The theories of audit expectations and the expectations gap

Executive Summary

This essay deals with the demand for audit functions and the resulting expectations in auditors’ work. The credibility of mandated disclosure of financial statements is the central issue for regulatory bodies attempting to protect the public interest. This requirement gives rise to a demand for auditing services. Since the beginning of the audit profession theories were made in order to specify and determine the audit functions. The ‘agency-theory’ is associated with the conflicting interests of shareholders and management of a company, suggesting that the less-informed party (shareholders) will have a demand for information that monitors the behaviour of the better-informed manager. Thus, audits of financial reports would be one form of such information, providing the shareholders with independent assurance about the ongoing developments. The ‘lending credibility theory’ is similar to the agency-theory and states that audited financial statements can enhance stakeholders’ faith in management’s stewardship. Another theory is the ‘theory of inspired confidence’, whereby stakeholders demand accountability from the management as an exchange for their contribution to the company. The last discussed theory is the ‘policeman theory’ which narrows auditor’s responsibilities to prevention and detection of fraud. All these theories describe the expectations the stakeholders have of the auditors, including protection against fraud, warning of future insolvency, general re-assurance of financial well-being, safeguards for auditor independence and understanding of audit reports. Although these expectations seem to be rather natural, however, an audit expectations gap does exist based mostly on the diversity of views about the audit function. The gap exists between what the public expects the auditor to do and what the auditor can and should do. Several suggestions were made to narrow the expectations gap, as well as providing statutes in order to describe audit functions especially concerning the responsibility to detect and report errors and fraud.

Introduction

Audit plays an essential role in serving the public interest to „strengthen accountability and reinforce trust and confidence in financial reporting“(ICAEW, 2005). However, scandals like Enron and WorldCom in the US or Parmalat in Europe have given the audit profession a lot of publicity, some of which is negative. Thereupon, global opinions were voiced demanding improvements in audit quality. As a result of these, changes have been made in order to promote greater transparency in the audit and accountability in auditors. Nevertheless, the demands for further improvements continue to exist. This raises questions about how (and to what extent) these various demands and concerns can be addressed.

To answer this question it is important to understand what auditing actually means, what is its purpose and what are the limitations and relationships that surround the audit role? Auditors face a number of conflicting pressures, for they need to satisfy the shareholders as well as other parties involved in the process. Each of these parties has its own expectations and demands concerning the duties of the auditor. Since the development of the profession several theories were formend trying to determine audit functions. Building on that, the aim of this paper is to illustrate the nature of audit expectations with regard to the interests of each party.

The essay is organised in three sections in order to highlight the structure. The first section gives a short description of the historical background of the audit function, referring to the original demand that caused the development of the audit profession, its purpose and goals, particularly with regard to the parties concerned. Different theories that try to determine the auditor’s duties are mentioned here. The second section deals with audit expectations in terms of auditors’ responsibilities, also responding to the expectations gap. It also considers components of the expectations gap and possibilities of eliminating these components in order to reduce the gap. The third, and last, part comprises a conclusion of the essay and a short outlook as to the audit situation.

Any attempt to explain auditing and to describe ist characteristics cannot succeed without providing sufficient explanation of the environment in which the auditors are acting and the reasons why they are actually needed.

The Demand for Auditing

The Industrial Revolution in the 18th century led to the development of large industrial companies with complex bureaucratic structures. In the course of time, specialists were needed to provide appropriate bookkeeping and auditing. Nowadays, the demand for auditors exists in the process of the communication of accounting information by which this information is transmitted to interested parties. The auditor is needed as an independent third party to “establish a degree of correspondence between assertions made by management and user criteria” (Soltani, 2007). This need results in four conditions: conflict of interest, consequences, complexity and remoteness. Because of the interaction of these four conditions, the users need the independent auditor to assist them to understand the information received. In the UK, the need for an audit has also been stipulated by the Companies Act 1985 which “requires all companies to appoint an auditor” (Letza, 1995) and regulates the functions the auditor has to perform, including the examination of the company’s annual financial accounts.

