Figure 3: Structure of the Audit Expectation-Performance Gap (Porter, 1993, 50)
According to Porter (1993, 50), the audit expectation gap has two major components:
a gap between what society expects auditors to achieve and what they can reasonably be expected to accomplish: 'reasonableness gap'
a gap between what society can reasonably expect auditors to accomplish and what they are perceived to achieve: 'performance gap', subdivided into:
a gap between the duties which can reasonably be expected of auditors and auditors’ existing duties as defined by the law and professional promulgations: 'deficient standards'
a gap between the expected standard of performance of auditors’ existing duties and auditors’ perceived performance, as expected and perceived by society 'deficient performance'
In ‘The audit expectation gap – plus ca change, plus c’est la meme chose?’ (1992, 137), C. Humphrey, P. Moizer, and S. Turley signaled two basic views as being the causes of the expectation gap:
Non-auditors poorly understand the nature of auditing, the roles, and responsibilities of the auditor and the probabilistic foundation of audit practice.
The expectation gap is an indicator of the evolutionary development of audit responsibilities; a direct consequence of time lags between the accounting profession identifying and responding to changing public expectations.
Narrowing the audit expectation gap, i.e., the ‘performance gap’ B. Porter, C. Ó hÓgartaigh and R. Baskerville (2009) regard to the importance of the monitoring of auditors’ performance. Porter et al. (2009, 179) recommend to implement stringent monitoring of auditors’ performance. Appropriate sanctions have to be imposed on errant auditors.
Porter et al. (2009, 179) state that to raise the confidence of financial statement users about the standard of auditors’ performance, they need to be aware that auditors’ compliance with several standards (ethical, quality control and technical) is being monitored stringently. “It is therefore important that reports on the monitoring process and its outcomes – including the sanctions imposed on those found not to complying fully with the standards – be placed in the public domain.”
Contemplating on the ‘reasonableness gap’, Porter et al. (2009, 180) proclaim that society in general needs to be educated about the audit function and what auditors can and cannot reasonably be expected to achieve.
Porter et al. (2009, 181) suggest that auditors could, for example, stimulate discussion about the auditor’s role and responsibilities within a section of society that extends beyond members of bodies such as the institute of directors, shareholders’ and business associations, and the accounting profession. An alternative is to seek opportunities to educate influential journalists about the audit function and work of auditors. From that, journalists may report adverse events affecting auditors in a more informed and less sensational manner.
This chapter has provided an introduction concerning audit services and has attended to the output of the audit process, the audit report. This chapter included a description of the form and contents of the audit report and described the main criticisms of the standard audit report.
Four types of audit reports are distinguished of which the ‘standard unqualified audit report’; issued by an auditor when the financial statements presented are free of material misstatements, is the main issue of this research.
One important question is whether the audit report is effective in communicating important information about for example the audit process, auditors’ duties and ‘going concern’ and does satisfy users’ information needs. Already in 1978, an early indication of concerns about the effectiveness of the audit report as a communication device was expressed in a report of the Commission on Auditors’ responsibilities’ (CAR).
The audit report was criticized because of its inability adequately communicate to its users the auditor’s function, the nature of the auditor’s work and auditors’ responsibilities. Nowadays, concerns about the audit expectation-performance gap are still alive.
Regarding the form and the contents of the audit report, the value relevance of auditors’ communications, various studies have already been explored. In the next chapter, several studies concerning the value relevance of the audit report will be commented in more detail.
4. Prior research on development audit report (1968 – 2009)
This chapter provides an overview of the existing empirical research literature concerning the value relevance of auditor communications.
4.1 Value relevance standard audit report
Following the Cohen Commission’s (1978) recommendations for improved communications between auditors and financial statement users, the Auditing Standards Board (ASB) of the AICPA issued an ‘exposure draft’ for a Statement on Auditing Standards (SAS) that would modify the standard short form audit report.
