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Professional Scepticism
and Judgment in
Financial Reporting
Nik Mohd Hasyudeen Yusoff
6 May 2016
UIA
What we will explore?
• Financial reporting
• Professional judgment
• Professional scepticism
• Cases
Financial reporting
• Financial reporting is part of the accountability
process where reports are prepared by
management a...
Financial reporting
• Complexity of business models, structures and
operations make financial reporting more challenging.
...
Financial reporting
• Revenue and cost recognitions are also challenging as business
operations are becoming more complex ...
Financial reports
Reviewed by
regulators
Prepared by
management
Approved by the
board
Audited by
auditors
Tabled to
shareh...
Professional judgment
FOR PREPARERS
PRINCIPLE 1 - Knowledge gathering and analysis
A professional accounting judgement can...
Professional judgment
FOR AUDITORS
PRINCIPLE 1 - Knowledge gathering analysis
A professional auditing judgement can only b...
Professional judgment
FOR REGULATORS
PRINCIPLE 1 - Review of financial statements
The regulator should assess whether the ...
PRINCIPLE 1 - KNOWLEDGE
GATHERING AND ANALYSIS
(PREPARER)
A professional accounting judgement can
only be made once all re...
PRINCIPLE 3 - PROCESS FOR
ASSESSING AND CHALLENGING THE
CLIENT’S JUDGEMENT
A professional auditing judgement can
only be m...
PRINCIPLE 3 - PROCESS FOR
ASSESSING AND CHALLENGING
THE CLIENT’S JUDGEMENT
• Is it consistent with a authoritative
account...
PRINCIPLE 3 - PROCESS FOR
ASSESSING AND
CHALLENGING THE CLIENT’S
JUDGEMENT
Assess whether the client’s
judgement on the ac...
Professional scepticism
• The word scepticism is formed from the root “skeptic,” which comes
from the Greek word “skeptiko...
Are Professional Judgment and Professional Scepticism the
Same Thing? Professional scepticism is necessary for high-qualit...
CASES
17
18
Case Study : Assets Impairment
Common Observations:
[Next Slide]
 Lack of verification and challenge of management’s a...
19
Case Study : Assets Impairment (cont.)
[BACK] 3
350
Forecast
2014
Forecast
2015
Forecast
2016
Forecast
2017
Revenue
(27...
Case Study: Risk of Management Override of Controls
20
PLC A
Board of Directors (6 members)
Independent Non-
Executive
Dir...
21
Case Study: Reliability of evidence provided by management
Leasehold Land B (vacant) 15
Total 18
PPE:
(lease expiring: ...
22
Case Study: Reliability of evidence provided by management (cont.)
6
Leasehold Land B (vacant) 15
Total 18
PPE:
(lease ...
23
Case Study: Reliability of evidence provided by management (cont.)
7
Leasehold Land B (vacant) 15
Total 18
PPE:
(lease ...
24
Case Study: Reliability of evidence provided by management (cont.)
8
Leasehold Land B (vacant) 15
Total 18
PPE:
(lease ...
Case study: Conflicting audit evidence
Included in the PIE’s cash and bank as at 29 February 2012 YE is a FD of RM25.7 mil...
References
• A professional judgment framework for financial
reporting, Institute of Chartered Accountants of
Scotland, Au...
Professional scepticism judgment uia 2
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Professional scepticism judgment uia 2

Discussing issues and challenges for auditors in exercising professional scepticism and judgment.

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Professional scepticism judgment uia 2

  1. 1. Professional Scepticism and Judgment in Financial Reporting Nik Mohd Hasyudeen Yusoff 6 May 2016 UIA
  2. 2. What we will explore? • Financial reporting • Professional judgment • Professional scepticism • Cases
  3. 3. Financial reporting • Financial reporting is part of the accountability process where reports are prepared by management and sanctioned by the board for the shareholders and stakeholders to assess the performance and financial position of a reporting entity. • As the management and ownership of the entity are separated, especially for publicly listed companies, there is an inherent risk of bias in the part of management is preparing the report.
  4. 4. Financial reporting • Complexity of business models, structures and operations make financial reporting more challenging. • Fair value accounting is the main stream principles behind International Financial Reporting Standards (IFRS). • IFRS requires assets and liabilities to be marked to market values and in instances where markets for those assets and liabilities are not active, complex valuation models would be used as proxies.
  5. 5. Financial reporting • Revenue and cost recognitions are also challenging as business operations are becoming more complex e.g. telecommunication industry. • Reliance on external experts is becoming a norm when dealing with complex assets e.g. retirement liabilities and intellectual properties. • Even for typical assets such as properties, plants and equipments, the valuation is based on the income streams expected out of those assets. • Disclosures are also important in the present financial reporting framework to compensate for situations where recognition and measurement may not be adequate.
