By Phil Cowperthwaite
Illustration: Mike Ellis
Threats of inherent bias in making judgments can be overcome if processes include appropriate safeguards
Professional skepticism and judgment are two hot-button issues in the audit world. Many experienced auditors are finding the mounting questions vexing, with the implied criticism of their judgment process. “I have been auditing for years. My judgments are just fine, thank you very much,” is a common refrain.
This attention to auditor judgment and skepticism comes at the same time as advances in cognitive psychology. There is increased attention on the way our brains are programmed to make judgments: it turns out that making good judgments is not intuitive and is much more difficult than initially realized. Specifically, our brains are programmed to make snap judgments, often based on little evidence and guided by strongly built-in unconscious biases. While the ability to react quickly and decisively may be vital to survival in life and death situations, it is not usually helpful in conducting an audit.
Many larger firms have developed sophisticated strategies for overcoming our unconscious biases and promoting sound processes for making judgments. These methodologies work well in team environments where auditors can question each other’s process and judgments. But the audit team on a micro-entity, defined as a low-risk engagement with client revenue less than $1 million, a small client staff and no onsite CFO engagement, is often one person. It can be a real challenge for one person to overcome the threats of inherent bias in making judgments, but it can be done if your judgment processes include appropriate safeguards.
Inherent unconscious bias in the judgment process
A recent spate of books on unconscious bias in the judgment process (Daniel Kahneman’s Thinking, Fast and Slow, Dan Ariely’s Predictably Irrational, and Richard Thaler and Cass Sunstein’s Nudge) shed light on our conscious and unconscious thinking processes and the challenges in making good judgments. Some of the factors auditors may not be conscious of include:
- The power of first impressions: our brains quickly make unconscious judgments based on first impressions. And first impressions unconsciously colour subsequent thinking, which affects how a person thinks about issues. Unconsciously looking through rose-coloured glasses can inhibit the skeptical attitude that is required in every engagement. Snap judgments based on first impressions and the barest of facts may be an advantage when being chased in the wild by an animal, but they aren’t helpful when facing a difficult issue on an audit such as assessing the ability of an entity to continue as a going concern in a turbulent market.
- Taking the easy route: we unconsciously default to easy judgments. Our brains evaluate situations and, based on our past experiences and recent impressions, unconsciously take the route requiring the least mental effort. It is important to note that easy does not equal lazy; this is just the way the human brain is wired. Unfortunately, unconsciously making easy judgments does not bode well for the auditor facing a new set of circumstances or a complex situation requiring various perspectives.
- Believing what we are told: if first impressions are positive, people are unconsciously inclined to believe what they are subsequently told. While this trait may be a marketer’s dream, it poses a direct threat to an auditor’s skepticism.
- Believing what we want to: we unconsciously discount evidence that contradicts our beliefs. This is a well-understood failing of many investors. Once they believe an investment is a good buy, they will heavily discount any contradicting evidence. The same is true for auditors. Once they head off in one direction, it takes conscious effort to be persuaded to change — even in the face of contradictory evidence.
- The influence of the initial position: the starting point of any decision has a big influence on how people unconsciously view probable outcomes. An auditor’s consideration of a range of outcomes of an estimate varies significantly depending on management’s initial estimate (Kinney, W.R., Jr., and C.M. Haynes, Analytical Procedure Results as Substantive Evidence). If the initial estimate is $10,000, then the auditor may consider a range of $5,000 to $20,000 as reasonable, whereas if that initial estimate is $100,000, then the auditor may consider a range of between $50,000 and $150,000 as reasonable. To avoid this unconscious bias, the auditor should be stepping back to see what the estimate should be — regardless of the starting point provided by management.
These are a number of serious unconscious threats to an auditor’s ability to make good judgments. What auditors are not capable of is changing their very nature. Auditors are human after all and cannot change the basic workings of their brains. What auditors can do is introduce safeguards to protect against unconscious bias. This is also essential to ensure a skeptical attitude. However it’s managed, auditors need to make good judgments on every engagement.
Barriers to making good judgments in micro-entity audits
Larger firms in Canada have developed sophisticated safeguards to shield the judgment process of audit teams from unconscious bias (e.g. Elevating Professional Judgment in Auditing and Accounting: The KPMG Professional Judgment Framework). These mechanisms include:
- using formal decision-making frameworks that result in questioning management’s judgments;
- engaging external experts where necessary; and
- becoming aware of and uncovering bias in auditor judgment at every level in the team hierarchy.