The auditor is appointed by the company’s shareholders and reports his results to his clients. The aim of the auditor’s report is to comment on how accurately the company presents its financial situation and how it is performing. This should reassure the shareholders that their investment is secured and also “help to reduce [...] the practice of misleading accounting procedures designed to show the company in a more favourable light” (Letza, 1995). Basically, the audit is represented as a process designed to evaluate the credibility of information of a company’s financial statements. According to Humphrey (1997), “auditing is not regarded as an exact science, designed to specify to 100 per cent accuracy the information contained in the financial statements. It is more a process of judgement, concerned to ensure that the information is reasonably accurate, true and fair, not true and correct, sufficient rather than absolute”.

The business world consists of different groups that are affected by, or paticipate in, the financial reporting requirements of the regulatory agencies. They are shareholders, managers, creditors, employees, government and other groups. The major recipients of the annual reports are the shareholders, including individuals with relatively small shareholding and large institutions such as banks or insurance companies. Their decision is usually based on the financial reporting and the performance of the company’s management, who have a responsibility to act in the interests of investors. Thus, the purpose of the financial statements is to assist the shareholders with the evaluation of management’s stewardship.

The creditor’s decisions are based on the examination and evaluation of a company’s financial resources, future performance and risk. Therefore, a company’s financial statements are of great importance to the bank loan officer as well as to the company itself, as this is the base for their potential loan extension. For employees, financial statements are an important source of information about the profitability of the company and its ability to pay. In the case of governments, the information may be used for tax calculations or government contracting (Soltani, 2007).

Wallace (1980) identified three hypotheses to explain the demand for auditing: the stewardship hypothesis, the information hypothesis and the insurance hypothesis. The stewardship hypothesis is best explained by the use of the agency theory. The theory describes the relationship between the management of a company (agent) and its shareholders (principals). It is assumed that the agent has a considerable advantage over the principal, for he possesses more information about the value of the company. This is also known as information-asymmetry and may lead to conflicts of interest between the shareholders and managers. In order for the principals to be able to rely on the information given by the management “there is an incentive for both managers and outside investors to engage reputable auditors” (Hayes et al., 2005). The audit function adds to the credibility of information, for users can have more confidence in the information, which assists them in their decisions. Although external auditing cannot be expected to eliminate information-asymmetry, it can diminish the effect of this asymmetry on a company’s value (Soltani, 2007). Another theory, based on public perception, is the lending credibility theory. The key issue of this theory is likewise the addition of credibility to the financial statements and the reduction of the information-asymmetry. Stakeholders need a guarantee for a “fair representation of the economic value of the firm” (Hayes et al., 2005).

The information hypothesis assigns an important role to the auditor in providing credibility to the financial statements. Given a situation of uncertainty, the demand for auditing has several possible explanations. The first one is the general belief that an audit enhances the reliability and credibility of financial statement data and provides assurance to users about their decisions. Another explanation is the dependence of the investors on the audit to produce information helpful in estimating risk, even if the audit results do nothing more than confirm the investor’s expectations and beliefs about their decisions (Soltani, 2007). The insurance hypothesis adds a supposition that the demand for auditing is created when the auditor acts as a guarantor for users against the risk of loss.

According to Limperg’s theory of inspired confidence, “the demand for audit services is the direct consequence of the participation of ouside stakeholders (third parties) in the economy” (Hayes et al., 2005). Therefore, since the information given to the stakeholders by the management might be biased, an audit of this information is needed. The fourth theory explaining the demand for audit services is the policeman theory. It restrains the auditor’s responsibilities on “arithmetical accuracy and on the prevention and detection of fraud” (Hayes et al., 2005). However, after several financial statement frauds and company collapses in the past this theory has been reconsidered.

The role of the auditor is essential for verifying the accuracy and correctness of the information provided by corporations. He acts as an intermediary between the management and the users of this financial information. To reduce the information asymmetry, the auditor has also to comminicate with those using the information he provides. Thus, it is important that the groups involved have an understanding of the audit’s meaning. However, in this case the opinions are divided. Several attitudes do exist concerning the expectations of the purpose and operation of the audit. Humphrey (1997) provides the most notable distinctions between views of auditing: as a socially oriented function, in which “the auditors are portrayed as ethical, socially responsible individuals”, and auditing as a monopolistic business.

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