  6. 6. Financial reports Reviewed by regulators Prepared by management Approved by the board Audited by auditors Tabled to shareholders
  7. 7. Professional judgment FOR PREPARERS PRINCIPLE 1 - Knowledge gathering and analysis A professional accounting judgement can only be made once all relevant information has been collected and analysed. PRINCIPLE 2 – Assessment of accounting guidance A professional accounting judgement can only be made in the context of the applicable accounting framework, accounting standards and other literature where relevant. PRINCIPLE 3 - Process for making judgment A professional accounting judgement can only be made after undertaking appropriate due process. PRINCIPLE 4 – Documentation of judgment A professional accounting judgement must be suitably documented.
  8. 8. Professional judgment FOR AUDITORS PRINCIPLE 1 - Knowledge gathering analysis A professional auditing judgement can only be made once all relevant information has been collected and analysed. PRINCIPLE 2 – Assessment of accounting and auditing guidance A professional auditing judgement can only be made in the context of the applicable accounting framework, accounting standards and other literature where relevant, as well as the appropriate auditing standards and guidance. PRINCIPLE 3 - Process for assessing and challenging client’s judgment A professional auditing judgement can only be made after undertaking appropriate due process to assess and challenge the client’s judgement. PRINCIPLE 4 – Documentation of judgment A professional auditing judgement and the assessment and challenge of the preparers’ judgement must be suitably documented.
  9. 9. Professional judgment FOR REGULATORS PRINCIPLE 1 - Review of financial statements The regulator should assess whether the professional accounting judgement has been appropriately disclosed in the financial statements or other document. PRINCIPLE 2 - Review of auditor and preparer documentation The regulator should assess whether the professional accounting judgement has been suitably documented. PRINCIPLE 3 - Decision The regulator should assess the judgement based on the facts and circumstances available at the time the judgement was made.
  10. 10. PRINCIPLE 1 - KNOWLEDGE GATHERING AND ANALYSIS (PREPARER) A professional accounting judgement can only be made once all relevant information has been collected and analysed. Understand the purpose, legal terms and economic substance of the transaction(s): • Read all relevant documentation, including contracts, agreements, correspondence, etc. • Consider the expected cash flows from the transaction and the impact on the entity’s cash position. • Consider why each party is undertaking the transaction in order to understand its commercial reality. • Identify if there are any related or linked transactions which need to reconsidered in determining the economic substance. • Consider the uncertainties and range of possible outcomes of the transaction. • Consider the effect of the transaction,once completed,on the entity’s assets,liabilities and operational capabilities. • Prepare a risk and reward analysis. Consider who bears the risk and who receives the benefits under a range of scenarios governed by the transaction. • Ask probing questions of those parties who setup the transaction–apply appropriate scepticism.
  11. 11. PRINCIPLE 3 - PROCESS FOR ASSESSING AND CHALLENGING THE CLIENT’S JUDGEMENT A professional auditing judgement can only be made after undertaking appropriate due process to assess and challenge the client’s judgement. Consider the uncertainties and range of possible outcomes of the transaction and compare with the client’s assessment of these. Review the client’s assessment of alternative treatments and the reasons for rejection. Evaluate whether significant assumptions made by the client are reasonable. Assess the client’s proposed accounting treatment. If the transaction is covered by existing standards, is the proposed treatment in accordance with the appropriate standard? If there is an element of judgement, refer to IAS 8 (paras 10-12), as appropriate, and assess the client’s proposed treatment, as follows: • Is there resulting financial information both relevant and reliable and does it give a fair presentation of the transaction? • Is it consistent with the treatment of similar transactions under the relevant accounting framework? • Is it consistent with the conceptual framework for broad principles on definition, recognition and measurement of assets, liabilities, income and expenses?
  12. 12. PRINCIPLE 3 - PROCESS FOR ASSESSING AND CHALLENGING THE CLIENT’S JUDGEMENT • Is it consistent with a authoritative accounting texts? • Is it consistent with generally accepted accounting practice in either the home or other countries? • Is it consistent with accepted industry practice? • Is it consistent with pronouncements of other standard- setting bodies with similar conceptual frameworks? • Is there any evidence which would contradict the client’s proposed treatment? Obtain appropriate advice from experts within the audit firm or externally, where necessary. Identify any client conflicts of interest or bias to ensure the objectivity of judgements. If there are possible conflicts of interest or bias, reassess the above considerations with a greater degree of scepticism. Be aware of any undue pressures from the client or audit firm and maintain your objectivity. Make your own judgement on the appropriate accounting treatment.
