Monday 14 July 2014

Corporate Responsibility Reporting (6)

Right lads, let's get serious.

Hopefully by now, we have established that the independence of the Big Four is organised within a system of laws, standards, guidelines and compliance mechanisms which are directed towards financial audit. The AA1000 series and the G3, which don’t pertain to financial audit, don’t extensively thematise independence. The Code and other instruments aligned with it, which do talk about independence in quite a bit of detail, pertain both to assurance and financial audit. 

So we can now look at how independence is entangled with an idea of professionalism. There is a long tradition of political and social thought which considers professionalism a socially integrative force, with a coherent pattern of influence extending outside its occupational specialisms. Does the element of professionalism give the Big Four’s independence, despite its orientation to financial audit, some kind of broader applicability?

Well, objectivity requires the practitioner “not allow bias, conflict of interest or undue influence of others to override professional or business judgments” (IESBA 2005:100.4; cf. IESBA 2005:120.1).  Independence of mind is the “state of mind that permits the expression of a conclusion without being affected by influences that compromise professional judgment, allowing an individual to act with integrity, and exercise objectivity and professional skepticism” (IESBA 2005:290.8). The recursive definition of objectivity by independence, and independence by objectivity, is elaborated outward towards more substantive markers with the mention of professional norms, in the phrases “professional or business judgment(s)” and “professional skepticism.” 

The term professional skepticism appears throughout the IESBA’s Code and the ICAEW Manual as something which ought not to be compromised, but it is never directly discussed.  The discussion of ISA (UK and Ireland) 240 is as follows: “The auditor should maintain an attitude of professional scepticism throughout the audit, recognising the possibility that a material misstatement due to fraud could exist, notwithstanding the auditor’s past experience with the entity about the honesty and integrity of management and those charged with governance.”[1]

In the US, SAS 99 takes a similar approach: “Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence.  The auditor should conduct the engagement with a mindset that recognizes the possibility that a material misstatement due to fraud could be present, regardless of any past experience with the entity and regardless of the auditor’s belief about management’s honesty and integrity [...] in exercising professional skepticism in gathering and evaluating evidence, the members of the audit team should not be satisfied with less than persuasive evidence because of a belief that management is honest.”[2]

These elaborations are reminiscent ICAEW’s more bureaucratic-rationalist formulation of objectivity, as “the state of mind which has regard to all considerations relevant to the task in hand but no other” (q.v.).  Their appeal is to pedantically “doing the job” – that is, to a bureaucratic rationality which rejects inductive opportunism, and the short-cuts offered by networks of social capital, in favour of minute compliance with procedure. 

What manifests locally as a laborious literalism is part of the profession’s collective self-constitution.  In this process a social form is created – the unfailing agent of a stipulated practice  – whose utility should outweigh the aggregate utility of various more pragmatic attitudes in their local contexts.

Shall we be a little Habermassy for a moment? So far, everything suggests that the professionalism of accountancy is a feature of systemic integration only. The steering medium of power, institutionalised in the regulatory standards and organisations that have been mentioned, standardises practitioners in an instrumental-purposive orientation.  Compliance with this professional template facilitates the coordination of action by the other major steering medium, money.  To the extent that different practitioners follow like courses in like situations they facilitate the mediatization of those situations. 

Correspondingly, the social substrate of independence seems to be systemically integrated.  It is no accident that the institutional forms of the independent auditor and corporation emerged coevally.  The Limited Liability Act (1855) capped the potential loss of any shareholder at the amount subscribed for in shares.  Similar legislation soon appeared in the US and Western Europe.  The Joint Stock Companies Act (1844) permitted companies to incorporate without royal charter or special parliamentary provision.  The Act also required that shareholders appoint auditors to arbitrate in the event of insolvency.  Initially, these auditors were drawn from among the shareholders themselves (Strange 1996:136).  As corporations grew larger and more complex, specialist insolvency practitioners diversified their services in order to fill the role.  These two Acts are the institutional foundation for the mediatization of owners’ relations.  In other words, nothing here bestows professional independence with a suggestion of applicability outside the audit of financial statements.  If we left our analysis here, professional skepticism would consist at heart of purposive-instrumental rationality.  The appeal to the “reasonable and informed third party” would simply be to the profit-maximising, risk-minimising subject of economic interests.

