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From Securities Regulation Daily, May 9, 2013

CAQ Study of SEC AAERs Reveals Audit Deficiencies Involving Insufficient Professional Skepticism and Failure to Identify Risk

By Jim Hamilton, J.D., LL.M.

A study commissioned by the Center for Audit Quality on outside auditors and SEC enforcement actions involving fraudulent financial reporting revealed insufficient professional skepticism, inadequate identification of risk, and failure to exercise due care. The study examined data from 1998 to 2010 and identified 87 instances of SEC investigations of fraudulent financial reporting leading to sanctions against auditors. In terms of penalties, the most typical consequence was barring auditors from SEC practice (73 cases). Nineteen cases involved permanent bars, while the other cases, on average, involved bars of approximately three years.

The study collected and synthesized data from the 87 cases, focusing specifically on allegations of audit deficiencies made by the SEC in its Accounting and Auditing Enforcement Releases (AAERs). While SEC AAERs are commonly used in professional research as a rich source of information about fraudulent financial reporting and auditor deficiencies related to those cases, noted the study, there are three important limitations. First, analyses of AAERs typically involve significant professional judgment. Second, the data rely on the outcome of the SEC’s enforcement process that is documented by the SEC staff in the AAERs. Third, AAERs present allegations of auditor deficiencies, with the audit professional and/or audit firm typically neither admitting nor denying the allegations.

Professional skepticism. Some of the cases reveal challenges in maintaining appropriate levels of professional skepticism. While the concept of professional skepticism has been embedded in auditing standards for decades, noted the study, in some cases auditors may have struggled to maintain an appropriate mindset throughout the various stages of the audit process.

An appropriate level of professional skepticism is a front-line defense against issues that might lead to audit failure. A lack of an appropriate questioning mindset and a failure to critically evaluate audit evidence create opportunities for a number of audit deficiencies to be present across all aspects of an audit.

While the SEC tends to include this general deficiency in most of its sanctions against auditors, observed the study, it is helpful to consider concerns noted by the SEC about the lack of sufficient professional skepticism to see if there are additional insights that might contribute to continual efforts to improve auditor skepticism.

Also helpful is PCAOB Staff Audit Practice Alert No. 10, which provides guidance to assist auditors in applying professional skepticism in their audits. The staff provides examples of instances where the auditor did not appropriately apply professional skepticism, and alerts auditors to common impediments to sufficient skepticism. The Alert also highlights the importance of the audit firm’s system of quality control and supervision in promoting professional skepticism.

Risk management. Similarly, while auditing standards have been risk-based for a number of years, more recent developments in the risk management area, including the emerging discipline of enterprise risk management, bespeak a number of complexities associated with any risk identification and assessment task.

The study noted that, in August 2010, the PCAOB issued a suite of eight auditing standards widely referred to as the risk assessment standards that became effective for audits of fiscal years beginning on or after December 15, 2010.

The study pointed out that any improvement in risk assessment skills that can be identified will enhance audit quality and improve the recognition of fraud risk. The study suggested that the audit profession may want to leverage insights that are emerging in other risk management disciplines to better train and educate audit professionals in risk identification and risk assessment tasks.

In some cases, the auditor failed to adjust audit procedures to gather sufficient competent evidence in light of risks identified and documented by the audit team. While this type of deficiency may be the result of insufficient professional skepticism and/or a failure to identify risks, it may also be triggered by a failure to adequately link audit procedures to underlying risks. Because prior research has shown that this type of linkage can be a difficult task, noted the study, greater emphasis on quality control review of these linkages may be beneficial, or new tools and techniques may be needed to facilitate this difficult linkage task.

Failure to exercise due care. In some of the cases reviewed, the SEC’s alleged audit deficiency involved auditors who failed to perform procedures generally accepted as appropriate and expected in most audits. In many of those instances, the deficiency did not appear to involve overly complex audit decisions as to what GAAS might require in the circumstances. Rather, the deficiency was sometimes linked to a failure to perform procedures generally understood to be core to any audit. Essentially, the auditor failed to do what a prudent auditor should know is expected in an audit.

MainStory: TopStory AccountingAuditing RiskManagement

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