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CRITICAL THINKING AND PRINCIPLES-BASED
REASONING: KEY IDEAS
As indicated in Chapter 3, professional rules of conduct follow a principles-based reasoning process in which a few key principles drive the logic of all the rules and their implementation. This approach has been so successful that accounting standard setters such
the International Accounting Standards Board (IASB) are planning to follow a similar
approach in establishing future International Financial Reporting Standards (IFRSs). The
purpose of a conceptual framework is to guide the development of standards consistent
with the framework. Consistency is important in logic because lack of consistency can
create contradictions, and contradictions violate the most basic principles of logic (e.g.,
for those who have taken a logic course, the principles of identity, excluded middle, and
contradiction are violated). Use of principles to guide standard setting means more
detailed rules can be overridden by the principles. If such principles are placed at the
beginning of a reasoning process, then we get top-down reasoning. In top-down reasoning, the most important reasons are listed first, followed by the less important ones. Any
conflict among reasons is resolved by giving priority to higher-level reasons. However,
there are a lot of factors that come into play in analyzing such reasoning. Perhaps the
most complex factor is the use of natural language in the reasoning process. Natural
languages, such as English or Mandarin, are quite versatile and have allowed people to
develop societies of amazing complexity. Many fields of study relate to some aspect of
language, including the studies of literature, linguistics, philosophy, and computer science,
to name a few. Auditors reason using natural language in their work. Rather than attempting to summarize what the humanities and social sciences contribute to natural language
reasoning, we will use a simple example to get at the key ideas.
Reasoning in natural language means being able to show or demonstrate that a statement is true. This is achieved by argument. An argument is a series of statements that
purport to support the truth of another statement, the conclusion (claim). Statements that
purport to establish the conclusion are referred to as the premises of the argument. This
is how one rationally justifies a conclusion or claim in natural language. Within the auditor’s report, the written conclusion, the audit opinion, should be justified in statements or
“argumentation,” in which reasoning actively organizes thoughts to support the conclusion.
Such justification should be provided in the audit file. The auditor, in fact, claims that this
is the case when he or she states in the report, “We believe that the audit evidence we have
obtained is sufficient and appropriate to provide a basis for the audit opinion.”
There is a logic to natural language reasoning and it boils down to the meaning of
words and how they are used in everyday reasoning. In essence, reasoning relates to how
a series of statements (the premise statements) work together to support another statement
called the conclusion. For example, if you tell someone that you are living in Canada,
chances are good that they will assume that you like ice hockey. What is their reasoning?
They might conclude you like hockey based on the fact that you live in Canada. Maybe
their view has been shaped by the popularity of “Hockey Night in Canada” broadcasts,
their recollections of the passion Canadians show when their team plays in the Olympics,
World Hockey Championships, or Canadians’ reactions to a Canadian NHL team winning
the Stanley Cup. All of these give the general impression that many, if not most, Canadians
are devoted hockey fans. So, someone could be forgiven for thinking that all Canadians
like hockey. This reasoning can be summarized in a two-statement argument, as follows.
1
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Premise: You live in Canada.
Conclusion: You like hockey.
Is this good reasoning? Philosophers say that it could be, but it depends on the conventions, social norms, and shared knowledge you have with the person with whom you
interact. Right away, you can see the complexity developing. You have to start making some
assumptions about the person you are dealing with and the context of the situation. For
example, to confirm their reasoning on this, you would have to assume the other party
knows the English language. In Chapter 19 (available on Connect), the concept of the
representativeness heuristic, from psychology, is introduced. This heuristic or rule of thumb
of judgment is commonly used in estimating a probability that event A originates from
process B. Such probabilities are typically evaluated by the degree to which A is representative of B; that is, by the degree to which A resembles B. It is the basis for stereotype judgments about groups of people. In this case, someone who sees Canada mainly in the context
of hockey games may very well have a stereotype that all Canadians are passionate about
hockey. They could find the above argument very convincing!
Moving beyond heuristics, however, philosophers have come up with some useful tools
to analyze reasoning. One of the most powerful is the syllogism, or the concept of the
“three-statement argument” for analyzing at least key parts of any reasoning. The above
argument is not a syllogism as it lacks a key statement. What could that key statement be?
We have a conclusion and one premise statement, which we can classify as an observation
or data or evidence about you (yes, this is like audit evidence), but we do not have a guiding principle or rule that we could say justifies the conclusion. A premise or statement
playing such a role has a special name in logic: “warrant” premise. If, through shared
knowledge and convention, both parties think the warrant premise is obvious, then there
is no need to specify it. You can leave the statement implicit. On the other hand, if you
want your stated reasons to really justify the claim made in your conclusion, philosophers
say that your documented reasoning should include the warrant. This is especially true if
your unstated warrant (or data or conclusion, for that matter) is not obvious to everyone
else. Documentation, such as the working papers in audit files, is one way to be accountable for the reasoning supporting your claim or conclusion. The warrant is so important
that philosophers call it the “major” premise in a syllogism. It is considered more important
than the data premise. Can you guess what the other person was using as a major premise
in the previous syllogistic reasoning? Here is a second argument with all three statements
of the syllogism now made explicit.
Warrant (premise 1): All who live in Canada like hockey.
Data (premise 2): You live in Canada.
Conclusion (claim): You like hockey.
Are you satisfied by the above reasoning (the premises)? If you are not satisfied, there
are two significant features within natural language reasoning that might help in evaluating
whether the reasons are “good enough.” One such feature is the inductive probability. The
truthfulness of an audit opinion is dependent on the truthfulness of other statements
(premises). If the premises are rationally acceptable, and the argument has logical strength,
then there is a sound argument. The logical strength of the link between the premises and
the conclusion is known as the inductive probability of the argument.1 The inductive probability applies to the argument as a whole (not unlike the overall evaluation given in an
audit opinion).
The inductive probability can be assessed through serious consideration of the meaning of the statements and their relationships to the conclusion. A common test is as follows:
Assuming that the premises of the argument are true, what is the probability that the
conclusion is true? Note that you are not asking IF the premises are true, but instead you
are assuming that they are true. If you cannot imagine any way that the conclusion could
1
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B. Skyrms, Choice and Chance, 3rd ed. (California: University of California at Irvine, 1986), p. 11.
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be false while the premises are true (you should think of this as a type of thought
experiment), then you should conclude that the inductive probability is 1.00.
What is the inductive probability of the above three-statement argument (i.e., the
second argument shown)? It is 1.00. If you assume that the first two premises are true,
then the conclusion must be true with a probability of 1.00, using the above test. You
are forced to reach this conclusion because of the quantifier “all” used in the first premise. “All” means without exceptions, and that includes “you” if you live in Canada. What,
then, is the inductive probability of the first argument, which has only two statements?
Its inductive probability is less than 1.00 if we can imagine at least one Canadian who
does not like hockey.
Inductive probability of 1.00 means that you have ideal logic in your natural language
reasoning. Philosophers call this type of logic deduction. Note that in the world of deductive reasoning there is no uncertainty. It is the same logic used in mathematics and the
inner workings of logic circuits in computers. It is ideal knowledge; the ancient philosophers referred to deductively obtained knowledge as wisdom. If, on the other hand, you
can imagine that the conclusion might be false while the premises are true, then the inductive probability becomes less than 1.00, and the resulting logic is called induction. Thus,
the first argument shown uses induction, and the argument itself is referred to as an inductive argument. However, the second argument uses deduction, and the argument itself is
referred to as a deductive argument. Note that a deductive argument requires a more complete specification of the premises relative to the counterpart inductive argument. Perhaps
this is one the reasons the ancients referred to deduction as “wisdom.” But that is not all
there is to the analysis; the specific words used in a statement and their meanings also
affect the logic.
Most natural language reasoning is inductive in spite of the fact that it cannot be called
“wisdom.” The world seems to function on induction; however, distinguishing between
high inductive probability reasons and low inductive probability reasons is useful. Good
reasoning should have fairly high inductive probability.
We can make our earlier sample argument inductive by simply changing one word in
the warrant, so that it reads as follows:
(revised) Warrant: Most people in Canada like hockey.
With this warrant, you should now be able to convince yourself that the inductive
probability (IP) is less than 1.00. And if you changed the warrant further to read, “Few in
Canada like hockey,” your IP plummets. This change illustrates how crucial the specific
words used in your reasoning are, and how significant they are to influencing its strength.
Be careful in the wordings you select when providing your reasons! IP relates to the logic
of the reasoning. The higher the IP of your reasons, the better the reasons are, all else
being equal.
But that is only part of the analysis of the reasons, or premises. In the real world, all
else is not necessarily equal. To complete our analysis of reasoning, we also need to incorporate the epistemic probability (EP) of the reasons; the second of the two tools for analyzing reasoning, as was mentioned earlier.
You might be troubled by the analysis up to this point because we have ignored
whether the reasons are true or not. To assess IP, you assume that the premises are true,
but how do we know that they are true? You do not have to know for certain; you just
need to have some idea of whether the premise is true. This is where your background
knowledge of the world comes into play in analyzing an argument. EP captures the concept
of the certainty of the truth of the premise in relation to the real world; in other words,
how well does the premise reflect reality? This is what is meant by the empirical question,
“What is the chance that the premise is true?”. The EP concept captures the degree of
empirical truth.
