The European Public Audit Oversight Reform. Which Effect Does it Have on Audit Quality?


Master's Thesis, 2015

57 Pages, Grade: 8,0


Excerpt

Inhaltsverzeichnis

I. INTRODUCTION

II. BACKGROUND
THE PIONEER – PUBLIC AUDIT OVERSIGHT IN THE U.S
THE FOLLOWER – PUBLIC AUDIT OVERSIGHT IN THE EU
THE VOLUNTEERS – PUBLIC AUDIT OVERSIGHT AT AN INTERNATIONAL LEVEL
THE INTENTION – ENHANCEMENT OF AUDIT QUALITY
AUDIT QUALITY
LINKING PUBLIC AUDIT OVERSIGHT TO AUDIT QUALITY

III. LITERATURE REVIEW AND DEVELOPMENT OF HYPOTHESES
RESEARCH ON SELF-REGULATED PEER REVIEWS
RESEARCH ON INDEPENDENT INSPECTIONS

IV. DATA AND RESEARCH METHOD
SAMPLE AND DESCRIPTIVE STATISTICS
EMPIRICAL MODEL
THE MODIFIED JONES MODEL
ABNORMAL WORKING CAPITAL ACCRUALS
DEPENDENT VARIABLE
INDEPENDENT VARIABLES
CONTROL VARIABLES

V. EMPIRICAL RESULTS

VI. SENSITIVITY TEST

VII. ROBUSTNESS TEST

VIII. CONCLUSION

IX. REFERENCES

X. Appendix
Appendix E: Description of the Dechow and Dichev Model

ABSTRACT

This paper examines the effect of the European public audit oversight reform on audit quality. Accounting scandals at the beginning of the 21th century called the audit profession into question and raised serious concerns on the oversight system in place. In an attempt to regain investors’ confidence, the European Commission (hereafter referred to as EC) followed the American example and passed Directive 2006/43/EC, which requires the Member States of the European Union (hereafter referred to as EU) to set up public oversight systems for statutory auditors and audit firms. The paper provides empirical evidence that managers are less likely to commit earnings management in the years following the regulatory reform compared to the years preceding the reform, indicating higher audit quality in the post-reform period. Member States of the EU can choose between two options for national public oversight of auditors; the full-time inspection model and the model which consists of peer reviews with an independent commission monitoring this process. I run several analyses with different models and test whether firms in jurisdictions that implemented the full-time inspection model exhibit lower discretionary accruals compared to firms in jurisdictions that implemented the modified peer review model. The results are contradicting and do not support a conclusion.

Keywords: quality of accruals; earnings quality; audit quality; public audit oversight.

Data Availability: Data are available from sources identified in the paper.

I. INTRODUCTION

This paper examines the relationship between the quality of audits and the two European public audit oversight models established by recent reforms. Accounting scandals in the beginning of the 21th century caused a change in the regulatory environment. The failure to detect accounting manipulations at Enron and WorldCom called the auditing profession’s credibility into question and raised serious concerns on both the quality of the work performed and the effectiveness of the self-regulated oversight system. In an attempt to regain investors’ confidence, and to regulate the audit industry, the U.S. Congress passed the Sarbanes-Oxley Act of 2002 (hereafter referred to as SOX). To mitigate the likelihood of accounting fraud, the Act requires corporate disclosures to be more accurate and reliable. Besides other reforms, it particularly emphasizes the importance of auditor independence, communicates corporate responsibility, and established the Public Company Accounting Oversight Board (hereafter referred to as PCAOB) to oversee the audits of public companies. The enactment significantly changed the oversight system for public companies from the approach of self-regulated peer reviews, monitored by the American Institute of Certified Public Accountants (hereafter referred to as AICPA) to external and independent inspections performed by the PCAOB. DeFond and Lennox (2011) show that the inspections impose proportionally higher costs on small and low quality audit firms, making it relatively more beneficial for them to exit the market. By arguing that non-exiting firms provide superior audit characteristics (e.g. overall size and industry expertise) they suggest that the inspections, performed by the PCAOB, improve audit quality (DeFond and Lennox, 2011).