Proposed changes to the standard audit report particularly involved the education of financial statement users about the audit process and the responsibilities of management and the auditor for the financial statements. The exposure draft attracted a high volume of response from financial statement users as well as auditors and their clients and encountered significant opposition, whereupon the ASB (1981) decided not to proceed with an expanded audit report.
Dillard and Jensen (1983)
J.F. Dillard and D.L. Jensen (1983) examined responses of preparers, auditors, and users of financial statements that precipitated the exposure draft. In ‘the auditor’s report: an analysis of opinion’ (1983), Dillard and Jensen report on their research results.
Dillard and Jensen (1983, 789) examined 388 written responses, received by the ASB in an answer to the issuance of the proposal. The principal groups of respondents were public accounting firms (256 respondents), industrial firms (101 respondents), and financial institutions (31 respondents).
Research results show that only 26.5 percent of public accounting firms expressed an unfavorable general reaction to the proposal, whereas a majority of both industrial firms and financial institutions expressed a negative reaction. The main reason for such a reaction is that the proposed change should weaken the opinion, i.e., reduce the auditor’s implied responsibility for the financial statements (Dillard and Jensen, 1983, 790).
Dillard and Jensen (1983, 791) also investigated respondents’ reactions to the specific proposals in the exposure draft, for example the proposal to delete the word ‘fairly’, the addition of the sentence ‘reasonable but not absolute assurance of material misstatement’ and the addition of words to indicate that the financial statements are the representations of management.
Considering the addition of the word ‘fairly’, Dillard and Jensen (1983, 792) found the highest disagreement percentages for each group across all proposals, that is, public accountants 27.3, Industrial firms 46.5 and financial institutions 48.4.
Stimulated by, among others, findings of the National Commission on Fraudulent Financial Reporting (NCFFR, 1987), the ASB issued a new exposure draft, modifying the standard short form audit report. In 1988, encouraged by positive responses to the exposure draft, the ASB issued SAS No. 58, ‘Reports on audited financial statements’. See also appendix 1, illustration 1: Comparison of the old short form and new form (SAS No. 58) of the audit report.
a paragraph explaining that the financial statements are the responsibility of management and that the auditor’s responsibility is to express an opinion on those financial statements; and
a brief explanation about the content of the audit process, and the limitations concerning this process.
In response to the issuance of SAS No. 58, a number of studies were designed to investigate the extent to which the long form audit report met its objectives. The revision of the audit report, expanding with additional paragraphs, led to concerns about the audit report becoming long, complex, and less understandable.
In 1993, the International Auditing Practices Committee (IAPC), forerunner of the IAASB (established in 2002), issued ISA 700, ‘The auditor’s report on financial statements’. The only differences between SAS No. 58 and ISA 700 are as follows:
ISA 700 does not contain ‘independent’ in the title of the audit report; and
ISA 700 states the audit is conducted in accordance with ‘International Standards on
Auditing’. SAS No. 58 refers to Generally Accepted Auditing Principles.
Kelly and Mohrweis (1989)
A.S. Kelly and L.C. Mohrweis (1989) examined the impact of the new SAS No. 58 audit report on users’ perceptions regarding the message conveyed by this audit report. In ‘Bankers’ and investors’ perceptions of the auditor’s role in financial statement reporting: the impact of SAS No. 58’, the authors report on their results.
To enhance the external validity of the research, Kelly and Mohrweis focused on participants from two distinct groups of financial statements users, bankers (50 participants) and investors (50 participants). The bankers have been chosen from three Midwestern banks, with the restriction that each has significant lending experience. The investors have been selected from a graduate business program at a major Midwestern university. Only those individuals that had actually invested in securities were chosen.
The participants were asked eight questions to address two major issues, dealing with the understandability of the audit report (Kelly and Mohrweis, 1989, 89):
What is the difference in communicating between the SAS No. 58 report and the old form audit report?