For those of you who were dissatisfied by the original argument given, chances are
that this was due to your disagreement with its major premise that all who live in Canada
like hockey. And the reason you disagreed with it is likely because you know someone in
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Canada who does not like hockey, making it difficult to accept this premise. You would
like to see it watered down to something like, “Most people in Canada like hockey,” or
even, “Some people in Canada like hockey.” Note that here we are dealing with only one
word in our statement. In logic, these are called quantifiers, and they help establish the
reach of the warrant. This illustrates that the choice of even a single, word within our
wording can greatly affect the strength of the reasoning. Language can be slippery! That
means we have to take care in specifying our reasoning.
Let us say, for the sake of argument, that it is true that 80% of people living in Canada
like hockey. Knowing this, what is the EP of the statement that all people in Canada like
hockey? We would have to say that the words do not match the empirics, and so the EP
of this original warrant is below 100%. The same would be true of the EP of the premises
“No one in Canada likes hockey” or “Few in Canada like hockey” because these statements,
used as warrants, do not suitably match the empirical knowledge that 80% in Canada do
like hockey. This illustrates that, ideally, our warrants should be statements that conform
as closely as possible to our state of knowledge about the world.
The principle that the language of our warrants should match the true nature of the
subject of the warrant as closely as possible applies to all premises in our reasoning.
However, this is less of a problem for data premises because data premises usually refer to
facts, which are verifiable and, thus, less controversial. For example, data premise EPs can
frequently be controlled by the amount of audit evidence gathered. In fact, the audit assurance concept provides a measure of the EP associated with the data we call audit evidence.
Hence, in audit engagements, data premises usually have high EPs, as is required by the
Canadian Auditing Standards (CASs). There is a lot of authoritative guidance concerning
this. In auditing, it is rather the major premises (warrants) that are problematic. You can
view the warrant premise as the major principle in reasoning, since it helps explain why
the data premise is relevant. However, you also want the warrant premise to be as true
(high EP) as possible. Ideally, all premises are true with probability 1.00, and with an IP
that is also 1.00. It is in conjunction with true premises that deduction reflects wisdom
concerning a conclusion, such as an audit opinion. Hopefully, now you can better appreciate why, when we put reasoning in standard form—first the warrant, then the data premise,
and then the conclusion—we get top-down reasoning. We get principles-based reasoning
also, if the warrant is also based on a principle.
Now that we know the elements of good reasoning, how do we put them together to
evaluate the reasons? An auditor is mostly interested in the truthfulness of the conclusion,
in the form of the audit opinion—the EP of the audit opinion. The EP of any conclusion
is a function of the truthfulness of the premises used in the reasoning and the IP of the
specific reasoning as stated by the auditor. If the premises are 100% true, then the EP equals
the IP.2 Note, however, that only the auditor and those who review the audit file (such as
in a court of law or an accounting oversight board) can directly assess the EP of the auditor’s conclusion, the audit report. Most users need to rely on the wording of the report and
an implicit appeal to expert opinion (or other authority) argumentation.3
For reasoning to be good, it should be “sound” with respect to its subject matter (its
contents) and to its form (structure). Reasoning is sound with respect to its subject matter
if all its component statements are true (i.e., the EP of the premises is 1.00), which is
dependent on the arguer’s knowledge of the field the argument deals with.
Reasoning is sound with respect to its form (validity) if its logical structure is appropriate for the burden of proof in the situation (i.e., has appropriately high inductive probability). This aspect of soundness is the focus of logic. In some cases, deductive logic is
required (e.g., mathematical or logical theorems). However, in most practical situations,
including auditing, inductive proof (i.e., an acceptable level of IP below 1.00) is sufficient.
Accounting and auditing deal with a world of uncertainties, and inductive argumentation
is the dominant one. But how high or low can the EP of the audit conclusion (opinion) be
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2
Skyrms, Choice, 1986, pp. 15–18.
3
D. Walton, The New Dialectic: Conversational Context of Arguments (Toronto: University of Toronto Press, 1998), pp. 56–57.
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and still appropriately meet the auditor’s social role? Audit standards claim that the auditor
provides “reasonable” assurance that the financial statements are free of material misstatement and present fairly. From a reasoning perspective, fair presentation means, in part,
being as precise in the reasoning and statements as the arguer’s knowledge allows.
There is frequently a trade-off between the IP of the reasoning and the EP of the
reasons. Remember that IP applies to the entire reasoning process (“If the premises are
true what is the chance the conclusion is true?”). EP applies to the statement, and, therefore,
the warrant has an EP and the data statement has an EP. What we and the auditor are
interested in is the EP of the audit opinion. How do you get that? If you know the rest of
the EPs and you know the IP, then you can think of the EP of the conclusion as being a
function of the IP and EP of the premises. This is the way to assess the strength of the
reasoning, or to determine how well the conclusion is supported by the reasons. To illustrate simply, we will represent the EP of the reasoned conclusion as a product of the IP
and EPs as follows:
EP (conclusion) 5 IP 3 EP of premise 1 3 EP of premise 2
This roughly corresponds to the analysis required, and it focuses on the important
thing, which is the interaction of IP and EPs of the premises. This is a straightforward way
to capture the meaning of language in the statements used. For example, we noted that
when “all” was used in the wording of the warrant, then IP was equal to 1.00 for that set
of statements. EP analysis, on the other hand, involves the need to take into account the
correspondence of each premise to the real world. If 80% is the real probability, but we
only have a vague idea as to its value, we use language to communicate this uncertainty as
clearly as possible; critical thinking and logic are very concerned with the clarity of the
communication. Thus, saying that “all” like hockey when 80% is more realistic is misleading, so the EP is below 1.00. “Most” corresponds more closely to the facts and, thus, would
have EP close to 1.00. Note that “most” cannot have higher EP than “80%” because 80%
is known for certain. The 80% warrant is the only that can have EP of 1.00 because this
wording exactly reflects the reality. So, the warrant with “most” has EP somewhat less than
1.00, and the warrant with “some” has even lower EP because it is not as accurate a reflection on of reality.
Now, let us get back to the original argument and combine the EPs with the IP. The
IP when using “all” in the premise is 1.00. But the EP of “all” is not true, although one
might interpret it as, say, 80% correct. So, an estimate of the EP of conclusion of the original
argument is IP 3 EPs 5 1.00 3 0.8 3 1.00 5 0.8, where IP 5 1.00, EP of warrant (with
“all”) is 0.8, and EP of data premise 5 1.00.
Normally, the real action in analyzing reasoning is the trade off between the IP of the
argument and the EP of the warrant. For example, if the warrant were stated as “most
people in Canada like hockey” then the IP goes down to about 0.8, because the conclusion
that “you like hockey” based on this argument corresponds to what we mean by “most.”
It is very important point to consider what would happen if we changed the wording
of the conclusion to correspond to what we really know. What if we had the following
argument:
Warrant: 80% of people in Canada like hockey.
Data Premise: You live in Canada.
Conclusion: The chance that you like hockey is 80%.
The IP of this argument is back to 1.00. (Note that if the conclusion of this argument
were stated as “you like hockey” then the IP would be only 80%. In other words, the
uncertainty is either made explicit in the argument or, if it is not, the strength of the argument is weakened. This is another illustration of the importance of relevant words in
affecting the strength of the reasoning.). The EP of warrant is 1.00, the EP that you live in
Canada is 1.00 (we have assumed throughout this appendix that you are not lying or hallucinating, and, therefore, when you say you live in Canada you actually do so—truly
skeptical philosophers consider such issues). Thus, the above EP of conclusion, based on
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the argument, is now 1 3 1 3 1 5 1.00. Note how this was achieved: Be as precise in your
wording of the reasons as is justified by your knowledge, and aim to maximize both IP of
argument and EP of premises.
High IP means giving a conclusion that does not go beyond the premises; it means
what it says. For example, if we used the warrant “Few people in Thailand like hockey,”
you would ask, with justification, “What does that have to do with your liking hockey?”
This is an example of an irrelevant premise in an argument. Similarly, if you used the warrant “No people in Canada like hockey,” not only is the warrant false but your conclusion
contradicts this warrant. These are examples of bad reasoning. To avoid bad reasoning,
think ahead to the claim or conclusion you want to make, and identify the more general
principles and concepts you can relate to this conclusion.
We have introduced the ethical and legal concepts to help identify these principles.
Your financial accounting courses provide additional principles. Finally, the textbook gives
more audit-specific reasoning. But remember that in practice arguments are more complex
than syllogisms. Audit arguments need to consider several warrants and to rank them in
a hierarchy. However, most audit issues seem to be reducible to a few general principles.
At the end of this section, a hierarchy of principles in financial statement auditing is outlined. Standards alone have not yet identified sufficiently clarified principles. Standards,
like the profession itself, are a work in progress.
Another thing to note about the last argument is that its conclusion contains a great
deal of uncertainty about your attitude to hockey. That is because that conclusion is based
on the reasoning given. You, personally, know what your attitude is toward hockey, but
other people need to be convinced, and that is why the argument is given. An auditor is
in a similar situation, trying to convince others (financial statement users) that the financial
reporting presents fairly. That is why an auditor needs to develop an argument based on
the audit work (data premise). The issues associated with this fundamental audit argument
are developed further in this appendix and throughout the text.