In consequence of the success of SOX, countries all over the world followed the American example and implemented similar public oversight approaches. In an attempt to restore investors’ confidence in the financial markets, the EC approved Directive 2006/43/EC in September 2005, which requires Member States of the EU to set up public oversight systems for statutory auditors and audit firms (EC, 2005a). Simultaneously, the EC passed Commission Decision 2005/909/EC and set up a European Group of Auditors’ Oversight Bodies (hereafter referred to as EGAOB) to ensure effective coordination of new public oversight systems and to provide technical input to the preparation of possible measures of the Commission implementing the Eight Company law Directive (EC, 2005b). However, the EGAOB is already history as from 2014 on supervision of the European system will be carried out within the framework of a Committee of European Auditing Oversight Bodies (hereafter referred to as CEAOB) (EC, 2014). In April 2014, the EC enacted Directive 2014/56/EU, which amends Directive 2006/43/EC and repeals Commission Decision 2005/909/EC. Member States of the EU have to implement the new requirements by 17 June 2016, when the Directive and the regulation become applicable (EC, 2015). Further information on the new requirements are provided in the following subsections.

While prior literature provides evidence on the success of SOX, it remains unclear whether the European reform has a similar effect on the quality of audits. Therefore, this paper addresses the first research question whether Directive 2006/43/EC led to higher audit quality, measured by earnings management. Particularly, I compute the level of abnormal accruals and compare the results of the period following the reform with the results of the period preceding the reform. The paper provides empirical evidence that audit firms provide higher quality in audit engagements performed after the enactment of Directive 2006/43/EC. I find a significant reduction in the level of discretionary accruals in the post-reform period compared to the level of discretionary accruals in the period preceding the regulatory reform. These results show that managers became more conservative after the reform evidenced by a reduction in the propensity to commit earnings management.

Member States of the EU can choose between two options for national public oversight of auditors. The first model consists of public oversight performed by full-time inspectors (comparable to inspections conducted by the PCAOB), whereas the second model consists of reviews performed by peers with an independent commission monitoring this process (Maijoor and Vanstraelen, 2012). Many European countries (e.g. Denmark and Poland) have chosen the peer review model, which is less expensive and intrusive. However, countries such as the Netherlands or Germany adopted the full-time inspection model and France even adopted a combination of both. Both models share the intention to enhance investors’ confidence through an increase in the quality of audits. As it remains unsolved which of the applicable public oversight models provides the highest audit quality, this paper addresses the second research question whether one of the suggested models is superior in terms of its effectiveness in reducing discretionary accruals. In particular, I examine whether the governments choice for a specific public oversight model is associated with higher/lower audit quality by comparing abnormal accruals reported by firms domiciled in a regulatory environment that implemented the full-time inspection model with abnormal accruals reported by firms domiciled in a regulatory environment that implemented the model which consists of peer reviews monitored by an independent commission. The paper provides initial evidence that firms in jurisdictions that implemented the full-time inspection model exhibit lower discretionary accruals, indicating that the managers of these firms are less likely to commit earnings management. Since the establishment of Directive 2006/43/EC was an ongoing process, 2006 is a year that reflects both the pre-reform and the post-reform period and the associated managerial behavior. In addition to the aforementioned two research questions I examine whether the year 2006 can be allocated to the pre-reform period or the post-reform period. The results show that the mean value, and therefore the level of earnings management, peaks in 2005 before it steadily declines until 2008. While the mean values are quite constant before 2006 the comparatively drastic reduction between 2005 and 2006 indicates that the reform already influenced managerial behavior in 2006.

The remainder of this paper is organized as follows. Section II. discusses recent reforms that attempt to restore investors’ confidence in financial markets, focusing on the developments made in the U.S., EU and at an international level. Section III. reviews relevant literature and develops the hypotheses. Section IV. describes the sample and research design, while Section V. presents the empirical results. In Section VI. I perform some additional testing and Section VII. concludes.