In phase I of the research, each participant responded to the eight questions after having read an audit report. To the participants questionnaires were assigned randomly. These questionnaires contained either the SAS No. 58 report or the old two-paragraph audit report. Responses of the participants are measured on a seven-point Likert scale with endpoints ‘strongly agree’ and ‘strongly disagree’ (Kelly and Mohrweis, 1989, 91).
In order to test users’ perceptions regarding the auditor’s responsibility (phase II), participants were given a second questionnaire. The questionnaire required each participant to indicate the nature of the change in the level of responsibility that the auditor assumes between the old report and the SAS No 58 report. The questionnaire included an audit report opposite to the report the subjects received in phase I (Kelly and Mohrweis, 1989, 91).
The authors found that bankers and investors reading the new report tended to agree that management was responsible for the presentation and disclosure in the financial statements. Based on their research findings, the authors further conclude that the new report enhanced users’ understanding of the purposes of the audit.
Kelly and Mohrweis (1989, 95) state that attention may be focused on improving the message being communicated about the auditor’s responsibility. The authors found participants to be uncertain as to the nature of the auditor’s responsibility.
Hermanson et al. (1991)
In ‘Does the new audit report improve communication with investors?’ (1991), R.H. Hermanson, P.H. Duncan and J.V. Carcello report on a questionnaire they performed in order to investigate investors’ understanding of the nature of the audit process, the responsibilities of the auditor and the nature of assurances provided by the auditor.
Hermanson et al. conducted their research in reaction to the issuance (1988) of Statement on Auditing Standards (SAS) No. 58, ‘Reports on audited financial statements’. Hermanson et al. (1991) developed a questionnaire in order to determine whether the ‘new’ audit report improves communication with financial statement users. Hermanson et al. (1991, 32) composed a sample of individual investors. They obtained a random sample of 1.000 of members of the American Association of Individual Investors (AAII).
Participants were randomly assigned to two groups of 500 individuals. The first group received the questionnaire with a copy of the old report, while the second group received a copy of the new audit report. The questionnaire included multiple-choice questions to measure the investors’ understanding of the client-auditor relationship and the responsibilities of both parties.
Hermanson et al. (1991, 35) found that users of the ‘new’ audit report (SAS No. 58) have a better understanding of the responsibilities of both the auditor and management. Users of the new audit report also were more aware of the level financial statement accuracy implied by an unqualified opinion. Hermanson et al. concluded that the level of understanding of the audit process remains deficient among users of the new audit report.
Gay and Schelluch (1993)
In Australia, July 1993, the Auditing Standards Board of the Australian Accounting Research Foundation (AARF) released a revised Statement of Auditing Practice, AUP 3, ‘The audit report on a general purpose financial report’. The revised long form report attempts to improve communication between auditors and financial report users and to enhance the users’ understanding of the auditor’s role in the financial reporting process.
G. Gay and P. Schelluch (1993) studied the effect of the ‘new’ long form audit report on users’ perceptions of the auditor’s role in financial reporting in Australia. In ‘The effect of the long form audit report on users’ perceptions of the auditor’s role’ (1993), they give an account of their results.
Gay and Schelluch (1993, 3) notice that the modifications as proposed by the revised AUP 3 are similar to those embodied in the United States Statement on Auditing Standards (SAS) No. 58 ‘Reports on audited financial statements’ (1988).
According to Gay and Schelluch (1993, 3), the objective of the auditing standards boards in both countries is to narrow the differences between users’ and auditors’ views of the auditor’s part in the financial reporting process. “The new long form audit report attempts to achieve this by making explicit reference to the auditor’s role and responsibilities, the audit process and the level of assurance provided by the audit.”
To establish the impact of the revised audit report on users’ perceptions regarding the role of the auditor, the nature of the audit and the financial reporting process, Gay and Schelluch (1993) conducted a research among sophisticated users, shareholders and ‘reasonably intelligent’ non-investors. 180 financial statement users took part in the research, including 60 senior bank-lending officers, selected from three national banks, 60 investors, and 60 non-investors with business backgrounds. Both investors and non-investors were selected from MBA students at Monash University. Subjects were asked to read an example of an audit report and respond to a series of questions based on their understanding of the reports.
