Further discussion of audit argumentation
A limitation of audit philosophy as it has evolved so far is that it has ignored the subject matter of financial statement auditing, which is the accounting theory and standards. Auditors must not only gather sufficient appropriate evidence but also use the evidence to effectively evaluate the financial reporting. The research trend is to link audit quality with accounting quality as discussed in DeFond and Zhang (2014). This suggests that a theory of auditing may not be separable from the theory, if there is one, underlying the subject matter of the audit. This integration has largely been missing in the literature. We have attempted to capture this integration in our argumentation framework of section 2.6, and it is further discussed in Chapters 10 and 11.
It may be that auditing should be embedded in a theory of corporate governance, the legal system, and other institutional aspects of an economy and culture, especially if auditing is viewed as a trust-promoting activity (Eilifsen and Willekens 2008). For example, cultural aspects of society that may have an impact on auditing include power distance and uncertainty avoidance as reviewed in section 2.6. Such influences can impact the level of assurance and materiality that should be used in an audit. So perhaps it should not be so surprising that early basic concepts of auditing included assurance and materiality, and this was already reflected in the 10 audit standards that existed at the time the first basic philosophy of audit study came out in 1961. The authors Mautz and Sharaf (1961) describe their pioneering study as the first attempt to develop a theory of auditing. The key concepts they focused on were: independence, ethical conduct, evidence, due audit care, and fair presentation. Interestingly, other than due audit care and evidence, little of the empirical audit research deals with these concepts. Moreover, other research on audit theory has tended to focus on evidence issues, e.g., Toba (1975), Kissinger (1977), and Steele (1992). Pratt and Van Peursem (1993) provide a more comprehensive conceptual framework for auditing.
In our view, what is missing from the conceptual framework is a fuller development of the fair presentation concept especially in light of the current debate about its interpretation (e.g., see DeFond et al. 2018 and Palmrose and Kinney 2018). The Mautz and Sharaf (1961) fair presentation concept thus seems to be a key feature of audit theory largely missing from subsequent theory research, although the audit quality concept may incorporate it. However, fair presentation is much more clearly linked to underlying accounting theory and this in turn suggests that audit and accounting theory may need to be linked more closely (Smieliauskas 1999).
One way to do this is to use the suitable criteria concept from the audit/assurance framework. Suitable criteria in any audit engagement is defined by the assurance concept of international standards. Specifically, suitable criteria are defined as assertions that “are capable of evaluation against suitable criteria” and that “the assertion is capable of reasonably consistent estimation or measurement.” The latest standards in 1SAE 3000. C12c, A19, A45—A50 now prefer use of the term “applicable criteria” in the engagement. In our view, this diminishes the auditor’s role by taking less responsibility for the appropriateness of the criteria, so we will continue to use the earlier concept of suitability in defining a more idealized role (such as whether the criteria result in fair presentation). This seems to be the solution preferred by Brydon (2019, 30—39) in his call for a new audit profession and new professional audit standards. To illustrate the distinction, see the question at the end of this chapter.
Suitable criteria serve as a basis for evaluating an accountability report, such as financial statements prepared by the accountable party (first party) in a three-party accountability relationship, where the auditor is the third party in the modern world accountability described in Chapter 1. Suitable criteria in financial reporting are discussed in more detail in Chapters 10 and 11. Suffice it to say that when suitable criteria are combined with argumentation concepts and the explanation concept in Dennis (2015), then the framework has the potential to incorporate most of the issues identified in recent standard-setting projects (such as ISA 540 as revised in 2018) and much prior research. Specifically, the general frameworks used here can incorporate the conceptual frameworks of IASB and FASB, along with their disclosure frameworks as well as the existing form of the conceptual framework for auditing in ISA 200 and the audits of note disclosures in IFAC (2011). In addition, since current audit standards are very risk oriented, we maintain consistency with this risk orientation by extending it to financial reporting issues.
We integrate the above using the Pratt and Van Peursem (1993) approach modified for current assurance standards and accounting conceptual frameworks in Figure 1.1 of Chapter 1. This figure is consistent with the proposed overall hierarchy of reasoning using argumentation concepts discussed in the preceding section.
