Enhancing Professional Skepticism: A Case Collection

The Professional Accounting Centre¹ of the University of Toronto, with the support and funding provided by CPA Ontario, is pleased to provide this Professional Skepticism Case Collection to inform professional accountants, students, and their organizations about the crucial expectations, nature, and strategies surrounding the development of a professionally skeptical mindset and its application. The Collection is evergreen in nature in that new materials and cases will be added when the need and opportunity to do so arises.

This Case Collection has been published as an open-source document on the PAC website with the intent that professors and other individuals will use and reproduce the cases and other aspects of the collection, at no charge, provided the source of such use is acknowledged as follows: Source: Professional Skepticism Case Collection for Professional Accountants, University of Toronto Professional Accounting Centre, (insert year of use), PAC website https://www.utm.utoronto.ca/pac/case-collections/enhancing-professional-skepticism-case-collection.

Table of Contents

• Acknowledgements
• Introduction and Purpose of the Professional Skepticism Case Collection
• Nature and Relevance of Professional Skepticism for Professional Accountants
• Review of Research and Professional Standards
• Framework for Considering the Development of Professional Skepticism
  • Recognizing that there is an anomaly that needs investigating
  • Investigating an Anomaly or Red Flag Professionally
  • Protecting the Public Interest
• Developing a Professionally Skeptical Mindset
  • Not Recognizing the Game the Client’s Staff was Playing
  • Four Insightful (Some Shocking) Learning Experiences
• Cases Collected
  • Applications of Professional Skepticism
  • Iconic Failures to Apply Professional Skepticism
  • Runaway Skepticism – Is the Auditor being too Skeptical?
• Resources on Professional Skepticism
• Case Notes - Solutions, Commentaries, or Lessons to be Learned

Acknowledgements

The Professional Accounting Centre of the University of Toronto is pleased to acknowledge:

• Funding support for the Professional Accounting Case Collection from the Chartered Professional Accountants of Ontario (CPA Ontario).
• The suggestions and contributions made to this case collection by many, including the following, in the form of ideas, cases, comments, and suggestions:

          Rod Barr, Anish Chopra, CPA Ontario staff, Al Donald, Harold Bridge, Jim Goodfellow,
          Michael Gottlieb, Stacey Hammett, Catherine Hancharek, Karim Jamal, Eric Lavoie,
          Robert Kidd, Alison Knight, Michel Magnan, Jim Morrison, Carol Paradine, 
          Antonio Pecora, Adam Reiterowski, Al Rosen, David Selley, Bill Swirsky,
          Michael Tambosso, Alan Willis.

• Initial co-authors: Leonard J Brooks, Jr., and Michael Marin.

Without their significant contributions, this case collection would lack the wisdom and experiences it contains.

It should be noted that not all suggestions have been incorporated, and that any errors in, or omissions from the case collection are my responsibility.                                                                              

Leonard J. Brooks, Jr. FCPA, FCA
Professor of Business Ethics & Accounting
Director, Professional Accounting Centre
University of Toronto

August 15, 2023

Comments and suggestions are welcome at len.brooks@utoronto.ca

Introduction and Purpose of the Professional Skepticism Case Collection

To protect public interest, professional accountants are expected to demonstrate professional values, ethics, and attitudes in their roles as employees, assurance providers, or consultants. These factors include, among others, integrity, objectivity, responsibility, due care, and the exercise of professional skepticism. If these factors are not in evidence, then the judgement of professional accountants is likely to be faulty, and their work product and opinions cannot be relied upon.  Consequently, the stakeholders – the current and future shareholders, employees, directors, customers, creditors, lenders, governments, and others – relying on the work of professional accountants, will be put at risk. These stakeholders, taken together, are known as "the public." Their collective interests are referred to as "the public interest," which professional accountants are committed to protect.

All the factors identified above are essential to the protective role assigned to professional accountants, but none is more important than the exercise of professional skepticism.  Without a sufficiently questioning mind, the discovery of errors, omissions, or manipulations are extremely unlikely to be discovered, and thus the interests of the public may remain unprotected.  There are many extremely embarrassing examples where management manipulated accounts or financial statements with the assistance or knowledge of professional accountants. These manipulations went unnoticed or unanalyzed by auditors to the detriment of misled investors, employees, lenders, creditors, communities, governments, and the broader public. Recent cases of such behaviour include Carillion plc, Sino-Forest Corporation, and Enron Corporation, and the reputation of the professional accountants involved with these companies, and the reputation of professional accountants in general, suffered. In the U.K., the conduct and mandate of professional accountants was challenged in 2018, and international ethics standards have been changed to ensure that the reputation of professional accountants would be focused on serving the public interest.