Suggested Hierarchy of Principles in Audit of Financial Statements
The goal is to serve the public interest: For example, one way of doing so is to reduce the
risk of cheating capital providers via financial reporting. (Cheating via financial reporting
is defined in Appendix 1B.)
I.
II.
III.
IV.
V.
Principles of ethics (highest-level principles)
Conceptual framework of financial reporting and related accounting standards
Principles of auditing
Audit evidence
Reach a conclusion on financial reporting (a fairness of presentation reporting framework requires the most complex argumentation in auditing).
EXAMPLE OF CRITICAL THINKING, INTEGRATING
ACCOUNTING AND AUDITING
The auditor’s unqualified report claims that the financial statements “present fairly” in
conformity with Canadian generally accepted accounting principles (GAAP). Note that this
is a claim the auditor makes and, therefore, he or she is fully responsible for being able to
justify this claim if challenged. Note that merely citing references to the Handbook may
not be sufficient to support such a claim, since the CICA Handbook does not define fairness of presentation but only provides guidance on GAAP and generally accepted auditing
standards (GAAS).
How do we know then when this claim is justified? As you will see, the text is devoted
to the topic of gathering sufficient appropriate evidence to help support this claim. However,
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you will also need to make use of the GAAP that you learned in your accounting courses
as part of the justification. Furthermore, you need to consider other issues, such as the role
of ethics, and you may need to consider whether the hidden assumptions of accounting
theory apply in the circumstances in order to fully support this claim from a criticalthinking perspective. Proper accounting depends on the legal, cultural, and regulatory
aspects of the environment that can affect the economics of the auditee. Critical thinking
reminds auditors to consider these broader aspects of financial reporting.
You can think of the accounting issues in auditing as consisting of two basic parts:
(1) the financial reporting in conformity with GAAP, and (2) the financial reporting that
is fairly presented. Historically, most auditors assumed that if sufficient appropriate evidence showed that the financial statements were within a material difference of GAAP
numbers, then an unqualified opinion was justified. However, as accounting standards
become more “principles based” and accounting standard setters put more focus on the
meaning of “present fairly,” auditors need to focus on fairness of presentation within GAAP.
In other words, there is increasing appreciation that not all GAAP will result in fair presentation in all circumstances. Auditors are expected, instead, to make decisions about the
proper application of GAAP in the circumstances. And if GAAP is vague on an issue, the
auditor’s critical thinking is further complicated.
Auditing and accounting standards are becoming more integrated, but the process of
integration is not yet complete. In the past, the two sets of standards developed independently of one another, thereby creating two sets of fairly independent criteria, or two professional “silos” of knowledge. This silo effect has been reflected in your courses—you
probably have taken courses in financial accounting and separate ones in auditing. This
silo effect explains why there are some inconsistencies between accounting and auditing.
For example, some argue that there are differences between accounting and auditing materialities, and some wonder why auditing is risk based while accounting is not, even though
each has their own set of uncertainties. There are also some important differences between
the two in basic qualitative criteria. The four principal qualitative characteristics of financial
reporting under CICA Accounting Handbook (Part II), paragraph 1000.18, are understandability, relevance, reliability, and comparability. In contrast, the assurance section, 5025.36,
of the CICA Handbook lists five qualitative characteristics: relevance, reliability, neutrality,
understandability, and completeness.
Under existing standards, the auditor is assumed to use something like critical thinking
(what the profession has historically referred to as “professional judgment”) to justify fairness of presentation in the circumstances. For example, the completeness concept of section
5025 does not seem to be quite captured by any of the concepts of paragraph 1000.18. So,
does this mean that fair presentation incorporates the completeness concept in financial
reporting? Current standards and conceptual frameworks give no definite answer.
As auditing and accounting reasoning become increasingly integrated, it is also
becoming evident that the fairness of presentation concept needs clarification. For example, fairness might refer to the completeness of disclosure, to the appropriateness of the
accounting in the circumstances, or to how well the accounting deals with the disclosure
of accounting estimation uncertainties of CAS 540 (covered in depth in Chapter 19,
Part I). These different concepts illustrate the importance of being aware of different
perspectives on an issue.
These issues suggest an important aspect of critical thinking in public accounting—that
auditor judgments about accounting uncertainties can have a big impact on what is considered fair presentation. Audit judgments will need to be integrated with accounting judgments in order to justify the auditor’s report. Also relevant to critical thinking concepts,
the following important warrant needs to be considered in auditor justification:
Warrant on integrated critical thinking for auditors with regard to accounting
uncertainties: The degree of uncertainty with respect to going concern, contingencies, and
other accounting estimates affects not only the audit report but also the proper form of
accounting disclosure.
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Note that this warrant does not exist in the CICA Handbook. It is one that a critically
thinking auditor would need to consider in deciding if proposed disclosures by a client
present fairly. Critical thinking is the type of thinking needed for the increasing demands
in current audit environment for higher quality in financial reporting.
In deciding on the degree of acceptable uncertainties for specific disclosures, auditors
need to consider a very important issue in their critical thinking—the “self-fulfilling
prophecy.” This refers to the fact that if the auditor were to insist on disclosure of goingconcern risks (or even for contingencies, such as lawsuits) then the mere act of disclosing
can cause the bad outcome that is disclosed, for example, by creating financing problems
for the company and thereby pushing it over the brink into failure (thus, a self-fulfilling
prophecy). The client might even sue the auditor if the disclosure is perceived as causing
the failure. For this reason, auditors have some reluctance in disclosing these problems.
However, the self-fulfilling prophecy problem looks at the issue of going-concern disclosure from only one perspective—that of management. What about the perspective of
prospective investors who are the ones relied on to prevent the company from going under?
Do they need to be appropriately informed of the risks of their potential investment? The
existence of these two perspectives creates an ethical dilemma for the auditor because both
need to be considered in deciding on the amount of disclosure that results in fair presentation for all parties concerned. Thus, focusing only on the self-fulfilling prophecy problem
is not true critical thinking. Similar issues arise whenever an accounting standard is argued
as having harmful effects on particular industries (e.g., the enormous resistance put up by
high-tech companies against the expensing of stock option compensation). It is usually
better to have such issues sorted out at the standard-setting level within accounting standards. But as in the case of going-concern problems, if the standard setters have not yet
resolved this, then the burden is left on the practising auditor to sort this out within the
context of a specific engagement. This is when critical thinking becomes very important
and the basis for documentation in the audit files. Such documentation of critical thinking
can be useful in showing due care in case the auditor’s judgment is ever questioned in court
or by the Canadian Public Accountability Board (CPAB).
Have auditors been doing a good job of implementing a critical-thinking perspective
in the case of going-concern problems? You be the judge. Studies have shown that half
of audited companies that fail did not have any indication of going-concern problems in
the immediately preceding audited financial statements. If you invested in a company
that failed within a few months of your investment, and there was no indication of problems in its audited financial statements, would you consider those financial statements
as fairly presented (e.g., think back to the Thai restaurant example from Chapter 1)?
Would you consider them to have “high” assurance that the financial statements are not
misleading? Keep in mind that when a company fails the actual realized values for its
assets are usually pervasively materially different from what was reported in the financial
statements. So when auditors fail to detect going-concern problems 50% of the time, are
they providing high assurance that there are no material misstatements for the failing
companies? These are the types of questions a critical-thinking auditor needs to ask.
REVIEW CHECKPOINTS
3A-1 Are auditors providing high assurance when
they fail to disclose going-concern problems
for failing companies?
3A-2 What is wrong with the self-fulfilling-prophecy
argument from the auditor’s perspective?
3A-3 Identify the perspectives possible and the
resulting arguments regarding the expensing of
stock option compensation.
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3A-4 How does the auditor know if the disclosure of
going-concern problems is complete, that is
what criteria tell the auditor that the client
needs to disclose going-concern problems?
3A-5 What do you think fair presentation should
mean, in addition to not being materially
misstated from a GAAP number? Can you
defend your decision to the rest of the class?
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9
Objectivity versus Independence
Another issue we will consider here is the relationship of the more traditional concepts
of objectivity and independence to critical thinking. A competent auditor needs to collect
and evaluate audit evidence in an impartial way. He or she must be convinced by the facts
of the situation. This is what seeking the truth means in critical thinking. The part of
critical thinking that considers other perspectives on an issue is also part of being impartial. Being aware of others perspectives does not mean you approve of that perspective.
For example, later you will learn that sometimes auditors need to “think like a crook” in
order to detect deceptions in financial reporting. This does not mean the auditor approves
of the way the crook is thinking. What it does mean is that the auditor will anticipate
what ways a crook might try to deceive and, therefore, the best procedures to detect these
activities.
This attitude of impartiality is what we call being objective. Objectivity is a state of
mind. Evidence of it is apparent in the form of the quality of critical thinking that is
documented in the audit files. Independence is a precondition of objectivity.
Independence in appearance is an indication to third parties of independence in fact.
Impairment of independence threatens the perceived objectivity and, therefore, the perceived quality of critical thinking (e.g., the thinking may be viewed as biased). The
quality of the critical thinking affects the quality of the audit and the audited financial
statements.
