Financial statement users’ understanding of the messages in the audit report



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List of abbreviations

AAA American Accounting Association


AAFR Australian Accounting Research Foundation
AICPA American Institute of Certified Public Accountants
APB Auditing Practices Board
ASB Auditing Standards Board
AUP Statement of Auditing Practice
CEO Chief Executive Officer
CFO Chief Financial Officer
FEE Federation of European Accountants
FRC Financial Reporting Council
GAAP Generally Accepted Accounting Principles
GAAS Generally Accepted Auditing Standards
HRA Handleiding Regelgeving Accountancy
IAPC International Auditing Practices Committee
IAASB International Auditing and Assurance Standards Board
IASB International Accounting Standards Board
ICAEW Institute of Chartered Accountants in England and Whales
IESBA International Ethics Standards Board for Accountants
IFAC International Federation of Accountants
IFRS International Financial Reporting Standards
IOSCO International Organization of Securities Commissions
ISA International Standards on Auditing
NBA Nederlandse Beroepsorganisatie van Accountants
NCFFR National Commission on Fraudulent Financial Reporting
PAT Positive Accounting Theory
PCAOB Public Company Accounting Oversight Board
SAS Statement on Auditing Standards

1. Introduction


This chapter introduces the research topic: ‘the value relevance of the auditors’ communications’. This chapter describes the background of accounting and auditing and defines the objectives and the problem definition of the research. In addition, this chapter contains a recapitulation of the research methodology and an overview of the outline of the research.

1.1 Background


This paragraph describes the background of accounting and auditing and introduces research topic ‘the value relevance of auditors’ communications’.
Financial accounting

Financial accounting is a process involving the collection and processing of financial information to assist in the making of various decisions by many parties external to the organization (Deegan and Unerman, 2006, 32).


The process of financial accounting leads to the generation of financial reports: financial statements. The principal classes of users of financial statements (financial statement users) are investors, bank lenders, trade creditors, employees, financial analysts, governments and the public.
The International Accounting Standards Board (IASB), an independent accounting standard-setter, published a ‘Framework for the preparation and presentation of financial statements’ (the Framework). The main objective of the Framework is to create a sound foundation for future accounting standards that are principles-based, internally consistent, and internationally converged.
According to the IASB-framework, the objective of financial statements is to provide information about the financial position, performance and changes in financial position of an entity that is useful to a wide range of users in making economic decisions. Elements of the financial statements are assets, liabilities and equity; the balance sheet, income, and expenses; the income statement. The cash flow statement reflects both income statement elements and changes in balance sheet elements.
‘Global Capital Markets and the Global Economy: A Vision from the CEOs of the International Audit Networks’ (2006), a paper written by the leaders of the six largest global audit networks, discusses the way global financial reporting and public company auditing procedures must adapt to better serve capital markets around the world. The Chief Executive Officers (CEOs) state that in this world of ‘mass customization’, standard financial statements have less and less meaning and relevance. “The future of auditing in such an environment lies in the need to verify that the process by which company-specific information is collected, sorted, and reported is reliable and the information presented is relevant for decision-making.” The CEOs mention the importance of non-financial information that will be part of the new reporting system as well.
Auditing and the audit report

In a decision-making process, decision makers rely upon information, financial statements, as prepared and presented by the management of an entity. The possibility that the information upon decided on is inaccurate is called the ‘information risk’.


Elder et al. (2010, 9) state that the most common way for users to obtain reliable information (reducing the information risk) is to have an independent audit performed. To enhance the degree of confidence of the intended users in the financial statements, a financial statement audit will be conducted. Decision makers use the audited information on the assumption that it is reasonably complete, accurate, and unbiased.
Based on an audit, an audit report will be issued. The audit report represents the auditor’s communications of findings to financial statement users. The audit report contains information about the audit, including its scope, and an opinion regarding the fair presentation of the financial statements.
Value relevance audit report

Financial statement users rely on the auditor’s report to provide assurance on the company’s financial statements. One important question hence is whether auditor communications communicate the appropriate information. Is the audit report effective in communicating important information about, for example the audit process, the auditor’s duties and ‘going concern’ or do investors need more (better) information to facilitate their investment decisions?


Concerning the information content and the effectiveness of the auditors’ communications, several studies already have explored. Various shortcomings of the audit report have presumed and, to address the perceived shortcomings through all years, several solutions have proposed. For example AICPA 1978, Porter 1993, Hermanson et al. 1991, Gay and Schelluch 1993, Manson and Zaman 2001, Porter et al. 2009 etc.