The judgements of professional accountants in all their roles depend on their awareness of hidden risks and their ability to investigate and analyse them. Both require the exercise of professional skepticism – of knowing when something does not, or might not, make sense.  While most professional accountants develop the curious, informed mindset required through trial and error, and/or by insightful experiences, these involve risks to the professional accountants involved, and to many other stakeholders.  This collection of cases was created to present needed experiences and to provoke the discussions needed to develop the required mindset and skills for professional skepticism without real exposure to painful possible risks and real-world consequences.

The cases, frameworks, and supporting documentation in this collection have been published as an open-source document on the Professional Accounting Centre (PAC) website for professional accountants, accounting students, and educators for their use in enhancing their understanding of and effectiveness in applying professional skepticism to serve the public interest.  The cases and other material may be used in class or in examinations or in other publications provided an appropriate sourcing statement is included, such as:  Source:  Professional Skepticism Case Collection, University of Toronto Professional Accounting Centre, (insert year of use), PAC website https://www.utm.utoronto.ca/pac/case-collections/enhancing-professional-skepticism-case-collection.  Where a case/framework or other material is used is drawn from another source, the original source must also be properly referenced.

The Professional Accounting Centre is pleased to acknowledge the support and funding of CPA Ontario for the creation and ongoing updating of this Case Collection. Accordingly, this DEI Case Collection will be evergreen in nature, with new cases, references and guidance being integrated in the future. As such, this Professional Skepticism Case Collection is intended to be of continuing assistance to CPA professionals and students. Suggestions for inclusion of new cases and other useful references should be directed to the Director of PAC.

Nature and Relevance of Professional Skepticism for Professional Accountants

Traditionally, the public have expected professional accountants² to conform to aspects of professionalism including:

Professional values, ethics, and attitudes include a commitment to technical competence, ethical behavior (e.g., independence³, objectivity, confidentiality, and integrity), professional manner (e.g., due care, timeliness, courteousness, respect, responsibility, and reliability), pursuit of excellence (e.g., commitment to continual improvement and life-long learning), and social responsibility (e.g., awareness and consideration of the public interest).            

            Professional values, ethics and attitudes, IAESB Glossary of Terms, p. 29.

Embedded in those expectations, particularly of integrity, due care, and an awareness and consideration of the public interest, is the expectation that professional accountants can be relied upon not to be party to unfair disclosure, nor to actions that break laws or regulations.  While unfair or inappropriate disclosure has long been explicitly the concern of professional accountants serving as auditors, expectations stimulated by scandals have been growing over time.  However, there has not been the same level of expectation and enforcement for professional accountants serving in management and other non-audit functions.  Recently, this apparent differential has been diminished by the adoption of ethics standards (i.e., NOCLAR Rules⁴) in some jurisdictions that require all professional accountants in audit and non-audit functions to report Non-Compliance with Laws and Regulations.  Consequently, while it is not surprising that professional skepticism has been traditionally defined for professional accountants with an audit reference as shown below, with the advent of NOCLAR Rules and the recent erosion of professional accounting’s reputation caused by notable scandals, a new broader definition is likely to be forthcoming soon that captures the need for all professional accountants to be concerned that they exercise adequate professionalism.

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.   

     International Standard on Auditing 200

     Toward Enhanced Professional Skepticism: Observations of the                             

     IAASB-IAESB-IESBA Professional Skepticism Working Group, August 2017

Scandals such as the bankruptcy of Carillion plc⁵ which occurred in January 2018, just months after the issuance of a clean audit opinion, have exposed deficiencies of professional accountants as auditors and the realization that professional accountants in management and other service functions must have known about the actions that led to the company’s downfall but did nothing or not enough to prevent them.  As a result, Carillion, a large and well-respected UK company with worldwide operations collapsed and required a government bailout to partially protect the public.⁶  This could have been prevented, or mitigated, if professional accountants in audit or other roles had exercised their professional skepticism, as expected, to discover the problems and come forward with timely information.  Instead, the public and other stakeholders were damaged severely, and the reputation of professional accountants was dealt a crippling blow – so much so that the role and responsibilities of professional accountants underwent a re-examination and NOCLAR Rules were developed by the IESBA that are gradually coming into force as more national professional accounting bodies adopt them.  In 2018, the Institute of Chartered Accountants of England and Wales (ICAEW) quickly issued a report entitled, “Scepticism: The Practitioners’ Take” that explored professional skepticism and how to improve it, which found that:

• “Professional skepticism is at the heart of what auditors do - Without it, the audit has little value.”  To paraphrase a British parliamentarian who was assessing the wreckage caused by a lack of demonstrated professional skepticism by professional accountants servicing Carillion plc: 

