Sometimes the organizational has high ethics, they can try
to educt the induvial and increase the level of ethics of that individual. But if the individual is not
really open to that, he will feel uncomfortable. Sometimes they won’t match so the organization
will let the individual go. The tone at the top plays a crucial role.

Opportunity: opportunity to take ethical actions.

These 4 will influence the business ethics evaluation that you will make and your intentions to
act. Example: your supervisor provides you with reasons to act in a different way that you
believe you should. You believe it’s not the right thing to do but you will do it anyway.

This will lead to the ethical or unethical behavior, based on what you will do.

2 Ethical Dissonance Model

It is the interaction between the individual and the organization, based upon person-
organization ethical fit at various stages of the contractual relationship in each potential ethical
fit scenario. There can be a disconnect between your own value and the organization.

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Four potential fit scenarios:
- High-High (high organization and high individual ethics): best-case scenario.
- Low-Low (low organization and low individual ethics): worst-case scenario. Neither you
nor the organization have high ethics
- High-Low (high organization and low individual ethics): The other people will say that
your behavior is not acceptable and will give it a try to socialize you in a sense that you
increase your ethical standards. The more the decisions are in conflict with what the
organization thinks is best, the more uncomfortable the individual is.
- Low-High (low organization and high individual ethics): worse than scenario 3.

3 Seven signs of Ethical Collapse

It occurs when organizations are essentially drifting from the principles of right and wrong.
Important to understand that ethical collapse doesn’t always implies that you have violated the
rules. Book of Marianne Jennings:

1. Pressure to maintain numbers: tension between ethics and bottom-line figures. Lot of
pressure to come up from the bottom-line figures. Also Tied to revenues, bonuses,…
2. Fear and silence
3. Loyalty to the boss: you think the boss is asking me to do something, I’m well paid, I want
to be loyal so I’m just going to do what he asks me to do
4. Weak board of directors: all major accounting frauds
5. Conflicts of interests overlooked or unaddressed: example: related to a weak BoD, when
the CEO is also in the BoD, you would like that those 2 were separated.
6. Innovation like no other company: makes these companies untouchable, makes them
blind to ethical issues. Exampme: Uber is really innovating data science software but
wasn’t that ethical because they had some problems with personal information of users.
Also Facebook; they have access to a lot of data.
7. Goodness in some areas atones for evil in others: people think if I do good in some areas,
this will justify or can undo something that I did wrong. But that doesn’t make any sense.
Example: donation to charities, this won’t justify that you manipulate other people.

4 Establishing an Ethical Culture

Ethical culture is part of the organizational culture.

What is corporate culture?

It is a set of values and shared values that govern how people act in a company. It is shared
beliefs of top managers in a company about how they should manage themselves and other
employees, and how they should conduct their business.

Corporate culture starts with an explicit statement of values, beliefs, and customs from top
management.

Corporate culture represents how things are done in the organization. Ethical culture represents
how things are done in the organization related to the ethical part. The Ethical Culture is a piece
of the Corporate Culture: it is an ethical environment that is created in the workplace by the

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organization’s leadership (tone at the top). Tone at the top is key in creating that ethical culture.
They are the ones creating the ethical environment.

What is the purpose of a code of ethics?

It serves as a guide to support ethical decisions making. It clarifies an organization’s mission,
values, and principles, linking them with standards of professional conduct.

Why important to have a strong ethical culture?

Because it is foing to support people to make good ethical decisions and behave ethically.

5 Ethics in the workplace

A code of conduct goes beyond what is legal for an organization and provides normative
guidelines for ethical conduct. Support for ethical behavior from top management is a critical
component of fostering an ethical climate.

Measures that could be taken to establish an ethical culture:

- Make that the tone at the top promotes an ethical environment
- Have an ethics board to make sure that the ethics are shared in the company
- Training for new joiners to make them aware of the ethics of the organization
- Clear policies on ethical conduct including a code of ethics
- Ethics training program that instills a commitment to act ethically and explains the code
provisions
- A top-level officer (Chief Ethics and Compliance Officer) to oversee ethics and
compliance
- Use internal auditors to investigate whether ethics policies are followed
- Strong internal controls to prevent and detect unethical behaviors
- Whistleblowing policies, including reporting outlets
- Ethics hot line for anonymous tips
- Ethics statement signed by employees
- Enforce ethics policies fairly and take immediate action against violators
- Reward ethical behavior and include in performance evaluation system  Rewards:
show that the organization cares about its people

5.1 Character and Leadership in the Workplace

What are the rules for managers to set ethical tone at the top?
- Consider how your actions affect others: example of Wells Fargo, when it affects yourself
it is much harder than when it affects someone else.
- Do no harm
- Make decisions that are universal: means that if something isn’t right in one place or for
one person, then it’s not right for anyone anywhere. Example: country with poor
pollution standards, you must decide what precautions to take to not harm the local
population, just like you would do in your own country. Don’t say ok here they don’t care
so I don’t care.