II. BACKGROUND

The aftermath of the high-profile accounting scandals shook the audit profession to the very foundations. Auditor’s systematic failure to conduct engagements with professional care damaged their reputation and even raised the question for their ‘raison d'être’. However, it is beyond debate that auditors who perform their responsibilities appropriately add value to the economy, specifically to stakeholders and investors. Consequently, regulators faced the challenge to restore public confidence by restructuring the audit professions’ general framework and guidelines. SOX summarizes U.S. regulator’s efforts to solve the delicate situation. Among the countless changes that came along with the enactment of the Act, the regulatory shift in the supervision of audit firms played the most decisive role in recovering public confidence in the audit profession. In consequence of the success of SOX, countries all over the world followed the example and implemented similar public oversight approaches. The following section discusses the global adaptions in audit oversight and will shed light on the corrective actions made to enhance audit quality in order to regain investors’ confidence.

THE PIONEER – PUBLIC AUDIT OVERSIGHT IN THE U.S.

The downfall of influential publicly traded companies such as Enron and WorldCom led to extreme losses among investors and damaged the confidence in the audit profession in a severe way. As a consequence, auditors were publicly pilloried and faced severe hostilities. Just before the breakdown in December 2001, Enron was named “Americas Most Innovative Company” for six consecutive years (Forbes, 2012), whereas WorldCom’s filing for Chapter 11 bankruptcy protection in July 2002 was the largest such filing in U.S. history at the time. In order to prevent comparable misbehavior and to regulate financial practice and corporate governance, the U.S. Congress issued the Sarbanes-Oxley Act of 2002. Named after Senator Paul Sarbanes and Representative Michael Oxley, SOX is arranged into eleven titles. Besides pervasive changes in guidelines regarding auditor independence, corporate responsibility and financial disclosure, the Act implemented the PCAOB as an independent third party performing oversight over the audits of public entities. The PCAOB replaced the AICPA that was implemented in the 1970s. Under the former self-regulated process public accounting firms engaged other firms to study and report on quality control policies and procedures and to assess to what extent the firm’s audit practice is consistent with its own system of quality control. Although requiring peer reviews was an important signal, a frequent criticism is that the reviewed firm could choose the firm that would perform the peer review (Hilary and Lennox, 2005), resulting in a small number of firms actually receiving unfavorable opinions. Opponents argued that firms often entered into ‘You scratch my neck; I’ll scratch yours’ relationships (Louwers et al., 2013). The fact that PCAOB inspections are conducted by individuals chosen by the PCAOB who are not current employees of public accounting firms increases the perceived objectivity and overcomes this important criticism of the peer review process.

The PCAOB’s responsibilities include the following: 1) registering public accounting firms, 2) establishing auditing standards, quality control standards, ethical standards, independence standards, and other standards relating to public company audits, 3) conducting inspections, investigations, and disciplinary proceedings of registered accounting firms, and 4) enforcing compliance with SOX (SEC, 2014). Whilst the PCAOB issues Auditing Standards for the audits of public entities (which are subject to the formal approval of the Securities and Exchange Commission), the authorization for developing standards for the audit of non-public entities continues to remain within the Auditing Standards Board within the AICPA. The transition is organized in the way that any existing standard that had been issued by the AICPA prior April 2003 serves as Interim Auditing Standard and might become subject to PCAOB amendments (Louwers et al., 2013). Besides the increase in perceived objectivity, PCAOB’s inspections might outperform traditional peer reviews for two additional reasons. First, the PCAOB is now charged with monitoring the quality of work performed by firms auditing public entities, providing suggestions for improvement in the firms’ system of quality control1, and bringing appropriate action against firms when substandard work is identified. This greater enforcement power facilitates the fight against the black sheeps of the audit market. Second, inspections might lead to more accurate audit reports due to the unprecedented access to confidential information (Gunny and Zhang, 2006). Under the traditional approach firms often withheld confidential information to keep competitive advantage. Taken all together, the PCAOB’s responsibilities are aligned to the shifts overall objective, which is to protect investors by improving the accuracy and reliability of corporate disclosures.

