Audit Expectation Gap

In today’s growing world of business, we see organizations reaching heights and falling dramatically. In last 100 years, the size of the companies has grown multiple folds and so is their list of stakeholders, especially investors. A huge investment in the past years is seen on the corporate governance activities to ensure a good image of the company. Auditing being a legal obligation for the companies now, ensure that the financial reports of the company are without any material misstatement and frauds.

Reports presented by the auditors work as an assurance for the investors and other stake holders. However, in recent years, while many corporate scandals and collapses, that were associated with auditors’ fraud and negligence, have been unveiled, the auditors’ legal liabilities became the bone of contention in almost every country. Auditing being an expensive activity is performed till a limited extent, best possible ways are implemented to avoid any chance of leaving the problems in the financial reports, but despite everything, things go wrong and probably would continue to be the same way.

We will find laws in every country to safeguard the interest of an auditor and the stakeholder as well. In this relation, there is seen an increase in the number of lawsuits filed against the auditors in the recent times. This gives us an indication that the investors are not satisfied with the way auditing firms are operating and or they are not producing the desired results. The atmosphere around and the job profile creates a necessity for the auditor to know its legal duties, so that they can discharge their duties properly.

On the other hand, in case of the investor or other stakeholders relying on the audit reports, we will see a lot of misperceptions about the duties of an auditor and this is why people expect a lot from the auditors. Many out of these are way beyond the capabilities of a person as an auditor. And we will also find people who don’t have basic knowledge of what legal duties auditors own them, and how they can protect their interest if the auditor fails to perform its job or breach its duties owned. The gap or the differences between the auditor’s performance and what the people expect from them is called the EXPECTATION GAP.

Although the existence of the audit expectation gap and its associated problems has been acknowledged for more than 100 years, it appears that LIGGIO (1974) WAS THE FIRST TO APPLY THE TERM “AUDIT EXPECTATION GAP” IN THE AUDITING LITERATURE. He defined the audit expectation gap as the difference between the levels of expected performance as envisioned by the user of a financial statement and by the independent accountant. Porter (1993) presented the problem in another way. Its structure of the gap name two major components, reasonable gap and performance gap.

1 Reasonable Gap – the difference between “what the public expects auditors to achieve and what they can reasonably be expected to accomplish” 2 Performance Gap – the difference between “what the public can reasonably expect auditors to accomplish and what auditors are perceived to achieve” AUDITORS’ LEGAL LIABILITIES IN AUSTRALIA UNDER THE COMMON LAW It is not easy for injured parties under the law of contract to sue the auditors Under the law of contract the existence of contract is only base for injured parties to file suits against auditors.

There is only a contract among audited entity and auditors, no contract to be had between auditors and third parties, i. e. all the parties that uses the audited financial reports. This makes it extremely complicated for injured third parties to take legal action against auditors when they bear loss due to auditors’ misrepresentation. Although tort of deceit does not need the existence of contract when injured parties take legal action against auditors for their fraudulent misrepresentation, the plaintiffs need to verify the intention of fraud or deceit that puts a significant proof burden on the innocent parties.

For the time being, as most misrepresentations are caused by negligence, thus it makes litigations under tort of deceit furthermore tricky. _LIABILITIES TOWARDS CLIENTS_ Although the clients can sue auditors for infringing the contract, the express term of contract cannot include everything. In addition to this, the breach of the implied term of contract is not easy to test. Thus, i t is pretty useful for the audited companies to protect their own interest if they can sue auditors under tort of negligence, as the standard of auditors’ legal duties under tort of negligence is not stagnant and evolves all the time .

Auditors may not be exempt for negligent behavior because the directors or management were also negligent; Auditors must not only rely on others assertion, they have to carry out their own audit procedures; Auditors must test the clients’ internal control system thoroughly before they place trust on it. Auditors must review the competence and consistency of internal control system and report all noteworthy deficiencies in the function of the internal control system to appropriate level of management. When management fails to act in response, auditors must report to Board of Directors.