  13. 13. PRINCIPLE 3 - PROCESS FOR ASSESSING AND CHALLENGING THE CLIENT’S JUDGEMENT Assess whether the client’s judgement on the accounting treatment is similar to your own or within acceptable limits. If not, discuss with your client and consider the implications for the audit and audit report (refer to appropriate ISAs). Consider whether your decision is one which you would be happy to defend against any possible reputational risk. Ensure approval/escalation procedure for key judgements have been followed to ensure that material judgements have been endorsed, where appropriate. Check the resultant accounting treatment and entries and ensure they make sense. Check the resultant note disclosures. Identify points in time where reassessment of judgement will be required – for example period ends or trigger points in the initial contract.
  14. 14. Professional scepticism • The word scepticism is formed from the root “skeptic,” which comes from the Greek word “skeptikos,” meaning “inquiring or reflective.” To inquire is “to seek information by questioning; to ask.” The characteristics commonly associated with being a sceptic include questioning and careful observation, probing reflection, looking beyond the obvious, and suspension of belief. • Professional scepticism incorporates the attributes commonly associated with being a sceptic in a professional setting that requires a standard of care and due diligence in the context of professional standards, regulation, oversight, litigation, negotiation, evidence collection and evaluation, professional judgment, complex business transactions, varying incentives and motives, rationalisation, and so forth.
  15. 15. Are Professional Judgment and Professional Scepticism the Same Thing? Professional scepticism is necessary for high-quality professional judgment, but it is only one component of what is necessary for the auditor to exercise sound professional judgment. For example, scepticism without requisite accounting and auditing industry expertise is not sufficient to obtain high-quality judgment. Attributes, Skills, Personality. Another aspect of defining scepticism is whether it fundamentally consists of a set of skills and behaviours, or whether it also involves knowledge and expertise or personality traits. While some scholars lean more toward skill and others toward personality trait, we believe ongoing dialogue is best served by considering professional scepticism in terms of a combination of personal traits, knowledge, and skill.
  16. 16. CASES 17
  17. 17. 18 Case Study : Assets Impairment Common Observations: [Next Slide]  Lack of verification and challenge of management’s assumptions  No basis to support conclusion made by management  Inappropriate determination of recoverable amount and incorrect comparison of recoverable amount with carrying amount  Undue reliance of and lack of professional skepticism on management representation
  18. 18. 19 Case Study : Assets Impairment (cont.) [BACK] 3 350 Forecast 2014 Forecast 2015 Forecast 2016 Forecast 2017 Revenue (270) 424 466 512 Projection 2013 Cost of sales Actual 2012 150 (135) Gross Profit 15 (245) 105 Admin and other cost (65) (LBT) / PBT (50) Tax (20%) - (LAT) / PAT (50) (85) 20 16 (4) Terminal value 115 (94) 21 17 (4) (296) 128 (10) 25 20 (5) (326) 140 (11) 27 22 (5) (359) 153 GP Margin 10% 30% 30% 30% 30% 30% (12) 29 23 (6) Value in Use = NPV = 1,300 773 Carrying amount of Sub A Goodwill 100 500 600 173 AUDIT CONCLUSION: NO IMPAIRMENT ON ASSETS AND GOODWILL Key assumption 1: Increase in revenue in FYE 2013 due to one new customer Key assumption 2: Constant growth rate (g) of 10% year on year Key assumption 4: WACC (r) of 13% Supported by a mere “Letter of Intent” Historical growth of company last 5 years = 5%, Forecasted for next 2 years – 7% Entire group’s average WACC, not specific to Sub A which actual cost of capital = 16% Key assumption 3: Calculated based on a growth rate of 11% Basis to higher growth rate? IMPAIRMENT = If r = 16%, g = 7% 401 429 459 (262) (281) (300) (329) 112 120 129 138 (97)(91) (104) (111) 21 23 25 27 (4) (5) (5) (5) 17 18 20 22 249 178 (422) 385 Example: Investment in a subsidiary which has been loss-making and in net current liabilities position
  19. 19. Case Study: Risk of Management Override of Controls 20 PLC A Board of Directors (6 members) Independent Non- Executive Directors (Audit Committee) Executive Directors (Run day to day operations) Collectively holds 42% interest in the PLC Father, daughter and son + + Risk of Management Override of Controls AOB’s identified deficiencies • Risk of management override not identified [ISA 200.15 & ISA 315.14]  Did not apply appropriate professional skepticism • Risk of management override was identified and considered a risk, however no additional procedures [ISA 240.33]  Journal entry testing – nature,[BACK]
