Professional Scepticism and

Judgment in Financial Reporting

Nik Mohd Hasyudeen Yusoff6 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 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.

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.

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.

Financial reports

Reviewed by regulators

Prepared by management

Approved by the board

Audited by auditors

Tabled to shareholders

Professional judgmentFOR PREPARERS PRINCIPLE 1 - Knowledge gathering and analysisA professional accounting judgement can only be made once all relevant information has been collected and analysed. PRINCIPLE 2 – Assessment of accounting guidanceA 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 judgmentA professional accounting judgement can only be made after undertaking appropriate due process. PRINCIPLE 4 – Documentation of judgmentA professional accounting judgement must be suitably documented.

Professional judgment

FOR AUDITORS PRINCIPLE 1 - Knowledge gathering analysisA professional auditing judgement can only be made once all relevant information has been collected and analysed. PRINCIPLE 2 – Assessment of accounting and auditing guidanceA 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 judgmentA professional auditing judgement can only be made after undertaking appropriate due process to assess and challenge the client’s judgement. PRINCIPLE 4 – Documentation of judgmentA professional auditing judgement and the assessment and challenge of the preparers’ judgement must be suitably documented.

Professional judgment

FOR REGULATORS

PRINCIPLE 1 - Review of financial statementsThe 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 documentationThe 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.

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.

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?

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.

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.

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.

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.

CASES

Case Study : Assets ImpairmentCommon 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

Case Study : Assets Impairment (cont.)

[BACK] 3

350

Forecast2014

Forecast2015

Forecast2016

Forecast2017

Revenue(270)

424 466 512

Projection2013

Cost of sales

Actual2012150

(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 AGoodwill

100500600

173AUDIT 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

Case Study: Risk of Management Override of Controls

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, extent, and timing

[BACK]

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 subsidiaryAscribed 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

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 officesAscribed 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

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 websiteAsking 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

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 landDate of report: 31.12. 2010Abscribed 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]

Case study: Conflicting audit evidenceIncluded 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

EXISTENCE?

WRONG DATE, NOT

ACCEPTABLE

NOT PUT IN FILE AS AUDIT

EVIDENCE

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