Implicit in the above framework is that to be accountable in assurance contexts, the auditor must address the stated purpose of a financial reporting framework, which is normally captured in the objectives of the conceptual framework. The auditor then makes use of the additional guidance from the financial reporting detailed guidance/standards (such as IFRS standards) to help determine what evidence is relevant. The auditor’s goal is assumed to be to act in the public interest and here is where incentives make a difference, though philosophers may argue that economists assume too much of a Machiavellian philosophy (i.e., acting too much like homo economicus, a theoretical economic person’s rationality, instead of homo sapiens, an actual person’s rationality), and empirical studies in economics show that this may be true (Thaler 2015).
To act in the public interest requires the auditor to be attuned not only to the professional rules of conduct but also to wider social expectations of the auditor’s role. Any gap between social expectations and what the auditor can realistically deliver contributes to an expectations gap. When the gap cannot be closed because of the inability of the audit profession to do so because of unrealistic public expectations, then the standards should clearly communicate the limitations of the auditor’s role. Recent changes in the audit report clarifying the auditor’s role are an illustration of ways to help close the gap (ISA 700).
The role of acting in the public interest is given more concrete form by the conceptual frameworks of assurance/auditing and the financial reporting system that is identified as the suitable criteria used in the auditor’s report. The auditor must obtain evidence relevant to the suitable criteria and reach an opinion/conclusion on the degree to which suitable criteria are met. The generality of the assurance framework helps structure the logic of the auditor’s reasoning process in three ways. First, by acknowledging the unique nature of the three-party accountability in which credibility (assurance) must be added to assertions aimed at the third party (financial statement users). Second, the credibility relates to the suitable criteria which can have a strong interpretive component in the circumstances such as that based on fair presentation that contributes accountability. Finally, the concepts of materiality and risk (where risk = 1 minus credibility). The important conceptual component not specified in the standards is the importance of argumentation to justify the conclusion on the overall assurance provided. As noted in Smieliauskas (1999, 68), an argument in its most general form is
“a series of statements or propositions, one or more of which (the conclusion) is supported by the others (the reasons).” Smieliauskas (1999, Ch. 4) also introduces the concept of natural language audit reasoning that combines explanations with arguments.
The explanatory element of audit reasoning is being increasingly recognized by others as an important element of audit theory (Dennis 2015). Audit opinions are justified by audit arguments in the audit file through what Smieliauskas (1999) refers to as natural language reasoning. The role of explanations is essentially to clarify why the premises support the conclusion in the particular circumstances of a given audit engagement. Explanations can involve interpretations of events, particularly when it is human actions that are explained. Expectations, beliefs, and desires constitute reasons for what was done or is expected to be done. It is not only the auditor’s reasoning that matters, but also the auditee’s. However, it is the auditor’s responsibility to evaluate both sets of reasoning in the circumstances of the engagement and reconcile them into a justification of the audit opinion.
Explanations and argumentation in philosophy have recently blossomed into a new branch of pragmatics, discussed earlier (Stanford Encyclopedia of Philosophy 2015). In this way auditors can apply skepticism to some of the research assumptions made, such as the perfect rationality of auditors, and develop more practical strategies to deal with realistic problems in a more coherent way. However, ideal types such as perfectly rational economic auditors are useful as paradigm cases. With advances in technology' such as artificial intelligence, which may result in more consistently rational auditors, the central issue increasingly becomes what should be the overall objective(s) of the audit that the audit opinion should be addressing. Brydon (2019) has begun the process of offering some authoritative recommendations.
The suitable criteria that are GAAP are probably better developed than any other suitable criteria, meaning that for many engagements auditors may need to rely on other professional standards or on a justified interpretation of social norms in the circumstances as part of a professional judgment. For example, auditor responsibilities to detect fraud that are covered in ISA 240 are based on concepts from criminology and other sociological research (Dorminey et al. 2012). To the extent auditors use these, they are less likely to be subject to the criticism reviewed earlier in this chapter than to the criticism they are ideologically blinded technocrats following bureaucratic norms. All this suggests that selection of suitable criteria needs to be carefully considered, especially when the subject matter is outside the auditor’s normal experience. This is especially crucial in public sector auditing where a large range of subject matters can be covered under the comprehensive auditing concept (e.g., see the website of Auditor General of Ontario for examples of recent reports at: www.auditor.on.ca/en/content/annualreports/reportsbytopic.html).