MORE ON ARGUMENTATION AND LOGIC
Logic is the study of reasoning. Reasoning is not the same as thinking, however. Thinking
includes things like daydreaming and playing tennis, whereas reasoning is actively organizing thoughts to either support a conclusion or provide an explanation. When reasoning is expressed in statements, it is called an argument. In particular, an argument consists
of a set of statements, one or more of which support (or provide reasons for) another
statement called the conclusion. The truthfulness of a conclusion (e.g., an audit opinion)
is dependent on the truthfulness of the other statements (reasons, or in philosophy frequently referred to as premises). If the premises are rationally acceptable and the argument has logical strength, then we have a sound argument. The strength of the link
between the premises and the conclusion is the central issue in the study of logic. This
strength can be measured by the IP of an argument, which is the probability the conclusion is true if the premises are true. Inductive probabilities apply to the entire
argument.
The auditor, however, is usually interested in the truthfulness of the conclusion
itself. This probability is referred to as the EP. EP is based on our stock of knowledge,
which, in turn, influences the strength of our argument. In particular, the epistemic
probability is a function of the truthfulness of the premises used in the argument, and
the inductive probability of the argument itself. If the premises can be assumed to be
100% true, then EP 5 IP. In this sense, the stronger the argument is, the stronger the
conclusion is.
Since the central problem in auditing is the strength of the auditor’s conclusion as
reflected in his or her opinion, it should immediately be apparent why argumentation is
so critical to auditing. The audit opinion, if it is to be justified, should be the conclusion
of an audit argument incorporating moral reasoning as well as reasoning with the evidence
gathered in the audit.
As in biomedical ethics, informal logic in the form of critical thinking appears to be
a good general reasoning model for supporting audit conclusions. Critical thinking also
dominates in law, other professions, and, in fact, in everyday reasoning. Perhaps it is for
this reason that philosophy has recently shown increased interest in critical thinking and
that it is rapidly evolving as a specialized branch of logic.
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Informal logic is the primary means of justifying audit conclusions. This is true regardless of whether the conclusion relates to ethical issues involving value judgments on people
or purely factual ones.
Of course, the overall audit conclusion should be consistent with the audit opinion
and supported by the auditor’s entire argument. The auditor’s argument should be
reflected in the audit working papers. The overall audit argument is a complex argument
with some premises supporting an intermediate conclusion (e.g., that inventory is fairly
presented), and the intermediate conclusions then become premises in the next step of
argumentation. Thus, each of the intermediate steps of reasoning that are linked together
to form a complex argument can be an argument in its own right. Ethical arguments are
thus intermediate arguments that help support the audit opinion. Generally, audit evidence is used to form auditor beliefs about fairness of presentation, and decisions as to
auditor actions, such as the wording of the opinion, are ethical decisions. Ethical reasoning is, thus, part of the complex audit argumentation that is needed to justify the audit
opinion. The complexity of ethical argumentation in auditing should be evident, for
example, from the boxes and discussion in the chapter related to independence and
objectivity.
Justification is generally viewed in philosophy as an evaluation of how a conclusion
was reached. This is usually done by looking at the reasons offered. There are two basic
philosophies to justification: coherentism and foundationalism. Foundationalism focuses
on individual beliefs as the ultimate source of justification, whereas coherentism looks
at whole systems of belief for justification. Critical thinking, which uses a pluralistic
approach, relies on a coherence theory for justification. As a starting point, critical thinking uses social norms that are accepted without recourse to other judgments. These
initial norms must, however, cohere with one another. This approach is dialectical in the
sense that justification is viewed as a discourse among the affected parties. In dialectic,
the starting points of justification are the premises conducted by the participants, followed by a search for conclusions that can be derived from the agreed-to premises.
Experience, background knowledge, and character, as well as general principles are
brought to bear in deciding how to resolve ethical issues within the dialectical
framework.
A coherent approach is a combination of inductive (reasoning from the particular
to the general) and deductive approaches (deriving particulars from the most general
assertions or principles). As in argumentation, a deductive approach has traditionally
been promoted as the best model for justification. For example, particular judgments
may be derivable from rules, which, in turn, are derivable from principles. In practice,
however, combining deductive and inductive approaches using different principles,
rules, theories, and judgments, depending on the circumstances, results in a system
more amenable to the dialectical framework, where not all premises may be acceptable to all parties. Thus, the concept of coherentism better captures the justification
needed to help resolve the conflicts of interest that can arise in ethical dialectics. As
a famous ethics philosopher, J. Rawls, has noted, justification is a “matter of mutual
support of many considerations, everything fitting together into one coherent whole.”
Principles in this context are more general guides that leave considerable room for
judgment in specific cases that provide substantive guidance for the development of
more detailed rules and policies. Principles, thus, are major reasons to be used in an
audit argument.4
We will summarize this discussion of critical thinking and logic by employing concepts
used in an argumentation model (Exhibit 3A–1) developed by philosopher Stephen
Toulmin. He has constructed a model that can be applied to any form of reasoning,
4
smi51414_app3A.indd 10
W. C. Booth, G. G. Colomb, and J. M. Williams. The Craft of Research (Chicago: University of Chicago Press, 1995), p. 145.
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Framework for Critical Thinking
11
Toulmin’s Argumentation Model
In narrative form, the model shows that “given grounds G, one may appeal to warrant W (which
rests on backing B) to justify the claim, C— or, at any rate, the presumption (Q) of C in the absence
of some specific rebuttal or disqualification, R.
Backing
B
Warrant
W
Qualifier
G
Q
Grounds
C
Claim
R
Rebuttal
The terms used in the model are described as follows:
• Claim—assertions put forward for general acceptance (the opinion or conclusion)
• Grounds—generally accepted and relevant “facts” on which the claim is based (the evidence)
• Warrants—general laws, rules, or principles making these facts relevant to the claim (the rationale/
criteria supporting the claim)
• Backing—support making explicit the body of experience relied on to establish the trustworthiness
of the warrants presented (the authorities supporting the rationale/criteria)
• Qualifiers—phrases showing what kind of and degree of reliance is to be placed on the
conclusions, given the arguments available to support them. These consist of adverbs and
adverbial phrases, that is, necessarily, certainly, presumably, in all probability, very likely, very
possibly, apparently, and so on.
• Rebuttals—extraordinary or exceptional circumstances that might undermine the force of the
supporting arguments
including legal reasoning, argumentation in the sciences, arguing about the arts, and ethical
reasoning. The major contribution of the model is to identify the major elements of argument structure.
This model was first proposed for use in auditing in a 1991 Canadian Institute of
Chartered Accountants (CICA) research study authored by Barnes. An illustration of it
would be applied to a financial statement audit is given in Exhibit 3A–2. We will use the
model as a cornerstone of our critical-thinking framework.
To further illustrate the universal features of this model, we simplify it to a standard
form involving three statements called a syllogism. Depending on what the statements actually, say we can have an infinite number of syllogisms. Syllogisms, while deceptively simple
looking, can be quite complex, depending on the meaning of each statement. Hence, syllogisms can capture the essence of many critical thinking features that we briefly review
in the next few pages.
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EXHIBIT 3A–2
Barnes Example Three (as modified)
A FINANCIAL STATEMENT AUDIT LOGIC MODEL
B
W
The accumulated experience of accounting and
auditing practitioners (as codified in the CICA
Handbook and other authoritative sources) has
demonstrated that:
Annual financial statements which reflect the assets,
liabilities, equity, and transactions of the company,
presented in accordance with generally accepted
accounting principles, can be said to present fairly
the company’s financial position, operating results,
and changes in financial position.
Q
Audit evidence and auditor
accounting knowledge provide
high assurance that user needs in the
circumstances are met through the
company's financial statements in
accordance with generally accepted
accounting principles.
So,
most likely,
the financial
statements are
fairly presented in
accordance with
generally accepted
accounting principles.
G
C
Major Features of Natural Language Reasoning in Assurance
Engagements, in Syllogistic Form
ARGUMENT 1
ARGUMENT 2
ARGUMENT 3
ARGUMENT 4
ARGUMENT 5
Statement
Premise 1
Warrant
5 Major Premise
All persons are mortal.
Statement
Premise 2
Data
5 Minor Premise
Socrates is a person.
Statement
Conclusion
Conclusion
5 Conclusion
Socrates is mortal.
• Argument 1 is the most abstract generalization of an argument. It does not distinguish
between an argument and an explanation or any other set of communications or
utterances.
• Argument 2 suggests the essential feature of argument structure: Some statements
(premises 1 and 2) purport to justify another statement (the conclusion) following
rationally from the premises.
• Argument 3 reflects three essential features of argumentation.
• Argument 4 (Aristotle’s system) specifies a generalization premise, the major premise,
which determines why the data are relevant to the conclusion. It corresponds to the
concept of a “warrant” (in Argument 3), which links the data premise to the conclusion.