Gay and Schelluch (1993, 9) concluded that the revised audit report has changed users’ perceptions of the auditor’s responsibilities and that the revised audit report improves users’ perceptions of the purpose and procedures of the audit as well as the responsibilities of the directors for the financial report.
Gay and Schelluch (1993, 8) found that users did not fully understand the auditor’s responsibility for material misstatements. Furthermore, research results indicate that user perceptions of the financial report accuracy were not altered by the revised audit report. The authors postulate that amendments to the wording of the revised AUP 3 audit report may be required and that modifications may be necessary to state clearly that an unqualified audit report does not mean that the related financial report is 100% accurate.
Manson and Zaman (2001)
S. Manson and M. Zaman (2001) conducted a research, following the introduction (1993) of SAS 600, ‘Auditor’s report on financial statements’. In their paper ‘Auditor communications in an evolving environment: going beyond SAS 600 auditor’s report on financial statements’, Manson and Zaman report on their research results.
Manson and Zaman (2001) investigated the extent to which the expanded audit report, SAS 600, has been successful in aligning the views of auditors, preparers, and users about issues dealt with in the expanded audit report. In addition, the authors examined the extent to which the three groups considered that it would be useful for additional matters, including corporate governance, to be reported upon by the auditor.
The Auditing Practices Board (APB) issued SAS 600, prescribing a new, expanded form for the audit report. The rationale for the change, an attempt to reduce the expectation gap, is based on the assumption that the audit report can be used to inform users about the duties en responsibilities of auditors (Manson and Zaman, 2001, 114).
Manson and Zaman (2001, 120) explored a questionnaire survey, which was sent to a number of individuals from the three groups: auditors (400), selected from the 1999 ICAEW directory, preparers (400), selected from the Stock Exchange Year Book, and users, investment analysts and corporate bankers (200), which have not been randomly selected. Respondents were asked to react to a certain statements concerning changes in the wording of the expanded audit report.
All three groups of participants believed that the inclusion of an audit report enhanced the credibility of financial statements, that SAS 600 is a readable document and that it clearly communicates the purpose of the audit. All three groups considered that the wording used in SAS 600 does give some indication of the role of judgment in the formation of the audit opinion.
Using the expanded audit report (SAS 600), auditors have been recommended to add a short description of their duties. Through the questionnaire however, Manson and Zaman (2001, 124) found that the wording used in the audit report is not considered by the respondents to clearly indicate the auditors’ responsibility for the detection of fraud.
Manson and Zaman (2001, 125) learned that financial statement users are in favor of an explicit statement in the audit report of the auditors’ assessment of the ‘going concern’ status of the client. Responses to questions concerning internal control indicate that the user group is interested in the issue of internal control and in particular, the extent to which the auditors have examined and relied upon the internal controls.
On the issue of corporate governance at last, Manson en Zaman (2001, 133) found that financial statement users as well as auditors and directors agree that auditors should always report on corporate governance issues. All three groups believe that the directors’ statement in respect of corporate governance is useful.
Based on their research results, Manson and Zaman (2001, 133) conclude that SAS 600 has been successful in clarifying the purpose of the audit and the respective responsibilities of auditors and directors. The authors however, postulate that the audit report is of limited value to users and that it needs to be extended to include information about the results of an audit.
Mock et al. (2009)
In ‘The unqualified auditor’s report: a research of user perceptions, effects on user decisions and decision processes, and directions for further research’ (2009), T.J. Mock, J.L. Turner, G.L. Gray and P.J. Coram report their results of an investigation of user perceptions regarding the unqualified audit report and the impact of audit reports on judgments of financial statement users.
Mock et al. (2009, 1) conducted a series of focus groups, including preparers of financial statements (CFO’s), bank lenders, financial analysts, non-professional investors and auditors. 53 individuals participated in the focus groups.
