This paper examines the audit expectation gap in Australia by examining the existing gap in auditing companies and the expectations of the Australian public. This paper will examine the role that auditors play in promoting financial accountability in Australia and extend of limitations. It will also look at the prevailing literature and studies on the expectation gap. Finally, the paper looks at some of the steps that have been taken to address the audit gap.
Audit expectation gap refers to the difference in perception of the auditors' role and responsibility between the auditors and other third parties as they conduct their work. This gap has an impact on the development of the auditing standards in a country. Most parties agree that this is an issue that needs to be addressed. It is believed there would be less litigation cases against auditors if third parties truly understood and appreciated the role of the auditors. The wider the expectation gap, the higher the unfulfilled expectations of the public which will lead them to have lower credibility on the opinions and recommendations of the auditors. The auditor's professional prestige is dented due to these perceived unfulfilled expectations.
Audit Expectation Gap in Australia
The widening expectation gap has been caused by a number of factors. There has been increasing number of financial scandals in major companies all over the world. This has caused an urgent need to ensure that the investor's funds are protected in various companies. Due to globalization, intense competition and industry-wide company restructuring, business processes and financial statements have become more complex to the users or investors.
There has therefore been an increasing level of reliance or dependability on the auditors to monitor the company and assure the public of the company's financial statements. There is an idealization of the public of the auditor's role and his actual audit role and responsibility (Lindsay, 1992). The primary responsibility of the auditor is to assess whether the financial statements give a true and fair status of the financial aspects of the firm.
It is not their primary responsibility to detect errors, irregularities and fraud. This role is actually for those who have been charged with the responsibility of governing the company. The company's shareholders have put the management in charge to run the affairs of the company. They are supposed to have internal controls in place that will assist them to detect errors and frauds. The auditors are expected to carry out their audit in such a way those errors and frauds may be detected (Barrett, 1996). They are supposed to have adequate planning, sampling and testing processes that will assist in detection of these irregularities however the responsibility of detection and prevention does not lie with them.
The expectation gap in Australia has been researched and examined by a number of experts. A research study was conducted in 1980 to determine what the auditor's responsibility when it came to detection and disclosure of errors, irregularities and fraud from auditors and non-auditors (Low, 1980). The findings showed that the perception of auditor’s role by auditors and users of financial statements varied widely and there existed a wide expectation gap.
Auditors occupy an important role or status in the society as professionals. They are expected to fulfil the expectations of the society and where it is deemed that they are not doing so, there will be actions taken to enforce conformity and even at certain times punish or penalize acts of non-compliance (Barrett, 1996). The role of an auditor is affected by the interactions of the expectations of the different interest groups in the society both locally and internationally.
The expectations of third parties keep changing depending on what is taking place in the society. This has been clearly observed with the effect that the company scandals in the United States had on the audit expectation gap internationally. Therefore the auditor finds himself occupying multi-role position with multi-expectations. It is a critical position to occupy in the society which auditors are acutely aware of. In another research, it was established that the shareholders had higher expectations of the auditors than what the auditors themselves considered to be reasonable (Beck, 1974). Education is one of the ways through which the expectation gap can be significantly reduced. A research study conducted on audit students in college found that the student's perception of the auditor's responsibility reduced significantly with more knowledge (Monroe and Woodliff, 1994). The students were asked questions regarding the responsibility of the auditors, the reliability of a company's financial records and statements and the future prospects of the company.
Students who had advanced in the course indicated that the auditor had a lower responsibility when it came to detection of fraud and errors. They also placed lower levels of reliance on the financial records and the future plans of the company. The marketing students were also part of the research project and for these students, both at the beginning and at the end of their studies, their perceptions on the role and responsibilities of audit did not significantly change.
The term expectation gap when it came to the preparation of financial statements was discussed in the 1970s where auditors felt that they were under attack on the quality of their performance. The increased pressure from the public came from the desire to hold others mainly professionals accountable or responsible for the misconduct of others. The expectations gap has two major components which are the reasonableness gap and performance gap (Chung, 1995). The reasonableness gap refers to what the society expects the auditors to achieve and what actually the auditors can really achieve within their roles. The performance gap on the other hand refers to what the auditors are expected to perform and what they can actually perform.
Auditors and analysts were involved in a study where they were questioned on the importance of unqualified audit reports. It was noted that both groups agreed that the audit report provided very little information on the financial stability of the company. The groups were questioned on the reliability and accuracy of the financial statements. It was noted that the auditors did not give any information on the effectiveness of management in governance of the company. There was uncertainty among the groups on whether an unqualified audit report meant that the management had discharged its statutory duties or not.
