AUDIT EXPECTATION GAP
The collapses of corporate giants such as Enron, HIH or One.Tel, even though after they were having a favourable audit opinion on their financial reports indicate that there is incompleteness in the process of Auditing. The purpose of this research essay is to discuss ‘audit expectation gap’ and explain the role of external auditors in the HIH and One.Tel collapses and how the actions of those auditors affect adversely to the stakeholder perceptions. Finally, this essay will suggest number of recommendations required to minimize or close the audit expectation gap.
First, let’s look at the definition of Audit Expectation Gap. Lee, Ali & Bien (2009) defined AEG as “difference between what the public expects from an audit and what the audit profession accepts the audit objective to be.” For example every audit is subject to an audit risk. Part of this audit risk cannot eliminate even though we perform the audit with the lowest level of materiality. So “accounting profession argues that one cause of the expectation gap is the public’s failure to appreciate the nature and limitations of an audit.” (Frank, Lowe & Smith 2001) These limitations are unavoidable. Furthermore, Lee, Ali & Bien (2009) mentioned that the AEG is “critical to the auditing profession because the greater the unfulfilled expectations from the public, the lower is the credibility, earnings potential and prestige associated with the work of auditors” (Lee, Ali & Bien 2009). Another unavoidable limitation is related to the fraud detection. “An auditor is not bound to be a detective, or, as was said, to approach his work with suspicion or with a foregone conclusion that there is something wrong. He is a watchdog, but not a bloodhound” (Vanasco 1994). On the other hand part of this AEG can be preventable. Those are the issues arise in related to the professional independence and the auditor’s competency and care of duty and diligent. To get a thorough understanding of this concept of Audit Expectation Gap let’s look at the role of auditors in HIH and One.Tel collapses.
Apparently, the cause for the HIH collapse was an issue of professional independence. “Investors who place value on auditor independence believe that independence in fact is present and also they believe independence has a desirable effect upon the quality of audits” (Nieschwietz & Woolley 2009). “Auditor independence and the appearance of independence are fundamental to an effective audit” (Lipton 2003). Arthur Anderson, the auditor for HIH had many threats to their independency. “the HIH board had three former Andersens partners, one Andersen partner was the chair of the board and continued receiving fees under a consultancy agreement, a partner was removed from the audit team after meeting with non-executive directors in the absence of management and Andersens derived significant fees from non-audit work which gave rise to a conflict of interest with their audit obligations” (Lipton 2003). Since Arthur Anderson is earning big bucks form their consultancy firm by giving consultations to HIH, they haven’t perform their audit in the interest of stakeholders. They have just pleased the management of HIH. So it is important to note that professional independency is key issue as far as the AEG is concerned. Furthermore, Collapse of One.Tel unveils another problem relates to audit opinions.
One.Tel management haven’t prepared their financial reports accurately. For example “Mr Hodgson’s second day in the witness box produced more startling evidence of One.Tel’s accounting practices, which allowed the company to turn a $7 million loss into a $25 million profit in 1999 and to conceal expenses of at least $173 million up to April 2000” (Barry 2002). To cover-up themselves the chairman of One.Tel John Greaves claims “If what we were doing was unacceptable, the auditors wouldn’t sign the accounts” (Barry 2002, p.159). The company management have asked public to believe the auditor. On the other hand BDO was paid a huge sum of money to perform the audit. “Until last November (2000), One.Tel’s accounts were audited by BDO, which was paid a total of $491,000 until November of last year. It was BBO which last September gave the company a health check and claimed it was fine” (Roy 2001). So even after spending that much of money if shareholders would not be able to get reliable information about the company means they just have wasted their money. “After the collapse shareholders are once again left wondering what they can expect for the thousands of dollars they pay auditing firms to keep an independent eye on a company’s bottom line” (Roy 2001). The stakeholders might have disappointed about the work done by auditors. The ICAA’s committee mentioned that BDO had “failed to observe a proper standard of professional care, skill or competence in the course of carrying out their professional duties” (Barry 2002, p.160). It also concluded that “BDO’s audit report was in breach of the corporations Law, Australian accounting standards and Australian auditing standards” (Barry 2002, p.160). Then it was appointed Ernst and Young as their external auditor. “Ernst and Young, informed the Board that its investigations revealed that the financial position of the company was not as reported to the Board on May17, and that a capital raising of $132 million would be insufficient to keep the company solvent”(ferret 2001). “Mr Packer and Lachlan Murdoch issued a statement saying they had been profoundly misled about the telco’s financial state.”(smh.com.au 2009) Ernst and young is more competent than BDO, but again it created the treat to auditors’ independence. James packer had a strong relationship with the Ernst & Young. “Ernst & Young chairman Brian Long, told the NSW Supreme Court yesterday of his and his firm’s lengthy association with media owners Kerry and James Packer and Packer-controlled companies”(Lampe 2005).