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 - Reflect before deciding: consider how your decisions will affect all relevant stakeholders.
Don’t be impulsive.

6 Surveys

6.1 KPMG’ Integrity Survey 2013

Conclusions:
People of integrity are self-driven to do the right thing.

KPMG’s Integrity Survey 2013 surveyed more than 3,500 U.S. workers
- Nearly 75% of employees observed misconduct within past 12 months
- More than 50% of employees reported what they observed could cause a significant loss
of public trust if discovered
- Main causes: Pressure to do “whatever it takes” to meet targets, not taking code of
conduct seriously, fear of losing one’s job for not meeting targets, rewarding employees
for results and not the means used to achieve them

When employees were asked what they would do on observing a violation of code of conduct:
23% would look the other way or do nothing.

6.2 2018 Global Business Ethics Survey

It is like KPMG’s survey but at a global business level.

There was a shift of attention in past decade from bribery, financial manipulation and fraud to:
- Mistreatment of employees: abusive behavior, sexual harassment and discrimination
(e.g., #MeToo)
- Data privacy

Employees are 15 times more likely to believe that their organizations reward and measure
ethical behavior when they see consistent, regular communication from upper management on
issues like trust and ethical conduct.

When organizations prioritize integrity, employees are:

- Less likely to feel pressure to violate ethics standards
- Less likely to observe misconduct
- Most likely to report misconduct they observe
- Less likely to experience retaliation for reporting

6.3 2020 Global Business Ethics Survey

They observed 5 major trends:

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Trend 1: Ethical culture strengths remains high
In 2020, +- 1 in 5 US employees were in workplaces with a strong ethical culture compared with
1 in 10 in 2000. Globally, 14% of employees were working in organizations with a strong ethical
culture.

Trend 2: Pressure to compromise standards is the highest it has ever been

Compared with 2017, US employees experienced 2x more pressure in 2020. Globally, 29% of
employees reported pressure in 2020, an increase from 20% in 2019.

Trend 3: Observed misconduct – while steady – is inching upwards.

In the US and globally, the most common types of observed misconduct included favoritism,
management lying to employees and conflicts of interest.

Trend 4: More employees are reporting misconduct

In the US and globally, +- 8 in 10 employees reported misconduct, which is good.

Trend 5: Retaliation rates have skyrocketed

79% of US employees and 61% of global employees reported experiencing retaliation, which is
unfortunate.

7 Behavioral Indicators of Fraud

Fraud is an example of clear ethical collapse.

Red flags that could be indicators of fraud. Indicators:

- Living beyond means
- Financial problems
- Unusual close association with vendor/client
- Control issues, unwillingness to share duties
- Wheeler-dealer attitudes
- Divorce/family issues
- Instability, suspiciousness or defensiveness
- Addiction problems
- Complained about inadequate pay
- Refusal to take vacations

8 Financial Statement Fraud

Most serious type of fraud.

Fraud schemes occur because an employee – usually top management – causes a misstatement
or omission of material information in the organizations’ financial reports.

Methods to use:
- Revenue Overstatement:
o Recording sales that never took place

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 o Recording future sales in the current period
- Expense understatement
o Capitalizing operating costs
o Not recording some expense at all
- Improper Asset Valuations
o Manipulating reserves
o Changing the useful lives of assets
o Failing to take a write-down when needed
o Manipulating estimates of fair market value

8.1 Why does Financial Statement Fraud occur?

The Fraud Triangle: opportunity, incentive, rationalization

What are the elements of the fraud triangle?

- Incentive: situational pressure. Incentive to commit fraud, which could be at the tone on
the top but also at the individual level as well. Incentive to commit fraud because you
have a personal benefit, or the organization can benefit from it. You take into account
your own self-interest but also the organization’s and others.
- Perceived opportunity
- Rationalization: rationalize the fraud, then you are able to live with it. One way to
rationalize; it is a one-time event and I’m never going to do that again. But when you
start, next year you will do it again because the situation is not better. The next year you
do it again, and it becomes huge.

In order to prevent financial fraud occur, the organization needs to establish corporate
governance.