Technical proficiency must exist in audit team in appropriate situations. The above argument of an auditor’s legal liabilities to clients demonstrates the increase in standards required by auditors. The above study makes it apparent, that Australian courts tend to apply the legal theory of proximity to rigorously restrict third party negligence claims. It seems that far from protecting auditors against third party claims, these decisions may tend to be certain that upcoming writs will be filed under the Trade Practices Act which is more efficient in protecting innocent parties’ interest.

However, as an audit report conveys only the auditor’s opinion, it would be essential for the plaintiff to reveal that the auditor did not have logical basis for the audit opinion (s. 51A). As s. 52 enforces strict liability on defendants, it does not concern with the purpose of the defendants. Hence, even a standard audit report conveys that the auditor has exercised reasonable skill and care in reaching an opinion as expressed, this does not amount to a factual representation to the effect that the audited financial reports are correct.

In the interim, Trade Practices Act greatly broaden the scope for third party liability to take account of infinite and vague class of totally unfamiliar and unforeseeable persons who might rely on audit opinion at any time in the future. As a result the consequences of s. 52 would be to enforce an unbearable burden upon auditors. CAUSES OF AND SOLUTIONS TO THE AUDIT EXPECTATION GAP Studies of the auditing literature demonstrate that the number of potential contributing factors to an audit expectation gap are numerous and diverse.

This section attempts to do more than just summarize the causes but rather to provide an in-depth assessment and discussion on the matter. It is hoped that such an effort will present the audit expectation gap problems in a more objective and significant manner. The audit expectation gap problem is most likely to be attributed to the following factors: (1) COMPLICATED NATURE OF AN AUDIT FUNCTION The general public’s poor perceptive of the complex audit function is expected to contribute towards the existence of an audit expectation gap.

According to Lee and Azham (2008), the complication of auditing could be owing to the fact that the purpose of auditing and the function of auditors have always been a dynamic rather than a stationary one. The complex nature of an audit role can also be seen by alteration in the auditing paradigm over the years. Given the complex nature of auditing and the objective of an audit, uncertainty is likely to be present among those who have inadequate knowledge and exposure in auditing. (2) CONFLICTING ROLE OF AUDITORS

A study carried out by Institutional Analysis of the best 100 Australian Companies on non-audit services in 2002 (as quoted in Leung, et al. , 2007) demonstrates that auditors received huge compensations from their services of taxation planning and advice, strategic consultation. A similar condition also existed in the U. S. A where accountants have become gradually more reliant on consulting. The _International Accounting Bulletin_ cited in Byrnes, et al (2002) revealed that in 1993, 31% of the auditing industry’s fees came from consultancy.

By 1999, that amount has increased to 51%. Cited also in Brynes, et al (2002) is a study of 563 companies conducted by Bailey from the University of Illinois’ in 2001 where it was found that on average, for every dollar of audit fees, clients paid their independent accountants, $2. 69 was for non-audit services. Bailey found that Puget Energy, based in Bellevue, Washington, had the greatest imbalance, paying PricewaterhouseCoopers only 34,000 for its audit, but over $17 million in consulting fees. Marriott International Inc. had a similar imbalance.

It paid Andersen just over $1 million for its audit, but more than $30 million for information technology and other services. (3) TIME LAG IN RESPONDING TO CHANGING EXPECTATIONS Humphrey, et al. (1992) argued that an expectation gap may take place as an upshot of time lags between the accounting profession identifying and responding to continually varying and increasing public expectations. Tricker (1982) argued that commercial crises lead to new prospect and requirements of accountability which consecutively lead to new hassle on the audit function and ultimately to changes in auditing standards and practice.

It was illustrious that issuance of accounting standards is mainly evident during periods of major crises in the corporate sector. This in turn suggests that the accounting profession is gradually and constructively responding to the changing expectations of society (Humphrey, et al. , 1992). (4) SELF-REGULATION PROCESS OF THE AUDITING PROFESSION Auditing profession functions under a self-regulatory framework. The underlying principle for self-regulation by a business is premised on the ground that service quality may be sustained all the way through self-regulation when the clients are not capable to compute the audit quality themselves.

