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Since the 1960s, an increasing number of big companies declared bankruptcy, and as a result external auditors have always been under attack by litigation regarding the quality of their professional performance. Investors turned to auditors and expected compensation from them. Indeed, auditors's insufficient performance could potentially mislead public and fail to give a true and fair view. However, even although there were also some cases in which external auditors had done what was required at that time, it is curious that the public continued blindly blame those external auditors for the lack of quality of audit reports and independence. Generally, it is said that the reason for this situation is that the auditors' work failed to satisfy the public. Therefore, to get a better knowledge of public's expectations, the concept of an audit performance-expectation gap was proposed by Liggio (1974), which defines it as the difference between the levels of expected performance as envisioned by the independent accountant and by the users of financial statements. It was then extended minorly by the Cohen Commission (1978) and Porter (1993). Since the concept of the gap was introduced, it has been considered to be one of the toughest issue for audit profession and regulators (Humphrey et al.1992). Through studying the audit performance expectation gap, this will probably improve the quality of auditing and prevent auditors from unreasonable charges. In this essay, firstly the meaning and manifestations of audit performance-expectation gap will be discussed. Further, the reasons for the existence of gap will be explained. Finally, this essay will discuss the effectiveness of steps that have been taken by professional bodies and regulatory bodies in terms of going concern and fraud detection, which are the main areas of expectation gap.
The definition and implications of audit performance-expectation gap
As for the explanation of audit performance-expectation gap, besides the definition by Liggio, many scholars and experts have proposed their definitions. For example, the MacDonald Commission (1988) in Canada states that the gap is between what society expects and what the auditors should be reasonably expected to do. However, most of the definitions are quite unilateral which have little help with improving auditors' performance but give them excuse to avoid reasonable penalizations. Thus this essay adopts the definition given by Porter (1993) who defines the audit performance-expectation gap as the gap between what society expects of auditors and what it perceives it receives them. Referred to Porter's theory, there are two components of the gap: (a) a gap between what society expects auditors to achieve and what they can reasonably be expected to accomplish ( designated the reasonableness gap); (b) a gap between what society can reasonably expect auditors to accomplish and what they are perceived to achieve (designated the performance gap). The component, performance gap, can be subdivided into two parts which are 'deficient standard' and 'deficient performance'. Based on Porter's concept, relationships among those subjects are depicted in following figure.
Figure 1. The structure of the audit expectation gap
According to the above definition, there is a mutual effect of both auditors and the society on expectation gap.
Manifestations of audit performance-expectation gap
Commonly there are three principal subjects in the study of expectation gap, which are the auditors, the public and the auditing standards. Specifically, the audit performance-expectation gap mainly occurs:
A) between auditors' performances and existed auditing standards
How well the auditors work in accordance with existed auditing standards is the evaluation criteria of auditors' performance. However, auditors are probably influenced by their ability, heavy workloads or their working environment so that auditors may deviate from auditing standards to a variable extent.
B) in the demarcation of auditors' responsibilities and internal accountants' responsibilities
The purpose of the audit is to express an opinion with a reasonable assurance that the financial statements give a true and fair view, and it is not to give a legal warranty that they are completely correct and without error. The Company Act (2006) clearly states that the responsibilities of audited companies cannot be replaced by auditors' duties. The audited companies should be responsible for the integrity and truth of financial statements. However, even although it has been declared that the auditors are not responsible for fraud detection, if auditors failed to detect fraud, the users of financial statements always blame the auditors.
C) in the scope of information disclosure
Normally, the public considers how much the audit reports can help them reduce information asymmetry and investment risk but rarely think about how auditors work. The public investors pin their hopes on auditors' disclosing as much information in the reports as possible, but actually disclosure is within the prescribed scope that public might be unaware of.
D) in what auditors' responsibility be
Auditors indeed have duty to detect any misstatement, manipulation and fraud in financial statements, but the extent to which the auditors should be responsible for the omission of those mistake has been an issue hotly debated in the auditing profession. The public believes that if the financial statements were audited, the auditors' opinion equates to an error-free guarantee. Nevertheless, auditors declare that their opinions cannot ensure absolute accuracy because of the use of audit sampling and materiality. Moreover, auditors explains that as long as they disclosed fatal errors in financial statements, they have already met the auditing standards.
Reasons for the audit performance-expectation gap
Illustrated by figure 1, Porter has concluded three reasons for the gap, which are:
When it is in auditing process, there are numbers of auditing postulates and objective uncertainties that need a considerable judgment ability and experience. However, in real auditing, there is quite a large percentage of auditing practitioners who have not any qualification. According to the research, over 18% of auditors surveyed in UK appear uncertain or in error about their existing responsibilities (Porter, 2004). Moreover, business activities are more complicated than the abilities of auditing technologies. Particularly if the complication is connected with fraud, most of auditor may have difficulties in dealing with the problem. The auditors' performance also depends on professional ethics. Auditors are appointed by public shareholders in theory, however, senior management of audited companies are clients who auditors work for in fact, because auditors get payment from those companies. As they are supposed to be economic rational, auditors may help audited companies hide some minor mistakes or even commit fraud to keep the contracts and to maximize their own profits.