9 (Sustainable) Corporate governance

What is corporate governance?

 It is a system by which companies are governed and controlled.

They want to lift corporate governance to a higher level.

Ecoda: European corporation of directors.

9.1 Best practices of governance

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Some examples:
- Independent directors enhance governance accountability
- Separation of the duties of CEO and board chair
- Separate meetings between the audit committee and external auditors strengthen
control mechanisms

Effective corporate governance must include the active and collaborative participation of all of
its principal parties:
- BOD
- Audit Committee
- Management
- Internal auditors
- External auditors

Who is responsible for financial statements?

- BoD: processing of financial statements
- Financial statements are the management’s responsibility!!
- Audit committee: supervision
- Independ auditor: verification

9.1.1 Audit Committee

Who are the audit committee members?

 Independent directors, minimum 3, with one having a financial expertise.

What is their role?

 Oversight of financial reporting:
- Internal audit function
- External auditors
- Review formal announcements of earnings, significant financial reporting judgments,
internal controls and risk management procedures, whistleblower and compliance
program, external auditor’s independence and objectivity and effectiveness of audit
process.

9.1.2 Internal auditors

What do they do?

- Monitor corporate governance activities and compliance with organization policies
- Review effectiveness of the organization’s code of ethics and whistle-blower provisions
- “Eyes and ears” of audit committee
- Assess audit committee effectiveness and compliance with regulations
- Oversee internal controls and risk management processes
- Assurance on how effectively the organization assesses and manages its risk
- Assurance on data security and privacy controls

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Internal controls:
The tasks of the internal auditors are to oversee the internal controls.

What is the purpose of internal controls?

 Reliability of financial reporting: Prevent and detect errors and fraud
o Asset misappropriations
o Materially false and misleading financial reports
o Inadequate disclosures
 Compliance with applicable laws and regulations: Ensure management policies are
followed
 Effectiveness and efficiency of operations
 Can be overridden by top management: Managers need to “walk the talk” of ethics

On PwC website: best practices for your internal control journey

You first need to define a clear scope of the key controls. Prioritize what you are going to focus
on. That implies that you have to know where the risks are.

Regards to people: internal controls need to be supported from top to down. Back up by senior
management. If management doesn’t really consider that it is important, it won’t work. The
decision makers define the internal control culture and play a key role in creating that culture to
all levels of the organization.

Technology: internal control processes can be automated. Data analytics is more and more used.

9.1.3 Whistleblowing

What is whistleblowing?
Employees (former or current) who report suspected violations (illegal, immoral, illegitimate) to
persons or organizations that may be able to take action

Famous cases?
- Financial fraud case: Worldcom – Cynthia Cooper
- Other type of scandals: Dieselgate, Panama papers, Wikileaks

Whistleblower laws protecting employees

- US: Dodd-Frank Act (to protect whistleblowers who provide information on a fraud
against retaliation) (effective since 2011)

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 - EU: Directive 2019/1937, implementation before December 2021

9.1.4 External auditors

They make sure they are no errors in the financial statement, no misstatement, no fraud.
They have an obligation to the public interest, that is why they need to conduct audits
independent of any influence of management or the company.
They also need to communicate effectively with the audit committee: accounting policies and
procedures, estimates by management; quality of financial reporting; potential violations of
laws.

10 Case: The parable of the Sadhu

1. Throughout The Parable of the Sadhu, Bowen McCoy refers to the breakdown between the
individual and corporate ethic. Explain what he meant by that and how, if we view the hikers
on the trek up the mountain in Nepal as an organization, the ethical person-organization fit
applied to the decisions made on the climb.

The organization in Nepal had a weak ethic because the group was not willing to take
responsibility for the Sadhu and carry him down the mountain.

The organization lacked a guide and a leader that everyone could relate to. Without the support
of an organization, an individual's ethics and values are diminished. It was impossible for
Stephen to get Sadhu down the mountain without the help of others. Therefore, Stephen
essentially gave up and followed the ethics of the organization.

Additionally, the individuals were unethical in not carrying the Sadhu down the mountain
because they would not be able to get back up before the snow melted.

As a result, individuals put their goals ahead of the Sadhu's welfare. Everyone did their part to
take care of the Sadhu if it was not inconvenient, creating an environment where people got
along to get along.

Ultimately, the organization broke down ethically, and everyone drifted into rationalizations,
claiming that they were providing the necessaries such as aid and foot to the Sadhu, when in fact
they put their needs before the life of the Sadhu.

2. Using the various ethical discussions in the first three chapters as your guide, evaluate the
actions of McCoy, Stephen, and the rest of the group from an ethical perspective.