“Without demonstrating professional skepticism, professional accountants are “mere spectators—commentators at best, certainly not referees—at the mercy of reckless and self-interested directors.… [The audits] appear to be a colossal waste of time and money, fit only to provide false assurance to investors, workers and the public.”⁷

• There is a shared responsibility for skepticism – Professional skepticism needs to be exercised by all professional accountants, not just auditors.
• An effective sceptic is neither a cynic nor a dupe - Exercising skepticism means not accepting the first answer at face value without following up, even if it sounds plausible.
• Auditor working practices need to support and encourage skepticism in the field.”⁸

Similar earlier scandals involving companies such as: Sino-Forest⁹, Enron¹⁰, and Livent¹¹ provide disturbing evidence of similar aspects of knowledge of, or malfeasance by professional accountants in management or C-Suite roles, which were not discovered or revealed by other professional accountants in audit/assurance roles because of a failure of professional skepticism.  These earlier iconic cases also generated significant changes in corporate governance and/or professional accounting (Enron precipitated the Sarbanes-Oxley Act¹²) or significant investor and regulatory interest and/or penalties (Sino-Forest, and Livent) or lawsuits (Sino-Forest). 

The cumulative impact of these iconic cases resulted in making professional accountants more sensitive to the protection of the public interest, and have resulted in modified international ethics standards, audit protocols, responsibility for reviewing risk management, finding fraud, and raising concerns when client or employer actions are not in compliance with laws or regulations (NOCLAR Rules¹³).  All these changes are designed to provide better guidance for professional accountants to lead them to better protect the public interest through enhanced application of professional skepticism.

Despite the many changes, deficiencies still remain in terms of the expected performance of professional accountants in management, as well as those in assurance or audit services.  For example, the Canadian Public Accountability Board (CPAB) noted in its CPAB Audit Quality Insights Report:

2020 Annual Audit Quality Assessments¹⁴:

The most common findings were related to auditing estimates involving significant assumptions and judgments about future conditions or events. Deficiencies included:

• Insufficient procedures to assess management’s selection and application of methods, assumptions and data used in developing fair value estimates.
• Lack of retrospective reviews of management judgments and assumptions.
• Insufficient evidence to demonstrate how inconsistent information was considered and resolved by the engagement team.
• Over-reliance on management representations without corroboration with third party evidence.
• Lack of evaluation to assess whether significant deficiencies in internal control exist when management has not taken appropriate steps to understand or address estimation uncertainty.

We also identified concerns over the quality of audit evidence obtained to address the risks of material misstatement and the effectiveness of supervision and review by more senior engagement team members. Audit firms must incorporate a greater level of professional skepticism through all stages of the audit. Effective challenge of management on key judgments requires engagements to be staffed with sufficient resources at all levels, including specialized expertise where needed. Firm leadership must ensure senior team members have sufficient time to invest in each audit engagement to effectively supervise and review the work of those with less experience.

Not surprisingly, to help rectify these deficiencies, CPAB has continued to investigate and publish helpful insights.  In May 2022, CPAB published its Fraud thematic review¹⁵ which explored improvements auditors could undertake including two cases¹⁶ that illustrate errors auditors make when they do “not exercise an appropriate level of professional skepticism.”  The two cases present instances when auditors failed to exercise sufficient levels of professional skepticism when auditing revenue recognition. The cases serve as invaluable lessons for both budding and seasoned auditors, aiming to prevent damage to the reputations of individual auditors, their firms, and to ensure that the public interest remains safeguarded.

In addition, increased guidance on professional accounting is becoming available from several other sources¹⁷, and international auditing standards are also being revised to incorporate a new focus on professional skepticism.¹⁸ 

Before considering how to develop and sharpen a skeptical mindset, it is useful to consider how accounting researchers have contributed to our understanding of professional skepticism, and how enforcement regimes focus attention on auditor deficiencies related to poor professional skepticism. 

Review of Research and Professional Standards

Introduction

Professional auditing standards define professional skepticism as “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.” In practice, professional skepticism is the idea that an auditor does not accept audit evidence without applying their own due diligence and independent verification. Professional skepticism is applied in making professional judgements that are then used to make appropriate decisions related to the procedures utilized and conclusions drawn from an audit.