Section 104 of the Act addresses the inspection process. According to Section 104 (a), the inspections shall asses the degree of compliance of each registered public accounting firm and associated persons of that firm with SOX, PCAOB rules, the rules of the Commission, or professional standards, in connection with its performance of audits, issuance of audit reports, and other related matters involving public entities. Dependent on the number of their audit engagements, registered accounting firms undergo PCAOB inspections in different frequencies. Section 104 (b) states that for firms performing audits of more than 100 public entities, inspections are conducted on an annual basis. Contrary, those charged with audits of 100 or fewer public entities are exposed to inspections every three years (SEC, 2002). The remainder of the Section mainly addresses adjustments to schedules, procedures, and the appropriate conduct of the inspection.

Apparently the PCAOB inspections do have many benefits over the traditional approach. However, the PCAOB has not been without controversy. Opponents lament that the passage of SOX imposes higher cost on public company auditors by increasing regulatory scrutiny, demanding stricter compliance with auditing standards, and by raising the penalties for misconduct. They argue that small auditors are incentivized to exit the market. This is supported by DeFond and Lennox (2011) who show that of the 1,233 small audit firms that were active during 2001-2008, 607 exited the market. This reduction of nearly 50% doubled the average number of clients per small audit firm (DeFond and Lennox, 2011). Whilst DeFond and Lennox suggest that non-exiting firms have superior audit characteristics (e.g. overall size, industry expertise), and therefore provide higher audit quality, the Government Accountability Office (hereafter referred to as GAO) cautions that the resulting higher concentration could also affect audit quality in a negative way (GAO, 2008). An increase in market concentration limits client’s choice when deciding on their auditors and potentially enhances auditors bargaining power (EC, 2010). However, an increase in auditors bargaining power might also affect audit quality in a positive way by reducing the fee pressure. Furthermore, Glover et al. (2009) criticize the inspector staffing model. They criticize that the board is largely composed of political appointees who lack expertise or experience in auditing, accounting and technical standard setting. Palmrose (2006) supports this concern by noting that most holders of major staff positions lack meaningful experience in auditing financial statements. Glover et al. (2009) point out that PCAOB inspectors indeed do come from public practice, but their expertise might become outdated, resulting in a lack of experience and technical training to effectively conduct inspections. Both the lack of expertise and political motivations led PCAOB “interim” standards to have essentially remained frozen in the last years.

THE FOLLOWER – PUBLIC AUDIT OVERSIGHT IN THE EU

In the last decades, the regulatory framework for financial reporting and auditing of the EU has changed dramatically. While in 1996 there were few common elements in the regulations across the EU, now the most important elements of financial reporting and auditing are subject to EU Regulations and Directives (Maijoor and Vanstraelen, 2012). For a long time statutory audit was regulated within the framework of the Eight Council Directive from 1984 (Council of European Communities, 1984). Lessons learned from the regulatory shift in the U.S. and financial scandals at European domiciled Ahold and Parmalat triggered the European accounting and corporate-governance reform. In an attempt to remedy the shortcomings of the original Directive, to restore faith in the audit profession, and to reinforce and harmonize the statutory audit function throughout the EU, the European Parliament approved Directive 2006/43/EC in September 2005 (Official Journal of the European Union, 2006). The new Directive introduces a much more rigorous and ethical audit process for company accounts by requiring the application of international auditing standards, establishing criteria for public supervision, introducing a requirement for external quality assurance, and clarifying the duties of statutory auditors. Furthermore, the Directive improves the independence of auditors by requiring listed companies to set up an audit committee (or a similar body) with clear functions to perform. Among all these amendments the most important is the new regulation that requires public supervision in all Member States. Based on Directive 2006/43/EC, Member States of the EU are required to establish public oversight bodies that have the ultimate responsibility for the oversight of: 1) the approval and registration of statutory auditors and audit firms, 2) the adoption of standards and ethics, internal quality control of audit firms and auditing, and 3) continuous education, quality assurance and investigative and disciplinary systems (EC, 2005b).

