Question 1: The role of professional skepticism in auditing financial statements
Professional skepticism is defined as having an attitude that embodies a questioning mind for auditors, often being alert of cases of fraud or errors in financial statements, and always ensuring that one conducts a critical assessment of the evidence (Mintz & Morris, 2019). Various regulatory bodies assert on the importance of professional skepticism where they insist that auditors should exhibit professional skepticism in planning and performing audits since there are various circumstances that can lead to the material misstatement of financial statements. Auditors can employ professional skepticism in cases where there is audit evidence that contradict each other. There are also situations where auditors can identify documents with questionable reliability used as a basis for inquiry in providing audit evidence. Situations or conditions that indicate the possibilities of fraud also demand professional skepticism by auditors (Mintz & Morris, 2019). As such, professional skepticism will help the auditor to avoid neglecting unusual circumstances or oversimplifying the results or applying inappropriate assumptions. Auditors should ensure that they explicate professional skepticism starting with the time they are assessing the acceptance of their engagements with their clients.
When assessing the acceptance, the auditor should determine whether the client’s management acts with integrity which is an ethical requirement for professionals (Smith, 2018). The auditor should be able to establish whether engaging with the client might place any threat to objective reporting and observation of practice ethics. The auditors should then proceed to use professional skepticism in the performance of risk assessment procedures, where the explanations offered by the management should be backed up by corroborative evidence (Mintz & Morris, 2019). Further, professional skepticism is needed in obtaining audit evidence, where the auditor should be prepared to often question or challenge the management of the sufficiency and reliability of evidence provided, especially in cases that depict risks of fraud. In evaluating evidence, the auditor is supposed to assess the evidence provided critically against any other evidence which might contradict the provided evidence and eventually undermine its appropriateness and sufficiency.
In the case of Imperial Valley bank, the auditors were keen enough to identify some of the risky areas facing the institution as depicted in the planning memo. Bill Stanley through Jacobs, Stanley & Co. did a commendable job in analyzing the situation of Imperial Valley, wherefrom the planning stage he identified various risks associated with the engagement (Mintz & Morris, 2019). Through professional skepticism, the auditor questioned some of the items noted by previous auditors that were risky areas for fraud and misstatements. For instance, the client had been flagged for lack of profitability caused by a high volume of loan losses. The client also had been identified to have been employing poor underwriting procedures which contributed to the losses. Another risky area was the narrow net interest margin that the client operated within, as a result of the bank paying the highest interest rates in the area.
The imperial bank was also identified as having material weaknesses in complying with the regulatory requirements, creating a risk for committing fraud and other misstatements (Mintz & Morris, 2019). Internal controls of the client were marginal at best, which raised questions as to why the management had not issued any reports of them. Prior auditors were not provided with audit evidence, and in their duty to exercise professional skepticism, they had expressed their concerns on the mater. There was also some internal office communication that was flagged by Stanley for potential audit risks. First, it was evident that the auditors were required to exhibit professional skepticism in reviewing loan quality, considering that the 1.25 percent minimum of loans outstanding which a statutory requirement would not suffice for the loan loss reserve (Mintz & Morris, 2019). There was the case of unmodified opinion from previous auditors on the bank’s 2015 financial statements, highlighting a case of capital impairment as declared by the Arizona Department of Corporations which further indicated that there was uncertainty for the bank to continue as a going concern.
Question 2: Role of assessing risk including materiality in an audit
In conducting an audit, every auditor should aim at obtaining reasonable assurance that the financial statements are exempt from material misstatement, which may eventually result in error and fraud. The evidence provided should be sufficient, relevant, and reliable, to avoid cases of material misstatement on the financial statements. The concept of materiality refers to the event where the firm’s financial information is depicted to be material in the way the financial statements were prepared, bearing the potential to alter a reasonable person’s view or opinion (Mintz & Morris, 2019). The financial statements will be considered to be materially misstated in the event they have various forms of misstatements that are important enough to result in the unfair presentation in all material respects as well as in conformity with the applicable financial reporting framework.