SAS No. 1 requires the use of professional skepticism, stating “due professional care requires the auditor to exercise professional skepticism.” While the auditing profession relies on the importance of professional skepticism in planning and performing a review engagement, and the notion of professional skepticism is widely accepted, it is difficult to explicitly define and measure. Despite audit deficiencies regularly being blamed on a lack of professional skepticism, there is no clear consensus on what professional skepticism is or how it can be measured and there is a discrepancy between the professional skepticism construct of researchers and that of regulators/practitioners.¹⁹

Professional Skepticism Perspectives

The two predominant perspectives of professional skepticism in the literature and in auditing standards are neutrality and presumptive doubt. Neutrality is the perspective in which the auditor assumes no bias in management’s representations ex-ante. The neutral view of professional skepticism reflects the “trust but verify” principle of auditing.²⁰ Presumptive doubt is the perspective that assumes there is some level of dishonesty or bias by management. Standards focusing on fraud are more indicative of presumptive doubt.²¹

Professional skepticism is both a mindset and an attitude. While regulators generally refer to professional skepticism as an attitude that includes a questioning mind and a critical assessment of evidence, practitioners often refer to professional skepticism as a mindset that influences auditors' professional judgment. The mindset component captures the idea that professional skepticism is reflected in particular ways of thinking, or processing information. The attitude component captures the idea that skepticism is reflected in auditors' evaluations, both cognitive and affective, of the evidence and of managements' assertions.

Importance of Professional Skepticism

By critically assessing audit evidence and other factors that may question the reliability of information provided by management, professional skepticism improves audit quality by enhancing the auditor’s ability to identify and assess the risks of material misstatement. This includes information that supports management’s assertions, and any information that contradicts such assertions. The matter of difficulty, time, cost, or belief that management is honest cannot be used to accept audit evidence that is less than persuasive. Professional skepticism is not limited to external auditors and should be present in all. Internal accountants and internal auditors need to exercise skepticism before providing information to external auditors and when ensuring that internal controls are sufficient. 

Theoretical Models of Professional Skepticism

Professor Mark Nelson developed a model for exercising skepticism that consists of two components: skeptical judgment and skeptical action²². His paper defines professional skepticism as “a heightened assessment of the risk that an assertion is incorrect, conditional on the information available to the auditor.” The model highlights that auditors’ incentives, traits, knowledge, experience, and training all combine to affect the amount of professional skepticism exercised during an audit. The lack of skepticism can be the result of failing to recognize potential issues (lack of skeptical judgment) or failing to adjust the audit to identified potential issues (lack of skeptical action). It is difficult to conclusively evaluate whether the auditor lacked skeptical action or skeptical judgement. The presumptive doubt perspective is more predictive of skeptical judgments and actions, especially in higher risk settings.²³

Scholars have extended the Nelson model by replacing the antecedents of professional skepticism with broader categories including auditor characteristics, evidential characteristics, client characteristics, and environmental influences²⁴. The subcategories are based on features of the audit environment that have been shown to affect auditor judgment and actions. First, each auditor brings different individual characteristics such as traits, experience, training, motivation, moral reasoning, and affect to each engagement. Second, while audit evidence is necessary in conducting audits, not all audit evidence is the same or considered equal. Third, just as with individual auditors, clients are unique. Fourth, external environmental characteristics such as regulations, standards, and the control environment influence auditors’ professional skepticism.

Trade-off & Incentive Misalignment

The theoretical models described above show that a professional skepticism trade-off exists. While professional skepticism is often considered to be an individual characteristic, or relatively stable trait, there are external factors that affect how skeptically auditors will behave. While skeptical auditors increase the likelihood errors are detected, applying skepticism is not in and of itself free. Budgets, deadlines, working practices, methodologies, and relationships with the client all impact skepticism. As auditors exercise more professional skepticism, they seek additional evidence to justify their audit opinion. This additional evidence increases the cost of the audit and when additional audit effort does not find errors, the extra cost is not justified. Empirically, evaluators penalize auditors who employ an appropriate level of skepticism but do not identify a misstatement²⁵. This result implies that in practice, skepticism may be discouraged because of incentive misalignment. This result also suggests that a lack of professional skepticism is not necessarily the result of the individual auditor and is context specific.

Measurement of Professional Skepticism

While there is significant research related to professional skepticism, it is a difficult construct to measure and operationalize. Professor Kathy Hurtt developed a 30-item individual characteristic skepticism scale derived from audit standards, psychology, philosophy, and consumer behavior research²⁶. Importantly, this measure allows professional skepticism to be both a relatively stable individual trait and a temporary state influenced by a given situation. She identifies six characteristics of professional skepticism: a questioning mind, a suspension of judgment, a search for knowledge, interpersonal understanding, self-esteem, and autonomy. The result is a 30-item questionnaire that receives responses on a 6-point agree/disagree scale that scores respondents from 30 to 180. The scale allows researchers to better understand how auditors’ innate trait skepticism is later applied to audit judgment and/or audit action as state skepticism and is the predominant method in the literature for measuring and operationalizing professional skepticism.²⁷ Research into individual differences has demonstrated that auditors with higher levels of trait skepticism as measured by Hurtt’s measure tend to exhibit more skeptical judgments including the focus on fraud cues²⁸, less reliance on management’s explanations²⁹, and paying more attention to aggressive or intentionally unethical behavior³⁰.