Simultaneously, Commission Decision 2005/909/EC established the EGAOB. Until the replacement by the CEAOB in 2014, the EGAOB acted as an oversight authority at European level. The Group was composed of high level representatives from Member States public oversight authorities or in their absence, of representatives from the competent national ministries. Their tasks were mainly to: 1) facilitate cooperation between public oversight systems of Member States, 2) contribute to the technical assessment of public oversight systems of third countries and to the international cooperation between Member States and third countries in this area, and 3) contribute to the technical examination of international auditing standards, including the process for their elaboration (Official Journal of the European Union, 2005). The aforementioned replacement process started with the financial crisis of 2007. In consequence of the financial crisis, the EC released the Green Paper: Lessons from the Crisis in October 2010. In order to ensure the full independence of the public oversight systems of all Member States from the audit profession, the paper addresses the need to reinforce the role of audit oversight. Particularly, it addresses the options to either transform the EGAOB into a so-called “Lamfalussy Level 3 Committee” or to establish a new European Supervisory Authority (EC, 2010). Both models aim to reinforce co-operation at the European level and to provide high quality advice to the Commission on audit matters. The Green Paper also considers the need to reinforce the dialogue between regulators and auditors.

It was not until April 2014; however, the EC enacted Directive 2014/56/EU, which amends Directive 2006/43/EC and repeals Commission Decision 2005/909/EC. Member States of the EU have to implement the new requirements by 17 June 2016, when the Directive and the regulation become applicable (EC, 2015). Similar to the repealed EGAOB, the newly established CEAOB shall be composed of one member from each Member State who shall be high level representatives from the competent authorities, and one member appointed by the European Securities and Markets Authority (hereafter referred to as ESMA). The CEAOB’s main tasks are to: 1) facilitate the exchange of information, expertise and best practices, 2) provide expert advice to the Commission as well as to the competent authorities, 3) contribute to the technical examination of international auditing standards, 4) contribute to the improvement of cooperation mechanisms for the oversight of public-interest entities’ statutory auditors, audit firms or the networks they belong to, 5) carry out other coordinating tasks, and 6) contribute to the technical assessment of public oversight systems of third countries and the international cooperation between Member States and third countries in that area. For the purpose of carrying out its tasks referred to the latter point, the CEAOB shall request the assistance of the ESMA, European Banking Authority (hereafter referred to as EBA) or European Insurance and Occupational Pension Authority (hereafter referred to as EIOPA) (Official Journal of the European Union, 2014). The fundamental changes in accounting and auditing were part of a broader development of creating one institutional framework for an integrated EU financial market (Maijoor and Vanstraelen, 2012). In contrast to the PCAOB, the CEAOB (also the EGAOB) did not replace existing national public oversight systems in European Member States. Instead, the bodies act as superior authorities to facilitate cooperation among the Member States. Another difference to the PCAOB is that the CEAOB is not directly charged with conducting inspections on audit firms. The Committee only contributes to the technical examination of international auditing standards. Furthermore, it is not responsible for imposing penalties, therefore possessing less enforcement power. Although the CEAOB responsibilities are strictly of an advisory nature, they share the overall target of the PCAOB responsibilities, which is to restore investor’s confidence in audited financial statements.

In the EU enforcement power is dedicated to the national oversight authorities. Member States can choose between two options for public oversight of auditors. The first model consists of public oversight performed by full-time inspectors (comparable to inspections conducted by the PCAOB), whereas the second model consists of reviews performed by peers with an independent commission monitoring this process (Maijoor and Vanstraelen, 2012). Many European countries (e.g. Denmark, Poland) have chosen the peer review model, which is less expensive and intrusive. However, countries such as the Netherlands or Germany adopted the model of full-time inspectors, while France even adopted a combination of both. Although using different approaches, both models share the intention to enhance investors’ confidence through an increase in the quality of audits.