B) deficient standard
The excessive cost of auditing may not be in the interest of society as a whole. Therefore the auditing standards are not only used to regulate auditors' behaviour but also ascertain a risk level that can be accepted by society. Besides, a number of ambiguous auditing standards may widen the gap. For example, it is illegal that auditors charges for the auditing assurance, but nothing is linked with the other business of auditors such as consultation. It would be inevitable to affect auditors' independence.
C) unreasonable expectation
Because of information asymmetry, society sets high hopes on auditors. To make the best investment decision, investors hope auditors can guarantee that the financial statements and reports of audited companies are free of errors and manipulation. Idealistically, it is best for the economy. In fact, it is nearly impossible. The respective comments by the AICPA secretary in 1939 can give an explanation:
We find that the public has believed that the CPA was an infallible superman; that the signature of a CPA invariable meant that everything was perfect; that it was unnecessary to read the accountant's certificate or the financial statements to which it was appended as long as the three major letters were in evidence.....Whether through its own fault or not, the accounting profession seems to have been over sold. Its limitations have been overlooked, while its abilities have emphasized. Now the public has been somewhat shocked to find that even auditors can be fooled by clever criminals. (quoted in Miller, 1986,p.35)
Moreover, information is very scarce and valuable within the market. However, accounting and auditing information is an exception. Public users of those reports can use it completely for free. Therefore, society naturally always ask for unreasonable quality of audit reports. However, auditors have to consider the cost of auditing such as time cost in order to maximize their own interest, because increasing charges of audit is not always an option for auditors.
Assessment of approaches used to narrow the expectation gap
Sikka (1998) says the expectation gap is an inevitable consequence due to the internal contradictions of capitalism. Although the gap might not be closed, the gap can be substantially narrowed. Many practical steps have been taken by regulatory and professional bodies to do this. Some of steps have been taken will be discussed in the following.
In terms of the reasonableness gap, it is the most intractable component. Common unreasonable expectations include detecting all fraud and even assuring business success in the future. Unreasonable expectations of the public could be reduced through education of the public, the users of financial statement specifically, about the role of the auditor and the auditing standards relating to his role. In ISA 200 (2009), the overall objectives of the independent auditor are stated very clearly which can facilitate public understanding of audit profession. FRC also did a revision to ISA 700, which requires the auditor's report to address risks of material misstatement, materiality and a summary of the audit scope. This revision would make the company-specific application of the auditing standards more transparent and could offer public investors a basis for engagement about the audit. To some extent, this may help the public to understand more fully what auditors really do. According to ISA 240, acknowledging the expectations related to fraud prevention is a more active way for auditors taking responsibility to narrow the reasonableness gap, as it extends the duty of auditors. The auditor is also expected to maintain professional scepticism throughout the audit and also the audit quality.
As for the deficient standards, ambiguous wordings in auditing standards should be avoided and clearer definitions should be given to the auditor for a better understanding about his duties. For example, 'materiality' has been interpreted in professional guidance as the degree of tolerable or acceptable error in financial statements but like the term "reasonable expectation" it is not beyond this. It is important that further clarification in relation to these terms are provided as the question to whether auditors have a responsibility to detect fraud depends on the interpretation of these terms( Power, 2000). After the Enron case, Auding Practices Board (2004) started to set standards on audit objectivity, integrity and independence in Ethics Standards 1, which gives more consistency of interpretation of auditing standards.
The deficient performance component may possibly be reduced by expanding responsibilities of auditors. As mentioned above, ISA 240 probably keeps auditors remain sceptic throughout the audit because there is a greater possibility for auditors to be punished because of their acts with negative influences (Sikka, 2003). By comparison, Huepkes (2005) argues that the threat of lawsuit may result in the the trend towards defensive auditing, where by auditors tend to interpret rules prescriptively rather than exercising subjective judgment. Humphrey (1993) describes that the issue of auditor independence as "going to the heart of the audit expectations debate". His notion of independence is extremely essential to public confidence in auditing reports. As discussed above, profits coming non-audit services for audit clients have taken over 70% of audit firms' total profits. It is hard to say if auditors still can be independent when their revenues are connected with audited company so closely. Thus, in the USA, the audit firms are not allowed to offer non-audit services for their audit clients.
The 'going concern' assumption was introduced by FRC in ISA 570 (2009) to address the risk assessment. Auditors need to prepare their report in a going-concern basis, which requires auditors to perform risk assessment procedures, evaluate management's assessment and report the likelihood of entity's ability to continue as a going concern. The auditors should obtain sufficient audit evidence regarding the appropriateness of management's use of the going concern assumption in the preparation of the financial statements (ISA 570, 2009). In other words, auditors need to give a prudential view of financial statement. This probably help auditors avoid involvement of business fraud so that it could narrow the reasonableness gap and deficient performance gap.
The audit performance-expectation gap can generally be divided into performance gap and reasonableness gap. They are conflicts between audit profession and the society. As mentioned earlier, the gap cannot be eliminated but possibly be narrowed to some extent. With the increase understanding of audit profession, the society's expectation becomes more objective and reasonable. With the development of auding technologies and anti-risk ability, the performance gap can be narrowed.
This essay discusses some sample remedies taken by regulators. Besides facilitating the public education of auditing, most of the steps try to narrow the gap through improving audit quality and specifying the auditor's responsibilities, particularly in related to fraud detection and going concern. Furthermore, narrowing the expectation gap helps auditors provide higher quality audit reports, and audit profession can be improved because expectation gap exists.