But another aspect of professional skepticism remains to be excavated. “An attitude of professional skepticism means the practitioner makes a critical assessment, with a questioning mind, of the validity of evidence obtained and is alert to evidence that contradicts or brings into question the reliability of documents or representations by the responsible party” (IAASB 2005 para 40).  This discussion recapitulates the tendency to discuss the constituents and supports of independence with reference to what they are not.  But there are also some hints here of professional skepticism as an attitude of temperance and restraint. The practitioner is asked to be vigilant against momentary lapses. The practitioner should also not set out to seek contradictory evidence, merely be alert to it. IIASB (2005) continues that the practitioner need not authenticate documents, but should consider “the reliability of the information to be used as evidence, for example photocopies, facsimiles, filmed, digitized or other electronic documents, including consideration of controls over their preparation and maintenance” (para 41).

Other discussions of professional skepticism position it more explicitly as a virtuous mean. It's a Goldilocks thing. Professional skepticism can viewed as the contextually appropriate amount of suspicion. The Canadian CICA manual states that an attitude of professional skepticism “means that the auditor makes a critical assessment with a questioning mind, of the sufficiency and appropriateness of audit evidence obtained and is alert for evidence that contradicts or brings into question the reliability of documents or management representations.  It does not mean the auditor is obsessively sceptical or suspicious” (CICA, 2003, 5090.07).

This notion of moderation and contextual appropriateness is the second aspect of the entanglement of independence and professionalism. It should be understood in relation to the ever-evolving ensemble of inferential techniques used by assurors. Seen in this light, professional independence is the capacity to draw knowledgably upon the precedent set in previous use of an inferential technique, while being alert to the inimical features of the circumstances in which it is applied, and the possible necessity of departing from tradition and forming new precedent.

The term inferential technique requires some unpacking.  Independence presupposes that the assuror is not directly familiar with the subject matter.  It is thus invested in the feasibility of some kind of indirect familiarisation.  For assurance to exist as a commodity, the assuror must have techniques to readily gain reliable knowledge of whatever subject matter for which the market demands assurance.

The techniques available to assurors to organise their investigations in particular areas, and to infer further information, often generalising their findings across larger data populations, have been historically variable.  Block tests, such as the detailed inspection of every transaction within a particular month, were a commonplace audit technique in the late nineteenth century, but now are seldom ever used.

In the audit context, three main trends in inferential familiarisation have taken place over the twentieth century.  The first is the rise in importance of internal controls.  Internal controls consist of management procedures and the measures in place to ensure compliance with them.  To take one example, clarity and precision in the allocation of responsibilities and reporting lines is considered a type of internal control.  The segregation of duties is another.  Supply purchasing may be divided into “initiation (e.g. the works foreman decides the firm needs more lubricating oil), authorisation (the works manager approves the purchase), execution (the buying department order the oil), custody (on arrival the oil is taken in by the goods-in section and passed with appropriate goods-in documentation to the stores department) and recording (the arrival is documented by the goods inward section and the invoice is compared with the original order and goods-in note by the accountants department, and recorded by them in their books)” (Mill champ 2002:87).  By the 1940s, the status of the reporting entity’s internal controls also had assumed great significance in determining the scope and methodology of individual audits.  This remains the case.

The next trend is the rise and partial decline of scientific sampling. According to Power (1997:73-75), statistically precise notions of representativeness first took hold in the 1930s.  However, their incorporation into audit practice was far from straightforward.  Clearly a scientistic idiom could improve the eminence of accounting expertise, but it could also erode the exclusivity of professional judgement, if audit were perceived as mechanistic.  See Gwilliam (1987), Elliott (1983) and Abbott (1988) for more on the relationship between audit and statistical methodology. 

The third and most recent trend is the rise of risk-based methodology.  The 1980s saw a shift in audit from the principle of scientific representativeness to one of selectivity based on risk (Power 1997:76).  An auditor will identify key risk areas on a client-by-client basis – for example, allowance for doubtful accounts, inventory obsolescence, accrued royalties, accrued trade spending, classification of intangibles and useful lives, long-term debt classification and revenue recognition – and concentrate scrutiny in these areas.  An event is considered to be risky as a function of both the likelihood of its occurring or having occurred, and its magnitude, typically formulated financially.  Risk provides a common framework for considering both the value of assurance to the client, and the assuror’s liability.