Using Kohlberg's stages of moral development, McCoy reasoned at stage 3 of Sadhu fairness. In
this stage, the individual focuses on what is in his or her best interest but takes into account the
interest of others. Although McCoy provided assistance to the Sadhu, he was primarily
concerned with passing the pass. McCoy justified his moral obligation by providing aid and
comfort to the Sadhu.

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Stephen initially reasoned at Stage 5 of the social contract by weighing the pros and cons of the
Sadhu's welfare. Stephen was motivated to carry the Sadhu down the mountain and tried to get
the other group members to help, but he was unsuccessful and eventually gave up.

Moreover, the group's reasoning was at stage 2, satisfaction of its own needs. The group
maintained a selfish attitude in which their goal was more important than getting Sadhu down
the mountain.

3. What role did leadership and culture play in this case?

Stephen took on the role of leader, trying to make the others understand that the Sadhu's life
was more important than their plans. He also asked the other groups who came to the mountain
to carry the Sadhu to the hut, and finally, he asked the Sherpas to carry the Sadhu 500 feet from
the hut.

Despite the cultural differences of each group, each group put their own self-interest ahead of
ensuring the Sadhu's well-being.

Furthermore, the groups justified not carrying the Sadhu by the altitude and the need to get
through the pass before the snow melts. This shows how the ethical climate of an organization
plays an important role in the organizational culture.

4. What is the moral of the story of the sadhu from your perspective?

From my perspective, the moral of the story is that even if an individual has a high ethic like
Stephen, without the support of the organization, the individual is lost. Stephen did not have the
resources to carry the Sadhu on his own and without the help of others, he was lost. Therefore,
low organizational ethics wins out over high individual ethics.

11 Ted Talk: Why do ethics matter?

Is there a place for ethics in a world that is constantly ignoring them?

She was called badly and put that on her resume.

We should relate ethics to your lives.

Anecdote: interview for a work Geneva: the work was to teach the customers how to launder
their money. She was going to be paid a lot., like she would not have to work after she turned 30
because she would have earned a lot. She never took it.

What is ethics? It is the moral principles that govern a person’s behavior. Synonyms: morals,
rights and wrongs, creed, credo, rules of conduct, virtues, conscience, standards.

Examples:
- Panama papers: they were legal, didn’t do anything wrong. But morally, it was wrong.

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 - Fox: has a new CEO and he sacked the entire ethics office.
- Wells Fargo: they have been creating thousands of fake accounts so that the salespeople
could beef up their commissions to get more money to take home.
- Uber: harassment and abuse in the company
- Tesco: fined £129 million for overstating accounts by £326 million

Why does ethics matter?

Building in Bangladesh collapsed: 1100 people died. They found out that the building was built
on a pond. 3 extra floors on the building that shouldn’t have been there. The building was built
too quick. All people hired to check the security of the building had been bypassed.
 people were bribed to make this happen faster so that all these people could get into the
building to design the clothes for the high streets.
 Corruption, bribery, illegal activity, unethical behavior caused 1100 people to die. People can
die because of it.
 how do you reconcile your moral and ethical values in a company that doesn’t

 Ethics matter.

Bring your own ethical standards to the organization that you work for. You have to hold your
own morals and values even if the people around you don’t have the same as you.

Imagine you work for an organization, you’ve worked in ethics your whole career, you’re good at
it, you love it. You like the people you work with. You like the company, its mission, its values.
Would you work for this company? This company is actually NHS (National Health Service).
NHS covered up huge data loss that put thousands of people at risk.
Ponder this: “bribery is a perfectly acceptable business expense” -> in some occasions it is.

When you think about an organization, figure out how you can integrate it into your company,
bring your own ethics and morals into that company.

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 SESSION 4: ETHICS AND PROFESSIONAL JUDGMENT IN
ACCOUNTING

1 Professional Judgement in Auditing

The foundation for audit quality is good professional judgement. It is related to the concept of
audit risk. Because if there would not be any risk, there is no professional judgement.

Auditors must make many judgments as evidence is gathered and evaluated.

What are some of those judgements?
- Accounting estimates (ex: accounts receivables, there is a certain amount that twill be
uncollectable, you have to make estimation)
- Immaterial fixed assets
- Provisions
- Brands, goodwill

Auditing regulators often cite problems in professional judgement as a root cause of audit
deficiencies.

1.1 What drives professional judgement

 Professional judgement is influenced by personal behavioral traits: attitudes, ethical values.