  20. 20. 21 Case Study: Reliability of evidence provided by management Leasehold Land B (vacant) 15 Total 18 PPE: (lease expiring: Year 2025) Factory and office building A 3 Statement of Financial Position as at 31 December 2012 (in RM’ million) Freehold Land D 20 Total 50 Land held for development: Freehold Land C 30 Management’s basis to support valuation and accepted by auditor Valuation Report Full valuation report for a condominium unit belonged to another subsidiary Ascribed Value: RM3.2 million AUDIT CONCLUSION: “Higher than Carrying Amount, Hence No Impairment” BUT 1. No evaluation to support the basis of comparison, ie. comparing a factory cum office to condominium Example: Valuation of properties
  21. 21. 22 Case Study: Reliability of evidence provided by management (cont.) 6 Leasehold Land B (vacant) 15 Total 18 PPE: (lease expiring: Year 2025) Freehold Land and building A (use as office and factory) 3 Statement of Financial Position as at 31 December 2012 (in RM’ million) Freehold Land D 20 Total 50 Land held for development: Freehold Land C 30 Management’s basis to support valuation and accepted by auditor One page fax letter from the valuer’s offices Ascribed Value: RM16 million AUDIT CONCLUSION: “Higher than Carrying Amount, Hence, no Impairment” BUT 1. Fax copy signed by a clerk from the valuer’s office but not evaluated by the auditor as to the quality and reliability 2. Contained limitation clause stating that “…provided lease term is extended another 50 years…”. Example: Valuation of properties
  22. 22. 23 Case Study: Reliability of evidence provided by management (cont.) 7 Leasehold Land B (vacant) 15 Total 18 PPE: (lease expiring: Year 2025) Freehold Land and building A (use as office and factory) 3 Statement of Financial Position as at 31 December 2012 (in RM’ million) Freehold Land D 20 Total 50 Land held for development: Freehold Land C 30 Management’s basis to support valuation and accepted by auditor iProperty website Asking price for a similar land: RM45 million BUT 1. No justification of using iProperty to support the valuation for Freehold Land C, particularly on the reliability of the “asking price” 2. No evaluation if the property in iProperty was comparable to Freehold Land C, for example, the physical condition and hence, no considering of adjusting the value to reflect such differences AUDIT CONCLUSION: “Higher than Carrying Amount, Hence No Impairment” Example: Valuation of properties
  23. 23. 24 Case Study: Reliability of evidence provided by management (cont.) 8 Leasehold Land B (vacant) 15 Total 18 PPE: (lease expiring: Year 2025) Freehold Land and building A (use as office and factory) 3 Statement of Financial Position as at 31 December 2012 (in RM’ million) Freehold Land D 20 Total 50 Land held for development: Freehold Land C 30 Management’s basis to support valuation and accepted by auditor Valuation report specific to this land Date of report: 31.12. 2010 Abscribed value: RM22 million BUT 1. No evaluation of the continue relevance of the outdated valuation report Example: Valuation of properties Valuation Report AUDIT CONCLUSION: “Higher than Carrying Amount, Hence, no Impairment” 2. Contained limitation clause stating that “…commercial land free from encumbrances…”, however Freehold Land D is an agriculture land [BACK]
  24. 24. Case study: Conflicting audit evidence Included in the PIE’s cash and bank as at 29 February 2012 YE is a FD of RM25.7 million 15 June’129 April’12 FYE 1 - 14 Feb’12 1 - 14 Mar’12 Vouched on 23 Mar’12 Conflicting Evidence GL Balance 29 Feb’12 Placement dates Maturity dates FD Certs Audit report sign-off Bank confirmation Receive 1st Confirmation What Could go wrong =RM20.0m? FD uplifted at FYE?? 4 May’12 Receive 2nd Confirmation Fax Bank confirmation Receive 3rd Confirmation Unknown Fax Bank confirmation = Balance as at 29 January 2012 Balance as at 29 February 2012 RM25.7m RM25.7m Balance as at 29 February 2012 RM5.7m= RM25.7m RM25.7m WRONG DATE, NOT ACCEPTABLE NOT PUT IN FILE AS AUDIT EVIDENCE
  25. 25. References • A professional judgment framework for financial reporting, Institute of Chartered Accountants of Scotland, August 2012 • Enhancing auditor professional skepticism, by Professors Steven M. Glover and Douglas F. Prawitt, Brigham Young University for the Global Public Policy Committee, November 2013 • Cases provided by the Audit Oversight Board, Securities Commission Malaysia

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