Professional auditors and organizations have taken various steps to try and reduce the audit gap. There has been the introduction of an expanded audit report and change in audit standards with aims of reducing the audit gap (Pound and Fensome, 1993). Various studies have been conducted on the effect that both actions have had on the perceptions of third parties. It was noted that audits carried out using the revised audit standards that required an expanded audit report significantly affected third party perceptions on the purpose of an audit, required audit procedures and the responsibilities of the directors or the managers of the company.
The expanded report clarifies the role of management and auditors. It provides a better understanding of the scope and extent of the audit. There are those who recommend that the audit duties and responsibilities can be expanded in order to meet the market expectation with an aim of reducing the expectation gap. The Institute of chartered accountants in 2003 recommended that the audit scope be expanded. The expanded role would include both core and external activities. The core activities would be internal controls, fraud and future prospects of the company while the external roles would relate to corporate governance, continuous disclosure, business risk management and quality of the accounting policies that the management has adopted (Institute of Chartered Accountants in Australia, 1994).
In a research study conducted in 1984, it was recommended that the short-form audit report should be replaced by the long-form audit report to provide more information for the users. Australia later adopted the long-form audit report and researchers wanted to find out whether the change had any effect on reducing the expectation gap in the country. In 1996, research was conducted on two groups, auditors and non-auditors who comprised of bankers and investors. The expectation gap was being examined in four areas, the auditor’s responsibility in the detection of fraud, the prevention of fraud, maintenance of the accounting records and the auditor’s judgment in selection of the audit procedures. The study results showed that the adoption of the long-form report reduced the expectations gap in these areas except for the responsibility of detecting and preventing fraud (Schelluch, 1996).
The investors and bankers had stated that the auditors are responsible for the soundness of the internal controls yet this is the responsibility of the management. This could be improved by the choice of audit words used in the report. However, the long form audit report needs to be further scrutinized when it comes to audit scope (Gay and Schelluch, 1993). The 1996 study showed that the users of the financial statements found the language used in defining the scope of the audit to be vague. The auditors used words such as “reasonable assurance’’ and “text basis”. It was also noted that the opinion paragraph remained fairly the same with the use of such words such as ‘presents fairly” which created uncertainty in the third parties.
In another study conducted in Australia, it was noted that there were significant differences in the audit expectation gap when it came to new and old reports. The major difference could be attributed to the wording in the new reports. The study, similarly to the study conducted to changing student's perception concentrated on the responsibility, prospects and reliability factor.
It was determined that the modified wording in the new reports changed the third party's belief on the nature of audits and the relationship between the auditors and the management. The changes in perception were however mostly in the naive users of the financial statements than on the sophisticated users due to the difference in audit knowledge. The study emphasized on the impact education had on changing user perceptions. It also highlighted the impact the audit wording had on the users. The wording should be more specific in order to reduce the expectations gap (Monroe & Woodliff, 1994).
In overall, the ability of the auditors to detect and prevent fraud is dependent on the independence of the auditors. Studies conducted have shown that the public is not pleased with the levels of independence in the audit of the financial statements. The public expects the auditor to work without bias or partiality. The auditor is supposed to be free from client pressure. He should not put himself in positions that affect his ability to report on fraud and other irregularities in a company.
The expectation in the third parties that the auditor is responsible for the prevention of fraud and errors is a controversial subject. It is a misconception that has caused endless debates between the auditors, politicians, shareholders, regulators, the media and the public.
It is only reasonable that the public would demand so much of the auditors. In the bankruptcy of World.com, 40% of the stock consisted of employee retirement plans. These scandals caused the public to not only lose confidence in the capital markets but to also lose credibility in the accounting profession (Gay, Schelluch & Reid, 1997). This was a profession that was esteemed highly however now it was being regarded with distrust and skepticism. The auditing and accounting profession has to come together and deal with the public expectation in order to maintain their professional credibility.
When Enron collapsed, 4500 jobs were lost and investors lost $70 billion of their money. An external auditing company, Arthur Anderson, was charged with the obstruction of justice in notifying the public what was happening in the company. Their independence had been compromised. Accountants who were supposed to be adhering to very high ethical standards were found to have participated in criminal behaviour. Auditors held in high esteem were noted to be complacent and ineffective. There has to be a fundamental change in the way audits are carried out in order to gain back the public’s trust and respect. At the same time, auditors should not under any circumstances take up the role of the management.
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