Aristotle’s syllogisms teach us that the more important premise is the warrant because
it determines which data are relevant for the conclusion. Warrants are also referred to
as connecting premises because they connect the data to the conclusion, thereby making
the data relevant to the conclusion. Warrants are usually rules or generalizations of
some type involving at least one quantifier (e.g., all persons are mortal). Theories and
models are forms of generalizations. A very common generalization used in everyday
reasoning is the conditional form. We frequently argue that if so and so is true then
something else must be; that is, the “If statement A is true, then statement B is true”
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13
type of generalizations that are represented symbolically as A → B.5 One of the most
important developments in psychology and artificial intelligence of problem solving is
that heuristics used by experts in a variety of fields can be represented in a uniform
way as sets of “if . . . then” rules (if certain conditions hold, then perform a certain
action; for example, in accounting, for leases, there are special rules for deciding if
leases are to be recorded as capital or operating leases). Such rules are known as productions, and a problem solver or production system can, therefore, be built from a set
of productions.6
• Argument 5 sets out a well-known syllogism to illustrate how syllogistic reasoning
works. This argument is expressed in natural language, the type used in all audit
engagements, rather than in an artificial, symbolic language, such as C11. The statements of Argument 5 align with the major premise, minor premise, and conclusion of
Aristotle’s syllogistic framework. The first premise (or warrant) is a generalization
that “explains” why the second premise supports the particular conclusion. Without
this first premise (or warrant), the second premise (data) alone would not “prove”
the conclusion. Given the first warrant, the conclusion follows 100% from the data
premise. Thus, the relevance of the data in Argument 5 is determined by the warrant.
This reinforces the importance of the warrant in making the data relevant to the
conclusion. Therefore, we should treat warrants and similar generalizations, such as
“laws” or models, as the more important premises in determining the relevance of
the data used.
The differences in deductive and inductive argumentation are noteworthy.
A deductive argument is one in which the conclusion is always true if the premises are
true. Traditionally, deduction has been viewed in philosophy as the ideal way of gaining
knowledge (the conclusion) from argumentation. The inductive probability (probability
of the conclusion being true when the premises are true) of a deductive argument is
always 100%. If the inductive probability is less than 100%, then we have a nondeductive argument, which is labelled inductive. Thus, with deductive argumentation,
the inductive probability is always 100%; whereas in inductive argumentation, it is less
than 100%.
Another complication with inductive arguments is that a true conclusion does not
necessarily follow from true premises. Deduction gets 100% inductive probability by
never going beyond the knowledge that is already inherent in the premises. But induction, in searching for new truths, goes beyond the premises of an argument to take the
risk of reaching a false conclusion from true premises. In this sense, while deduction
is truth preserving, induction is truth creating. For example, the most common argument form used in the sciences is as follows:
ARGUMENT 6
ARGUMENT 7
ARGUMENT 8
Major premise (warrant)
A ⇒ B
Theory
All persons are mortal.
Minor premise (data)
B
Data consistent with
(verifying) theory
Socrates is mortal.
Conclusion
A
Conclude theory is true
Socrates is a person.
• Arguments 6, 7, and 8 illustrate the formal fallacy of affirming the consequent and are
invalid. They demonstrate that a true conclusion does not necessarily follow from true
premises. The inductive probability is less than 100%, and the argument is, therefore,
inductive. Argument 7 should be regarded with caution. There may be other reasons
for observing data (B) predicted by theory (A) of the major premise. Hence, we are
not 100% sure that theory A is true. The reasoning in Argument 7 is quite familiar in
the sciences. Argument 8 illustrates that observing that an object is mortal does not
guarantee it is human. Socrates may be the name of a horse.
5
A. Garnham and J. Oakhill, Thinking and Reasoning (New Jersey: Wiley-Blackwell, 1994), pp. 85 and 166.
6
Garnham and Oakhill, Thinking, p. 203.
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Consider the following two arguments that are typical of everyday reasoning:
ARGUMENT 9
ARGUMENT 10
Warrant:
Visitors to Mexico almost never
contract malaria.
More than half the visitors to Mexico
contract Montezuma’s revenge.
Data:
Jack is visiting Mexico.
Jack is visiting Mexico.
Conclusion:
Jack will not contract malaria there.
Jack will not contract Montezuma’s
revenge there.
• Arguments 9 and 10 are inductive arguments. There is a higher inductive probability
for Argument 9 than Argument 10, which is evident from the wording and meaning
of the two arguments. But which conclusion has the higher EP is not clear because we
do not know the probabilities assigned to the warrants. Thus, EPs are a function of
additional information that may be available. They would be represented as additional
warrants and data to the argument. For example, if we added to Argument 10 the
evidence that Jack has visited Mexico many times without experiencing Montezuma’s
revenge, most would find the conclusion much more likely to be true. The effect of
specific wording on the argument is important. Imagine replacing Mexico with Canada
in Arguments 9 and 10. The EPs would be affected considerably, thereby illustrating
the potentially important role of natural language and common sense background
information in everyday reasoning, including audit reasoning. These effects open the
way for rhetorical moves that can shift the persuasiveness of the argumentation one
way or the other.7 As examples of how persuasive misleading arguments can be, consider the following arguments, which most university students get wrong.
Argument 11:
Warrant: All roses are flowers.
Data: Some flowers fade quickly.
Conclusion: Therefore, some roses fade quickly.
Is the above a good argument? Most university students say yes, mainly because it
seems they look at the believably of the conclusion. They agree that it is true, so they
assume the argument is true. Do not make this mistake as an auditor! The argument must
support or justify a conclusion. Does it? If both premise and data are true it does not follow that the conclusion is true: roses might not be the flowers that fade quickly.
Argument 12:
Warrant: The bat costs $1.00 more than the ball.
Data: A bat and ball cost $1.10
Conclusion: The ball costs $0.10
This argument is wrong! $0.10 may seem like the intuitive answer. If you think that
then you are wrong because the total cost is $1.20 if the cost of the ball were $0.10. Thinking
this through should reveal to that the correct cost of the ball is $0.05, and the bat costs
$1.05. These exercises with syllogisms should illustrate that the simplicity syllogisms can
be misleading. Below is another syllogism that illustrates additional properties. Arguments
11 and 12 should illustrate to you the amazing complexity of even three statement syllogisms. That is because of the complexity of language, the way meanings of individual words
can change within the context of statements, and the background knowledge about the
world needed to get at those meanings. Note that despite sharing of considerable background knowledge (common knowledge), some people will have more or different background knowledge than others. For this reason, the analysis of the same syllogism (and
other reasoning such as that of management’s) can vary. This helps explain why effective
7 J. Sillince, “Rhetorical power, accountability and conflict in committees: An argumentation approach,” Journal of Management
Studies, Volume 37, Issue 8, December 2000, p. 1130.
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communication among audit team members is needed in order to identify the best audit
argument (i.e., with the best reasons) in the circumstances.
Argument 13:
Warrant: If the sky is green, then the grass is pink.
Data: The sky is green.
Conclusion: The grass is pink.
The argument above is a syllogism that has IP of 1.0 but EP of 0; that is, it is logical
in a hypothetical world that has no empirical content. This is also a deduction that is
internally but not externally valid (i.e., not sound because premises are not true).
Argument 14:
Warrant: If there is sufficient audit work and detected errors are immaterial, then give
an unmodified audit opinion.
Data: Detected errors are immaterial.
Conclusion: Give an unmodified audit opinion.
Argument 14 is an inductive one that depends crucially on what is considered sufficient audit work. The data must be sufficient as well as indicating immaterial errors in
order to support an unqualified opinion without corrections. Sampling theory of Chapter 10
helps the auditor decide on the important matter of the sufficiency of audit evidence (the
data). This illustrates the role of more formal models in the audit decision process.
Critical thinking means that we have good reasons to believe a claim or make decisions.
Those reasons include other people’s (such as management) attempts to persuade us to take
an action or to believe something. Attempts to persuade may be argumentative or nonargumentative. Most of the latter are referred to as rhetoric, which we will define here as any
attempt to persuade solely through the power of words used (e.g., “you are either with us or
against us”). Rhetoric can be used to assist in providing good reasons, or it can be abused
to provide bad reasons or no reasons to accept a claim (conclusion), decision, or action.
Rhetoric makes use of linguistic phenomena, the power of words, in persuading us to
accept a claim, decision, or action. This power is achieved through cognitive meaning
(factual) and emotive meaning (negative or positive overtones) associated with words.
Linguistic phenomena include ambiguity, vagueness, metaphor, rhetorical questions, irony,
sarcasm, and generalizations. Critical thinking makes use of language and linguistic phenomena to develop the reasoning for a claim, decision, or action. Deciding whether rhetoric is used to provide good reasons is part of critical thinking.
The pejorative use of the word “sophistry” refers to intellectual charlatanisms involving
use of language to deceive people. In ancient Greece, the sophists trained students to persuade their audience in either side of an argument—a very practical skill for the growing
litigiousness of Athenian society—leaving the impression that any reasoning could be used
as long as it was effective in influencing people. What mattered was who won the argument,
not who was right. The study of rhetoric includes positive use of language, as by famous
authors (e.g., Shakespeare), as well as the effective use of language to deceive. Rhetoric is
a major component in the study of literature.
Our focus here will not be so much on the bad reasons that are possible for a decision
as it will be in good reasoning, although some common errors in reasoning and attempts
at intentional deception will be noted. An entire book can be written on the types of bad
reasoning that have been used throughout history (e.g., the Big Lie technique used in many
dictatorships to blame scapegoats for a nation’s problems). Our interest, however, will be
on the potentially bad reasoning that is used in our profession, including within the standards. We will first focus on what makes for good reasons, and then use this good reasoning framework as a benchmark to more easily identify the bad reasoning. In this appendix,
we put emphasis on those aspects of good reasons that are generally independent of the
field in which the decision is made (field-independent aspects of reasoning). These more
universal elements of reasoning are part of the study of philosophy, especially logic.
