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Audit has always been an essential role for providing the public with creditable, confidence and reinforcement of trust in the financial reporting. The disclosure of financial statement is mandatory and it is the main issue for the regulatory for protecting the interest of the public from chances of manipulated books of financial reporting. The demand of audit service is increasing as the reporting of financial report is mandatory and is a main issue of the regulatory compliance act for control to serve to the best interest of the public. The auditor's responsibility has always been associated with the agency theories as the management of the firm may not always act to the best interests of the shareholder. The management would at times not only consider what is best for the company but also the best for they are own interest. This would be a conflict of interest between the management and the shareholders, as the management of the firm are actually being hired by the owners of the firm which is the shareholders, thus the management should only act with the best interest to the shareholders (Volosin, 2007).
Background of Audit Expectation Gap
The history of company frauds, auditor's competency in detecting fraud which causes the expectation gap has a very long history. However, the term audit expectation gap only came about in recent times. Therefore, professional and professors have done numerous research and studies to seek and find a definition to solve the issue. This has proven to be complex and continuously changing problem which seems like the style is evolving overtime, as even till today, the gap has not been eliminated. There is not a clear solution or picture to close the audit expectation gap as of today. The scope and definition of audit expectation gap varies from researchers and studies. Porter (1993) explain that the audit expectation gap is being define as the reasonableness gap between what is expected from the society towards the auditors achievements in detecting frauds and what the auditors can reasonably be able to accomplish. Porter (1993) also mention that the performance gap between what reasonable expectations the society can have from the auditors' accomplishment and what the auditors are perceived to achieve. To further breakdown the performances gap, it can be split into deficient standards and deficient performance (Porter, 1993).
Moreover, ever since the Enron and WorldCom incident in the United States, this has given an image of how the audit could not be perfect in detecting all frauds from the management of the company, adding mostly negative impact of the image of the audit. Therefore, the expectation gap of audit have been rise globally and shareholder voicing out demands of improvements in the result and quality of audit. Improving the audit accountability and promoting greater transparency are the main changes being made in recent years, however, further research into the reduction of frauds continue to exist.
Further looking into expanding the auditor's responsibilities and enhancing their independence to close up the expectation gap. It is a difficult task or even an impossible mission to change the public's perception as this has been a long time belief that depends on auditors to be fraud detectors. Auditor's responsibility should be increase by means of adding additional level of reporting and accountability. Statues should not only come into play only when protecting the liability of the auditors but also increase and ensure that they take on more intensive responsibility.
The objective of this research is to find out the best balance and practices which the auditor could impose to reduce the expectation gap.
Independence is said to be the fundamental of the reliability of auditors' reports. Some causes which resulted in the reduce independence are economic dependence of the auditor on the client, audit market competition, the provision of non-audit services as well as the regulatory framework. These cause auditors to be unable to compile a fair report. Therefore, if auditors are independent, the expectation gap will be reduced. However, the auditor's independence may be influenced by conscious inaccuracy or by unconscious in inaccuracy in the reported information (Sucher and Maclullich, 2004).
The conscious inaccuracy may arise due to factors such as having a close relation with the client, dependency on the client business for livelihood, drive by a desire of economic and social success, a blood relationship or marriage relationship with client and the competitions arises from the audit market (Sucher and Maclullich, 2004).
Also the unconscious inaccuracy which contribute to some factors like the auditor's reliance on the client's branch manager, external confirmation while making opinions on account such as confirmation from debtors, creditors and banks, lastly the dependency of the management for verification and valuation of assets to a greater extent (Sucher and Maclullich, 2004).
In this report, using two cases studies from the Lehman Brothers Holdings Inc. and Americans International Group (AIG) to further understand and examine the limitations of audit firms and the various reason why audit could not be totally independent.
Chapter 2 - Literature Review
There are constraints that audit need to seek for and only provide reasonable assurance for the statements that free itself from material errors. Statistical sampling are often a way adopted by in auditing. Cases like the financial auditing, sets of required financial statements are said to be either true or fair only when they are free from material misstatements, like if there are concept that influenced by both the quantitative and qualitative factors. In recent times, the argument of auditing should have gone way beyond just the true and fair which has gain an increasing momentum. The United States "Public Company Accounting Oversight Board (PCAOB)" has also release a concept which is based on the same (McKenna, 2011).
There is a need for an assessment to be able to measure or calculate the value of something. Therefore, the process of coming out with an assessment may require an audit with sufficient independent professional, the purpose for the independent professional is to provide a way of measurement rather than just an expression of an opinion of the fairness of financial statements or quality of the performances (McKenna, 2011).