If professional skepticism is influenced by both personal and situational factors, professional skepticism must measure the trait, or stable personal characteristic, and the state that is temporary and context dependent³¹. The distinction between state and trait professional skepticism is critical because state professional skepticism can be changed much easier than trait professional skepticism. In that sense, the paper adjusts the dimensions of the trait scale related to evidence collection and evaluation because these are influenced by situational factors in auditing, such as time pressure and contradictions in client evidence.

Research has found that auditors’ innate traits are associated with professional skepticism, but trait skepticism interacts with state skepticism³². This could help explain why some studies have found a positive relationship between trait and state scepticism and other studies have found no relationship³³ Given that there is no clear consensus related to trait–state skepticism, it is difficult to identify appropriate levels of professional skepticism in practice³⁴.

Enforcement of Professional Skepticism

While regulators often blame a lack of professional skepticism on audit failures, it is difficult to understand what constitutes insufficient skepticism because professional skepticism cannot be reliably measured or explicitly demonstrated. Researchers have reviewed SEC audit enforcement actions and PCAOB inspection findings to understand how regulators evaluate skepticism³⁵. Counterfactual information includes information about fraud risks that the auditor should have been aware of and evidence of client misrepresentations that the auditor could have been more skeptical of. PCAOB enforcement is related to the number of audit deficiencies and a professional skepticism quality control deficiency, which suggests that skepticism may be inferred from other types of deficiencies. Importantly, without clearer expectations and processes for evaluating skepticism, auditors must visibly demonstrate and document skeptical behavior to ensure compliance and mitigate the likelihood and consequences of enforcement.

PCAOB and SEC Enforcement Actions

The SEC and PCAOB provide enforcement releases that list recent offenses.

• https://pcaobus.org/oversight/enforcement/enforcement-actions
• https://www.sec.gov/divisions/enforce/friactions.htm

Framework for Considering the Development of Professional Skepticism

There are many factors that motivate the development and sharpening of a professionally skeptical mindset, and many more that may contribute to the process.  Broadly speaking, however, there are three phases to be considered in the proper development and exercise of professional skepticism:

1. Recognizing that there is an anomaly that needs investigating, 
2. Investigating the anomaly professionally, and
3. Using the information developed effectively to protect the public interest³⁶.

Recognizing that there is an anomaly that needs investigating

Recognizing anomalies is crucial for a professional accountant.  Without this skill, a professional accountant cannot be relied upon to exercise the professional values, ethics, and attitudes vital for protecting clients, fellow professionals, and other stakeholders, including the public.  Recognizing when an anomaly needs investigating requires:

• A professionally skeptical mindset: This means being curious, open to all possibilities, not too trusting, and prepared to challenge information presented,
• An understanding of the underlying facts and context of the reality (i.e., understanding the business and its environment) being described in the financial statements or documents sufficient to recognize anomalies,
• An understanding of potential risks, errors, and malfeasances possible, and
• An insight into the likely motivations of those involved to predict and anticipate their behavior.

A professionally skeptical mindset is one that is always aware that reality may not be as represented, and that facts presented need to be challenged, not just accepted.  Phrases such as “Trust but verify” are particularly relevant and are often much more meaningful to professionals who have experienced duplicitous or misleading behaviour in the past.  The cases in this collection have been chosen to impart the wisdom gained by shocked professionals who have realized they were/could be misled, and to instill an attitude of constant vigilance and openness to unsavory, hidden possibilities. 

As one senior professional accountant put it, you should mentally be counting the fingers on your hand after every interaction with management – in other words, always be on guard.  Constant vigilance is expected of non-assurance professionals as well.  In order to develop a mindset of constant alertness, another senior audit partner makes a habit of taking a new student to lunch, where he begins the conversation by asking how the restaurateur could cheat the accounting system?  A curious, always-alert mindset is a critical starting point for a proper level of professional skepticism.