However, despite the emphasis here on the more abstract aspects of good reasoning, we
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nevertheless use important examples from the public accountant (PA) profession to show
how these aspects apply to professional practice.
The preceding sections demonstrated that both language and context can have important
roles in influencing the strength of all argumentation, including assurance arguments. These
two factors explain why rhetoric is also important to audit argument evaluation. In its broadest
sense, the word rhetoric covers the logic, the language, and the context of argumentation. But
it is up to the PA to use rhetorical principles in effective argumentation and to expose through
skepticism and critical analysis any deception that management and other accountable individuals attempt through their own rhetoric. Some have developed an analysis of rhetoric as an
economic transaction, using the “selling” of an idea as analogous to selling a good. The gist of
the analysis is that when information costs are high (the listeners are uneducated or the information is difficult to understand because it is complex), then rhetorical devices, such as appealing to the authority of the speaker or using emotional appeals, become more important.8
Perhaps the most important use of rhetorical devices is to aid in making ethical decisions.
If rhetoric can be used in a conflict-of-interest situation to persuade a party to accept a particular position that is not favourable to him or her, it may play a useful role in the reporting of
that position. The disclosure should then be consistent with the aims of the agreement. Rhetoric
should not, of course, be used to mislead people about the nature of the agreement.
Rhetoric helps to make PAs aware of the power of language in influencing people’s
beliefs. For example, accounting labels, such as “assets,” “expenses,” and “losses,” send signals to users about how well resources have been managed. Thus, accounting terminology
itself has an important rhetorical effect. To maintain relevance, PAs will need to be aware
of rhetorical impact. This relevance of rhetoric can only increase as accountability becomes
more important in society (i.e., the audit society evolves).
A good illustration of an application of rhetorical principles in accounting can be found
in accounting firms’ written responses to a company’s invitation for alternative opinions on an
accounting matter.9 The raw data came from a regulatory agency’s files, and the correspondence makes it evident that accounting firms were engaging in the use of rhetoric in these
specific situations. The “winning” firm’s arguments would clearly affect the accounting for the
case and might even become part of the audit working paper file justifying the accounting.10
Context includes not only the immediate physical circumstances of the engagement
but also broader features, such as reputation of the person making the argument and social
aspects of the accountability relationship being reported on. For example, tone of voice and
body language can convey the strength of convictions. In some situations, context itself
may be the message and override anything that is said or written, regardless of the strength
of the logic of the expressed argument. Consider, for example, an arguer who loses credibility, such as an auditor who lacks the appearance of independence. Ultimately, arguments
are intended to persuade—and thus add credibility. If they fail this acid test, the assurance
engagement fails as well. This is why the most important ethical principle is to maintain
the reputation of the profession.
Emotions are important for reasoning because they help shape the basic goals of reasoning and influence our intuition. This does not mean advanced mathematics or logic are
intuitive, however; instead, these types of mental tools are learned and have evolved to
solve more complex problems.11
The primary role of the emotions seems to be to decide on the ranking of objectives
that triggers thinking and actions.12 Emotions seem to be indispensable to coordinating the
various mental modules and are, therefore, essential for all human reasoning.13 This helps
8
R. A. Posner, Overcoming Law (Cambridge, Mass: Harvard University Press, 1995), pp. 501–3.
9
J. Amernic, “The rhetoric versus the reality, or is the reality “more” rhetoric? A case study of public accounting firms’ responses
to a company invitation for alternative opinions on an accounting matter,” Critical Perspectives in Accounting, February/April 1996,
pp. 57–77.
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10
Amernic, “Rhetoric,” 1996.
11
S. Pinker, How the Mind Works (New York: WW Norton & Co, 1997), pp. 338–341.
12
Pinker, Mind, p. 73.
13
Pinker, Mind, p. 70.
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explain why the mind does not always seem to follow logical rules. Formal logic can give
trivial truths yet miss consequential ones. Other complications include the meaning of
words and language understanding in specific contexts, background knowledge of the reason or his or her implicit assumptions, uncertainties, and special mental modules inference
rules tailored to specific contexts, especially the cheater detection inference rules.14 It is,
therefore, not surprising that philosophers long ago concluded that reasoning depends on
three basic appeals—its logic, its emotional quality, and the reasoner’s perceived character.
The persuasiveness of the reasoning to a particular audience is determined by all three
appeals. The latter two appeals are frequently based on the rhetorical aspects of the reasoning. An auditor would have to consider all three aspects of the reasoning. For example, the
auditor’s perceived character is influenced by the perceived independence and objectivity of
the auditor.
Imbedded in the above standardized framework format is the assumption that reaching
the goal involves some decision making. In fact, as we will see, the end result of critical thinking is reaching some kind of decision, whether it is on an adjusting entry or the wording to
choose in notes or an engagement report disclosure. This has traditionally been referred to
as professional judgment. Professional judgment is part of critical thinking.
We explain the principles and concepts for a professional judgment framework in
Chapter 19 (available on Connect), after you have learned more about professional issues
affecting auditors. This framework is also consistent with the broader framework for critical thinking.
The reason there is no true theory of professional judgment is because there is no set
of universally acceptable hypotheses that are capable of verification through observation in
the audit setting. For example, there is no universally acceptable set of social laws or behavioural laws on which to base a theory of professional judgment in auditing.15 Because many
effects in auditing are based on intentional, meaningful actions dependent on context
rather than physical cause and effect relationships, general laws are difficult to establish.
As a consequence, the logic used in audit professional judgment involves less formal reasoning that includes evaluation of thought processes as well as the intentions behind the
thought processes.16 Many options may need to be considered, each with positive and
negative consequences for a given intention and context. As a result, most reasoning in
auditing is not as mathematical and abstract (i.e., universal) as in the physical sciences. Of
course, when appropriate, more rigorous mathematical or logical tools can always be
included to help guide professional judgment
So, the key to professional judgment are the standards of the profession combined with
the critical thinking concept. We will be studying the GAAS and related guidelines throughout the rest of this book.
In summary, critical thinking involves use of the following principles that should be
actively considered in analyzing a controversy or issue facing the auditor (such as a
disagreement with management on a financial reporting issue). The principles having a
dominant ethical component are marked with an “E.” As you can see, all of the principles
other than the strict logical ones have an important ethics component. In particular,
note how important a questioning mind is. It represents a mental attitude that incorporates the rest of the critical-thinking principles. It should be clear that skepticism is a
key part of critical thinking through the questioning mind concept. Thus, critical thinking takes traditional audit virtues and extends these to a more holistic approach to
judgment.
It is important to be aware of various elements of critical thinking, which we briefly
review here and summarize in a series of principles.
14
Pinker, Mind, p. 338.
15
R. Audi, The Cambridge Dictionary of Philosophy (Cambridge, U.K.: Cambridge University Press, 1995), p. 612.
16
Audi, Cambridge Dictionary, p. 636.
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Principles of Critical Thinking
1.
2.
3.
4.
5.
6.
7.
(E) Critical thinking has a purpose that leads somewhere, has implications and consequences, settles some question or solves a problem.
(E) Critical thinking requires an enquiring mind that identifies an important issue or
controversy, considers what the goals are in light of the many perspectives possible on
the issue, and decides on the best goal in the circumstances. Critical thinking identifies
the claims that need to be justified to achieve a goal
(E) Critical thinking is used to persuade someone (including yourself) to accept a
claim. Of course, others may try to persuade you to accept another claim. And you
and others are aware you may have these conflicting claims. You try to resolve this in
a cooperative way via the critical thinking process, in which you and others are openminded and receptive to being persuaded by good reasoning.
Critical thinking is based on reasoning using argumentation. The argumentation supports or justifies a claim related to resolving a controversy or issue.
(E) Critical thinking is expressed through and shaped by language, which can be used
to develop concepts and ideas.
(E) Critical thinking requires being aware of the power of language, how this power
can be manipulated, and the importance of specific words chosen to persuade. The
words chosen reflect value judgments and have emotional content, which is communicated to the listener. This is part of the persuasion process.
(E) Critical thinking requires making important assumptions and reasons explicit so
that they are open to scrutiny by others. This is the best path to truth and knowledge,
and these are the ultimate goals of a questioning mind.17
These principles can be viewed as ideals in the ways issues and controversies should
be analyzed. They will rarely be achieved exactly in professional practice, usually under
some very formal conditions using very precise language and concepts. Nevertheless, they
can be useful guides to action in the sense they help achieve accountability for one’s claims
and any decisions that result from them.
We saw in Chapter 1 that a special type of accountability, three-party accountability,
is central to the assurance concept. Critical thinking in an assurance engagement requires
that the audit provide three-party accountability in the audit reasoning process. For example, the context in an assurance engagement means that the auditor needs to be aware of
the three-party accountability and that at least three different perspectives on an accounting
issue are possible.
The above principles are very general in that they can be applied to any discipline or
field of study. In this respect, the principles are independent of the field. To apply these
principles to a specific field such as auditing requires the addition of audit and accounting
specific concepts and principles. But these more specific parts of audit thinking should
ideally conform to the framework of critical thinking as much as possible. Simply being
aware of these and similar principles are important steps towards becoming a critical
thinker.
The first principle states that critical thinking has an objective and tries to be practical.
