Key Issues Such As The Auditing Expectation Gap Accounting Essay

Published:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

The statement in itself raises an number of issues, in this case the researcher interprets concept of an auditor challenging a business model to represent the conflict of interest between independence and auditing duties and responsibilities.

It may be wise to start with a definition of auditing the American Auditing Association (1973) considers that auditing consist of "a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users". As such the very definition of what auditing is gives a preliminary as to the answer to the question and avenues of interest for further explanation. In the first instance the statement makes use of the phrase "objectively obtaining" here one may consider that this is a part of the audit process and such objectivity constitutes the concept of independence, the auditor will simply report what he or she sees regardless of how any one of the businesses stakeholders including managers will react to the finings of the audit. Secondly, the statement is limited to implying that the role of the auditor is to communicate the information they find during the course of their audit. The statement dose not expressly imply that there is a duty for the auditor to necessarily challenge business model or management practises not to recommend expressly any form of improvements. As such, one may consider that if this definition of the audit process is to be taken as the basis for expectations then the challenging of business models on the behalf of the auditor is unlikely to be one of the key expectations of the audit process.

The basics of auditing

As with all corporate legal entities there is a principal agent relationship, the principal being the owner of the business who is in absence and the agent who acts as the manager. As such the principal provides capital and provides a contingent reward to the agent. In return the agent is accountable to the principal for maximising long term profitability. Specifically from the financial auditing perspective, the principal has a responsibility to provide fair and accurate financial report to the principal. Eilidsen et al (2010) argues that information asymmetry and a conflict of interests leads to the possibility of a risk of misinformation being transmitted between agent and principal.

In order to ensure that such misinformation does not ensue, an auditor is hired on the behalf of the agent who undertakes to assess the financial statements of a company and report on the validity of such statements with regard to the quality of information provided and to consider whether or not such statements have been prepared in accordance with the relevant laws and accounting standards. Despite the face that the auditor may be thus seen as working for the principal, the fact remains that in reality whilst the principal has the right to reject the choice of auditor the auditor or audit company will be chosen by the agent. As thus this may be seen as creating the first conflict of interest and the creation of the first key expectation which is that despite bringing hired by the agent, the auditor will work in an independent fashion which is free from bias and gives a report which is in the best interest of reducing the informational risk of the principal and others who wish to use the companies financial statements.

The role of the auditor

Whilst the role of the auditor and the auditing firm grew out of the accountancy profession, the auditing role in itself is perceived by many to be a separate profession and thus independent of those working in other areas of accounting and accountancy. In broad terms, the role of the auditor is to given an independent account of the suitability or not of financial statements and other documents produced by a company so that stakeholders of the company may decide wheatear or not such documents are trustworthy as a source of information for further analysis. As such, the role of the auditor is not to provide an opinion upon the strengths and weaknesses of a business but rather that the information being presented by the company is a fair and actuate reflection of the facts. From this position the stakeholder using the data is then able to make their own mind up about the financial and operational wellbeing of the company.

Having considered the basic role of the auditor, not surprisingly one of the key features or expectations is that an auditor will thus be completely independent of those who have prepared the information to be audited and those operating within the organisation as a whole. This may be considered as one of the "key expectations" of the auditor from those stakeholders who rely upon the services of the auditor for further decision making. As such, where such an independent status if forgone by engaging in additional value added activities including management consultancy then this may be defined as forming one of the "expectation gaps" between the auditor and those that rely on the services provided by an auditor (Eilifdsen et al 2010).

Another key issue which is debated in terms of expectations and the expectation gap is how far the role of the auditor goes in determining risk due to issues connected to fraud and misinformation. As Jones (2010) indicates the view in times past was that the role of the auditor was to be "the watch dog not the blood hound". This is to say that the role of the auditor is to report and detect any risks which they might be reasonably expected to find given the information provided and the application of common sense but not to necessarily act in a way which assumes suspicion of a firm or to actively seek out corruption and misinformation. Such an approach largely comes from the Lord Justice Lopes ruling back in 1896 in which it was considered that "an auditor is not bound to be detective, or… to approach his work with suspicion or a forgone conclusion that there is something wrong". In other words an auditor would normally assume that all is well unless there was some express detail found which merited further suspicion.

