At what point in the audit should an auditor exercise professional skepticism?

The exercise of professional scepticism by auditors in the current environment is now more important than ever.

In brief

• Auditors must exercise professional judgment, which requires professional scepticism.
• Lack of professional scepticism by auditors has become a key focus of regulators worldwide.
• There are practical ways auditors and firms can develop a clear-eyed and questioning attitude.

Performing a quality audit in the current uncertain climate will require auditors to exercise heightened levels of professional judgement and professional scepticism in order to deal effectively with the range of challenges that COVID 19 is posing for both clients and audit practices. Regulators not only expect auditors to maintain an appropriate level of professional scepticism during every audit, but also expect to see documentation demonstrating how professional scepticism has been applied.

What is professional scepticism?

To show professional scepticism means:

• having a questioning mind
• being alert to anything that may indicate misstatement due to error or fraud
• critically assessing audit evidence.

What do regulators say about professional scepticism 

Because professional scepticism is integral to professional judgment, it’s essential to high-quality auditing. Yet audit inspections by the Australian Securities & Investments Commission (ASIC) and the New Zealand Financial Markets Authority (FMA) have raised concerns about the level of scepticism being shown by auditors.

ASIC’s focus area in their 2019 audit inspection report requires audit firms to consider: “Whether appropriate professional scepticism is exercised about the sufficiency and appropriateness of audit evidence, accounting treatments and accounting estimates.”

FMA’s 2019 Audit Quality Monitoring Report stated: “Audit firms need to give consideration to the users of financial statements when carrying out audits. Professional scepticism is not always applied well by auditors or communicated to directors.” 

What factors drive scepticism?

Many factors influence the level of professional scepticism shown by auditors and engagement teams, including:

• personal attitudes and ethical values
• levels of education, training and experience, and therefore overall competence
• the actions of the firm’s leadership and the engagement partner
• the culture, incentives and business environment of the audit firm.

How can I boost professional scepticism?

• Have the self-confidence and strength of character to maintain an enquiring mind.
• Suspend trust: rationally and logically consider all the likely options, not just the one that is being put in front of you.
• Resist the temptation to just accept the easy answer.
• Go beyond simply providing evidence to support disclosures. Consider alternative disclosures or viewpoints as well.

The Art of Professional scepticism series

The following 5 guides make up the series:

• The Art of Professional Scepticism: an overview of the series
• Art of Relationship Building guide
• Art of Problem Solving guide
• The Art of Enquiry: A guide for auditors on asking questions
• Spotlight on specific audit areas (the case studies)

Section on how CA ANZ can help?

eLearning available on professional scepticism. What do you need to produce a quality audit? Professional scepticism! Strengthen your ability to consistently apply sceptical behaviour to every audit and understand how to overcome challenges and avoid judgement traps.

Read this if you are a chief executive officer, chief operations officer, or chief retail officer at a financial institution.

There’s been much buzz around the recent announcement by the Biden administration that up to $20,000 in federal student loans will be cancelled for low- to middle-income families. And, rightfully so, as the debt cancellation is anticipated to be eligible for up to 43 million Americans with roughly 20 million borrowers expected to have their remaining student loan debt eliminated entirely.1 Although the relief does not apply to private loans, financial institutions should see this as an opportunity to enhance the customer experience. 

Trusted advisors 

Financial institutions are often seen as trusted advisors by their customers and may be a go-to resource for customers when making financial decisions. Debt cancellation of up to $20,000 can have a major financial impact on households, especially provided relief is only eligible to borrowers with household income below $250,000 ($125,000 for individuals).2 And, with roughly 20 million borrowers expected to have their remaining student loan debt eliminated, this may free up significant monthly cash flow for those borrowers. Even though student loan repayments have been on hold for the past couple of years for many borrowers, the cancellation of this debt may free up deposits those borrowers had set aside in anticipation of the recommencement of loan payments. Now that this remaining debt is expected to be forgiven, how might they use this debt forgiveness to better their financial health? Community banks and credit unions are in the driver’s seat to assist customers in making this decision.

Data analytics

With the onset of data analytics—the understanding of how transaction, financial, and other information may be used to understand customer needs—many financial institutions are well-positioned to recommend services tailored to each customer. Although making sense of this data and putting it into something actionable can be challenging, the rewards can be tremendous. For instance, analyzing spending habits or cash flow trends can equip an institution with the insights needed to assist a customer when asked how best to deploy this excess wealth. Do they have any loans with your institution they should pay off or pay down? Given the current interest rate environment, this may also prove to be beneficial for the institution, as it could then re-deploy these funds at a higher interest rate. 

Knowing your customer

A simpler approach than using data analytics to provide actionable insights is just simply knowing your customer. This is something community financial institutions excel at and is one of their biggest value propositions. When working on financial institution audits, we often ask about specific customers as part of our audit procedures. I am always awed by our clients’ ability to provide one of their customer's stories on a whim. Bankers have well-developed relationships with their customers. Customers are neighbors, restaurant servers, bartenders, firefighters, the list goes on. These are people bankers see out in their communities—you may even have children that go to the same school together. The point I am trying to make is that these relationships are much deeper than any relationship data analytics can provide. What major life events are your customers anticipating? A wedding? A child? A vacation? Needing a new car? These are all items that data analytics may not be able to tell you but personal relationships with your customer, and general knowledge about your community, will. How can you, as their trusted advisor, provide them opportunities to save for these major life events? I don’t want to discount the importance of data analytics but, I also want to stress the importance of these personal relationships. However, combined, they create a powerful tool for community bankers.