THE VOLUNTEERS – PUBLIC AUDIT OVERSIGHT AT AN INTERNATIONAL LEVEL

In September 2006, the International Forum of Independent Audit Regulators (hereafter referred to as IFIAR) was established to regulate public oversight at an international level. In comparison to the PCAOB or CEAOB, the IFIAR is neither a standard setting body, nor required by law. While IFIAR members have regulatory authority within their own jurisdictions, the IFIAR is not itself a regulator (PCAOB, 2011). Nevertheless, the Forum shares the objectives and visions of the PCAOB and CEAOB. The intention of audit regulators from initially 18 jurisdictions was to create a platform for dialogue and to share knowledge of the audit market environment and practical experience of independent audit regulatory environment with a focus on inspections of auditors and audit firms (IFIAR, 2014). Furthermore, the Forum wants both to achieve consistency in regulatory activities and to facilitate the information exchange between audit regulators (PCAOB, 2011). All these activities are performed against the backdrop of enhancing investor protection by improving audit quality. Similar to the PCAOB and CEAOB, the IFIAR emphasizes the importance of independent inspections on the quality of audits. Therefore, the IFIAR Charter requires members to be independent of the profession and to be engaged in audit regulatory functions in the public interest. Besides several Working Groups that address various work streams, which are important to audit regulators on a daily basis, the IFIAR convenes on an annual basis for high-level plenary meetings and Inspection Workshops to exchange information and experiences relating to inspections of firms. Results are published through periodic public reports, press releases and an official website. While the IFIAR possesses no enforcement power, the results of the meetings are valued by those charged with enforcement power. Comparable to the responsibilities of the CEAOB, the IFIAR’s activities are strictly of an advisory nature.

Besides its function as a communication channel, the IFIAR is member of a group of regulatory and international public interest organizations (also referred to as Monitoring Group). The Group oversees audit and accounting related standard setting activities of the International Federation of Accountants (IFAC) and monitors activities of the Public Interest Oversight Board (PIOB), which, in turn, oversees the public interest activities of the International Auditing and Assurance Standards Board (hereafter referred to as IAASB) (IFIAR, 2014). Therefore, the IFIAR indirectly monitors the IAASB, which promulgates the International Standards on Auditing (IASs). Since its creation, IFIAR’s membership has grown rapidly. Nowadays, the Forum brings together independent audit regulators from a total of 50 jurisdictions. This cultural diversity enables members to gain insights into a variety of perspectives on audit practices (IFIAR, 2014).

THE INTENTION – ENHANCEMENT OF AUDIT QUALITY

The newly established institutions in the U.S., EU and at an international level combine the objective to protect investors’ by improving audit quality through stricter supervision of public audit firms. The recent development of these public oversight authorities raises the question of whether the regulatory reforms actually led to higher audit quality. Before Section V. will evaluate the effectiveness of the European reform, the next subsections provide some general knowledge on audit quality and its main drivers. Furthermore, I will show how public oversight might increase the quality of audits.

AUDIT QUALITY

Audit firms face the risk that auditors will express an inappropriate audit opinion when the financial statements are materially misstated (e.g., giving an unqualified opinion on financial statements that are misleading because of material misstatements the auditors failed to discover) (Louwers et al., 2013). According to Francis (2011), audit quality is achieved by the issuance of the appropriate audit report on the client’s compliance with Generally Accepted Accounting Principles (hereafter referred to as GAAP). He argues that there are gradations of audit quality across a continuum from low-to high-quality audits and that audit quality is affected at different levels. These levels are: 1) audit input, 2) audit process, 3) accounting firms, 4) audit industry and audit markets, 5) institutions, and 6) economic consequences of audit outcomes. A comprehensive understanding of the drivers of audit quality requires research at all levels (Francis, 2011). However, the remainder of this paper will primarily focus on level 2) and 5), and on the question what impact the newly established European regulatory reform does have on audit quality.