However, Jones (2010) goes on to point out that ISA 240 (redrafted) has now in essence made such an approach all but invalid and that the auditor now has an active duty to seek out such miscreant activities. The precise phrase used is that the auditor should conduct their duties with "professional scepticism" as opposed to conducting there duties in a "passive" way.

The evolving role of the audit firm

Some consider the changing role of the auditor and the audit firm and how this has added or subtracted from the independence and effectiveness of the auditor. Citron (2002) indicates that over time those involved in the auditing business have developed there services far beyond the mere conducting of financial audits, since the 1990's audit firms have taken on a large range of additional roles and service provisions including down stream accounting activities and well as more upstream and value added services such as management and business consultation.

One issue which has arisen which is highlighted in the statement is whether or not challenges to business models falls within the remit of the auditor. If it is considered that such challenges do fall within the legitimate role of the auditor then one may question weather such services should be marketed as additional extra services by auditing firms, in essence auditors should be carrying out such services as part of the core offering without the need for additional payment. On the other hand, if such services are to be considered as not part of the core function of the auditor then one may consider that there the potential for a conflict of interests from a number of sources. On the one hand, one may consider that involvement as a management or other form of consultant with a business then prevents the true proclamation of independence since the auditor or audit firm acting in the capacity as a consultant is now effectively a stakeholder of the organisation as opposed to being a truly independent agent. Additionally, there is also the conflict of interest in the form of self interest and the potential for corruption or unintentional bias. For instance, can an auditor be truly expects to maintain a fully independent status free from bias and the influence of those within the organisation they are auditing when there are lucrative management consultancy contracts either ongoing or worse potential up for renewal. Those who would answer this in the negative would point to a number of cases in which a lack of independence between auditors and those within a firm has lead to large losses in shareholder value in a short space of time, the collapse of Enron in 2001 is often cited as the classic example (Tricker 2009 Mallin 2010).

The dilemma however for those analysing the industry is to consider the figures and potential financial rewards involved in the industry. Whilst back in 1989-1990 the bulk majority of auditing firms made the largest proportion of their income (75%) from the primary activity of auditing and taxation activities, by 2001-2002 this had declined to 58%. In replacement, consulting and other related activities had come to contribute around 42% of fees for the largest audit firms (Accountancy, 1990, 1995 and 2002). From a financial perspective, audit firms have benefited greatly from engaging in a wider range of service provisions, whilst fees for the largest firms totalled £1.27 bn in 1994-1995 a rise of 40% on there 1989-1990 levels this has risen again by a staggering 130% to £2.92 bn in 2001-2002.

Independence as Brand

Thus far the paper has considered the traditional view that the role of the auditor is an independent one and that this is both a necessity and a desirable state for the industry. However, this is not the only view of why the independence of an auditor or the audit firm is an important feature. Some sources (Citron 2002) indicate that in actual fact one of the key reasons for the independence of auditors is not due to the desirability of independence from the clients or users perspective but the fact that independence is a part of a valuable brand for those operating in the auditing business. In short, independence is a valuable brand which builds trust, repeated sales and adds value for the profession. As such, in relation to the statement one consideration is that it may not be reasonable to expect auditors to challenge business models directly not because this is not in the interest of either the business or the wider stakeholder but because it is not in the interest of the auditor. One consideration is that by taking such actions, the auditor loses a degree of independence be becoming a quasi-consultant, in doing so the auditor or audit firm risks detracting from the value and status of the services provided by such firms and individuals.

Transparency and Self Regulation

Others, such as Canning and O'Dwyer (2001) argue in a similar vein to those who consider independence as a brand that the independence guise is not always solely a consideration which is in the public interest. In this case the argument made is that promoting the element of independence and transparency is done for reasons of maintaining privileges as the right to self regulation which are associated with the professions of which the auditing industry has been a large benefactor (Lee 1995, Willmott 1986).

As such, in relation to the statement again the consideration is to what extent audit firm should either be obliged to or wish to engage in the challenging of business models. Again the argument would be that the reason against this would be to maintain a sense of independence and transparency in the mind of the public. Only by maintaining such an image in the publics mind set can those who operate in the profession hope to preserve such a privileged status with self regulation rights. As such, the key consideration again is that the concept of independence and transparency is implemented not for the good of the public but for the good of those operating in the industry.