 Objectivity and due care are attitudes and behaviors that enable professional judgement.
 Professional skepticism is essential in making professional judgements.
 Professional judgement and skepticism influence ethical decision-making?
Why? Because you are carefully and consciously going to evaluate and consider alternatives
and then make a decision. And you will be able to justify that decision.

2 Judgement biases are very common

“Why good accountants do bad audits” (Bazerman et al. Harvard Business Review, 2002) was
published almost 2 decades ago, but still applies.

It might be titled “Why good people make bad decisions” – the points they make apply to all
complex judgement tasks.

Main point: people unconsciously engage in biased information processing.

- It’s easier to consider only information that supports a position that is held, not
contradictory information
- Positions are often taken based on self-interest, or incentives in the environment

2.1 Judgement biases depend on environmental factors

Features of the auditing environment make it difficult to avoid theses biases:

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 - The client’s asserted account balances are usually known prior to testing. When you are
going to do the audit, you get the figures. You know what the figures of last year are. This
is going to influence you.
- Auditors work very closely with their clients, becoming colleagues and friends, trust
relationship naturally develops.
- Auditors often work with the same client personnel year after year  can lead to a bias
because you have certain expectation how the client behaves. If you believe someone is
really honest, you will assume he will still be in the future and you will be blind for
another kind of behavior.
- The client hires the auditor and pays the fee

3 The profession’s response: Judgement frameworks in auditing

The auditing profession and auditing educators are increasingly focused on improving auditor’s
judgment on engagements. One response is training their personnel.

The firms have developed guidance and position papers. One good example is KPMG’s
Professional Judgment Framework.

4 KPMG Professional Judgment Framework

 Judgement is the process of reaching a decision of drawing a conclusion where there are a
number of possible alternative solutions.

 Judgment occurs in a setting of uncertainty, risk, and often conflicts of interest.

 Components revolve around one’s mindset:

o Clarify issues and objectives
o Consider alternatives
o Gather and evaluate information
o Reach conclusion
o Articulate and document rationale

 Prescriptive framework is used but pressures, time constraints, and limited capacity may
cause deviations.

 Auditor should approach matters with objectivity and independence, with inquiring mind
and critical assessment of audit evidence

4.1 Visualization of framework

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4.2 Elements of the KPMG Framework

 In the center is the “mindset”: auditors should approach matters objectively and
independently
 The KPMG framework notes that auditors’ judgments and decisions can be intentionally
biased, but that is rare.
 Judgments can also be unintentionally biased due to unknowingly using mental shortcuts,
or following self-interest
 The KPMG framework identifies common “traps that catch us” and cause unintentional
bias (Judgments traps)

4.2.1 Judgment “Traps” – Rush to Solve

The “rush to solve” – decision makers want/need to make a quick judgment. They under-invest
in early steps, and go with the first workable alternative/

Many of the specific “traps” are related to tendencies to make a “snap judgment”.

In auditing, engagement teams are always under time pressure, but especially so during busy
season: Research (Lopez & Peters 2012) finds lower earnings quality for busy season audits.

4.2.2 Judgment “Traps” – Availability

An example: the availability tendency, we consider information that is most easily available in
memory. This is actually related to the rush to solve.

We then use the wrong information or solve the wrong problem. Example with the video: he
removed the snow on a car other than his own.
 you go to the easiest solution.

Professional example:
- Analytical procedures – do client account balances differ from your expectations? If so,
why?
- Auditors often ask management for an explanation. Because it is easier, but the risk is
high that you will not consider all alternatives.
- Then test management’s explanation instead of developing their own ideas.

Example:

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The auditor notes that the estimate of bad debts is lower this year. The auditor asks a manager
why, who says “a change in our customer base”. Rather than think of other possible
explanations, the auditor seeks evidence to support management’s explanation. The problem:
this is a “non-error” explanation, may block thinking about possible errors/ may be difficult to
prove it does not account for the whole different/ the auditor may run out of budget chasing it
down.

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4.2.3 Judgment “Traps” – Framing

Related to susceptibility to framing of a problem:

- A “frame” helps to simplify or guide information use
- Judgments can vary considerably when the same question is asked in different ways
- Examples:
o Glass is half empty or half full
o A program that will save 90 of 100 lives, or will risk losing 10 of 100 lives
o 95% employment versus 5% unemployment

The way of framing results in different mindsets.