In order to measure audit quality, prior literature uses a variety of proxies. Kinney et al. (2004) measure audit quality by restatements, Lim and Tan (2008) by the propensity to issue a going concern report, while others use audit related litigation as an indicator (e.g., DeFond and Francis, 2005; Bonner et al. 1988; Francis, 2004). Besides the audit report, which is directly under the auditor’s control, the client’s audited financial statements serve as a means to determine audit quality. Financial statements are jointly produced by clients and their auditors (Antle and Nalebuff, 1991). Empirical studies conducted by Becker et al. (1998) and Francis et al. (1999), linking statistical properties of financial statements with audit characteristics show that clients of Big 4 auditors (PwC, KPMG, EY, Deloitte) have smaller abnormal or unexpected accruals than clients of non-Big 4 auditors. Quality auditors reduce abnormal accruals (e.g., Becker et al., 1998; Francis et al., 1999), and especially positive abnormal accruals (Becker et al., 1998). In particular, studies find that earnings quality is higher when the auditor is larger in both overall size and engagement office size (Francis and Yu, 2009; Choi et al., 2010), and when auditors have more industry expertise (Reichelt and Wang, 2010). Contrary, further studies find that earnings quality is lower in the initial years of the engagement tenure (Johnson et al., 2002), and when audit firm alumni held key executive positions in client firms (Menon and Williams, 2004; Lennox, 2005). As Big 4 audit firms incorporate relatively more audit characteristics associated with high earnings quality, the aforementioned researches imply that Big 4 audit firms provide higher audit quality. DeFond and Lennox’s’ (2011) suggestion that audit firms that survive PCAOB inspections provide higher audit quality supports this assumption.

LINKING PUBLIC AUDIT OVERSIGHT TO AUDIT QUALITY

Auditors act as intermediaries between companies, creditors and potential investors and help to satisfy the demand for high-quality information by the lending of credibility to information. While conducting an audit, auditors need to comply with three fundamental principles: 1) the responsibilities principle, 2) the performance principle, and 3) the reporting principle. These fundamental principles are established to meet the main purpose of an audit, which is to enhance the degree of confidence that intended users can place in financial statements (Louwers et al., 2013). These principles, which define auditor’s responsibilities, are stated in publicly accessible standards. Nevertheless, public reactions after the accounting scandals prove the existence of an expectation gap. Porter (1993) states that the expectation gap consists of two components: (1) a gap between what the public expects auditors to achieve and what auditors can reasonably be expected to accomplish (the reasonableness gap), and (2) what the public can reasonably expect auditors to accomplish and what auditors are perceived to have achieved (the performance gap). Arguing that nowadays the primary users of the audited financial statements are pretty sophisticated investors, Vanstraelen et al. (2012) suggest that the audit expectation gap is much more of a performance gap. McEnroe and Martens (2001) summarize some of the exaggerated expectations related to auditor’s responsibilities that lead to this gap. They state that information users expect auditors to penetrate into company affairs, engage in management surveillance, and detect illegal acts and/or fraud on the part of management (McEnroe and Martens, 2001). However, auditors are not required to make legal determinations. According to AU-C Section 240 “Consideration of Fraud in Financial Statement Audit”, their responsibility is confined to the expression on financial statements (AICPA, 2014).

Audit firms internally reacted to this expectation gap by offering fraud investigation and dispute services. On regulatory level, the AICPA and the Auditing Standards Board (hereafter referred to as ASB) sought to reduce the expectation gap with a series of Statements on Auditing Standards (SASs) (McEnroe and Martens, 2001). Standards in question have been amended and auditor’s responsibilities were redefined. While auditing standards set the design for testing whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework, public oversight authorities provide additional assurance on the operating effectiveness. In particular, inspections (peer reviews) evaluate the audit process, which is one of Francis’ aforementioned levels that affect audit quality. By reporting on the audit process, public oversight has the ability to improve transparency and might increase both perceived audit quality and audit quality in fact. The remainder of this study concentrates on audit quality in fact. Additionally, inspections (peer reviews) might reveal auditors competencies and their degree of independence.

[...]


1 Internal mechanism that intents to provide reasonable assurance that the firm and its personnel: 1) complies with professional standards and applicable regulatory and legal requirements, and 2) issues reports that are appropriate in the circumstances (Louwers et al., 2013).

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Details

Title
The European Public Audit Oversight Reform. Which Effect Does it Have on Audit Quality?
College
Maastricht University  (School of Business and Economics)
Grade
8,0
Author
Year
2015
Pages
57
Catalog Number
V495142
ISBN (eBook)
9783668996403
ISBN (Book)
9783668996410
Language
English
Tags
quality of accruals, earnings quality, audit quality, public audit oversight
Quote paper
Matthias Linke (Author), 2015, The European Public Audit Oversight Reform. Which Effect Does it Have on Audit Quality?, Munich, GRIN Verlag, https://www.grin.com/document/495142

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