Question

The audit report was recently expanded from the previous six paragraph format. The new format includes a section on key audit matters. This was an attempt to narrow the expectations gap. Discuss the expectations gap and whether you think the new audit report is likely to have any significant effect.

Answer 1

‘Auditing’ as it is understood now-a-days evolved some two thousand years ago.
Expansion of industries and commerce in a big way which took place in post-industrial
revolution era, gave rise to various types of business organizations.
In particular, the emergence of joint stock companies which are managed by persons
(Directors) other than the proprietors, (i.e. shareholders) warranted some sorts of satisfaction
to the shareholders, that their money was not being misused. For this purpose, it became
necessary for Directors to render accounts to the shareholders at regular intervals (usually on
annual basis).The Directors in some cases, in order to conceal their inefficiencies or other lapses,
had started adopting fraudulent accounting practices. The governments, therefore made
some legal provisions, whereby accounts were required to be checked and reported upon by
an independent person other than the Directors. These persons came to be known as
Auditors.
The primary objective of an audit is to provide a report by the auditor, stating therein
his opinion on the truth and fairness of financial statement so that any person using such
statements can have a critical appreciation of the information contents of the statements in
them. The audit therefore provides an opportunity to users of financial statements to
understand the information contained therein in a realistic and transparent manner.
However, users of these audited financial statements see auditors in different lights,
and as such expect different duties from them, therefore leading to the problem of
expectation gap. There is now a considerable evidence of a gap when external auditor’s
understanding of their roles and duties is compared against the expectations of various user
groups and the general public, regarding the process and outcome of the external audit (i.e.
audit expectation gap).Audit Expectation Gap
There is now considerable evidence of a gap when external auditors’ understanding
of their role and duties are compared against the expectation of the various user groups and
the general public regarding the process and outcome of the external audit (i.e audit
expectation gap). The credibility of external auditors is increasingly being called into
question in many countries around the world, as evidenced by widespread criticism and
litigation directed against auditors (Porter, 2003)
The phrase “Audit Expectation Gap” was first introduced into the literature over
twenty years ago by Liggio (1974). It was defined as the difference between the levels of
expected performance “as envisioned by the independent accountant and by the user of
financial statements. Tweedie (1987) set out the extent of the problem as follows:
“The public appears to require:
· a burglar alarm system (protection against fraud).
· a radar station (early warning of future insolvency).
· a safety net (general re-assurance of financial well being).
· an independent auditor (safeguards for auditor independence).
· coherent communications (understanding of audit reports)”
Porter (1993) concluded that earlier definitions of audit expectations gap were
excessively narrow in that they failed to recognize the possibility of sub-standard
performance by auditors. She highlighted the importance of considering the full extent of the
audit expectations gap, and argued that this can only be done by comparing society’s
expectations of auditors against the perceived performance of auditors. Viewed in this way,
the gap can be widened either by an increase in society’s expectations (some of which can
be unreasonable) or a deterioration in perceived auditor performance (sub-standard
performance arises where the auditor fails or is perceived to fail to comply with legal and
professional requirements). Conversely the gap can be narrowed either by a reduction in
society’s expectations on an improvement in perceived performanceAccording to Millichamp (1996), the expectation gap is concerned with the external
auditor’s role as stated in the regulation and statute law. Many users misunderstand the nature of the attest function, especially in the context of an unqualified opinion. Some users
believe that an unqualified opinion means that the entity has foolproof financial reporting.
Some feel that the auditor should not only provide an audit opinion, but also interpret the
financial statements in such a manner that the user could evaluate whether to invest in the
entity. There are also users who expect auditors to perform some of the audit procedures
while performing the attest function like penetrating into Company affairs, engaging in
management surveillance and detecting illegal acts and/or fraud on the part of management.
It is these high expectations on the part of users of financial statements that create a gap
between auditors’ and users’ expectations of the audit function. In addition, the users also
place the responsibility for narrowing the gap on auditors and others involved in preparing
and presenting financial statements.
Various studies have confirmed the existence of the audit expectation gap. Prior
literature in audit expectation gap evinces that the expectations gap between auditors and
financial statement users has existed for the past 100 years. The audit expectation gap has
become a topic of considerable interest world wide, for research in general, and in the
advanced countries like the U.S, the U.K, New Zealand, Germany and Singapore in
particular for the last thirty years. This is due to the occurrence of series of corporate
failures, financial scandals and audit failures in these advanced countries and their
subsequent impact on other countries’ audit profession. The literature available on audit
expectation gap and related matters evinces the extent to which the auditing environment has
become litigationsThe widespread criticism of and litigation against auditors indicates that there is a
gap between society’s expectations of auditors and auditor’s performance as perceived by
society. The majority of research studies indicate that the audit expectation gap is mainly
due to users’ unreasonable expectations of audits as well as their unrealistic perceptions of
the audit profession’s performance. According to these studies, the differences may be
attributable to users’ misunderstanding of what is reasonably expected from an audit, and of
the actual quality of the audit work. Although a number of explanations for the existence
and persistence of the audit expectation gap appear in the literature, references to users’
misunderstandings of the role, objectives and limitations of an audit, inadequate audit
standards and deficient auditor performance capture the main essence of its causes. This
results in users’ dissatisfaction with auditor’s performance that undermines confidence in the
auditing profession and the external audit function. The term ‘expectation gap’ is commonly
utilized to describe the situation whereby a difference in expectation exists between a group
with a certain expertise and a group, which relies upon that expertise. The public perception
of an auditor’s responsibility differs from that of the profession and this difference is
referred to as the Audit expectation gap.
The audit expectation gap has a long persistent history. The central issues
incorporated within it are fraud detection, auditor independence, public interest reporting
and the meaning of audit reports and these issues have not only remained unresolved since
the emergence of the term, ‘audit expectation gap,’ in the 1970’s, but also have a history that
is as long as that of the Company auditing itself (Humphrey et. al., 1993).Types of Expectation Gap
1. The Performance Gap – This is caused by the failure to conform to statutory
requirements and professional standards by auditors.
2. The Standard Gap – This exists where statutes and the professional standards fail to
properly reflect the appropriate standard of performance deemed appropriate by the
courts of law.
3. The Feasibility Gap – This is caused by society’s increasing, and often unrealistic,
demands for accountability.
4. The Communication Gap – This is caused as a result of inadequacy in the report
issued by auditors or upon the conclusion of the statutory audit and the unreasonable
expectation of the intended users

The purpose of communicating key audit matters is:

A. Enhancing the communicative value of the report of the auditor by offering better transparency about the audit which was executed.

B. It offers additional information to users of such financial statements in assisting them to understand those matters which in the professional judgment of the auditor, were of critical importance in the audit of financial statements of the relevant period.

C. It might also assist the users of such financial statements to understand the entity and also help in understanding the areas of crucial management judgment in such audited financial statements.

Communicating the key audit matters in the report of the auditor is with respect to an auditor having formed his/her opinion on financial statements overall. However, communicating the key audit matters in auditor’s report is:

(a) Not a substitute for the disclosures in financial statements that relevant financial reporting framework necessitates management to make, or which are otherwise essential for achieving fair presentation

(b) Not a substitute for an auditor expressing his/her modified opinion when circumstances of any specific audit engagement require such expression as per SA 705 (Revised)

(c) Not a substitute to report as per SA 570 (Revised) when any material uncertainty exists with respect to conditions or events which might bring substantial doubt on the ability of the entity in continuing as a going concern

(d) Not a separate opinion on the individual matters