In addition to an attitude of constant awareness, a professionally skeptical mindset involves constantly asking the question: “Does this make sense?”  Frequently, transactions and/or financial disclosures are manipulated or inaccurate in ways that could not physically happen.  For example, in the Sino-Forest case, despite that the volume of logs required for the reported revenue could not have been physically shipped from the remote growing location, the auditors failed to consider the required transportation capacity. In the case of Enron’s soaring profitability, the annual associated growth rates of revenues, assets, and liabilities in the billions did not make sense – they were incredible.  In the case of Carillion plc., the company’s continued profitability was driven by acquisitions, but ongoing operations were unprofitable, and cost overruns on construction contracts were hidden – but external professional accountants involved never questioned whether there was a going concern problem.  A professional accountant must always be asking: “Does a transaction, an anomaly, or a representation make sense, given the facts, the nature of the business, and the context in which it operates, not just in the short run, but also in the medium and longer term?” 

Unless a professional accountant effectively challenges the sensibility of all facts, the existence of a problem will not trigger the awareness of the need for further investigation. This means that a professional accountant must be technically competent with traditional accounting, auditing and disclosure matters, and with contextual and risk factors related to economic and industry developments, as well as to the capabilities of their employers or audit clients to conduct their affairs.  Clearly, the knowledge base needed to exercise professional skepticism is far larger than just knowing the rules of financial disclosure and audit guidelines. 

Professional accountants also need to be aware of risk factors including potential manipulations, fraud, and other malfeasance that might occur so that they can be alert for those possibilities. For example, in an industry under pressure to grow, revenue recognition principles may be at risk of being manipulated, or costs of construction being held back from timely recognition. 

Additionally, to sharpen their awareness of the potential risk for specific types of malfeasance, professional accountants need to understand human motivation and the likely tendencies of the personnel they work with or those employed by their audit clients. One senior professional accountant suggested that there should be a continuous effort to figure out “what game is likely being played by the people involved – are they likely to hide losses, manipulate revenue or profits, trigger bonuses, or hide fraud”.  Speculating about possible risks can be very helpful in ensuring effective professional skepticism that will unearth malfeasance.  In an industry subject to debt covenants, pressure from lenders to meet those covenants may motivate misstatements.  In the case of Wells Fargo, when executives mandated a quota system for staff to achieve to spur sales of services to customers, employees resorted to falsifying customer requests for those new services in order to keep their jobs³⁷.  Wells Fargo’s CEO and Vice President were terminated, and they returned $50+ million in bonuses that were ultimately considered to be falsely generated. Following the customer scandal, Wells Fargo lost many customers, including the State of California, and Wells Fargo investors suffered significant financial losses.

The recognition of anomalies – or red flags as they are commonly known – requires constant vigilance by professional accountants, but even that is not sufficient.  Since it is well known that over 40% of problems are discovered from tips from employees³⁸, professional accountants must also consider whistleblower concerns, and risk management analyses as sources of matters to be pursued. 

Informal discussions and observations also often reveal facts worth following up, such as:

• When asked about an inventory shortfall relative to the stated book value, a long-time warehouseman commented: “That amount of inventory would not fit in our warehouse.”
• When a manager was asked about questionable expenses incurred in Bermuda during an audit, he responded: “That’s Bermuda”, implying funny business happened there.
• A warehouse manager drives a Porsche which he could probably not afford.

It needs to be recognized that aptitude for skepticism varies among professional accountants.  Each professional accountant, including supervisory members of assurance firms and senior accountants in corporate or organizational management, should be aware of the potential for cognitive bias³⁹ that reduces the ability of some people to be skeptical.  Where such cognitive bias is suspected, tests using cases in this collection may be helpful, and training to sharpen the aptitude for skepticism should be undertaken.

Investigating an Anomaly or Red Flag Professionally

Exercising professional skepticism effectively depends first on identifying an anomaly or red flag that needs investigation, and second on being able to discover the nature and facts involved sufficiently to understand the problem and finally to craft a remedy that protects the public interest. 

Discovery of the nature of a problem often requires more than a general sense of what the genesis or driver of the problem might be – it requires an ability to tease out the facts involved.  Often, a professional accountant has been known to suspect a problem but has been unable to discover the nature and relevant facts because they lacked skill in posing questions.  For example, demanding answers to accusatory questions may be quite unhelpful.  Instead, here are a number of questions and guidelines offered by very senior and successful professional accountants:

• Being skeptical does not mean you need be unfriendly, just keep asking questions when an accounting number looks unusual.
• Be firm, but don’t be disagreeable.
• Ask: Could you help me understand this … ?
• Ask: Does this make sense to you?
• Ask: What questions did you think I should have asked but didn’t?

On other occasions, professional accountants have not been sufficiently alert to the existence of conflicts of interest such as familial connections, misguided bonuses, or stock market options that lead to dysfunctional behaviour and the risk of fraud. 

