Theoretical Background Behind Auditors Liability Accounting Essay


The audit expectation gap has a long history since there is a widespread concern with the existence of the expectation gap between the auditing profession and the public.An expectation gap exists when auditors and the public hold different beliefs about the auditors' duties and responsibilities and the messages conveyed in audit reports. [2] This is to show that the information gap has arisen here. The International Auditing and Assurance Standards Board (IAASB) defines the information gap as "the divide between what users believe is necessary to make informed investment and fiduciary decisions, and what is available to them thorough the entity's audited financial statements, the auditor's report or other publicly available information" [3] .

In many circumstances, particularly in the case of corporate collapses, investors and lenders wrongly treat business failures as audit failures. [4] There is a tendency for third parties to blame auditors for the failures of directors and senior management in supervising the business and its operations. The difference in perceptions of the auditor's role between users and auditors is explained by the 'Expectation Gap Theory'. This theory suggests that the users and auditors to provide assurances concerning 'material fraud, irregularities and the viability of the business and its management' [5] . In reality, the auditor has a duty to give a reasonable assurance as to whether or not financial reports are free from material misstatement, and should not perceived as providing an absolute guarantee on the accuracy of financial statements. Therefore it is the director's and management s responsibility to maintain proper financial records and internal control.

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Porter (1993) argues that expectations could only be regarded as reasonable if these expectations are compatible with the auditor's role in society, and are cost-beneficial for auditor's to perform. [6] 

The unreasonable expectations in Malaysia are due to a combination of factors such as users misunderstanding and unawareness of the duties and responsibilities of auditors, the misinterpretation of the objectives of an audit, and exaggerated expectations on the part of users of auditors output. It was found that unreasonable expectations are more pronounced among the general public than among financially competent and highly educated management, particularly in the accounting field. [7] 

In a recent study in Malaysia, [8] the sub-standard performance was mainly originated by the lower quality work performed by the auditors. It is argued that the elimination of the fraud detection role by the external auditor contribute to the deterioration in the quality of audit work. In this context, the auditors certainly believed that they were not primarily responsible to detect fraud in their client company while the public still believed that the main purpose of audit was to detect any fraud or wrongdoing by management. The study further elaborates on the second factors which give it credit to the gaps. Deficiency of auditing standard particularly the use of broad and subjective wordings in the standard itself. One of the obvious examples was the use of word "true and fair view" in the audit report. For auditor, the word does not justify that the financial statement was 100 percent perfect. However, the users of the financial statement may perceive that auditor had performed thorough auditing so that the financial statement free from any misstatement whether it is due to fraud or error. The same concept applies on issue on materiality which was subject to different interpretations for various groups of financial statements users. [9] Apart from that, the third reason was the unreasonable expectation by the users of financial statement. Apparently, well published cases on corporate collapse originated from manipulation of financial statement. Public are now expect more from auditors as the primary controlling element. However, at the same time, the auditor had to follow their standard that governed their roles and responsibilities in performing the audit i.e. subject to the use of sample and materiality concept. These are an obvious reason contributing to the existence of an audit expectation gap.

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Another research from Malaysia, [10] The result of the study indicate the existence of "knowledge gap" and "deficient performance gap" between auditors and corporate managers. Overall, the result indicates that, the auditors in Malaysia are knowledgeable about their duties and the corporate managers have limited knowledge of auditor's duties and they are less satisfied with some of the duties performed by the auditors. [11] 

The auditing profession believes that the increase in litigation against and criticism of auditors can be traced to the audit expectation gap.

The audit expectation gap is detrimental to the auditing profession as it has negative influences on the value of auditing and the reputation of auditors in the modern society.

Neither the user nor the audit should be blame of the existence of the expectation gap because of such contributing problematic factors. [12] 

The review of the causes of an audit expectation gap shows that the reasons for such a problem are indeed varied and complicated. They arise from a combination of misconceptions and ignorance on the part of users; the complicated nature of the audit function; unreasonable expectation on the part of stakeholders and the public and inadequate performance by auditors, situations that are in turn caused by the various reasons discussed above, plus inappropriate legislation in Malaysia. Given the diverse range of problematic factors contributing to existence of the expectation gap, it is argued that neither the auditor nor users should solely be blamed for the present "audit expectation gap" crisis.

Based on the findings of the causes of the audit expectation gap in Malaysia, this study proposes a number of remedies for this problem. It is hoped that these proposed solutions will provide the regulators of the accountancy profession in Malaysia with some meaningful insight into ways to mitigate the audit expectation gap and the associated consequent problems. This in turn, should help to enhance the quality of accounting and auditing practices in Malaysia. [13] 

A review of the literature identifies various causes which contribute to the existence of an audit expectation gap. The user misunderstanding and unawareness of the duties and responsibilities of auditors is likely to contribute towards the existence of an audit expectation gap. The general public's poor understanding of the complicated audit function is also contributed to the existence of an audit expectation gap.

