Managing The Audit Function

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This short essay aims to investigate and analyse the various aspects of as also the causes behind the gap that appears to exist between (a) the expectations of shareholders about the purposes of external or statutory audits, and (b) the aims and objectives of auditors in conducting such audits.

Recent decades have witnessed the occurrence of numerous instances of financial wrong doing and frauds in the conduct of organisational operations by the managements of big and small commercial firms (Kaplan & Williams, 2010, p 3). Such actions have more often than not resulted in the collapse of small and big firms and in significant losses to shareholders and other stakeholders. The financial and accounting scandals at Enron and WorldCom in the early years of the present century resulted in losses of millions of dollars to their shareholders (Kaplan & Williams, 2010, p 3). The financial crisis of 2007-2010, which occurred in large measure to the collapse of large, well established and widely reputed banks and institutions like Lehman Brothers, Bear Stearns, Goldman Sachs, Fannie Mae and Freddie Mac resulted in extensive investor losses (Kaplan & Williams, 2010, p 3). Whilst some of these institutions like Bear Stearns and Goldman Sachs were saved by governmental and private sector intervention, others like Lehman Brothers became bankrupt, leading to huge investor and shareholder losses (Picket, 2010, p 7). Such incidences of corporate failures induced by financial misdemeanour on the part of managements are resulting in intense soul searching and analysis by investors, regulators, media institutions, financial system participants and members of society (Picket, 2010, p 7).

Intense debate and discussion is specifically occurring on the role of statutory auditors in the prevention of such crises, with specific regard to detection and reporting of corporate fraud (Ovidiu-Constantin, 2009, p 3). Associations are constantly being drawn by various stakeholders on the relationship between the inadequacies of auditors in detection of fraud, and in fulfilment of their statutory and wider responsibilities, and the occurrence of financial scandals and corporate collapses (Ovidiu-Constantin, 2009, p 3). Such inadequacies, it is felt, are leading to lack of generation of critical red light and early warning information to shareholders, their failures in exiting from corporations engaged in financial malpractice, and to their consequent destruction of wealth (Ovidiu-Constantin, 2009, p 3). External/ statutory auditors on the other hand are firm in their opinions of the main aims and objectives of such statutory audits being the verification of the truth and fairness of accounts and not the detection and public information of fraud (Ovidiu-Constantin, 2009, p 3).

Such gaps between the perceptions of shareholders and statutory auditors have resulted in the development of an expectation gap, a phenomenon that is increasingly becoming a matter of concern for investors, accounting firms, regulators and standard setters (European Commission, 2010, p 3). The European Commission, in a 2010 Green Paper on Audit Policy: Lessons from the Crisis, makes the point that disenchanted stakeholders may well be unaware of the limitations of statutory audits, with specific regard to areas like (a) materiality, (b) sampling techniques, (c) the roles of auditors in fraud detection, and (d) management responsibilities, which in turn leads to the development of expectation gaps (European Commission, 2010, p 3).

The commission advocates the need for vigorous discussion and debate on the issues that need to be addressed in ensuring that financial statement audits and audit reports become “fit for purpose”. (European Commission, 2010, p 4)

Commentary and Analysis

The expectation gap that exists between users of audit reports and external auditors has been confronting the accountancy and auditing professions since the days of the Industrial Revolution, when auditing was first taken systematically for the checking of managerial work in business firms; first in the UK, and then in other western nations. Sikka, et al, (1998, p 3) state that users of corporate reports, namely investors, politicians, journalists and others expect financial auditors to “detect and report material fraud and irregularities, among other things”. The auditing profession, in response however argues that (a) members of the public misunderstand the role of the auditor and that (b) the detection and reporting of fraud is not a major objective (Sikka, et al, 1998, p 3).

The auditing profession by and large continues to hold the view that responsibility for prevention and detection of fraud rests with corporate and business managements. Auditors, they state, are not and cannot be held responsible for prevention of frauds and errors (Picket, 2010, p 9). Auditors can nevertheless play very positive roles in prevention of frauds and errors by discouraging and deterring their occurrence. Auditors, members of the profession feel, must necessarily plan and conduct their audits with professionally sceptical and questioning approaches, recognising at all times that conditions, events, and environments may well be found that indicate the possible existence of fraud or error (Picket, 2010, p 9). Auditors should, based upon their assessment of audit risks, develop audit programmes and procedures to obtain reasonable and substantial assurance about identification of significant errors and frauds in the preparation of financial statement. They are expected to implement processes and procedures that will lead to discovery of fraud and errors in financial statements (Picket, 2010, p 9).

Auditors must also seek adequate and suitable audit evidence to confirm that frauds or errors that may be material to financial statements have not occurred (Cangemi & Singleton, 2003, p 17). They must, in the case of occurrence of frauds, also ensure that their effect is appropriately reflected in financial statements or corrected. Audits, however, are subject to inherent limitations and to unavoidable risks regarding the non-detection of material misstatements, resulting from fraud, in financial statements (Cangemi & Singleton, 2003, p 17). ISA 240, which deals with auditor responsibility with regard to fraud in audits of financial statements, clarifies that responsibilities for prevention and detection of fraud essentially lie with managements (Picket, 2010, p 9). The managements of business firms must accordingly implement and operate adequate and appropriate accounting and internal control systems for prevention and detection of fraud. The external auditors cannot certainly be held responsible either for prevention or for detection of fraud (Picket, 2010, p 9). Auditors can, in fact, where misstatements on account of fraud are detected after the completion of audit, be held responsible only for failure in adhering to principles and procedures (Cangemi & Singleton, 2003, p 17).