The second principle states that this objective is identified with a questioning mind that
takes into account different perspectives. Implicit here is some kind of social context
involving communication. This idea came from the ancient concept of discourse, or open
debate, and discussion, making the alternative viewpoints clear to all. The basic idea is to
resolve conflicting viewpoints. The contexts of politics, courtroom, and open debate on
any social issue are the paradigm cases. But critical thinking takes the conventions that
evolved in these settings and applies them to reasoning on any subject matter in any
17
See www.criticalthinking.org; A. Fisher, Critical Thinking, an Introduction (Cambridge, U.K.: Cambridge University Press, 2001); and
W. Hughes, Critical Thinking, 2nd ed, (Peterborough: Broadview Press, 1996).
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context. The key idea is that it involves an issue with conflicting viewpoints and that a
reasonable decision must be made. This is really a problem that arises in ordinary daily
reasoning when dealing with people and life’s problems. Except most times it is sufficient
to deal with the problem informally, using intuition and “common sense.” When you think
about it, however, common sense is largely a sharing of norms of acceptable behaviour (like
no smoking in classrooms). In this sense and the sense of trying to learn the process of
critical thinking, the exercise is one of cooperation for the common good by those affected
by the issue, but always in a specific context.
The third and fourth principles focus on how to achieve the objective of resolving the
issue. Principle three acknowledges that what is really at stake is persuasion of people. For
example, management may be trying to persuade investors, and the auditor’s task is to
reduce the risk of deception in management’s persuasion attempt to acceptable levels. How
is this achieved? We use the time tested technique from philosophy called argumentation
to reduce this risk. So, what critical thinking is saying is that argumentation is the way we
establish our claims. The principal claims of interest in auditing are the ones made by
management about the financial statements. These management claims are verified in the
auditor’s report. But the audit report is itself a claim, which we call a conclusion or opinion,
about the results of the audit. This claim also needs to have a supporting argument. This
is why we are interested in arguments that the auditor will make to support his or her
opinion (the auditor’s claim). Although the profession has traditionally not thought of it
this way, the increased attention to quality control, new types of audit engagements, and
increased auditor accountability to the accountability boards is putting increased expectations on auditors to justify their conclusions on stronger philosophical grounds. This
accountability is achieved by justifying one’s conclusions better, and that means paying
more attention to the structure of sound argumentation, including on ethical issues as part
of the reasoning.
The fourth principle, that we reason by argumentation, is probably the least familiar
and least intuitive, which is why the first section of this appendix focuses on argumentation concepts. As explained in the argument concept discussed earlier, this means providing good reasons for a conclusion, claim, or action. Arguments can be stated in an infinite
number of forms, but the reasoning process itself can be put into a standard form. Doing
this in real life situations can be quite difficult and we have discussed the most basic
issues already. A major complication is that many reasons in an argument are themselves
claims that, in turn, may need a supporting argument in order to be justified for use as
a valid reason. But the point is that we can reconstruct all arguments in a standard form,
such as a syllogism, and then apply the analysis to that form. So, what critical thinking
says is that the critical thinker must be prepared to defend his or her reasons and assumptions if they are called into question by an opponent, such as a court or an accountability
board. In other words, the auditor must be prepared to justify their decisions and
judgments.
Argumentation takes place in all levels of social life, although not as formally as discussed here. There can be arguments among friends, in a court of law, in the political arena,
and among experts. Auditors have to be prepared to argue among experts, and it is these
situations where more formality and uses of professional standards and concepts come to
the fore. Debate is a form of argumentation that brings together various techniques of
persuasion, right choice of words, demeanour, tone of voice, as well as intelligence. Whether
in a courtroom or regulatory hearing or dealing with a client or the media, debating skills
can be as useful for auditors as they are for lawyers and politicians.
In debating teams or clubs or even in business case competitions, the arguer must be
prepared to argue on an issue. The major point of such debates is not necessarily to find
the truth but to improve debating techniques generally. But the debate needs a focus, an
issue, which is what the second principle is about.
The point of debate is to convince or persuade another party of the correctness of a
claim. This is an essential element of all critical thinking and why we have the third and
fourth principles. Also, being aware that there are different viewpoints, and that good
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arguments recognize these viewpoints, need to be taken into account in justifying a claim.
And it may turn out that no one viewpoint can dominate. This is summarized in Exhibit 3A–3.
For example, in this exhibit, can you identify the three parties in three-party accountability?
(Refer back to Exhibit 2–4 in Chapter 2). Management (circle 2) is the accountable party
that makes the assertion to the users (circles 1, 3, 4, 5, and 6), and these assertions are verified by the PA (circle 3). Who wins the debate is decided, in large part, on who has the
burden of proof in establishing a claim. This is largely determined by social conventions.
For example, under criminal law in the Anglo-American system, an accused is presumed
innocent until the state can establish guilt “beyond a reasonable doubt.” When the state has
done this it has met its burden of proof in court, but if not, the accused does not have to
prove that he is innocent and so wins the case (i.e., wins the debate). Critical thinking is,
thus, a disciplined thinking that takes into account various social norms and other contextual factors in the reasoning process. The remaining principles clarify other aspects of critical
thinking.
The fifth principle recognizes that a major influence on viewpoint or perspective is the
words and concepts one uses. It is important to be aware that choice of words affects value
judgments and the taking of an ethical position. For example, whether to call use of company resources an “investment” or “speculation” illustrates that the choice of words can
imply different motives and, hence, different ethical valuations. Accounting terms can be
used as euphemisms, which is reframing the harm in the words so that it seems less
immoral. Applying an “expense” label to a cost instead of a “loss” label makes the cost seem
more acceptable because the incurrence becomes necessary to running the business. It is
very important in critical thinking to be aware of the power of language in reflecting such
value judgments, and, if you disagree, to address that issue in your argumentation so that
the language used reflects the perspective taken. Another example of this is that financial
statements “present fairly.”
The concepts used also influence viewpoint. Concepts are important in that they help
us assign meaning to our senses and the information we use. Immanuel Kant’s views on
this have been very influential in computer science and artificial intelligence. These views
can be summarized in the statement: “Concepts without data are empty, and data without
concepts are blind.” What this means is that both concepts and data are needed to make
EXHIBIT 3A–3
Multiple Points of View with Respect to a Given Set of Facts
Note:
• Only some of the facts are
highlighted in any point of view.
2
Management
1
Investor
3
Auditor (PA)
• All points of view ignore or play
down some facts.
• No single point of view provides
total understanding.
• Understanding multiple viewpoints
increases insight.
6
CRA
4
Regulator
5
Creditor
The total set of facts relevant to understanding a given set of events
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21
sense of the world, including in critical thinking. In other words, concepts provide meaning
to our observations and evidence, and without concepts we have no way of knowing how
useful or relevant our evidence, including audit evidence, is.
This is reflected in arguments by the fact that the most important reasons (major
premises) are usually conceptual ones based on some assumed model, theory, or principle.
These major premises determine what data are relevant in an argument. For example, in
auditing you will learn about management assertions. These are the major points at issue
in financial reporting. They, in turn, are embedded in the theory and assumptions of
accrual accounting, which determine the kind of data needed to verify the assertions. For
example, much of financial reporting is based on historical cost. So, to verify assertions
related to historical cost, auditors need evidence on what the auditee actually paid for various items. This means that the relevant evidence the auditor needs to gather is driven by
historical cost accounting theory. This illustrates that the evidence is less important than
the historical cost accounting theory because without the theory, we would not know what
evidence to gather. For this reason, audit evidence is treated as a minor premise in audit
argumentation and in critical thinking and also why principles of audit auditing are shown
lower down in the hierarchy below the accounting standards. The accounting determines
the “suitable criteria” for the engagement and these criteria determine what evidence is
relevant for the audit. For example, the historical cost concept is what gives meaning and
relevance to the audit procedures that involve gathering evidence about records related to
what was actually paid.
Making this relationship between concepts and evidence explicit is a necessary component of critical thinking. But critical thinking is also practical. It does not necessarily
question everything, but it must be ready to respond if challenged. Normally, it is sufficient
to refer to authoritative sources, such as GAAP, rather than reproducing all the arguments
used in accounting theory. However, auditors must be prepared to defend the appropriateness of their accounting choices in case someone questions their actions (such as the CPAB
or a court of law). Critical thinking means that auditors should be prepared and anticipate
such eventualities, and this is a major reason why it is important to be aware of other
viewpoints. The fact that it is the auditor who uses the words “present fairly” requires
nothing less from the perspective of the critical thinker. As more people question the auditor’s role and the quality of financial reporting, a structured critical-thinking approach is
probably the best way to rationally justify one’s claims and decisions in a particular
engagement.
Being aware of the framework and having an understanding of its components is
the first step to being a critical thinker. Applying these concepts and principles to a
specific situation is the best way to understand them better. Keep in mind, however,
that the framework is very general and applies to all fields of study. To be a critical
thinker in a particular field such as auditing requires combining these critical thinking
concepts and principles with the more field-specific ones of accounting and auditing.
This is most evident in the explicit argumentation that is developed to support an audit
conclusion.
You will not need to make all your assumptions, concepts, and principles explicit
because your audience may readily accept the vast majority of your reasons. It is only a
few contentious reasons that normally are the centre of controversy, and most people will
agree with or accept most of your reasons without question. This is because in a society,
we share much common knowledge (the obvious or common sense items) and many
social conventions (such as a shared language and all its conventions for efficient
communication—often taken for granted). A good critically thinking auditor should be
able to anticipate which reasons are going to be controversial (i.e., be able to understand
the perspectives of others), sharpen the argument to explain why a reason is appropriate
in a particular case, and have this reasoning documented in the audit file to support the
auditor’s position.