The gap here

4.2 Deep Pockets Theory

Third parties will often look towards the auditor when searching for a solvent party from whom losses may be recovered, even though auditors do not provide a guarantee as to the viability of a company [14] . This is referred to as the 'Deep Pocket Theory' whereby shareholders and creditors tend to sue auditors for breach of common law and statutory duties [15] . The reason auditors are regarded as having 'deep pockets' is because they are required by law to carry professional indemnity insurance [16] . Auditors are targeted by third parties because there is little advantage in bringing proceedings against a company that is insolvent, or whose assets are difficult to locate or realize [17] . This is despite the fact that there may be good arguable claims against a company, especially where the directors and management are clearly at fault [18] . Overall, these theories provide an explanation for the high instances of litigation against auditors by third parties seeking compensation.

4.3 Agency Theory

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While the expectation gaps and deep pocket theory suggest that the theoretical background behind auditor's liability, that cause the rising of the legal action taken against the auditors, the agency theory plays its important roles in the principal-agent relationship.

Audits serve a fundamental purpose in promoting confidence and reinforcing trust in financial information. The principal-agent relationship, as depicted in agency theory, is important in understanding how the audit has developed.

Principals appoint agents and delegate some decision-making authority to them. In so doing, principals place trust in their agents to act in the principals' best interests. However, as a result of information asymmetries between principals and agent and differing motives, principals may lack trust in their agents and may therefore need to put in place mechanism, such as the audit, to reinforce this trust.

Thus, in addressing the auditor's liabilities and responsibilities, Douglas V. DeJong and John H.Smith [19] has develop an application of agency theory as a broader theory to determine audit responsibilities within legal environment faced by the auditor. Previous agency theory applications in auditing have assumed a conflict between the objectives of managers and investors and have focused on the role auditing plays in monitoring the investor-manager relationship. In this study, the author focus more specifically on the investor-auditors relationship that is established through the audit process and the role that courts play in resolving disputes in this relationship.

This is best illustrate the relationship exist between investor - auditor in the situation when investor making an investment decision, an investor faces two risks. The first risk is business risks, which represents a measure of general business success or failure. An investor is exposed to business risk in any firm he consider purchasing; however, the investor can mitigate the influence of an individual firm's business risk by investing in a diversified portfolio of firms. The information risk, the second risk faced by the investor, is the probability that the financial statement information used by the investor in his decision is inadequate and unreliable. Thus, inadequate and unreliable financial statement information in investment situation can lead to an incorrect decision which will reduce the investor's profit. The diversification does not necessary reduce the information risk because the decision depend on the financial statement information available to the investor. The way of reducing the information risk is by requiring audited financial statements. In order to links the auditor to the investor, the auditor express their opinion to the produce the information and presented in financial statement. The auditor when contracted to audit the financial statement put their liability if failure to perform at the standards requirement which may leads to the misleading of information and investor losses. Thus, auditor must bear the responsibility for the loss. The audit fee received by the auditor represents his compensation for the work performed and responsibilities assumed through the audit report. Thus the investor-auditor relationship is established.

The legal system provides an economic incentive for the auditor to fulfill his responsibilities in this environment. It does this by instituting penalties for not meeting audit responsibilities. These penalties are in part a function of the damages suffered by the investor due to the unreliable and inadequate information contained in the audited financial statements. Because auditor penalties are a function of the investor's loss due to the unreliable and inadequate information contained in the audited financial statements, the audit risk faced by the auditor is a function of the investor's information risk and the potential loss the investor faces due to this information risk. [20] 

Agency theory would hypothesize that a more appropriate defense would also include a cost argument. For example, if the point of contention in a legal suit against the auditor is not covered by existing auditing standards, a defense that consists only of denying responsibility because the situation was not covered by existing standards may be inadequate.

If the auditor can demonstrate that the cost connected with increased audit responsibilities were greater than the reduction in the investor's information risk, or that the investor could have reduced his information risk more cheaply by means other than the audit, the defense could have a higher probability of being successful. To illustrate this point, consider the successful defense of Touche Ross in its litigation involving Cedars of Lebanon Hospital Corp. in Miami:

Hugo Black, Jr., one of the accounting firm's attorneys, told the jury that the board of directors 'has the best chance of stopping that stuff and nipping it in the bud.' He added: 'There was collusive fraud at the top. The evidence will show … that there is no way that an outsider auditor can catch collusive fraud at the top'["Two Jury Verdicts…", 1982]

The growth of the modern corporation led to the prevalence of absentee owners (shareholders) and the use of professional managers to run the corporation on a-day-to-day basis. In this case, the managers served as agents for the shareholders (referred to as principals) and fulfilled a stewardship function by managing the corporation's assets.

Accounting and auditing play important roles in this principal-agent relationship. First it