Duty of care and industry problems

One of the key issues for the audit which is linked both the concept of independence, transparency and the basic functions of the audit is to whom does an auditor owe a duty of care. Cousins et al (1998) argue that in effect one of the problems with the auditing profession is that they have effective legal duty of care which is an almost unique status to the industry. Cousins et al (1998) also goes on to point out that there are further problems in the industry which can often lead to profiteering at the expense of those who are supposed to be protected by the services of the auditor. Here it is indicated that over 600,000 companies per year require the services of an auditor in the UK, yet the market is monopolised by just six large firms who have internalised the £3.5bn market for auditing services as well as the volume of other related services which brings the market to a value of £7.3 bn. Yes Cousins et al (1998) goes on to argue that the role of poor auditing has played a significant part in the creation of many corporate financial scandals including the Maxwell pension scandal and the BCCI bank collapse, here Cousins et al (1998) goes on to state that the auditors in such scandals have never been held to account or even given an explanation as to how key elements of the audit failed to deliver a warning to those with a valid interest. The paper goes on to argue that whilst the industry has been forced to look at its process and practises through shear embracement, this has not lead to a plethora of greater regulation on the behalf of external sources. On the contrary, those in the audit profession have sought greater levels of protection from legal repercussions as the result of what may be considered a breach of the duty of care in any other industry.

This presents an interesting concept when considered against the backdrop of the expectation gap. Here one may consider that under any other business model, where there is a gap between expectations and the provision of a good or service, in the most serious of circumstances this may lead to a consideration that there been a breech in the duty of care and thus give those who make use of the good or service the rights to a legal remedy. However, if Cousins et al's (1998) assertions are to be considered as correct, then there is the consideration that in effect any expectation gap between those who should benefit from the auditors services and the auditors will not result in a breech of the non-existent duty of care and thus gives rise to no legal remedy on the behalf of the user.

Business Risk

At this point it is worth considering the issue of business risk specifically. As Eilifsen et al (2010) indicates, managers implement business strategies and objectives in order to generate a profit and then a sustained competitive advantage (Porter 2004). However, there are always risks which are involved in both the implementation of such strategies and objectives and there ongoing operation. Eilidsen et al (2010) argues that in this case it is the role of the auditor to consider risks in the misreporting of information associated with such strategies and objectives. For instance in the case of significant risks in a business model then an auditor may consider that the value of assets have been overstated based upon historical but potentially inaccurate sales revenue figures or historical asset values. As such, by understanding the risks of a given business model an auditor is able to better identify the sources of risk and where to look for potential issues of intentional (fraudulent) or unintentional misinformation.

Whilst one can see the desirability of the auditor being able to assess and understand a business model from the perspective of detesting issues which may need to be identified and reported on the question in relation to the statement of the question is weather or not on identifying such risks to the business model these should then be communicated to those in management positions within the company. On the one hand, the positives of such an action would almost certainly be an improvement or reduction in business risk however, there is also the consideration that such an action would go beyond the role of the auditor and into the role of management consultant. Here again, this may be seen as fuelling a difference in the "expectation gap" from the perspective of those who consider the role of independence of the auditor as one of the key features of the service.

A further consideration may be an assessment of the skills possessed by the auditor in order to effectively act as a consultant. In order to assess and report upon the risks and thus make recommendations, an auditor must understand a wide range of issues including industry and environmental factors, the nature of the entity, accounting policies, the organisations strategies, performance measures and internal controls (Eilifsen et al 2010). Only when all of these skills are in place can an auditor truly act in an advisory capacity which thus again begs the question of weather such an individual is primarily acting in the capacity of an advisor as that of a management consultant.

Enron and other high profile scandals

One of the key reasons for the sudden rise of interest in the auditing function has been the plethora of large scale scandals and collapse of organisations which have seen shareholder lose millions in a short space of time and in some cases national governments being called upon to bail out businesses which have suffered the woes of fraud and poor accounting practises. One of the large items of interest which serves as a good case study is that of the Enron scandal in 2001 which will now be considered here in more detail.

