Recent discussions around undisclosed material weaknesses have raised questions about the true state of internal controls over financial reporting among public companies.
The Public Company Accounting Oversight Board has observed that the volume of restatements following clean audit opinions “show that often a material weakness is not identified even when a known misstatement occurs and suggest that there may be undisclosed material weaknesses in the internal control over financial reporting.” The data seems to support earlier Securities and Exchange Commission suspicions that companies are not adequately disclosing material weaknesses.
That begs the question: Why have the majority of issuers with financial restatements received a clean audit opinion on ICFR?
Several factors are likely at play here. Commentators cite tensions between auditor and client over close calls as one dynamic in the evaluation of undisclosed weaknesses. It is said that auditors are conscious of the long-term business relationship, and downgrading findings to a significant deficiency—especially if the client pressures the firm—can be the easier path to take.
Perhaps the issue of undisclosed material weaknesses is yet another reminder of the significance of objectivity and professional skepticism when performing an audit. In a pivotal 2002 Harvard Business Review paper, “Why Good Accountants Do Bad Audits,” the authors advanced the view that rather than deliberate corruption, the “more pernicious problem with corporate auditing, as it’s currently practiced, is its vulnerability to unconscious bias.”
Recall that Sarbanes-Oxley Act of 2002 was intended partly to put the accounting industry under closer federal oversight. SOX presumed that the underlying problems result from ethically challenged accountants and auditors falsifying the numbers. Yet due to the often subjective nature of accounting standards and interpretation, with the close relationship between accounting firms and their clients, “even the most honest and meticulous of auditors can unintentionally distort the numbers in ways that mask a company’s true financial status.”
Professional Skepticism and Bias
To provide management and boards of directors with a rigorous and quality audit, auditors must be able to exercise professional judgment free from interference. In a past column I wrote that audit regulators were asking auditors to embrace a skeptical mindset and to challenge corporate executives more vigorously before signing off on an audit. These calls for skepticism reignited the debate over measures to ensure auditor objectivity and independence. PCAOB standards (in Staff Audit Practice Alert No. 10) “define professional skepticism as an attitude that includes a questioning mindset and a critical assessment of audit evidence, and it is essential to the performance of effective audits under board standards.”
But to exercise professional skepticism well, auditors need to recognize different types of bias and how it can affect the performance of an audit. Generally bias is the inclination to hold a partial perspective that is preconceived or unreasoned. As a result, bias can lead to inaccurate interpretations of information and supporting records. The result is a deterioration of the impartiality that is crucial to all audits and investigations.
Like most skills auditors should cultivate, the ability to approach each audit engagement with the appropriate degree of professional skepticism, free from bias, must be intentionally nurtured through education and practice.
Conscious biases are ones that the affected person is aware of, and might be able to control or adjust for. Their existence often coincides with an appearance of a conflict of interest.
Unconscious biases are a bigger challenge. Research suggests that individuals have more of these unconscious biases than we would care to admit.
Examples of unconscious bias that can affect an audit include:
Availability bias refers to the inclination to make decisions based on information that is most readily available. The more difficult information is to obtain, the less likely individuals are to bother seeking it.
Group think or consensus refers to the desire for harmony or conformity in a group, and results in irrational or dysfunctional decisions. Group think involves members attempting to minimize conflict and reach a decision without proper consideration of alternative views.
Rush to judgment can come when there are tight deadlines and professionals unconsciously overlook important evidence, cluster differing facts under the same umbrella, or commit other errors of judgment, to save time and meet their deadline.
Probably the most damaging of the unconscious biases to the performance of an audit is confirmation bias: the tendency to search for or interpret new information in a way that confirms your preconceptions, while avoiding information and interpretations that contradict present beliefs.
Consider how individuals interpret news reports that have political implications, whether the news is related to the economy, legislation, or foreign relations. People naturally tend to interpret the news in a manner that supports political or ideological beliefs you already hold.
The more familiar and comfortable one gets with another person, the more biases in favor of that other person begin to creep in, sometimes significantly. Auditors are especially susceptible to the bias that results from repeated interaction with management and others whose assertions and responses to questions are the starting point for much audit work. This form of bias has led to all those calls for auditor rotation.
Bias in Practice
Auditors make judgments all the time while performing audit procedures. What constitutes an exception in an audit test? On the surface it seems a simple question, but anyone who has conducted audits understands that the answer is not always straightforward. Audits use significant judgment for decisions about which test results require follow-up or explanation and which do not. These judgments and an auditor’s professional skepticism are shaped, in part, by the implicit biases brought into the audit work.
Bias is particularly harmful with respect to over-reliance on explanations from management for fluctuations from expected results, whether regarding year-to-year comparisons, budget-to-actual analysis, or other ratio analyses and benchmarking. Bias can impair an auditor’s ability to apply professional skepticism to the responses from management and others in connection with analytical procedures.
The role of the auditor is to issue an objective opinion on the financial statements, regardless of the effects that the work or opinion might have on client relationships. While the majority of audits are performed very well, when significant failures do occur, they are often attributed to:
An inherent desire to believe what people say and to trust representations of management, particularly in response to questions arising from analytical procedures. As a result, the auditor accepts management’s explanations and representations without sufficient corroboration.
A desire to nurture a long-term relationship, which can lead to certain assumptions about the honesty and integrity of individuals and the effectiveness of controls or processes.
How can bias be minimized? The authors of that HBR paper did not believe SOX reforms address the fundamental problems of bias. They noted academic research that requiring auditors to reveal their conflicts of interest can potentially lead to even more bias. The authors proposed more “radical” remedies such as full divestiture of consulting and tax services by an audit firm, and auditors having a fixed, limited contract period during which they cannot be terminated.
The authors did say that auditors must appreciate the profound effect that unconscious biases can have on professional judgment. Given that it is virtually impossible to start out unbiased (never mind keeping a fully objective mindset throughout an audit), how can professionals identify and counter their own biases?
The first step is self-awareness. Acknowledge that no matter how professional you believe you are, all individuals are susceptible to the effects of unconscious influences. Once you are aware of potential biases and how they can impair your work, you can take action to eliminate or reduce your inherent biases.
Like most skills auditors should cultivate, the ability to approach each audit engagement with the appropriate degree of professional skepticism, free from bias, must be intentionally nurtured through education and practice. When auditors begin their next engagement, they should consider how their view of bias and professional skepticism might affect their evaluation of the audit evidence. They should take time to document their thought process and its effect on that evaluation.
When you seek to disprove a preconceived notion, you sometimes end up proving it—and other times you may save yourself from making a big mistake. Otherwise, as author of Willful Blindness Margaret Heffernan observes, “You cannot fix a problem that you refuse to acknowledge.”