Knowing your customer—an example

As an example, you may know your customer is planning for a wedding and that they took some wedding wish-list items off their list because they couldn't afford them. Does the proposed debt cancellation allow your customer to now afford—or save for—some of these items? You may not know the answer simply based off previous conversations with the customer but, a quick phone call and discussion will provide you with an answer. And, even if the answer is: “No, this does not change my wedding budget,” it at least shows them that you were looking out for your customer and being proactive. 

Knowing your customer combined with data analytics—an example

Taking this example a step further, what if you had data analytics that displayed your customer’s spending habits? Is there a way to query payment transactions that would allow you to identify which customers have federal student loans? This information, paired with your knowledge gained from knowing the customer, allows you to provide targeted, actionable insights. Knowing their monthly cash flow, what loans they have outstanding (based on cash outflows), and deposit balances, you can be more strategic in your outreach, not only in who you reach out to but how you structure your outreach. For instance, could a customer benefit from using those forgiven student loan payments to now pay down other debt carried at higher interest rates?  Or, going back to an earlier example, if you know when the customer’s wedding is and their monthly net cash flow, is there a deposit product you could sign them up for that would allow them to work towards affording some of their wedding wish-list items that previously couldn’t be afforded?

Saving for retirement

Another aspect to consider is saving for retirement. Although borrowers are eligible for loan forgiveness of up to $20,000, most will likely only be eligible for $10,000 in forgiveness, as the $20,000 is only for Pell Grant recipients.2 To some customers, $10,000 may not seem like a lot. But, when considering the time value of money, a customer’s perception may change. Using an example from a recent Accounting Today article1, a 40-year-old man is expected to live to 81.5 years old. Therefore, assuming an annual return of 6% over 40 years, $10,000 can turn into more than $110,000 over four decades. Those who live to 90 can turn $10,000 into more than $200,000. Institutions with wealth management divisions may find colleagues who have great suggestions on how best to approach these conversations. Even if the customer has short-term spending needs/desires, as many do, steering these forgiven student loan payments towards retirement may be the most prudent decision. But sometimes a customer needs to see the potential impact plotted out and hear it from an outside, trusted source.

Customers with loan repayments restarting

To this point, the discussion has been on those customers that will benefit from loan forgiveness. But what about those that will not benefit as well as those that will only partially benefit (i.e., the entirety of their loan balance will not be forgiven)? Loan repayments are set to recommence in January 2023. Many borrowers haven’t had to make loan payments for over two years and some newer college graduates have never had to make a loan payment. These loan payments could come as a shock to those who have never made such a payment, as well as to those who previously had, if their spending habits have changed due to loan forbearance. There are two different perspectives to consider for these customers: credit risk and, sticking with the theme of the article, the customer experience.

Credit risk

The end of the loan forbearance period could have a significant impact on certain customers’ financial situations. For some, it could be the make-or-break point on being able to make their loan payments on other loans, possibly some of which are with your institution. Does the recommencement of these student loan payments change your customer’s risk profile? Do they now require closer monitoring?

Customer experience

Closely linked to credit risk, financial institutions should also see the recommencement of student loan payments as an opportunity to enhance the customer experience. Financial institutions should be proactive in reaching out to customers they know will be impacted to see if they feel prepared. This may be a difficult conversation to have but, it is one your customers will likely appreciate. If they aren’t prepared, are there steps the institution can take to assist the customer? Deposit products may again be worth mentioning to customers. Or, for those severely impacted, does the institution need to consider workout agreements with such customers? This provides a prime opportunity to work with your institution’s collections and credit risk departments. Keeping them in the loop (and vice versa) will help provide a seamless customer experience.

Institutions should also consider if this presents itself as a larger marketing opportunity, to attract new business. Although marketing decisions are generally based on potential return on investment (ROI), the ROI in this case may not quite be there, given the relatively small amounts. However, is this an opportunity for your institution to highlight its financial advisory services? 

In closing

For something that seems so simple on the surface, there is a lot to consider once you start diving in. Financial institutions have a big role to play and should see this as an opportunity to increase what are hopefully already strong relationships with customers. For those customers anticipating debt cancellation, financial institutions should essentially ask themselves: how can customers utilize their debt cancellation in a way that makes the most sense for them given their current financial situation and anticipated life events? For those that aren’t anticipating debt cancellation, financial institutions have an opportunity to be proactive. This proactivity will not only benefit the institution but will also show the institution is prepared and cares about assisting their customers and helping them transition back into student loan payments as smoothly as possible. 

This is a lot to unravel, especially in such a short time. As always, your BerryDunn Financial Services team is here to assist. Also, please feel free to reach out via our Ask the Advisor feature.

Why should the auditor exercise an appropriate level of professional skepticism?

Whose responsibility is it to apply professional skepticism?

Are you required to exercise professional skepticism when conducting a routine financial statement audit?

At which situations will professional judgment be a necessary consideration?