Sometimes countervailing pressures inhibit the application of professional skepticism such as when audit budgets or supervisors do not allow enough time to properly consider potential risks and relationships, or when an individual’s reputation is so respected or feared that their activity is not challenged thoroughly such as with Bernie Madoff⁴⁰ and Garth Drabinsky⁴¹.  Fear can be caused by possible legal action or loss of a client, or the triggering of a going concern crisis, or lack of courage to investigate senior executives to avoid an unpleasant conflict. 

Even when a red flag is recognized and investigated properly, sometimes a professional accountant can become unreasonable in their assessment of the risk involved.  A senior professional accountant identified this as the problem of runaway skepticism – where a professional accountant is too skeptical of a management-proposed accounting treatment or valuation, thus causing serious, unintended harm to a company’s fortunes as well as to its shareholders.  For example, a professional accountant can become so entrenched in their views that they precipitate unnecessary disclosures such as in a going concern note that needlessly undermines a corporation’s prospects and/or harms investors.  Several potential instances of this problem are included in this case collection.

Protecting the Public Interest

Using the information developed through professional skepticism to protect the public interest is at the core of professionalism for all professional accountants.⁴²  This is made evident in many ways.

As noted above, the ICAEW’s publication, Scepticism: The Practitioners’ Take leads off by saying: “Professional scepticism is at the heart of what auditors do. Without it, the audit has no value.⁴³ The IFAC International Code of Ethics for Professional Accountants⁴⁴, to which the Ethics Codes of all IFA member professional accounting bodies are to be harmonized, considers professional skepticism to be fundamental to independent judgement that is in turn fundamental to the protection of the public interest by professional accountants.  The NOCLAR Rules, which are currently being adopted by member professional associations, mandate that professional accountants who learn or suspect that their employers or clients are not in compliance with laws or regulations must bring that concern to the attention of senior professional accountants in the organizations, and then if it is not addressed satisfactorily, to those involved in governance, and ultimately to the public – all with the objective of protecting the public interest. 

In the future, confidentiality should not be a barrier that inhibits professional accountants from protecting the public interest.  Historically, professional accountants believed their ethics codes mandated complete confidentiality regarding their employer's or client’s actions. However, confidentiality guidelines were never intended to protect fraudsters or those engaged in malfeasance.  And now, the responsibility to protect the public interest has been specified in ethics codes as the over-riding duty of professional accountants and professional skepticism will be expected to be applied in that context.

The most significant barrier for using understandings gained through the use of professional skepticism may be that professional accountants will have to demonstrate morale courage to a greater than current degree.  In other words, professional accountants will have to confront being bullied, stigmatized, or prosecuted for bringing forward embarrassing facts or behaviour rather than keeping silent as they have in the past.  This change will, as with many other aspects of developing and applying professional skepticism, require and benefit from training, and with working with educational materials like the professional skepticism case collection that are specifically designed to prepare professional accountants for serving the public interest.

Developing a Professionally Skeptical Mindset

Understanding the preceding sections of this Case Collection is essential to the development of a robust and effective professionally skeptical mindset.  However, most senior professional accountants interviewed in preparation for this case collection developed their highly acute sense of professional skepticism and the need to be constantly vigilant by encountering one or more indelible and often shocking experiences during their professional career.  Since personal experience varies, and most assurance work is performed by people with less than five years’ experience, this case collection was created to provide impactful, realistic case experiences  for students or individuals who might never encounter useful learning experiences, or who would make mistakes when dealing with those personal learning experiences that could prove costly to the professional accountants themselves, their employer or firm, the profession as a whole, and to stakeholders included in the public interest.

Before studying the collected cases, it is advisable to review the mindset development stories of two senior professional accountants offered to provide an insight into the type of indelible and/or shocking events the collection seeks to provide to stimulate individual learning. 

Not Recognizing the Game the Client’s Staff was Playing

I was a senior articling student assigned to complete the audit of a Canadian-based, U.S. subsidiary of a large conglomerate that manufactured healthcare products for worldwide distribution.  I proudly thought the audit went really well – the client staff were very friendly and helpful, I found many material items needing adjustment, and the client happily made the adjustments prior to finalization.  They also discovered several items needing adjustment.  When finished, I passed the file to the partner who scheduled a meeting to visit the client and discuss their results prior to signing off, which he did about a week later.  The following week he called me into his office and asked if I had multiplied the final net profit by the yearend Canada/U.S. exchange rate.  I said that I hadn’t thought that was an audit test we had to do, but he asked me to do it and then come back to him.  When I did the multiplication, I discovered the U.S. equivalent of the annual profit was $1,000,000.00.  I realized that the client’s staff had been playing a game with me, and their adjustments were designed to offset the ones that I had found.  I was shocked, and I resolved to be on guard for such behaviour in the future.  The partner had subsequently realized, based on an offhand remark during the client debrief, that the Canadian management team had promised the U.S. head office that their operation would produce a net profit of $1 million U.S. for the global consolidation – and they did!