Considering the audit report, the CEOs (2006) postulate that in a new world of customization, users of information will be accustomed to making fine distinctions, and to deciding what level of ‘granularity’ they are willing to pay for. Today’s world however, is more ‘black and white’: “For example, the current audit opinion is like an ‘on and off’ switch: either a company’s financial statements do or do not comply with prevailing accounting conventions”.


According to the CEOs (2006), users of financial information want to receive more nuanced opinions from auditors about the degree of a company’s compliance with financial reporting standards. Investors may even apply for an auditors’ opinion concerning the overall health and future prospects (going concern disclosure) of the companies they audit. Regulators and the liability system in any country should accommodate these types of requests.

1.2 Objectives


During the last decennium major financial (accounting) scandals, for example Enron, WorldCom, Kmart, and Royal Ahold have been detected. Green and Reinstein (2003, 25) state that improved communications between the auditor and stakeholders would not have prevented scandals as signaled before. Additional information however might have allowed capital suppliers and other financial statement users to decide more informed, consequently limiting their losses.
It is not clear-cut that when deciding on investments, financial statement users consider the audit report. Misunderstanding of information being communicated by means of the audit report however, can lead to unintended investments, misallocation of resources and / or loss of confidence in the audit function.
The purpose of this research is to investigate the value relevance of the auditors’ communications. ‘Value relevance’ implies the ability of auditors’ communications, i.e., the audit report, in communicating effectively about the audit process, the responsibilities of the auditor, the nature of assurances provided by the auditor and other items, which could be important in a decision-making process.
‘Value relevance’ will be established by assessing users’ understanding of messages as contained in the audit report and identifying users’ needs and requirements regarding topics which should be attended to (more extensively) in the audit report.

1.3 Problem definition


The main question hence is:
What is the value relevance of the auditors’ communications, i.e., does the audit report enhance the financial statement users’ understanding of the auditor’s duties, the audit process, assurances provided and other important topics, or is additional and / or other information required in facilitating a decision-making process?
In order to realize an answer to the main research question, the following sub questions need to be answered:


  • What is the purpose of performing audit, and assurance services, and concerning the audit, which theoretical explanations underlie the demand?

  • What is the purpose of issuing an audit report, and which types of auditor communications are distinguished?

  • Which subjects are included in a standard audit report?

  • Which shortcomings of the standard audit report have been expressed?

  • Which studies on the information content of auditor communications have been conducted formerly and what conclusions can be drawn from these studies?

  • Which research method is most suitable to investigate the value relevance of auditors’ communications?

  • What are the results of tests of users’ understanding regarding messages in the audit report and when comparing the output of different classes of financial statement users, which differences exist?

  • Concerning the purpose of facilitating a decision-making process, which topics should be attended to or in the audit report should be attended more extensively?



1.4 Methodology


P.G. Swanborn (2009) sketches the distinction between ‘descriptive’ (what is) problems, ‘explanatory’ (in which way does it come about) problems and ‘design’ (what can we do about it) problems.
The problem in this research could best defined as an explanatory problem. The purpose of the research is to establish and to demonstrate the causal character of the association between the form and the content of the auditors’ communications and users’ understanding of certain topics, like the audit process, auditors’ duties, assurances, going concern, and other topics that could be important in a decision-making process.
In order to establish the value relevance of the auditors’ communications, both a literature review and an empirical research will be conducted.
The main purpose of a literature review is to provide an overview of significant literature as published on the topic of auditors’ communications. To acquire an understanding of the research topic, in which way this topic has been researched, and which key issues have been found, theoretical literature as well as empirical research literature will be identified and evaluated.
In this study, the research question is focusing on financial statement users: the population. Various groups of stakeholders (see chapter 1.1 ‘Background’) could be distinguished. In order to realize a well-founded portrait of users’ opinions, each class of financial statement users, or the majority of users’ classes, has to be involved.
Considering the breadth and the diversity of the target population, it will not be possible to select unbiased or random subsets of individual financial statement users. This research has not the intention to be accurately representative of its population; applying a qualitative research strategy will be satisfactory.
Different classes of financial statement users will be involved in this research. In this research, the ‘financial statement users’ are institutional investors, bank lenders, and financial analysts. These user groups have different approaches in processing information and making economic decisions and consequently will use and analyze the audit report in a different manner.
According to P.G. Swanborn (2009, 114), surveys are conducted when the research questions deal with opinions, attitudes, motives, norms, values, aspirations or plans for the future. Swanborn distinguishes five main types of surveys, namely: face-to-face surveys, telephone surveys, surveys with a computer voice, postal mail surveys, and web and e-mail surveys.
In examining respondents’ opinions and interpretations regarding messages in the audit report, a mail survey or e-mail survey is the most applicable research method.



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