Example of framing effects in auditing:

Bedard & Graham (2002) study what happens when a risk assessment question is “framed”
positively or negatively. Auditors responded to one of these versions:
- Positive: “The company’s accounting function is appropriately organized, staffed,
trained, and/or administered.”
- Negative: “The company’s accounting function reveals a number of weaknesses or risks
related to organization, staffing, training, and/or administration.”
Auditors with the negative frame identified 40% more risk factors for their riskier clients.

4.2.4 Judgment “Traps” – Confirmation

The confirmation tendency: people put more weight on information that is consistent with their
preferences.
- If the auditor first gathers a lot of consistent evidence, he/she might stop looking for
more information
- Potentially making the wrong decision

Public oversight bodies are especially concerned about this type of bias – inspections often
identify auditors just accepting management’s word & not trying to disconfirm it.

4.2.5 Judgment “Traps” – Overconfidence

The overconfidence tendency: people tend to overestimate their own abilities to perform tasks
or to make accurate judgments and decisions. As a result of this, they are going to cease
collecting information and potentially making the wrong decision.

Professional example: Harding and Trotman (2009) find that audit superiors are overconfident
in predicting the knowledge of subordinates.

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If so, what will happen? The work that they performed is not verified well enough. They think
that they can rely on their work no matter what.

4.2.6 Judgement “Traps” – Anchoring

The anchoring tendency: decision makers start from an initial numerical value and then to
adjust that value insufficiently in forming a final judgment.

Example: in analytical procedures, research shows that auditor’s expected balance for an
account is affected by management’s asserted balance.
For example: audited revenues are $52M in 2016, $56M in 2017. Client management’s unaudited
revenues in 2018 are:
- $60M
- $52M
Prior to doing any testing, what is your expectation of “true” 2018 revenues?

4.3 Avoiding Judgment “Traps”

A key step in avoiding judgment traps is awareness of them.

The KPMG Framework says: actively question your assumptions, consider potentially
disconfirming evidence, seek more complete information. Not just accept everything that is in
line with what you had in mind.

Consulting with others can also help reduce these tendencies, these traps.

Decision aids are another commonly used means of improving decision quality in auditing.

5 What makes a good “coach” in auditing?

Note that the framework starts and ends with coaching. It is all about learning, help people
learning from their mistakes.
Supervisor review of audit work is an important quality control practice in firms.
Good coaching implies not just telling the subordinate the work is correct or incorrect, but also
helping them to avoid mistakes later and to develop as a professional.
Coaching is a skill. Are audit supervisors good at it?

6 How can we improve auditor judgment?

Auditing regulators, audit firms, and researchers have considered several ways:
- Changing auditing standards
- Changing audit firm guidance
- Decision support systems
- Changing economic incentives

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6.1 Changing auditing standards

 The KPMG Judgment Framework recommends that talking to others will help avoid judgment
biases.
 Auditing standards should encourage team interaction, this could help.
 One example is the requirement for “fraud brainstorming”
 The engagement team is required to discuss risk of fraud, consider specific risk factors, and
plan how to address them. This should ensure all important information is shared and
considered. But does it work?

6.2 Changing audit firm guidance

To increase auditor skepticism, just saying “be more skeptical” doesn’t help. Research has
studied whether firms can prevent judgments biases adopting new steps in the audit process.
Examples:
- Instructing auditors to “counter-explain” an initial conclusion (say why it might be
wrong)
- Instructing auditors to explicitly consider multiple explanations (and then narrow them
down through testing)

6.3 Decision support systems

In large audit forms, electronic decision aids are used to support many keys steps in the audit.
- Client acceptance and continuance decisions
- Risk assessment (misstatement/fraud)
- Control and substantive testing (e.g.: test planning, sample size)
- Closing the audit, reviewing work
A decision aid can “force” consideration of evidence, or just offer ideas. Example: linking
identified risk factors to specific tests.
(EY helix)

6.4 Changing economic incentives

Some changes have already been made:

- Restrictions on audit firms providing non-audit services to their clients
- Regulators watching incentives and rewards for partners (incentives for audit quality,
not just bringing in revenues)
- Requiring joint audits (e.g.: France)

The greatest change that could be made is to not have the clients be in charge of hiring the
auditor and setting the fee. The chance of this is very low.

7 Auditor Skepticism

What is professional skepticism?

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 Professional skepticism is an attitude that includes a questioning mind, being alert to
conditions which may indicate possible misstatement due to error or fraud, and a critical
assessment of audit evidence.

What are some of the problems with professional skepticism? What constraints do auditors
face?
- Issue of information asymmetry: the client has all the information, and the auditor has to
get it from him.
- The auditor has responsibility for the entire audit, but their team is spread all around the
world and that creates some challenges of managing a diverse team.
- Auditor faces a ticking clock where they have to get all their audit done within a
reasonable amount of time. Making decisions under this kind of pressure creates a
cognitive bias.