The general rule is for audit to always be independent evaluator that provides some degree of quantitative and qualitative analysis rather than just providing an assessment which implies lesser independent and much more consultative approach. The assessment outcome has to be related to the norms which is usually set as the event, product and task (McKenna, 2011).
The United States has actually came out with an Auditing Standards Board (ASB) which are the senior technical committee allocated from the American Institute of Certified Public Accountants (AICPA) which also provide quality control, attestation and auditing statements, guidance and standards to Certified Public Accountants (CPAs) for private companies which are non-public firm audit (AICPA, 2010).
This has been created on October 1978 and began its composition of nineteen members coming and presenting from various industries and sectors, which include the public accountants from the educational, government and private entities. It has done its announcement through guidelines, interpretations and statements that all CPAs has to adhere when performing attestations and audit (AICPA, 2010).
Following an extensive researches of some studies from the AICPA and they are sub committees, the government council actually did establish the importance of the ASB as to make maximum out of the authoritative people in the body to create the Generally Accepted Auditing Standards (GAAS) , therefore gathering and replacing every previous senior technical committees. There is a requirement that all AICPA members along with the public accountants to follow the guideline from the ASB's pronouncements which relates to the attestation, audit and quality controls. This has define the auditors responsibility and to provide necessary guidelines to allow them to complete the emitted reports and working among others (AICPA, 2010).
The United States of America actually start the Sarbanes-Oxley (SOX) Act as of 2002 which started changing the hierarchy and making the generally accepted principles of auditing standards. The legislations completed the Securities Exchange Commission (SEC) and PCAOB, and finally the authority for auditing regulation and public auditors professional practices standards from the audit of public firms, all this are referred as the "Issuers". The public accountants and those companies which audit public firms are all required for registration with PCAOB and adhere to all interpretation, principles, rules and standards accordance to the PCAOB which is related to public company audits and reports, and also the quality control and attestation. PCAOB adopted the ASB's attestation and auditing standards for they are temporary audit rule in the year 2003 (AICPA, 2010).
There have been subsequently changes from the AICPA which the designation of the people who are leading GAAS of the authority settings in 2004. PCAOB has been designated to be one of the authoritative body of the GAAS related for public firms and while ASB will be designated to the non-public firms (AICPA, 2010).
Chapter 3 - Case Studies
Lehman Brothers Holdings Inc.
Lehman Brothers Holdings Inc. was operating as a global financial services firm before the company declared they are bankruptcy in year 2008. In the United States, the company was actually the fourth biggest investment bank just behind the leading top three which are Goldman Sachs, Morgan Stanley and Merrill Lynch. They are main operations were equity, fixed income sales and trading, investment banking, investment management, researches, private banking and private equity (Mamudi, 2008).
The company on 15 September 2008 filed for the act Chapter 11 bankruptcy protection which follows with a massive exodus from almost all of the company's clients, a steep deep in losses for the company's stock price and the devaluation of the company assets from the credit rating agencies. The company filing of bankruptcy was the biggest bankruptcy filed in the United States history. The company has played a major role in causing the super global financial crisis in the year 2008 (Mamudi, 2008).
The audit firm responsible for the audit held in Lehman Brothers Holdings Inc. were Ernst and Young LLP. Andrew Cuomo from the New York Attorney sued Ernst and Young LLP saying that Ernst and Young LLP helped the firm of facilitating some considered as a major accounting fraud in Lehman Brothers financial condition deceiving the public. From year 2001 to 2008 before the filing of Lehman Brothers bankruptcy, the company consulted on the transactions which were make approve by Ernst and Young which will on purpose move some of the debt off the balance sheet and reduce the Leveraged Ratios. Andrew Cuomo noted that this was done via what was known to as the Repo 105 transactions (Freifeld, 2010).
Andrew Cuomo (2010) mention that the company practiced the house of cards business model which in term manage to cover the billions of liabilities from the public for years before the company declared bankruptcy. The repo 105 transactions which include the sale and repurchasing of agreements are actually the short term financing which the company used to transfer a sum of fifty billion off the company's balance sheet and temporarily showing the investors that the company was not carrying a lot of debt. The higher the leverage means that the company capacity to be able to absorb economic financial shock that could also scare off lenders (Freifeld, 2010).
American International Group Inc. (AIG)
American International Group Inc. (AIG) which operates as an American multinational insurance corporation and the corporate head office is at 190 Maiden Lane in New York City. Reported from Forbes Global 2000 list, AIG was once the twenty nine biggest company in the world and listed under the Dow Jones Industrial Average from 8 April 2004 to 22 September 2008 (Forbes, 2008).
