02. Professional Skepticism and Professional Judgment

✅ What is Professional Skepticism?

Definition: A questioning mindset that includes being alert to conditions that may indicate misstatement due to error or fraud, and critically evaluating audit evidence.
Required in all audits, including private company audits.
Key traits:
- Questioning mind
- Suspension of judgment
- Search for knowledge
- Interpersonal understanding
- Self-confidence
- Self-discipline

✍️ Professional skepticism is not about assuming dishonesty, but neither should it presume complete honesty. It is about objective doubt and thorough verification.

✅ What is Professional Judgment?

Definition: The application of auditor's training, knowledge, and experience to make sound audit decisions within the framework of auditing standards.
Multiple responses may be appropriate based on context.

✅ Elements of Professional Skepticism (Academic Research Based)

Element	Description
Withholding judgment	Delay conclusions until sufficient evidence is obtained
Interpersonal understanding	Recognize that people's motivations may distort their representations
Self-confidence	Resist persuasion and undue influence
Self-direction (autonomy)	Decide independently rather than accepting others' claims
Search for knowledge	Desire to go beyond the obvious

✅ Judgment Biases that Affect Audit Quality

Bias	Description
Confirmation Bias	Focusing on evidence that confirms one’s beliefs
Overconfidence Bias	Overestimating one’s ability or knowledge
Anchoring Bias	Overrelying on initial values or assessments
Availability Bias	Using readily available information over more relevant data
❌ Autonomy is not a bias – it's an element of skepticism.

✅ Professional Judgment Process (Center for Audit Quality)

Step	Description
1. Identify the issue	Clearly define the problem or decision
2. Gather facts and information	Including relevant accounting and auditing literature
3. Analyze and evaluate alternatives	May include multiple reasonable options
4. Make the decision	Choose the best supported response
5. Document the rationale	Required for transparency and defensibility

❌ Determining the audit opinion is not part of the professional judgment process — it is the result of it.

✅ Auditor’s Performance Responsibilities under GAAS

Plan the audit
Properly supervise assistants
Determine and apply materiality
Maintain professional skepticism and professional judgment
Obtain reasonable assurance that financial statements are free from material misstatement

✅ Reasonable Assurance

Defined as:

“A high, but not absolute, level of assurance that the financial statements are free from material misstatement.”
Absolute assurance is not possible due to:
- Sampling
- Fraud risk
- Complex estimates

✅ Application & Deeper Concepts

This section connects the core principles of skepticism and judgment to practical audit procedures and high-risk areas.

1. Connection to Audit Risk Assessment

Professional skepticism is most actively applied during the planning phase to identify and assess the Risks of Material Misstatement (RMM).
It involves critically questioning management's assertions, especially in areas like:
- Complex or unusual transactions.
- Revenue recognition policies.
- The potential for management override of controls.

2. Relationship with Audit Evidence

Skepticism guides the auditor in evaluating the quality and reliability of audit evidence. A skeptical mindset leads an auditor to prefer evidence that is more reliable.
Hierarchy of Evidence Reliability:
- External evidence (e.g., bank confirmations) is more reliable than internal evidence (e.g., internal company memos).
- Evidence obtained directly by the auditor (e.g., observation, inspection) is more reliable than evidence obtained indirectly (e.g., inquiry of management).
Requires auditors to thoroughly investigate contradictory evidence rather than dismissing it.

3. Application in Specific High-Risk Areas

A higher degree of professional skepticism and judgment is required in areas prone to management bias or complexity:
- Fraud Risk: Evaluating the 'Fraud Triangle' (Incentive/Pressure, Opportunity, Rationalization) and its implications for the audit.
- Going Concern: Objectively assessing the feasibility of management's plans to mitigate going concern issues, rather than accepting them at face value.
- Auditing Accounting Estimates: Critically reviewing the assumptions, data, and models used for estimates (e.g., allowance for doubtful accounts, fair value measurements).
- Related Party Transactions: Scrutinizing the business rationale and substance of transactions to ensure proper accounting and disclosure.

4. Inherent Limitations of an Audit

This concept formally explains why only reasonable assurance, not absolute assurance, is provided. It expands on your existing notes.
Absolute assurance is unattainable due to:
- The Nature of Financial Reporting: Many financial statement items are based on subjective judgments and estimates, leading to inherent uncertainty.
- The Nature of Audit Procedures:
  - Auditors use sampling because it is impractical to test 100% of transactions.
  - A well-concealed fraud, especially involving collusion, may not be detected by standard audit procedures.
- The Need for Timely Reporting: The audit must be completed within a reasonable period to be relevant, which creates a balance between cost and benefit.