These safeguards are designed primarily for an engagement executed by a team of auditors.
There are, however, a number of complications that make eliminating bias in the judgment process in a micro-entity audit a challenge. The audit team on a micro-entity engagement is typically one person and, in some cases, two people, such as a junior staff person and the engagement partner.
Also, management is often not knowledgeable about accounting and financial reporting, which makes the initial identification of issues all the more difficult. Second guessing one’s own judgment is especially hard when it likely involves unconscious bias. Implementing excessively formal and rigid judgment processes is not conducive to an efficient or effective micro-entity engagement where flexibility is essential.
Develop a process to reduce unconscious bias
The good news is that there are safeguards you can implement in even the smallest audits to significantly reduce the impact of inherent and unconscious bias in judgment.
Safeguards take both time and conscious effort, and they will only work if the professional implements them diligently. The even better news is that the process of conscious decision-making gets easier with practice. Documenting the process, a valuable safeguard in its own right, means you will have complied with the documentation requirements for significant judgments as you make them — an added bonus.
The following 10-step process should help an auditor working on a micro-entity audit reduce bias in making significant judgments:
- Clearly state the issue. Overcome the power of first impressions by clearly stating an issue. This can clarify the problem and allow the auditor to focus attention on the real concern. For example: is the issue one of uncertainty regarding an estimate, or rather the implications of that issue on debt covenants and a possible calling of a demand loan? This is the time to stand back and ex-pand your perspective.
- Document which stakeholders will be affected by the judgment. Get away from the unconscious tendency to take the easy route initially presented. Focus on the more complex picture. Are the stakeholders primarily creditors, management, members and/or the client’s customers? It’s important to understand who could be affected, as groups could have different tolerances for the outcome and have their own biases. For example: in a not-for-profit organization, a modest change in an estimate could result in an unexpected surplus requiring repayment to a funder. In this case, the impact on management and the funder need to be considered.
- Determine the possible outcomes and whether they differ for various stakeholders. Looking at an issue from more than one perspective avoids unconscious influence from the initial position presented. Given the principal stakeholders involved, how will various outcomes be perceived? Think of the impact of various possible outcomes and how they compare to management’s estimate.
- Evaluate the process management has gone through to develop the issue, what evidence it has provided, and what you have done to verify it. This is instinctively done by trained auditors. Unfortunately, it is often the only step auditors perform in making a judgment and is subject to the threat of unconsciously giving inordinate weight to supporting evidence. Consciously review the evidence management has provided. Has it explored a range of options or just looked at one? Are its assumptions reasonable and can you obtain evidence to corroborate them?
- Obtain evidence from other sources and evaluate its quality. Safeguard against the unconscious bias to give greater weight to evidence confirming management’s assertion and less weight to that contradicting it. Have you looked for evidence that refutes management’s assertion and if so, was it persuasive? If not, are you letting your unconscious take the easy route? If you can’t find any evidence at all to refute management’s assertion you should at least document where you looked.
- Determine whether consultation with some-one else is necessary. In most cases in micro-entity audits, consultation will not be needed as the engagements are by definition low risk. If consultation is not necessary when evaluating a significant risk, document why you believe this is the case.
- State and document your conclusion and the impact on your audit. Documentation proves time and again to drive quality judgments and quality audits. A few minutes taken to document your process is time well invested.
- Document why you believe your conclusion to be correct. While it is important to document the outcome you believe is true, it is just as important to document why you disagree with the other outcomes identified. Why, for example, were you not persuaded by evidence you found contrary to the judgment you made? Why were other options not considered or, if they were, why were they discarded? Again, this is a safeguard against unconsciously giving inordinate weight to evidence that supports your case.
- Evaluate the cumulative effect of management’s judgments for evidence of bias. By assessing the combined impact of judgments, you may see evidence of management consistently leaning one way.
- Consider revisiting your judgment in next year’s audit. How well did you do? This will provide feedback on the quality of your judgment process and is a requirement in every recurring audit.
Audits of micro-entities may be low risk by definition, but significant judgments are still necessary and auditors must still approach these engagements with a skeptical attitude. Unconscious biases can have a detrimental impact on auditor judgments. Regardless of the size of the audit team, it is important to have safeguards to protect against these unconscious threats. A rigorous process to help reduce unconscious bias in making judgments is essential in even the smallest of audits.
Phil Cowperthwaite, FCA, is a partner of Cowperthwaite Mehta and a member of the IFAC’s Small and Medium Practices Committee
Technical editor: Ron Salole, vice-president, standards, CICA