Four Insightful (Some Shocking) Learning Experiences

One of my first assignments was to check the petty cash at a client where the co-owners and the comptroller were friends of the partner, and one co-owner had been my scout leader.  I was surprised that the petty cash was $1,000, which seemed high for the operation at the time, and the disbursements were only about $100 a week, but I thought nothing of it then. However, I was unable to audit the supporting documents in the account for recent transactions because they were missing. After questioning the comptroller, he found other invoices at the back of the filing cabinet drawer. And to thank me, he took me out to lunch. But I noted the question and follow-up in the audit file. Six months later the CA doing the year end audit work, having read my file notes, again could not find some supporting invoices. This led to him involving another partner and further investigation that showed the petty cash invoices were often missing.  The other partner thanked me for identifying the issue and advised that the comptroller, who was the owners’ and my partner’s friend, had been fired much to the personal embarrassment of the two owners. It was a lesson to me!

The next happening that strengthened my skepticism was when as a first-year student I was auditing a 6-store retailer’s inventory. The inventory count cards of the prior week had too many in one person’s handwriting. And I could not understand why the store showed a profit when I saw there was so few customers buying. Then an employee who was an old acquaintance from my public school days commented in passing that her department inventory was high. So, I recounted that department inventory myself, after work hours, and looked at the sales since the count a week prior. It showed that the count inventory could not be correct. I advised the manager and the next thing I knew a senior audit partner was out there. One thing led to another, and the Controller confessed to overstating the inventory. This was passed on to the controlling shareholder-President, and after that I was always welcomed by that client.  After that experience, I always asked myself if the client’s P&L made sense.

The next occasion was when as a second-year student, I was auditing a large retailer’s discounts and rebates on purchases.  A common practice was that suppliers paid these at their yearend but delayed by a month. However, as a percent of purchases, these rebates looked to be more than the documented rebate schedules allowed. So, I decided to match the accrued rebates to cash later received, and found that in some cases the cash receipts were significantly delayed. In later questioning, the rebate accountant confessed that he was recording accrued rebates early to accelerate income. Management missed their bonuses that year and my practice of asking “why” increased.

After I left public accounting and became the CFO of a conglomerate, I frequently needed to review the financial records of acquired companies. One company, previously owned by a businessman of questionable reputation, showed an income credit from their benefit plan, and that alerted my skepticism. I asked my benefits manager to do a detailed review of the transactions that year and it was found that the company had understated its benefit costs. It turned out that the company valuation was some $10 million too high.

Learning from experience is often regarded as priceless, but the mistakes one makes in the process may be very painful, and not only to the learner.  Hopefully the review of professional skepticism provided, the framework developed, and the insights offered coupled with the cases collected will significantly sharpen the understanding and application of professional skepticism by professional accountants.

Cases Collected

Cases have been collected that:

• Stimulate the development of an alert, continually questioning, professionally skeptical mindset,
• Deepen the understanding of the application of professional skepticism,
• Illustrate iconic failures that have changed professional accounting, and
• Present difficulties in its application such as runaway professional skepticism.

All 24 cases presented initially in this collection have been selected to stimulate the development of a professionally skeptical mindset and deepen the reader’s understanding of how to apply professional skepticism.   The cases are categorized in the Table below to identify the Audit (A), Management (M) and Governance (G) issues they raise.  They can be download by clicking on the table provided below.  Cases are made available as an open-source document at no cost to professional accountants, accounting students, and educators for their use in enhancing their understanding of and effectiveness in applying professional skepticism to serve the public interest. 

The cases and other materials in this collection may be used in class or in examinations or in other publications provided an appropriate sourcing statement is included, such as: 

Source:  This case/framework/material is reproduced, with permission, from the Enhancing Professional Skepticism Case Collection of University of Toronto’s Professional Accounting Centre, year of download, https://www.utm.utoronto.ca/pac/case-collections/enhancing-professional-skepticism-case-collection.

Where a case/framework or other material is used is drawn from another source, the original source must also be properly referenced.

PAC Professional Skepticism Case Collection
Table of Cases and Case Issues:
Audit (A), Management (M), Governance

Resources on Professional Skepticism

To follow

Case Notes - Solutions, Commentaries, or Lessons to be Learned

Notes on each case are available for professional accountants, professors and instructors who apply to the Director of the Professional Accounting Centre at len.brooks@utoronto.ca. The form of a case note varies from a Solution, a Commentary, or Lessons to be Learned. To preserve the utility of the cases for examination purposes, case notes may not be released directly to professional accounting students without modification.