In financial statement auditing, auditors are the ultimate experts, in the sense there is no professional group that lays claim to higher expertise in auditing and accounting issues. Thus we can expect audits of financial statements to meet the highest standards of accountability. For this reason, most of this book focuses on financial statement auditing.
The fact that financial statement auditors are the ultimate professional experts in both the audit process and the suitable criteria that apply means that one should expect consistencies between audit and accounting reasoning in these engagements (ideally). Specifically, the materiality and risk concepts should be treated consistently. The degree of integration of the reasoning between auditing and accounting has been a source of controversy since Mautz and Sharaf proposed fair presentation as a key auditing concept, however. Over the decades, the importance of the integration of audit with accounting has varied. For example, Smieliauskas (1999) argued that in financial statement auditing the suitable criteria of accounting theory were not separable in evaluating the quality of the auditing. To some degree the Cohen Commission Report (1978) also was suggestive of the integration of accounting theory with auditing theory, at least with respect to issues such as going concern. However, for the most part research and standards have treated audit and accounting theory as independent, e.g., Pratt and Van Peursem (1993), Flint 1988), Toba (1975), and Kissinger (1977). In this book we develop an integrative approach, in part because the need for verifiability of information in recent proposed changes to accounting conceptual frameworks has been questioned. We therefore discuss the verifiability of financial statement information in more detail in Chapters 10 and 11.
With this overview of auditing research and theory, in the following chapters we look at research on specific aspects of professional standards and regulator}' environments. These are further developed empirically and analytically in later chapters dealing with the incentives auditors have to act in an optimal manner.
If the objectives of financial reporting are aligned with user needs and concepts and principles are aligned with the objectives, it follows from definition that the verification of meeting these principles of reporting should deter fraud of incompetence and fraud due to intentional misstatements by management (i.e., unethical financial reporting), and meet the objectives of financial reporting and their audits. That would mean a high inductive probability in the audit argumentation.
However, it is important to be aware that there may be higher-order social norms that may invalidate the above logic just using the professional standards. The professional standards may be insufficient for new and unanticipated circumstances. This is illustrated by the court decision on interpreting fair presentation in the Continental Vending case discussed in Mano et al. (2006). Sometimes “common sense” based on shared social norms conflicts with professional accounting standards, i.e., the accounting standards may be considered unethical in certain contexts. A good historical example is the Continental Vending case discussed in Mano et al. (2006). Another example is the concept of hypernorms in the Sprint Case discussed in Verreault et al. (2004). If hypernorms conflict with authentic professional norms such as IFRS or ISAs, then the auditor would be well advised to go with the “common sense” of the hypernorms of society. This is an important part of professional judgment because the auditor should act in the public interest and it may turn out that the public does not accept the profession’s principles in certain situations (for example, in wartime companies may not be allowed any profits to be made off war production because “war profits” may not be considered ethical when other members of society are sacrificing their lives for the war effort). Meeting the public interest may mean something quite different when times are good vs. when times are bad, or when there is a national emergency. Thus the importance of even very general warrants may vary based on wider social context. For this reason, it is important for the auditor to be sensitized to the effects of social context on financial reporting. This would be the kind of information captured in the explanatory component of audit argumentation as discussed earlier.
End-of- chapter question
The simplest arguments consist of one premise and a conclusion. For example,
Premise: The financial statements are in conformity with Generally Accepted Accounting Principles (GAAP).
Conclusion: The financial statements present fairly.
Question: Do you believe the above reasoning is correct for an auditor? Can you think of examples where it is wrong? Hint: see examples in DeFond et al. (2018).
How could the wording and premises in the above argument be changed so that the conclusion is very likely or even guaranteed to be true if you can assume the premises are true?