7.1 A scale for measuring professional skepticism

Rate yourself on the following statements: (1= strongly disagree, to 6 = strongly agree)
1. I often accept other people’s explanations without further though.
2. I wait to decide on the issues until I can get more information.
3. The prospect of learning excites me.
4. I am interested in what causes people to behave the way that they do.
5. I am confident of my abilities.
6. I often reject statements unless I have proof that they are true.

7.2 When to exercise professional judgment and skepticism?

Auditors should exercise professional judgment and skepticism when:

- Determining the nature, timing, and extent of audit procedures
- Determining the sufficiency, competency, and relevancy of evidence
- Evaluating management’s judgments and estimates
- Considering fraud in the audit
- Determining the conclusions based on the audit evidence obtained

7.3 Challenges to professional skepticism

• Motivated blindness: Auditors may see what they want to see and easily miss
contradictory information when it’s in their best interest to remain ignorant.
• Incentive system: rewarding results rather than high-quality decisions

7.4 Safeguards to professional skepticism

• Personality traits: diligence, thoroughness, objectivity and reliability are traits that
influence level of professional skepticism.
• Levers: accountability to reviewers and regulators serve as a lever that impacts skeptical
judgment and skeptical action

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8 Audit Deficiencies

Findings of a study of audit deficiencies for the Center for Audit Quality that resulted in
sanctions from the SEC include
– Failure to gather sufficient competent evidence
– Failure to exercise due care
– Insufficient level of professional skepticism
– Failure to obtain adequate evidence related to management representations
– Failure to express an appropriate audit opinion

Satyam Case resulted in PwC being sanctioned due to a lack of due care and exercise of
professional skepticism by accepting evidence provided by management that was less than
persuasive.

9 Public Interest in Accounting

When professional judgment is compromised, the public loses trust in the accounting profession.

The reputation of the profession is built on its historical foundation of ethics and integrity.

IFAC’s Policy Position Paper #4, A Public Interest Framework for the Accounting Profession: A
distinguishing mark of the accounting profession is the acceptance of its responsibility to act in
the public interest.

International Ethics Standards Board for Accountants (IESBA) include integrity, objectivity,
professional competence and due care, confidentiality, and professional behavior.

Key area of concern is independence.

10 Threats to Independence

Examples of Threats to Independence

Threat Example
Self-Review Preparing source documents used to generate the client’s financial
Threat statements.
Advocacy Threat Promoting the client’s securities as part of an initial public offering
or representing a client in U.S. tax court.

Adverse Interest Commencing, or the expressed intention to commence, litigation by

Threat either the client or the CPA against the other.
Familiarity A CPA on the attest engagement team whose spouse is the client’s
Threat CEO.
Undue Influence A threat to replace the CPA or CPA firm because of a disagreement
Threat with the client over the application of an accounting principle.

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Financial Self- Having a loan from the client, from an officer or director of the
Interest Threat client, or from an individual who owns 10 percent or more of the
client’s outstanding equity securities.
Management Establishing and maintaining internal controls for the client.
Participation
Threat

11 Safeguards

Source of the
Examples of Safeguards
Safeguard
Created by the Professional resources, such as hotlines, for consultation on ethical
profession, issues.
legislation, or Education, professional standards, ban on non-audit services
regulation
Implemented • The client has personnel with suitable skill, knowledge, or
by the client experience who make managerial decisions about the delivery of
professional services and makes use of third-party resources for
consultation as needed.
• The tone at the top emphasizes the client’s commitment to fair
financial reporting and compliance with the applicable laws,
rules, regulations, and corporate governance policies.
• Policies and procedures are in place to achieve fair financial
reporting and compliance with the applicable laws, rules,
regulations, and corporate governance policies.
• Policies and procedures are in place to address ethical
conduct.
• Policies are in place that bar the entity from hiring a firm to
provide services that do not serve the public interest or that
would cause the firm’s independence or objectivity to be
considered impaired.
Implemented Policies and procedures addressing ethical conduct and compliance
by the firm with laws and regulations. Audit firm quality control procedures

12 Global Code of Ethics

 International Ethics Standards Board for Accountants (IESBA)

 Code of Ethics for Professional Accountants (IFAC Code)
 Principles:
- Integrity
- Objectivity
- Professional competence and due care
- Confidentiality
- Professional behavior

13 Examples of regulations

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  Financial relationships
 Family relationships
 Business relationships
 Employment or association with attest clients
 Providing novattest services to attest client.