Accounting professionals also stress that the detection of fraud and error should specifically be an important objective of the internal audit function of corporations and an integral part of corporate governance, rather than the responsibility of external auditors (DeZoort & Harrison, 2008, p 4). Contemporary internal audit standards also indicate a concerted effort for increasing fraud standards. The new risk management standard of the Institute of Internal Auditors in fact states specifically states that “the internal audit activity must evaluate the potential for occurrence of fraud and the ways in which organisations manage fraud risks”. (DeZoort & Harrison, 2008, p 4)

A study of auditing literature reveals the expectations gap to be a recurring issue. It constitutes an important issue for auditors because increase in the expectations gap effectually reduces the credibility, prestige, and earning potential associated with audit work (Sikka, et al, 1998, p 5). It is also an important issue for investors, regulators, policy makers and members of society because the wealth creation process and political stability in a capitalist economy relies significantly upon public confidence and belief in existing accountability processes (Sikka, et al, 1998, p 5). With the statutory or external audit of financial statement being an important element of the existing accountability framework, it is not surprising for the expectations gap to attract considerable institutional interest and general debate. Its continuance and increase is also felt to constitute a threat to corporate governance and to the legitimacy of auditing institutions (Sikka, et al, 1998, p 5).

Whilst the academic literature on the gap is fragmented, to say the least, the majority of studies on the issue are based upon the assumption that the correct reading of audit reports requires the acceptance of the values preferred by the auditing profession (Sikka, et al, 1998, p 5). This assumption also implies that the gap can be reduced significantly if the intentions of auditors could be correctly transmitted to various users and regulators (Sikka, et al, 1998, p 5). Many commentators attribute the development and increase in the expectation gap to be due to confusion in the minds of users, misunderstanding, and lack of knowledge about auditing purposes and practices (Picket, 2010, p 10). Some experts also uncritically accept the definition and problem resolution favoured by the auditing profession, namely that poor understanding of auditing objectives amongst users can and should be corrected by appropriately educating users (Picket, 2010, p 10).

Sikka, et al, (1998, p 7) state that the present day tendencies of the auditing profession to reduce or restrict their responsibilities for detection of fraud differ significantly from its attitudes in the 19th century, when it frequently associated auditing expertise and skills with detection and reduction of fraud. Auditing professionals, at that time, strived to enhance the symbolic and material value of their work by positioning themselves as specialists capable of reducing investment and stock ownership risks (Sikka, et al, 1998, p 7). The profession has subsequently worked towards institutionalising its responsibilities for ascertaining the truth and fairness of presented accounts and shifted the meaning of audit away from fraud and its detection (Sikka, et al, 1998, p 7).

Experts state that the expectations gap continues to be perpetuated because of inherent contradictions in the preferred meanings about the practice, nature and outcomes of auditing. Auditing professionals, as sellers of auditing services, work towards securing the symbolic and material value of their labour, which they have historically done by successfully asking the state for monopolistic control over supply of external audit work and at the same time by reducing their legal obligations and liabilities (Sikka, et al, 1998, p 8). The buyers and regulators of such auditing labour, on the other hand, wish to ensure that audits are of the required quality to secure public and investor confidence in capital market operations (Sikka, et al, 1998, p 8).

The uneasy and sensitive relationship between auditing professionals and the buyers of their services is mediated through obscure, complex and self regulatory mechanisms. Such a relationship is also made more complex by the relationships of auditors with managements, upon whom they rely for selling more profitable services (Sikka, et al, 1998, p 9).

Recommendations and Conclusions

The current concern about auditing responsibilities and the perceived inadequacies about the capabilities of existing auditing practices to ensure the safety and security of investor wealth, particularly from the incidence of fraud and financial misdemeanour by corporate managements is resulting in intense debate amongst investors, regulators and members of the auditing profession. A number of suggestions and measures are being debated on making auditing practice fit for purpose.

Current practice appears to indicate that auditors work towards ensuring that financial statements adhere to specific financial reporting frameworks, rather than towards checking whether they provide true and fair view of accounts. It thus becomes important for auditors to stress more on substance, even as they are also required to maintain form (European Commission, 2010, p 9). It would also help if auditors transferred their obligatory sceptical attitudes to active challenging of managerial positions from the perspectives of users. It is important for auditors to extend their focus, which until now has been largely based on historical information, to assessment of forward looking information given by corporate managements. Such information would in fact be extremely relevant for the certification of going concerns (European Commission, 2010, p 9).

External observers also state that the credibility of audit work would increase significantly if auditors were to become far more transparent about their internal governance and independence processes. Auditor independence should become an unshakable foundation of the audit environment and should be brought about through the application of numerous principles concerning rotation of audit, audit fees, and corporate governance (European Commission, 2010, p 11). The provisioning of non auditing services is considered to be a significant barrier to auditor independence, an issues that needs to be studied significantly by regulators as well as audit firms in order to arrive at uniform international norms on the matter (European Commission, 2010, p 11).

The continuance of the expectation gap is a matter of concern in the contemporary dynamic business environment. With volumes of business, corporate investment and investor activity expected to rise steadily, it is important for auditors and regulators to take strong and concerted action to improve the credibility of auditors with the investing population. A number of steps can be taken in this matter to achieve this objective.

Concrete progress will however not be easy to achieve without the adoption of a more proactive and open attitude on the issue by auditing professionals.