AIG has also been an accounting scandal and is known as dealing with improperly booked transactions with the company Berkshire Hathaway Inc. and this has created an artificially strong reserves of AIG. The disclosures only came to light when SEC and the New York Attorney General Eliot Spitzer are getting ready for question to AIG's chief executive officer Maurice Greenberg and Berkshire Hathaway's chief executive officer Warren Buffett regarding the controversial reinsurance deal. The company Berkshire Hathaway has mention that Warren Buffett was totally unaware of how the structure of the transactions were make or even aware of any improper use for the transactions (NBC, 2005).
PriceWaterHouseCoppers (PwC) was the audit responsible for the improper transactions deal between AIG and Berkshire Hathaway. PwC has been the auditor for AIG for several years, and through these years, has been disregarding these questionable dealings. PwC has been the auditors of choice for AIG ever since the predecessor firm like Coopers and Lybrand, this has a relationship between AIG and PwC of a history of over twenty years. And because of PwC role in the dominant force for auditing in insurance firms, it could have worked over the outfit of the boundary to be treated especially closed relationship from being a regulator to a shareholders alike (BusinessWeek, 2005).
There was indeed strong questions of this improper structured deals going on in AIG but was over looked by PwC for a very long period of time. It is questionable that this transactions are of material amount and the audit method use was unable to detect or have PwC turn a blind eye into the transactions (BusinessWeek, 2005).
Chapter 4 - Data Analysis
All auditors are being employed by the shareholders or investors for the sole reason of overseeing the company for checking the company results and to present a true and fair view of the company financial results. But the problem could lay in the audit report which are presented to the company's directors and chances of potential financial discrepancies rows over or misgivings about the corporate policies and practices are actually kept behind closed doors. Further disagreements should have spirals out of control, the auditors are and should have refused to sign off any accounts for the company.
Lehman Brothers Holdings Inc.
If used the principles based auditing in the United Kingdom, this should supposed to get a box ticking treatment around the accounts in the United States, which is considered rigid and merely complying with the figures to meet the legal regulatory requirements and rules. Yet the shareholders and investors in Lehman Brothers could have found that the stricter United States accounting rules have prevented the sales and buyback practice which have disguised its fifty billion liabilities and while if used the United Kingdom rules, this would allow them.
American International Group Inc. (AIG)
For the case of AIG, even the big four are corporation and would need to buy insurance for they are individual company, hence they would also need companies like AIG to support into they are individual company insurance policies and pricing. Therefore the management of both companies could have they are unseen agreement on some issues which bring both party profit and into a state of both party gain agreement. PwC being the auditor of choice for AIG for the pass twenty years are not favorable to being independent as the leader of the team of audits are set into a comfortable stage with AIG and therefore could have miss looked into some obvious frauds in the transactions.
Limitation of Audit Firm
It has been a centuries of old system for auditing that has long been criticized by the public for being too costly and is always on the verge of being under scrutiny for falling short on detecting the problem areas of the audited company.
And because of a solution to reduce cost that has been criticized, reducing cost would have only reduce the ability of detecting frauds in a company. The audit team being deploy to a company usually made up of mostly trainees and junior accountants. And being task to check on the financial statements produce from the holding company and the holding company's subsidiaries.
Taking samples of transactions just to comply with the rules of accounting and reporting to satisfy themselves. The external auditors should have also liaise with the internal auditors who are actually the whistle blowers from within the company. However, due to the reputation of the audit company they are representing, they will just accepted transactions chosen by the company and does not require the information which the internal auditors could produce to them.
Chapter 5 - Conclusion
Auditing has become increasingly difficult as implementation of new rules and regulations change over the years. Studies and research of ways to reduce the expectation gap between the auditor, client and public have proven that the gap can never be eliminated. The auditor experience does play a major role to reduce the gap, the overly reliance of an academic knowledge alone and the lack of the needed years of practical work exposure and experience will cause the auditor to be unable to recognize an observable condition from the client representation. However, the auditor relationship with the client for business may force the auditor to have a desire of not to know, and the acceptances of the client presentation alone without enforcing their professionalism of both knowledge and experience on the client. It is also the public responsibility to understand the gap before finalizing the financial statement which they use to analysis.
The audit expectation gap can never be eliminated due to the sole fact that audit are never completely independent and will not be totally working towards the best interests of the shareholders and public investors. Audit firm are still being driven by profits and market competition. From analyzing the report, the best possibility that audit could seek full independent is that the audit company are not being run by profit driven investors rather it could be only run by the government of the country and it is the duty of the government to allocated the audit company to audit the individual corporation and companies has no rights to change auditors as they wish. However, scandal could also arise from individual in the authority's body.