Byington and Sutton (1991) claimed that the outcome of self-regulation is the conception of licensing boards and other government policies that put a ceiling on practices of a profession and thus craft rents that occurs from a professional monopoly which controls the smallest acceptable level of service quality and access into the profession. (5) THE UNAWARENESS AND UNREASONABLE EXPECTATIONS Humphrey, et al. (1993) had linked the problem of expectation gap problems with the misconception of the nature, reason and capacities of an audit function.

The lack of knowledge of the public is liable to cause irrational expectations being imposed on the duties of the auditors. The unreasonable expectations of the public are exposed in the following comment of the AICPA secretary in 1939 in the aftermath of the McKesson Robbins scandal: We find that the public believed that the certified public accountant was an infallible superman; that the signature of a CPA invariably meant that everything was perfect; that it was unnecessary to read the accountant’s certificate or the financial statements to which it was appended as long as the three major letters were in evidence.

Whether through its own blunders or not, the accounting business seems to have been oversold. Its limitations have been ignored, while its capability has been highlighted. According to Lee and Azham (2008) unreasonable expectation of auditors may have destructive implications on the audit profession as the public might not be competent enough to identify the involvement of auditors to society and consequently this may challenges the value of the audit function. The grounds for an audit expectation gap are two-fold.

Firstly, it is because of the disagreement between minimal government regulation of the profession, and the profession’s right to self regulation, and particularly, the problem of the profession’s overprotection of self-interest. Secondly, it has resulted from the “clash between auditors and the public over the preferred meanings about the nature, practice and/or outcomes of auditing. Besides, Swift and Dando (2002) suggest that the audit expectation gap may possibly

have resulted from factors such as a lack of technical know-how, the timeliness and significance of auditor communication, a lack of assurance-provider independence, and the low commitment to the public interest of the law. According to Gay _et al_ (1998) the accounting profession’s responses to the gap can be bridged through either defensive or constructive approaches. The defensive responses comprise of: (i) “Emphasizing the need to educate the public and reassure them about the exaggerated public outcries over isolated audit failures.

(ii) Codifying existing practices to legitimize them. (iii) Attempting to control the audit expectation gap debate and repeatedly propounding the views of the profession”. In contrast, the constructive responses include: (i) “Emphasizing an awareness of the objective of an audit. (ii) Readiness to extend the scope of an audit” CONCLUSION Debates can be stretched and arguments can be produced for and against the laws which safeguard the interest of the auditor and the investors.

The objective to impose legal liabilities on the auditor should project concern for both the innocent investors and innocent auditors. If investors are suffering losses from auditors fraud, negligence of duty and breach of contracts on one side then we can see auditors performing well ethically and exposing scandals on the other side. This situation leaves us in a dilemma where we have to define the legal duties of the auditors, which can neither be too wide or too narrow.

Too much of pressure will work adversely and effect the auditing profession on a whole, where ethical people will find hard to survive. Both of the above situations are not suitable for society and business economy. More pressure will be seen on auditors after the S 52 of TPA has been introduced. Effected parties eye the professional indemnity insurance and will hit the auditors for the same. This insurance is the only money left in the centre to prey upon in case there is a failure or loss to the share holders. There should be a clear distinction between a business failure and audit failure.

Auditors as they are not governing the company, but are only performing random testing to insure that all the financial reports are well made and are without any frauds and misstatements should also be safeguarded as they are performing a job much required for the society. There should be a limitation on the auditor’s liability in financial terms if he is not a part of the fraud but if he is found cheating, this liability can be changed to an unlimited one. REFERENCES Lee, T. H and Azham, Md. A. (2008). The evolving role of auditor: Where do we go from here?

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_Critical Perspectives on Accounting_, _3_, 137-161. Porter, B. (1993). ‘An Empirical Study of the Audit Expectation-Performance Gap’, _Accounting and Business Research_, vol. 24, no. 93, pp. 49 – 68 Tricker, R. I.. (1982). Corporate accountability and the role of the audit function. In: Hopwood, A. G. , Bromwich, M and Shaw, J. (Eds. ). _Auditing research: Issues and opportunities_. London, Pitman Books Byington, J. R. and Sutton, S. G. (1991). The self-regulating profession: An analysis of the political monopoly tendencies of the audit profession.

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