In the case of materiality, Stanley was able to identify that the management had failed to provide evidence of the information it was providing to the auditors, yet the auditors had complained about it. Imperial Valley was out of compliance with the regulatory capital requirements, since it had failed to realize the 6:1 ratio of thrift certificates to capital after audit adjustments were done, yet it had earlier reported that it was doing okay with a deficit of only $32,000 despite the audit adjustments indicating that it had undercapitalized by $622,000 with no additional capital contributions made (Mintz & Morris, 2019). The bank was faced with massive losses and further analysis indicated that it is not possible to test the liquidation value of the assets due to most of the assets being loans receivable, in the event that the bank would cease to operate.
Question 3: Evaluation of ethics of the auditors’ decision if they support management’s position and reduce the number of loan write-offs
The client’s position which is the Imperial Valley Community Bank’s management position is that the auditors should reduce the number of loan write-offs. The management believes that their customers were good for the money and they would eventually pay off their loans, considering that most of the loans were made on a timely basis (Mintz & Morris, 2019). Management believes that the auditors should consider the nature of their business, where they offer loans that most commercial banks are unwilling to offer hence a considerable amount of risk should be accepted. According to the AICPA Code of Professional Conduct, auditors should adhere to ethical standards of integrity, objectivity, and independence, public interest, due care, professionalism, and confidentiality (AICPA, 2019). If the auditors went ahead and adhered to the management of the Imperial Valley, they would give an unmodified opinion, which would be against their responsibility to the regulatory authority and the audit firm would also find itself facing a lawsuit for misleading investors. This way, the audit will have acted in an unethical manner, disregarding their call for professionalism as well as integrity (Smith, 2018).
Question 4: Assessment of the Quality of the Audit
As an engagement quality review partner, I am supposed to offer an objective evaluation of the significant judgments that have been made as well as conclusions reached by the auditors in the case. To start with, it is imperative to review the engagement planning especially the risks identified in connection with the client’s acceptance process. The audit demonstrates that the auditors conducted a risk analysis of the client and established there were various material misstatements which were red flags for fraud and errors, yet instead of first questioning these issues the firm went ahead and accepted the engagement. The audit firm was aware from the assessment stage that the management had failed to provide evidence for the information provided to previous auditors even after they complained, and it went ahead and accepted the engagement (Mintz & Morris, 2019). Therefore, from the engagement planning stage, there were financial reporting issues and risks.
The second assessment is on the assessment of audit responses by the audit team as they identified risks in the performance of the procedures required by the standards. In this effect, the auditors made significant strides in pointing out various risks and misstatements in the audit responses by the management, such as the issues of maintaining the 6:1 ratio of thrift certificates to net equity capital. The client provided information that depicted it was within the regulatory requirements, but audit adjustments depicted otherwise. With the audit results, it was highly unlikely that external investors would inject additional capital considering there is a high possibility of continued losses due to highly risky loans extended by the bank. This audit report is therefore of high quality as the audit adjustments depict the true picture of the financial health of the bank. An assessment of the internal controls of the bank depicts that there were material weaknesses in the lending function of the bank. The bank officials who were family members or closely related offered loans on basis of faith since they knew the borrowers, rather than due diligence on the capacity to pay based on collateral or income of the borrowers and credit scores (Mintz & Morris, 2019). The report that there were weaknesses in internal controls which was evident from the fact the firm did not meet the 1.25% general reserve requirement is effective and indicates that the audit was of high quality.
- AICPA. (2019). Code of Professional Conduct. Retrieved 4 December 2019, from https://pub.aicpa.org/codeofconduct/Ethics.aspx#
- Mintz, S., & Morris, R. (2019). Ethical Obligations and Decision Making in Accounting Text and Cases (5th ed.). McGraw-Hill Education.
- Smith, A. (2018). The Theory of Moral Sentiments. La Vergne: Neeland Media LLC.
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