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EXERCISES AND PROBLEMS
EP 3A-1
Failure to Follow GAAS. It is going to be a long
night! First thing this morning, the senior partner
of your three-partner firm, Peters, Peters, and
Paul (“PPP”), called you into her office to tell you
that she had a confidential but exciting assignment for you. The firm has been retained to
review the audit working papers of another firm
in connection with its audit of TVB Software
(TVB), a public company. That firm, Yeller,
Louder, and Soft (YLS), had performed the audit
of TVB for the last two years, since the date it
went public. It appears that the bank did not
EXHIBIT EP3A-1–1
renew TVB’s loan when it matured some six
months ago, and TVB was unable to obtain other
financing. As a result, your firm’s client lost a
good portion of the $2 million he had invested in
the shares of TVB. Your client is suing the auditors of TVB, alleging that they failed to perform
the audit in accordance with generally accepted
auditing standards (GAAS) and that as a result,
your client relied on financial statements that
were not correct when he made his decision to
hold on to his TVB shares. The last audited statements are included in Exhibit EP3A-1–1.
Extracts From Audited Financial Statements
TVB SOFTWARE
BALANCE SHEET
AS AT DECEMBER 31
(IN THOUSANDS OF DOLLARS)
ASSETS
20X3
20X2
Current Assets
Prepaids
$
Accounts receivable
237
6,146
Inventory
$
410
5,410
13,904
9,382
20,287
15,202
Other Assets
Fixed assets
13,640
14,975
Goodwill
4,084
4,310
Other assets
6,950
7,010
24,674
26,295
$44,961
$41,497
LIABILITIES AND SHAREHOLDER EQUITY
Current Liabilities
Bank indebtedness
$ 4,940
$ 1,749
Accounts payable
10,641
5,940
140
3,643
1,400
1,400
17,121
12,732
18,210
19,990
8,500
8,500
Deferred revenue
Current portion of long-term debt
Long-term Debt
Share Capital
Retained Earnings
Total Liabilities and Capital
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1,130
275
$44,961
$41,497
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Framework for Critical Thinking
23
(Continued)
TVB SOFTWARE
INCOME STATEMENT
FOR THE YEARS ENDED DECEMBER 31
(IN THOUSANDS OF DOLLARS)
20X3
20X2
$21,724
$31,490
Cost of Sales
15,908
20,130
Gross Margin
5,816
11,360
1,760
3,170
Research costs
304
3,775
Marketing and sales
501
2,607
1,739
1,889
Sales
Sales and Administrative Expenses
Salaries
Interest
Other
Net Income before Taxes
Income Taxes
$
Net Income
657
16
4,961
11,457
855
(97)
—
203
855
($
300)
TVB SOFTWARE
FOR THE YEAR ENDED DECEMBER 31, 20X3
From Note 1—Accounting Policies
Goodwill
Goodwill is amortized to income over its 40-year life.
From Note 7—Fixed Assets
Fixed assets comprises the following:
DECEMBER 31, 20X3
COST
ACCUMULATED
DEPRECIATION
BOOK VALUE
Computer Equipment
$29,790
$26,100
$ 3,690
Furniture and Fixtures
10,650
7,700
2,950
Building
11,000
4,000
7,000
$51,440
$37,800
$13,640
Total
Victoria Smyth, the partner, has reviewed the
contents of YLS’s working papers. Her notes are in
Exhibit EP3A-1–2. You have been asked to review
these notes and prepare a report identifying any
departures from GAAS to support your client’s view
that the audit was not conducted in accordance
with GAAS. In this regard, you should note whether
each instance is a clear departure from GAAS or
whether the matter is grey and, therefore, subject to
smi51414_app3A.indd 23
potential challenge in court. Victoria is also concerned that your firm may have some professional
responsibilities under the Rules of Professional
Conduct in connection with this agreement. She
would like you to identify these for her.
Required
Prepare the report requested by Victoria Smyth.
(ICAO adapted)
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EXHIBIT EP3A-1–2
TVB Software
“PRIVILEGED”
Victoria Smyth’s notes on review of audit working papers of TVB Software prepared by Yeller, Louder, & Soft
1.
I reviewed YLS’s working papers at their office. The audit report for the year ended December 31, 20X3,
was signed by YLS on February 20, 20X4.
The working papers were neat and appeared to be well organized. All of the files have been prepared by
audit staff and have been reviewed by a YLS junior audit partner, though not the one who signed the
financial statements. This is the only public company audited by YLS.
I asked to review the files of the previous year but was told that YLS only retains one year of files. The
20X2 files had been destroyed. I reminded YLS that the 20X2 files had now been subpoenaed by the
Court.
2.
The audit was staffed by two YLS PAs. Neither had performed audits of a software company before, but
one of them had several years of auditing experience. The other PA had recently qualified and had spent
the previous two years working for a government internal auditor’s department. The audit partner told me
that he was not concerned about this other PA because he was related to TVB’s CFO and, hence, had a
good knowledge of some of the workings of the company.
3.
The audit was fully substantive in nature. All three of YLS’s files contain working papers documenting the
results of its substantive testing. Each section of the work contains a checklist of substantive tests. The
tests appear to have been developed specifically for this assignment. The steps on the checklists appear
to be signed off and cross-referenced to the appropriate working papers.
4.
The first file is called the “TOP FILE” and contains several memos to file. The most significant of these are
as follows:
a. Materiality: A short memo sets materiality at $400,000. The memo notes that the company is not
currently profitable although it is expected to be in the near future. As a result, it is more appropriate to
use balance sheet numbers to determine materiality. Once the company becomes profitable, YLS
would expect to use normalized income as a basis for materiality. Thus, one per cent of total assets is
approximately $400,000.
b. Plan: A short memo sets out that the audit will be fully substantive against a materiality of $400,000
and follow the approach used in the previous year, including the tailored audit programs developed
that year.
c. Engagement letter, signed by the client.
d. Legal letters to each of TVB’s lawyers, each with a standard reply.
e. A standard management representation letter, containing no unusual or tailored paragraphs.
5.
Prepaids: As these amounts were not material, YLS only compared this year’s schedule to that of the
previous year. There were no unusual items on either of the schedules.
6.
Accounts receivable: The audit work in this section included a confirmation of the 15 largest accounts and
10 other accounts selected at random, covering 79% of the population. All but two of the confirmations
(totalling $326,000) were received back with no problems noted. In view of the satisfactory result on the
other confirmations, no additional procedures were carried out in relation to these two items.
A review was done to identify subsequent payments, and as at the date of the audit opinion, 85% of the
receivables had been collected. Of the remaining accounts, none were above $100,000, so no further
work was carried out.
Procedures were carried out to ensure that balances outstanding at year end related to shipments before
year-end. These procedures included agreeing amounts to invoices and shipping documents.
7.
Inventory: The inventory consisted of software packages, most of which were manufactured by TVB, and
some purchased for modification and resale.
YLS attended the inventory count at year-end and reviewed the procedures necessary to achieve a proper
cut-off. As a result of these procedures, YLS found cut-off errors that resulted in an overstatement of
sales of $182,500. They concluded that as this amount was not material, no adjustment was necessary.
They also reviewed the inventory valuation by reviewing the process for allocating costs to specific
products. This is a very complex process and the audit work seems to be detailed and thorough with
much recomputation and testing in the files. They concluded that the allocation methodology was
appropriate in the circumstances. They did not identify any errors.
8.
Fixed assets: YLS’s work was limited to reviewing the schedule of purchases (there were none above
$100,000) and recomputing the depreciation for the year.
9.
Goodwill: YLS recomputed the amortization for the year.
10.
smi51414_app3A.indd 24
Bank indebtedness: YLS confirmed the amount of the bank indebtedness and the long-term debt, which
is also owing to the bank. The confirmation noted that the debt was up for renewal in June of the
following year. There is a note in the file that company management was confident that the debt would be
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Framework for Critical Thinking
25
Continued
renewed for a five-year term. As well, the file contained copies of some internal TVB memoranda, written
over a four-month period in 20X3, summarizing management’s meetings with the bank and supporting the
view that the debt would likely be renewed. On this basis, YLS concurred with management’s view that
the debt should continue to be classified as long-term debt.
11. Accounts payable: The files contained a confirmation of 100% of the accounts payable. All of the replies
were in the file and all discrepancies had been followed up. As a result of these procedures, YLS
concluded that accounts payable were understated by $232,000 but that as this amount was immaterial,
no adjustment was required.
12. Income taxes: Very detailed work was carried out in this section by a tax manager from YLS. The review
appears very thorough, and amounts are reconciled down to the penny.
13.
smi51414_app3A.indd 25
Profit and loss: YLS carried out analytical procedures, comparing the current year’s results to those of the
previous year on an account-by-account basis. Explanations were obtained from management for all
variances over $50,000 or 5% of the previous year’s balance.
The file includes a detailed review of all invoices paid to outside consultants, including several other
accounting firms, and copies of their reports. One of the assignments relates to a “business review” of
TVB carried out at the request of the bank. The report for that assignment is not in the file.
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