Enron was once the US's seventh largest company operating in the energy sector. Despite this fact in December 2001 the company filed for bankruptcy in the wake of a large scale public scandal (Economist 2002). In essence, shareholders had suffered from an overstatement of the value of assets to the tune of around $600 million between 1997 and 2000 due to irregularities in the statement of profitability attributed to the companies "off-balance sheet vehicles". On investigation of the case and after trying to establish why Andersen the audit firm had not detected such mal-practices the findings were that the auditor had, not only had the auditor picked up such findings but had then also participated in document shredding and other activities designed to disguised the poor practises. This took the case of Enron from being a mere bungling on the behalf of the audit from to one of fraud and collusion between the auditor and those wishing to inflate the profitability of the company.

The key question however in this case is why did the audit in question choose to collude with those who were guilt of wrong doing. The article in the Economist (2002) indicates that whilst Andersen took $25m a year from Enron for auditing fees a substantial amount of money in itself, the company actually made a greater amount of money from providing management consultancy fees to the company. As such, one may consider that those auditing the firm had a considerable conflict of interest in that it is unlikely that Andersen would have continued to receive such lucrative contracts in the consultative field if a poor or that is to say truthful audit of the company's financial status had have been published. As such, some argue that not only is it not desirable for auditing firms to engage in such management consultation exercises but that regulators such take steps to ban the practise.

The article (Economist 2002) goes on to point out that whilst it would have been unfortunate if this has been a single episode in which there had been a collusion between auditors and wrong doers it has not been an isolated incident. In the same week as the Enron scandal KPMG has also come under criticism for breaking rules that require and audit firm not to have an investment or financial interest in the firms for which they are auditing.

Conclusions

Having conducted the research there are a large number of conclusions which may be reached in relation to both the statement and other areas of interest which have been raised. In relation to the statement, it would appear that the answer is that the challenging of business models would appear to be an expectation too far for the auditor. Not only does this paper consider that it may be an expectation too far but also that such an activity may even be undesirable. In the first instance it may appear that auditors taking on such a role could help to reduce risk. However, the major issue is that when an auditor undertakes such a role they risk becoming a quasi-consultant, as such this potentially undermines the independence of the auditor a trait which may be seen as undesirable for all in both the profession and from the point of view of the service user.

One of the other key issues raised in this paper is the value of the independence of an auditor, time and again the paper has demonstrated the importance of the truly independent status of the auditor however, one consideration is that in many cases it is the auditor in them self that will benefit to a greater extent from a reputation as an independent agent rather than just those to whom they supply their services. This has been demonstrated with regard to a number of considerations including how independence functions as an effective from of branding through to the consideration that such independence helps the industry to maintain its self regulatory privileges, an element which the industry has fought hard to keep and would be difficult to justify if a less independent status has been maintained by the audit profession. For all these reasons it may be further considered that it is not the job of the auditor to get further involved in the activity of actively challenging business models during the audit process or as an added value service.

Writing Services

Essay Writing
Service

Find out how the very best essay writing service can help you accomplish more and achieve higher marks today.

Assignment Writing Service

From complicated assignments to tricky tasks, our experts can tackle virtually any question thrown at them.

Dissertation Writing Service

A dissertation (also known as a thesis or research project) is probably the most important piece of work for any student! From full dissertations to individual chapters, we’re on hand to support you.

Coursework Writing Service

Our expert qualified writers can help you get your coursework right first time, every time.

Dissertation Proposal Service

The first step to completing a dissertation is to create a proposal that talks about what you wish to do. Our experts can design suitable methodologies - perfect to help you get started with a dissertation.

Report Writing
Service

Reports for any audience. Perfectly structured, professionally written, and tailored to suit your exact requirements.

Essay Skeleton Answer Service

If you’re just looking for some help to get started on an essay, our outline service provides you with a perfect essay plan.

Marking & Proofreading Service

Not sure if your work is hitting the mark? Struggling to get feedback from your lecturer? Our premium marking service was created just for you - get the feedback you deserve now.

Exam Revision
Service

Exams can be one of the most stressful experiences you’ll ever have! Revision is key, and we’re here to help. With custom created revision notes and exam answers, you’ll never feel underprepared again.