All these regulated are aimed to reduced independent

14 Concluding thoughts

Technical are important in accounting but so are ethical reasoning abilities.

Safeguards can be put into place to reduce or eliminate threats of compromising independence,
integrity and objectivity, but nothing can substitute for ethical intent and ethical action!

15 Video: Professional skepticism inside the mind of the auditor

Skepticism through the lens of cognitive bias. How cognitive bias can inform not just the auditor
but also the standard setters, the preparers and the public who are using the reports.

Wanted to find out that with is it that auditors are still seem to be finding a problem 10 years
after the global financial crisis.
Auditors face 3 constraints:
- Issue of information asymmetry: the client has all the information, and the auditor has to
get it from him.
- The auditor has responsibility for the entire audit, but their team is spread all around the
world and that creates some challenges of managing a diverse team.
- Auditor faces a ticking clock where they have to get all their audit done within a
reasonable amount of time. Making decisions under this kind of pressure creates a
cognitive bias.

One important thing that we do know about professional skepticism is that professional
skepticism is not just about people being different. Yes some people are inherently professional
skeptic than other, but it is basically about the interaction between differences between people,
and environmental conditions, things like time pressure and client environment.

When you move to business, you still need to retain some sort of critical mindset. Whether you
call it professional skepticism or something else, it’s within the DNA of an auditor.

On the one hand, we have the regulator who is issuing constantly new guidance and regulation.
On the other hand, we have the audited company which doesn’t always seems to see what
actually the benefit of all that regulation for them is.
It is a challenge to maintain the professional skepticism, to match the expectations from both
parties.

16 Video: Professional skepticism

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 3 elements to the definition of professional skepticism:

7. Critical assessment: Requirement for the practitioner to make a critical assessment of the
validity of evidence obtained.

• Search for knowledge: refers to the desire to investigate beyond the obvious as well as
the desire to corroborate. This takes knowledge and understanding further by requiring
the practitioner to draw inferences and apply evidence-based thinking.
• Suspension of judgment: requires the practitioner to withhold judgement until
appropriate evidence is obtained.

Example: a judge in a murder case has received a lot of media coverage. The media has
portrayed the defendant in very poor light due to his previous job-related convictions. How will
the judge exercise critical assessment? The judge would not automatically assume guilt. But this
doesn’t mean that the judge should ignore other information. The judge would draw inferences
to previous convictions when judging the defendant’s character and regard for rules and
regulations. In arriving at the verdict, the judge would require evidence and proof to
substantiate or corroborate the arguments put forward by the defense and prosecution. The
judge would arrive at a verdict by weighing up the facts and evidence at his disposal.

8. Questioning mind: need to make the critical assessment with a questioning mind and attitude
of professional skepticism.

- Disposition to enquiry: asking questions

- Autonomy: moral independence and conviction to decide for oneself rather than
accepting the claims of others.
- Self-esteem: self-confidence to resist and to challenge assumptions or conclusions

Example: auditor of Blue Ltd

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In the current year, management revalued their fixed assets. How will you evaluate a
questioning mind in relation to the revaluation?
 Make enquiries regarding the reasons for revaluation and the method used to arrive at the
revaluation.
 Would exercise autonomy by conducting your own revaluation calculations or obtaining the
use of your own expert. You would not simply accept the claims by management or
management’s expert.
 You would exercise self-esteem by inspecting the calculations and assumptions of
management’s calculations and challenge the reasonableness of the assumptions in respect to
other entities operating in similar industries.

9. Alertness: also requires the practitioner to be alert to evidence that contradict or brings into
question the reliability of documents.

- Interpersonal understanding: the practitioner needs to recognize people’s motivations

and perceptions can lead them to provide bias or misleading information.

Example: auditor of Orange Limited. You have been informed that management’s bonuses are
dependent on the achievement of a preset net profit target. Current year: revenues increased
more that 10% in comparison to prior. While tax expense decreased by 13%. Management are
pleased with Orange Limited’s performance as they have satisfied the bonus requirement.
How will you react to this information in respect of alertness?
 You would be alert to the possibility that the net profit may be misstated in order to meet the
target.
 You would also be aware of the increase in revenue with the decrease in tax expense. This
appears to be a contradiction to the normal relationship between revenue and tax expense. You
would expect that an increase in revenue would also result to an increase in tax expense.
 You would further recognize that management may provide misleading information to cover
up possible misstatements.

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 SESSION 5:

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