Different categories of stakeholders met separately. Preliminary areas of discussion were the audit report and participants’ perception of its intent, audit procedures and financial statement content and other issues that might be inferred from the audit report.
One main issue Mock et al. (2009, 3) learned through the research was the misunderstanding of financial statement users regarding the level of assurance intended to be conveyed by the auditor report. “Across focus groups, the level of assurance generally was thought to be closely related to the concept of materiality.”
Reflecting on ‘internal controls’ Mock et al. (2009, 5) found that focus group participants generally did not assume an unqualified audit opinion indicates anything about the quality of internal controls. Some focus groups however, recommended that the quality of the internal controls be explicitly included in the auditor’s report.
Mock et al. (2009, 6) call attention to the overall usefulness of the unqualified audit report. Research results express that not all focus groups consider the audit report when perceiving a company’s performance. Besides, when examining focus group results in detail, Mock et al. became conscious of a serious disconnect between what auditors may believe they are communicating in an unqualified auditor’s report and what users infer from that report.
Porter et al. (2009)
B. Porter, C. Ó hÓgartaigh, and R. Baskerville (2009) investigated the audit expectation gap in the United Kingdom (UK) and New Zealand (NZ). They also conducted an experiment to ascertain financial statement users’ understanding of the messages conveyed in the audit report.
The experiment involved 252 MBA students (used as surrogates for reasonably knowledgeable financial statement users), selected from universities in NZ and in the UK, and randomly allocated to one of four groups. Each group was provided with a set of financial statements and one of four variants of the standard unqualified audit report. The participants were asked to indicate their opinion on 10 different statements related to the messages conveyed by the auditors’ report.
Porter et al. (2009, 187) found that the content of the auditor’s report makes no difference to financial statements users’ understanding of the responsibilities of directors and the auditor for the financial statements or the nature of the audit process. From this, the authors conclude that the audit report may not be a useful tool for narrowing the audit expectation gap and that other means may be more effective.
As part of the experiment (Porter et al. 2009, 187), respondents were asked to identify the most important items in an audit report. Among the most important items are included:
The auditor’s ‘true and fair’ opinion;
A statement of the directors’ and auditor’s responsibilities with respect to the financial statements;
Identification of the audit firm which conducted the audit; and
The audit qualifications, types, and reasons.
Gold et al. (2009)
A. Gold, U. Gronewold, and C. Pott (2009) conducted an experiment in order to investigate financial statement users’ perceptions regarding auditor and management responsibilities and the reliability of audited financial statements. The ultimate purpose of this research was to establish a possible reduction of the expectation gap under the revised ISA 700 audit report.
The experiment (Gold et al., 2009, 11) involved experienced auditors; selected from both big4 and non-big4 firms, financial analysts; selected from database Bloomberg and students; selected from the Erasmus University, Ruhr University Bochum and University of Münster. The experiment was performed twice: one experiment was conducted with Dutch participants and the other one with German participants. The full sample comprised 205 German and 58 Dutch auditors, 62 German and 20 Dutch analysts and 109 German and 46 Dutch students.
The experiment was conducted as a web-based survey (Gold et al., 2009, 12). Participants were asked to read a short company description, a summary of the firm’s financial statements, and an audit report. One group of participants received a ‘complete audit report’ (ISA 700, revised), while the other group received an ‘opinion-only’ version of the audit report. Participants were then asked to respond to a series of questions concerning:
Responsibilities of the auditor and company’s management, that is, producing the financial statements, detecting, and preventing fraud, and responsibilities concerning the soundness of the firm’s internal control structure.
With respect to misstatements, fraud, and errors, the reliability of the financial statements.
Gold et al. (2009, 26) found that financial statement users ascribe greater responsibility for the financial statements to auditors as compared to auditors. Despite of the new wording in the ISA 700 (revised) audit report and its detailed explanations of the auditor’s responsibilities and the task and scope of the audit, the authors did not find a reduction in the expectation gap. When the complete audit report is provided, as for the reliability ascription, the authors found the expectation gap to be even increased.