Components of the Expectation Gap in Auditing

Audit Expectations Gap

There has always been a misunderstanding and a gap in expectations surrounding the role of the auditor and the significance of the audit report. This expectations gap has been highlighted even more in the last ten years, first with accounting scandals such as Enron’s fraudulent accounting and WorldCom, and then with the onset of the financial crisis with the increased questioning of the failure by auditors to foresee the looming crisis. These events have also given rise to a crisis within the audit profession itself, causing auditors to seriously examine their own function and how their role can be improved. The result has been discussion of the future of audit and the future role of auditors. This discussion has covered many issues that are components of the expectations gap, such as auditor independence, the role of the auditor in detecting fraud, and the meaning and significance of the audit report.

Users of accounts such as company management, investors, creditors and the general public all have their own view of what the auditor should be doing, and of the significance of the audit report. Invariably their expectations of what the audit can achieve are too high, and the resulting gap between expectation and reality leads them to question the value of the audit in its current form. Company management is asking how it is possible to obtain value for money from an external audit, that is a legal necessity and that does not necessarily produce worthwhile information, advice or assurance about their financial situation. Investors are asking about the value of the audit report and how far, if at all, it guarantees that all is well with the company in which they intend to invest. Creditors who may have suffered from the accounting scandals and from the financial crisis, are asking how the auditors could have been unaware of the huge financial problems lying just underneath the surface.

Independence of Auditors

The independence of auditors is seen by the investing public as essential, if the audit is to have any meaning. Yet in the early years of the new century, the business world was shaken by scandals such as the Enron collapse, caused at least partly by a lack of audit independence. Many large companies have retained the same auditors for many years, long enough for personal relationships to arise between senior audit staff and company management, which could jeopardize the ability of the auditor to act in a truly independent manner. There are pressures for the largest companies to adopt one of the Big Four firms as their auditors, and there has generally been a trend towards consolidation of audit firms, and therefore a relative lack of competition in the sector. Although auditors may be changed at the time of a company’s annual general meeting, a change of auditors is in reality, relatively infrequent and the danger of a lack of audit independence remains real.

Although measures were taken following the financial scandals to safeguard audit independence, by restricting the ability of auditors to offer other types of service to their audit clients, these measures were not equally strict in all countries. The measures taken were certainly far stricter in the US with the Sarbanes Oxley Act than in many European countries. For example, in many European countries it has remained possible for the auditors to perform many other services for their audit clients, leading to the possibility of a situation where the auditors are forming an opinion on tax planning transactions taken by their client, on the advice of colleagues from the same audit firm.

There are now many discussions around these measures to ensure the independence of auditors. These focus on measures such as compulsory rotation of auditors every few years, or a requirement for joint audits to ensure that the relationship between management and the auditors is not too close. Although such measures might ensure more audit independence, they would also lead to significant inefficiency. Auditors who deal with the same client year on year, build up expertise with the business that allows them to perform their task more efficiently as the years pass, and this expertise would potentially be lost. Joint audits would cost much more effort and expense in coordination between the audit firms, leading to more expense for those firms and for the client.

Please continue to page 2, for more information on components of the expectation gap.

Auditors’ Role in Detecting Fraud

In the case concerning the Kingston Cotton Mill Company in 1896, the judge’s view was that the auditor should be a watchdog not a bloodhound, not suspecting a company’s employees or officers of wrongdoing without reason, but remaining vigilant for any illegal activity. However the public’s perception is that the auditor’s role in detecting fraud should be more active, and here too there is an expectations gap. The investing public, and sometimes also the company management, cannot understand how the auditor could possibly overlook any fraud within the organization, given that the role of the auditor is to examine the transactions performed during the year, and ensure that the assets and liabilities are correctly stated on the balance sheet. This misunderstanding of the auditor’s role in detecting fraud is a significant component of the expectations gap.

However from the auditor’s point of view, the detection of fraud is not the main purpose of the audit. The auditor is concerned with ensuring that the financial statements give a true and fair view of the transactions of the company, and of its financial position at the balance sheet date. Much of the fraud that may be committed within a company, while it is substantial in terms of the aggregate amount of money involved, may concern a very small percentage of the company’s turnover and assets, and may simply be immaterial from the point of view of the audit. The auditor will assess the internal controls within the company to form an opinion as to how far they can be relied on in the audit work, and it is the company’s own internal systems that should be picking up signs of fraudulent activity.

Linked to this is the question of the nature of the audit and how it is conducted. Here too there is an expectations gap. The public, and some company directors, may expect that the auditor will go in and review every transaction, checking and cross checking to ensure that all is well. The reality of the audit is very different and may be inexplicable to the public and their high expectations. Rather than examining large numbers of particular transactions, the auditor is likely to be concerned with assessing the internal controls and the internal audit function, to determine the extent to which they can be relied upon by the external auditor. Individual transactions may be examined, but the auditor will be very concerned with walk through tests and statistical sampling, to ensure that the systems are working as they should. The manager, investor or creditor who is expecting forests of green, and brown ticks in books of account and on computer print-outs, will be disappointed with the outcome in terms of colored ink. The image of the auditor as the person who goes through the records with a toothcomb, ensuring that every transaction is examined, is another component of the expectations gap.

The Audit Report

On 8 February 1850 William Welch Deloitte sat down in his office in Basinghall Street, London, took a last look through the accounts of the Great Western Railway, took out his quill pen and, with a flourish, wrote the words “Audited and approved”. On seeing these words, investors could sleep soundly in their beds, creditors could pursue their business with confidence and the directors could congratulate themselves on their sound stewardship of the company.

How things have changed. In the intervening years the audit report has become a kind of coded message, understood only by the inner circle of initiates, yet inexplicable to the general public. Many investors may only take a fleeting glance through the audit report, unable to decipher the true meaning, but looking for a subtle change in wording that might hint at a gathering storm somewhere in the company.

In the future, the stakeholders and especially the investors, are likely to expect more information to be stated in a clearer and more accessible manner. They may want more comment on future issues that may arise in the company being audited. Although the auditor is looking at financial statements for the past year, these contain some figures relating to future events, for example provisions and contingencies. The auditor also has to be satisfied that the company is a going concern. Investors may feel that they were let down by audit reports in the years leading up to the financial crisis.

Auditing in the Future

Those responsible for regulating the audit profession are well aware of the expectations gap and the need to close it in the future. Discussions on the future of audit will cover the meaning of the audit report and what it communicates to the user of the accounts. They will take another look at auditor independence, and consider the role of rotating auditors and joint audits. Discussions may include the role of the auditor in detecting fraud, and how this may be adapted to the current financial climate. The result of these discussions will be a reform of many components of the expectations gap, but it is unlikely that the gap will ever be entirely closed.

References

“What’s the Future of Audit? The Discussion Begins to get Serious” by Jim Peterson - https://www.jamesrpeterson.com/home/2010/04/whats-the-future-of-audit-the-discussion-begins-to-get-serious.html

“Learn about our Founders” on the Deloitte global website - https://www.deloitte.com/view/en_GX/global/about/overview/history/learn-about-our-founders/index.htm

Image credits:

objects_briefcase2.jpg by justcola on morguefile

september09a 021a.jpg by jdurham on morguefile