The skeptics are back, and they want you—or at least the internal and external auditors among you—to be more skeptical too.

Audit regulators and others are once again asking auditors to embrace their cynical side and more effectively challenge corporate executives before signing off on an audit. These calls for skepticism stem from concern that auditors were too soft with their clients in the run-up to the financial crisis and have reignited the debate over effective measures to ensure sufficient auditor objectivity and independence.

Proponents for more reform argue that recent regulatory measures, including the creation of the Public Company Accounting Oversight Board, EU Directive 2006/43/EC, and others, have not adequately ensured auditor independence. This has led to calls for more changes such as audit firm rotation in the United States and replacing the current requirement for auditors to exercise an “enquiring mind” with a new test of “presumptive doubt” in Britain.

The consistent view is that application of an appropriate degree of professional skepticism is a crucial skill for auditors and one that is wanting. The PCAOB issued new guidance last December making a stern call for greater skepticism and objectivity on the part of public company auditors. Staff Audit Practice Alert No. 10 is intended to remind auditors of requirements that already exist for them to approach their work with an independent, skeptical mindset.

The alert citied examples the PCAOB has seen through its inspection process and disciplinary proceedings where professional skepticism was lacking. In one case, an engagement team failed to gain an understanding of how an outside pricing service valued certain hard-to-value financial instruments, even ignoring audit evidence that would suggest the price was issuer friendly. In another, the team didn't evaluate the effects of a determination by management that it didn't need to test plant, property, or equipment for impairment, despite plenty of evidence that they might be impaired due to operating losses, goodwill and intangible asset impairments, a projected loss for the upcoming year, and reduced or delayed customer orders.

What Is Professional Skepticism?

PCAOB standards define professional skepticism as an attitude that includes a questioning mindset and a critical assessment of audit evidence. The International Standards on Auditing (ISA 200) define professional skepticism as “an attitude that includes a questioning mind, being alert to conditions that may indicate possible mis-statement due to error or fraud, and a critical assessment of audit evidence.”

The typical challenge of meeting a standard is finding the right balance. The degree of skepticism to be applied is important because it influences the effectiveness and the efficiency of an audit. Too little skepticism undermines audit effectiveness; too much risks unnecessary cost. Opponents of new audit reforms further claim that too much skepticism can result in auditors being too confrontational, which can weaken trust between the auditor and executive management and thereby damage audit quality.

Being able to focus on the right areas (observing and not just seeing) can provide the mental alertness to concentrate and apply professional skepticism as it is needed.

With the right leadership, however, the appropriate balance can be found, and the fear of taking it too far should not deter auditors from enhancing their approach to professional skepticism. Audit leaders need to recruit and train people so that they develop the skills needed to apply skepticism with a sense of when and how to challenge management.

The appropriate application of professional skepticism is dependent on a robust risk assessment that focuses attention on those areas where there are higher risks and susceptibility to mis-statement. Risk assessment procedures can identify the unusual transactions or matters that warrant heightened scrutiny and the need for more persuasive supporting evidence.

Audit firms and internal audit shops need to nurture skeptical behavior. The PCAOB alert provides recommendations on how professional skepticism can be promoted within the organization:

Tone-at-the-Top Messaging. Consistent communication from leadership that professional skepticism is integral to performing a high-quality audit, backed up by a culture that supports it, could improve the quality of work performed by managers and staff.

Performance Appraisal, Promotion, and Compensation Processes. An organization's performance appraisal, promotion, and compensation processes can enhance or detract from the application of professional skepticism in its audit practice, depending on how they are designed and executed.

Professional Competence and Assigning Personnel to Engagement Teams. To perform the audit with professional skepticism, it is important that personnel assigned to engagement teams have the necessary knowledge, skill, and ability required in the circumstances, which includes appropriate technical training and experience.

Engagement or Project Level. An opportunity to address and emphasize the importance of maintaining professional skepticism is during the discussion by the audit lead and other key team members of the susceptibility of the financial statement or process being reviewed to material mis-statement. This discussion includes consideration of facts and circumstances of areas that may be susceptible to fraud, including how fraud might occur (setting aside beliefs that the team members may have that management are honest and have integrity).

Impediments to Professional Skepticism

In the alert, the PCAOB recognizes that auditors often operate in an environment where there are numerous impediments to skepticism. PCAOB Chief Auditor Martin Baumann noted that, “As a practical matter, auditors are often challenged in meeting this fundamental requirement, but it's important for auditors to be alert to unconscious human bias.”

It can be helpful, especially to the novice auditor, to be self-aware of the roots of unconscious bias that can intrude in the performance of audit procedures. The general opportunities for bias described by academics and professional organizations are strikingly similar and can be generally categorized as follows:

Ambiguity. Bias thrives wherever there is the potential of interpreting information in different ways. Auditors and their clients can have considerable leeway in answering even fundamental financial questions and must be alert to bias.

Attachment and Level of Trust. The PCAOB notes that, “Over time, auditors may sometimes develop an inappropriate level of trust or confidence in management, which may lead auditors to accede to inappropriate accounting.” Moreover, auditors have strong business reasons to remain in a client's good graces and are thus motivated to seek their approval.

Scheduling and Workload Demands. Time and workload can create insidious pressure to complete assignments too quickly and even take shortcuts. Auditors should be on guard as such pressures can lead one to prefer data that is easier to obtain versus evidence that is more relevant and reliable.

Auditors should keep these impediments in mind and appreciate the profound effect that unconscious bias can wreak on their professional judgment.

Releasing Your Inner Sherlock Holmes

With concepts to enhance independence such as audit firm rotation still in abeyance, what else can an individual auditor do to better assure they are performing with the appropriate degree of professional skepticism? Perhaps it is worth considering what detective Sherlock Holmes can teach us about observation and attention.

As Holmes often tells his companion Dr. Watson, “You see, but you do not observe.” Being more mindful throughout the audit process is a skill the auditor can strive for to avoid falling into the complacency of completing rote procedures.

Fraud examiners in particular are aware of the potential for attentional blindness, where focus on a single element or situation causes the other elements to literally disappear. This phenomenon was made famous in a provocative scientific study where the subjects repeatedly failed to see a person in a gorilla suit walk onto the basketball scene because they were so focused on a specific activity being performed by one of the teams. It's a phenomenon magicians use to keep audience members from noticing the sleight of hand. Fraud specialists now know that during interviews it is better to focus on certain key behaviors than be distracted by other actions that can obscure careful observation.

This attentional blindness illustrates the limitations of our ability to focus. That is why Holmes is careful about where and when he deploys his keenness of observation—spread yourself too thin and you're likely to miss a critical detail. Being able to focus on the right areas (observing and not just seeing) can provide the mental alertness to concentrate and apply professional skepticism as it is needed. Accountants are trained to count in sophisticated ways; an auditor should consider themselves a scientist in his or her world and be observant in applying data analysis that can reveal something most would miss.

Professional auditors are trained that independence is necessary to prevent them from coming to conclusions that are biased in favor of their clients. Auditors are told that they “should strive for accuracy, or at worst strive for conservatism that introduces a slight negative bias to the client's financial situation.”

In the aftermath of the global financial crisis, recent audit inspection reports in various jurisdictions have noted areas where regulators and oversight bodies believe that auditors should have more clearly demonstrated professional skepticism. It is in the public interest to reemphasize to the audit profession the important role that professional skepticism has to play in their performance of audits.