Exploring Professional Skepticism and Earnings Management in Audits

The assignment examines two pivotal concepts in auditing: professional skepticism and earnings management. Professional skepticism is vital for auditors as it involves a questioning mindset that helps ensure audits are conducted with due diligence, enhancing their reliability. It includes assessing biases, corroborating evidence, and maintaining an attitude of neutrality and doubt when necessary. Earnings management, on the other hand, refers to the methods managers use within accounting standards to influence financial reports to achieve desired outcomes, which can be both ethical (such as timing adjustments) or unethical (like manipulative practices). The analysis highlights the challenges auditors face in detecting earnings management due to its complex and sometimes subjective nature. Additionally, it underscores the importance of auditor independence and robust audit procedures in mitigating these challenges. Discretionary accruals play a significant role here; they allow managers flexibility in financial reporting, which can either inform stakeholders about the company's prospects or mask underlying economic issues through aggressive accounting practices. The study encourages auditors to enhance their skills and knowledge to better navigate these complexities and uphold the quality of financial reporting.

RUNNING HEAD: KEY AUDITING CONCEPTS
KEY AUDITING
CONCEPTS

KEY AUDITING CONCEPTS 1
To: Margaret [e-mail]
From:
Subject: Basic Understanding of Key Auditing Concepts.
Hello, Ms Beresford
Please find below the detailed understanding of following auditing concepts.
PROFESSIONAL SCEPTICISM
Auditors while performing an audit engagement, are required to exercise certain approaches
such as professional judgement and professional scepticism in their work since audit is
conducted to enable the auditor to express an opinion about the true and fair view of the
financial statements of an entity. Professional scepticism requires the auditors to remain alert
to anything unusual indicating the possibility of material misstatements in the financial
statements of the company, which they come across during the audit process. The approach to
keep a questioning mind throughout the audit process is necessary to critically assess the
audit evidences which assists them in drawing a conclusion based on which audit opinion is
formed. Although it is not the statutory duty of auditor to detect the frauds and errors in the
financial statements but still they are supposed to follow the concept of professional
scepticism if they find any information that casts doubt about the reliability of necessary
documents and the inquiry responses of the relevant parties. Even if there are contradictory
evidences on a particular audit matter the auditor must apply professional scepticism to
determine the genuineness of the audit evidences.
There are 3 main elements of professional scepticism which interact whenever auditor
encounters the unusual situations (Hurtt et al., 2013). These are attributes mind-set and the
action. First one is the Attributes includes the auditors knowledge and skills. Second element
is Mind-set includes the auditors behavioural approach towards the audit i.e. the auditor
cannot start his work of audit with suspicious framework of mind about the entity’s
management. Therefore, the auditors should not be influenced by the evidences that are less
persuasive by nature. Actions is the third element which involves gathering and critically
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KEY AUDITING CONCEPTS 2
examining the audit evidences to assess the genuineness of the entity’s books of accounts.
For the purpose of critical assessment auditors must the sufficient and appropriate audit
evidences. While pursuing the approach of professional scepticism auditors must extend the
audit procedures whenever they find anything unreasonable. Moreover, auditor is also
required to assess the appropriateness of going concern assumption adopted by the company
and if during the audit engagement he identifies certain indicators which affects the
reasonability of going concern assumption he must extent his audit procedures.(Quadackers,
Groot &Wright, 2014).
Auditors are the external parties appointed by an entity for the purpose of conducting audit so
as to raise the level of confidence of the investors and other stakeholders of the company.
Therefore, to ensure their independence auditors are required to apply professional scepticism
in the audit planning and while performing the audit procedures.
Earnings management
It is the practice where the business managers manipulates the financial reports of the entity
in order to deceive the stakeholders about the company’s financial position so as to ultimately
attain the economic benefits. As the value of firm is influenced by the level of earnings
reported by it, the managers tends to manipulate the earnings with the motive of attaining the
economic incentives (Cohen & Zarowin, 2010). It is therefore difficult to determine whether
these practices of earnings management are acceptable or they form part of fraud done by the