Each inferential techniques is historically variable in the sense of what assurors do, in the typical consequences of their practice, in the reputation attaching to the technique in various segments of society, and in the legal duty of care associated with it. 

This last point deserves expansion.  For it to be worthwhile to accountants to provide assurance, the general level of liability must not be prohibitively high in relation to the inherent limitations of the techniques at hand.  For example, in the landmark ruling re Kingston Cotton Mill [1896] 2 Ch. 297, the courts decided that it was not the auditor’s duty to take stock to check against management representations which were prima facie unsuspicious.  “An auditor is not bound to be a detective, or [...] to approach his work with suspicion or with a foregone conclusion that there is something wrong.  He is a watch-dog, but not a bloodhound.  He is justified in believing tried servants of the company in whom confidence is placed by the company.” 

Inferential techniques which overlap with threats to independence correspond with particularly fierce negotiations of liability and regulatory responsibility.  For example, SOX now obliges US listed firms to rotate their auditors on a regular basis.  Long-term auditor-client relationships, which arguably make it easier for auditors to gather information, are recognised by this legislation as a threat to independence.  This has specific bearing on the technique of rotational testing, in which auditors work their way rotationally through different client site visits and systemic emphasis over a number of years.  Similarly, consultancy work arguably produces an epistemological advantage which can be carried over into audit.  SOX also proscribes the provision of a variety of consultancy services by auditors.

The question which now arises is whether the professional stewardship of this ensemble of inferential techniques, and its relationships with state, market and socio-cultural system, can be understood as systemically-integrated action, characterised by purposive-instrumental rationality.  My view is that it cannot.  Certainly the audit process exists within an envelope of mediatization, insofar as it aims to optimally prepare the audited organisation for steering by the non-linguistified communication medium of money, in its various institutional forms of taxes, fines, investment, loans and so on.  The negotiation of liability is also subordinate to a system imperative.  To put it bluntly, the more the accountancy profession can reduce its liability through the courts, the more lucrative its monopoly franchise on the statutory audit commodity.  But within these territories circumscribed by steering media, communicative action of various strengths plays a significant role.  In its market relationships, the accountancy profession is engaged in educative and learning processes with each audit client.  In familiarising themselves with internal controls, auditors act communicatively with management and employees.  In testing them, important forms of evidence include oral discussion and confirmation in writing.  On its frontier with the state, the profession defends and reformulates its interests deliberatively through the courts and various consultative forums.  In relation to the socio-cultural system, the profession replenishes its head-count not only by training new accountants, but by socialising them into a tradition of the contextually appropriate exercise of an ensemble of inferential techniques. 

The lifeworld resources which the profession draws upon include a permanent regime of training, career progression involving formal and informal mentoring, a tradition of professional congeniality and discussion, a preoccupation with ethics, as well as a relatively homogeneous pool of cultural and ideological norms. 

As well as the purposive-instrumentally rational subject of economic interests, the Code’s appeal to the “informed and reasonable third party” implies an appeal to an agent of this lifeworld.

Phew! This completes the analysis of professional skepticism. Philosophical skepticism with respect to a proposition concerns more than doubting the proposition’s truth. The philosophical skeptic will not assent that the truth of the proposition is in principle knowable. Philosophical skepticism is more than a variety of contrarianism, since there may be many technical and normative implications which follow from a proposition being knowable or not.  A similar concept can be seen to exist within assurance, inasmuch as techniques of inference are supposed to be able to reduce the probability of misstatement, but never to zero.  

But the modifier “professional” of “professional skepticism” does not indicate that the subject of the Code should be philosophically skeptical in relation to a particular object set characteristic of the profession, or that she should endlessly disperse any aura of indubitability that may emanate from this zone of professional responsibility.  The two main connotations of professional skepticism are rule-based consistency and moderation.  Thus professional skepticism is held in tension between a bureaucratic rationality, which emphasises rules, and a legal rationality, which requires balance between tradition and sensitivity to inimitable contexts, and which sediments a particular history of technological development of inference, and the legal negotiations surrounding it.