In conclusion, to completely close this AEG we have to find solutions for both avoidable and unavoidable issues causing for AEG. To close or minimize the gap arise with unavoidable limitations it can be recommended to make investors aware of it. The auditors can include a clause which explains those limitations such as auditors cannot guarantee that the company haven’t involved with any fraud since auditors are not fraud detectives. Government and other accounting professional bodies can also use media to educate public about this problem. Secondly, it is very important to take serious actions to overcome the preventable problems such as threats to auditors’ professional independency and auditors’ lack of competency to perform the audit since these issues might reduce the public trust and confidence over the audit opinions. Some people have already came-up with suggestions to overcome these problems. Financial reporter, Edmond Roy (2001) suggests that “system of rotating individual audit partners within a firm so that no one partner looks after a particular client’s audit for more than a short period of time” But if the assurance firm as a whole is getting a benefit by performing a particular audit this suggestion might not help much. He also suggested that the “audit work shared between the various big firms and auditors being appointed by an independent committee, or by the Australian Securities and Investments Commission” (Roy 2001) I believe that the latter suggestion is more effective. By doing it, the company managers find it difficult to create a strong relationship with audit companies. But again sharing audit work between several companies creates conflicts among those auditing companies Such as setting the materiality levels, evaluating internal control systems, identify the audit risks, determining sampling techniques…etc. Also, this suggestion not only increase the complexity of the work of ASIC and increase the government spending but also it increases cost of the audit and none of the shareholders would ever like to spend that much of huge money for auditing. So even though those suggestions work well in closing AEG I believe that those are practically impossible. The best option that we can have is amend regulations to increase the disclosure requirements. Make all the connections and relationships whether it is direct or indirect to be disclosed in the financial reports. And imply server penalties especially for assurance auditor and audit partner who have not disclose it. On top of that it is very important to carry out random investigations by ASIC to check whether the auditor is performing its work competently and see whether there are any kind of undisclosed connections between auditor and the client. ASIC can ask ICAA or CPA to perform such random investigations.
- Barry, P, 2002, One.Tel’s cash SOS, then it all fell apart, viewed 24 March 2011, <http://www.smh.com.au/articles/2002/07/31/1027926916297.html>
- Barry, P, 2002, Rich Kids, Transworld Publishers, Milsons Point, NSW.
- Ferret, 2001, One tel appoints administrators, suspends trading, viewed 31 March 2011, <http://www.ferret.com.au/n/One-Tel-appoints-administrators-suspends-trading-n686030>
- Frank, KE, Lowe, DJ, Smith, JK, 2001, “The expectation gap: perceptual differences between auditors, jurors and students”, Managerial Auditing Journal, vol. 16, no.3, pp.145-150.
- Lampe, A, 2005, Onetell auditor was linked to packer, viewed 25 March 2011 <http://www.smh.com.au/news/business/onetel-auditor-was-linked-to-packer/2005/10/25/1130239522655.html>
- Lee, TH, Ali, AM, Bien, D, 2009, “Towards an Understanding of the Audit Expectation Gap”, CFAI Journal of Audit Practice, January, vol. 6, no.1, pp.7-35.
- Lipton, P, 2003, “The demise of HIH: corporate governance lessons”, Keeping Good Companies, June, pp.273-277, viewed 18 March 11, <http://www.australian-corporate-governance.com.au/hih_royal_commission.pdf>
- Nieschwietz, R and Woolley, D, 2009, “Perceptions of auditor independence: evidence from CPA’S, loan officers, and general public”, Academy of Accounting & Financial Studies Journal, June, vol.13, no.3, pp.93-106.
- Roy, E, 2001, Role of company auditors under the spotlight, viewed 31 March 11. <http://www.abc.net.au/pm/stories/s309176.htm>
- Smh.com.au, 2009, Court to hand down judgment on One.Tel, viewed 31 March 2011. <http://news.smh.com.au/breaking-news-business/court-to-hand-down-judgment-on-onetel-20091117-ik7m.html>
- Vanasco, RR, 1994, “The Audit Committee: An International Perspective”, Managerial Auditing Journal, vol.9, no.8, pp.18-42.