Who Rewards Appropriate Levels of Professional Skepticism?

Abstract

The audit profession’s technical and ethical standards require the application of
professional skepticism throughout the financial statement audit process, as auditor skepticism is
essential for detecting financial statement fraud and protecting the investing public. However,
recent research suggests that audit supervisors often punish staff for exercising skepticism,
presenting auditors with an ethical conflict between acting in their own self-interest and acting in
a way that improves audit quality and protects the public. This research also suggests that
supervisors who reward appropriate skeptical behavior, regardless of the outcome, appear to
develop staff that are more likely to detect and convey fraud red flags to their superiors. Building
on this research, we use a case-based survey to identify the characteristics of audit supervisors
(audit seniors and managers) who are more likely to reward appropriate skepticism, even if it
ultimately does not identify a misstatement. We find that trait skepticism, especially suspending
one’s judgment, positively drives the evaluations of professional skepticism in our setting. Also,
we observe that when supervisors believe that their own audit partner will view the skepticism
favorably, they “pay it forward” by rewarding their own staff who engage in skepticism. Our
findings identify the characteristics that audit firms may want to develop and foster in auditors
rising to supervisory levels.

Keywords: fraud red flag, incentives, performance evaluation, professional skepticism, rewards

JEL Classification: M40, M41, M42