management to mislead the investors. Financial reports are considered as the most effective
way of communication of information between the company and the stakeholders about the
financial performance of the company. The critical nature and usefulness of financial reports
necessitates the need of audit of financial statements by an independent party (auditors) so as
to increase the creditability of financial statements in the eyes of the shareholders. Therefore,
the auditors are required to maintain the highest degree of independence while conducting an
audit and at the same time auditors are also required to apply professional scepticism and
professional judgement during the entire audit process. The exercises of earnings
management can either be for the purpose of showing higher income or for showing the
lower income in the financial statements of the company (Badertscher, 2011). For example,
the managerial remuneration system of a company requires the managers to generate a certain
level of earnings so as to earn incentives and bonuses and in order to gain the incentives the
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KEY AUDITING CONCEPTS 3
managers engage themselves in the earnings management exercises. The company may be
suffering losses which is affecting the reasonability of its going concern assumption then to
raise funds from financial institutions the management may increase the earnings in the
reports as going concern assumption is based on company’s viability to continue business in
the future. Also, to gain the governmental subsidies and assistances management adopts the
practice of earnings manipulation (Gunny, 2010).
Discretionary accruals:
Accruals are one of the two components of total earnings of the company. The other
component is the direct cash flows from the operations of an entity. The total accruals are the
estimates and judgements made by the management to reflect better economic performance
through improved earnings accounting. Accruals can be either discretionary accruals or non-
discretionary accruals (Linck, Netter & Shu, 2013). Discretionary accruals is the component
that the managers can select on their own, within the accounting regulation’s flexibility, to
adjust the cash flows of the company (Badertscher, Collins & Lys, 2012). Discretionary
accruals offers the business managers with the flexibility to manipulate the company’s
earnings so as to influence the stakeholders. Due to the involvement of extensive managerial
judgement this component is more subjective than the other components of earnings. The
audit of the entities with more discretionary accruals is difficult than the audit of entities with
lesser amount of discretionary accruals (Kent, Routledge & Stewart, 2010). This type of
accruals at times holds two elements that are, the disturbance caused by the unethical and
aggressive reporting done by the managers for their personal benefits and the information
element which enables the managers to share their inside information. Since the highly
skilled auditors have greater experience and knowledge to separate the information element
from noise, they are capable of enhancing the informative quality of discretionary accrual by
restricting the unethical and unreasonable reporting practice.
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KEY AUDITING CONCEPTS 4
List of References:
Badertscher, B.A., 2011. Overvaluation and the choice of alternative earnings
management mechanisms. The Accounting Review, 86(5), pp.1491-1518.
Badertscher, B.A., Collins, D.W. and Lys, T.Z., 2012. Discretionary accounting choices
and the predictive ability of accruals with respect to future cash flows. Journal of
Accounting and Economics, 53(1), pp.330-352.
Cohen, D.A. and Zarowin, P., 2010. Accrual-based and real earnings management
activities around seasoned equity offerings. Journal of accounting and Economics, 50(1),
pp.2-19.
Gunny, K.A., 2010. The relation between earnings management using real activities
manipulation and future performance: Evidence from meeting earnings
benchmarks. Contemporary Accounting Research, 27(3), pp.855-888.
Hurtt, R.K., Brown-Liburd, H., Earley, C.E. and Krishnamoorthy, G., 2013. Research on
auditor professional skepticism: Literature synthesis and opportunities for future
research. Auditing: A Journal of Practice & Theory, 32(sp1), pp.45-97.
Kent, P., Routledge, J. and Stewart, J., 2010. Innate and discretionary accruals quality and
corporate governance. Accounting & Finance, 50(1), pp.171-195.
Linck, J.S., Netter, J. and Shu, T., 2013. Can managers use discretionary accruals to ease
financial constraints? Evidence from discretionary accruals prior to investment. The
Accounting Review, 88(6), pp.2117-2143.
Quadackers, L., Groot, T. and Wright, A., 2014. Auditors’ professional skepticism:
Neutrality versus presumptive doubt. Contemporary Accounting Research, 31(3), pp.639-
657.
Kindly use the references in case any follow up is required on any of the above explained
topics.
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KEY AUDITING CONCEPTS 5
Yours Sincerely,
Students Name
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