This assignment is going to include a discussion on the perception of the external audit report, an explanation how and why wording in the external audit report has evolved, as well as an explanation and discussion on the IAASB’s proposals and a comment on possible future developments.
Purpose of the external audit report
When dealing with the purpose of the external audit report it comes down to who is being asked the question as there are many perceptions as to what exactly the purpose actually is. The Institute of Chartered Accountants in Australia believe “The objective of the financial statement audit is to add credibility to management’s financial statements.” (The Institute of Chartered Accountants in Australia 2008). They also go on to say how an audit allows different user groups to feel more confident in an entity’s financial statements because there is reasonable assurance that a true and fair view is present. (The Institute of Chartered Accountants in Australia 2008) However some users of accounts see things differently “Others felt 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” (McEnroe & Martens, 2001: 347). Looking at things from yet another angle the law also has an opinion on the purpose of auditors and audit reports, in the famous case of Kingston Cotton Mills Co. (1896) Lord Justice Lopez stated “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, not a bloodhound.” (Court of Appeal 1896) Basically meaning the audit report can never be guaranteed to have zero errors. To summarise things a just definition that probably would be accepted by a majority of parties is that the purpose of an external audit report is to express an opinion as to whether or not the information presented in the financial statements reflects the financial position of an organisation at a particular date, thereby providing reasonable assurance of a true and fair view. However different users will most likely always perceive the purpose slightly differently to each other, removing the expectations gap is easier said than done. Public accounting professions will have to react and evolve fast enough to keep up to pace with the changing business and social environment to completely eliminate the gap. (Sherer & Turley, 1997)
How and why the wording in the external audit report has evolved
One reason as to why the wording of external audit reports evolved was the fact that terminology in the reports was not always interpreted the same way, “existing audit reports are misunderstood by many readers” (Bailey, Bylinski & Shields, 1983: 355)
(McEnroe & Martens, 2001: 348)
The table above shows how the phrase ‘present fairly’ was perceived in different ways not only by investors but also by auditors themselves. Although there were proposals to have this phrase removed from the audit report strong resistance from the financial community meant it was never enacted. Terminology being interpreted differently led to an information gap and to counter this as well as enhance overall communication between auditors and financial statement users, the Cohen commission and Treadway commission made many recommendations. One proposal which was successful and lead to a change was “the addition of a paragraph explaining the scope of the audit” (PCAOB 2011).
Another reason for change is the planned global harmonisation of standards. With the ASB and IAASB planning on converging U.S GAAS and the International Standards on auditing there became a need to provide more consistency across international borders. (Morris & Thomas, 2011) One way to ensure the wording is clearer and easier to understand is the new definitions section, “The “Definitions” section defines any terms or expressions that are being introduced in a standard for the first time.” (Morris & Thomas, 2011: 2)
The wording of the external audit report has evolved because what is being demanded has changed. Users want greater clarity along with more transparency because more than ever individuals want a deeper insight in to an audited firms financial statements, which is probably a result of the recent financial crisis which hit the global business world with no clear warnings. (Bussiere & Fratzscher 2006) However the difficulty lies in finding cost effective solutions which still enable some form of commonality to maintain consistency internationally.
The IAASB has proposed the inclusion of an “Auditor Commentary” section. This would help users of the statements understand more what exactly the auditor is doing and the processes he carries out to develop an opinion, meaning there may be a reduction in the expectations gap. However the commentary relies on the auditor’s judgement on what is most likely to be important, meaning different auditors may reach different conclusions, which could in turn lead to differences of opinion; this may affect the harmonisation of audit reports and comparability. Also the commentary would be provided at the discretion of the auditor, meaning more time and effort would have to go in to each audit but with no extra fee, one may question the cost effectiveness. However other entities such as investors may benefit because increased understanding may lead to greater usefulness when it comes to decision making. An alternative could be a universal section explaining audited financial statements or the audit; even though no two audits are exactly alike this approach could still help develop basic understanding and would also ease the auditor’s tasks. One may expect investors and shareholders would be in favour of the proposal whilst auditors may not be as pleased unless fees also increase proportionally.
Another proposal is to assess management’s assumptions in a conclusion. A conclusion including the appropriateness of the going concern assumption and whether material uncertainties have been identified may help point out early issues that need to be dealt with, this could in fact prevent future unexpected financial crisis from occurring and may also increase financial statement transparency. However the report should be neither overly optimistic or pessimistic. One may also expect a reduction in the information gap. It’s fair to say most stakeholders would be in favour of this proposal, apart from managers of course.
Also proposed was a statement as to whether any material inconsistencies between the audited financial statements and other information have been indentified, this may enhance the report providing a clearer and maybe even a more complete picture of a firm and operations. An issue is that not all future events can be predicted accurately and so a statement about the absence of material uncertainties is not a guarantee, users may misinterpret this which would widen the expectations gap.
Prominent placement of the auditor’s opinion and other entity- specific information along with further suggestions to provide transparency were also proposed. This may help assist when it comes to navigating through complex financial statements and will also help point out specific areas were the auditor’s effort was focused. A narrowing of the information and expectation gap may be the outcome however one could argue changes to the audit report alone may not be enough and that information outside of statements also has to improve to provide a more meaningful change. A possible alternative could therefore be to provide authoritative educational material maintained by the IAASB, in a sense helping users navigate through reports more freely although the problem which arises here is a general guide may not be specific enough.
Possible future developments
Users of financial statements seem to be in agreement that audit reports need to improve and welcome the fact that the IAASB has sought improvement “I am fully supportive of your current initiative” (Robert Mednick, 2012), however not all users believe the suggestions made are appropriate “we do not agree with the proposals” (Roger Harrington, 2012). To summarise some stakeholders believe the proposals given would just lead to a duplication of information provided by managers and that the report would become prone to boilerplate commentary. (WESTWORTH KEMP, 2012) Although they may provide more information to underpin the pass or fail opinion there may be potential for increased audit costs. It may be appropriate to not make some aspects of the improvements mandatory and instead include a voluntary element. Also any going concern commentary should be clear and evident to users so that comments are not taken out of context. However a lot of users agreed with the proposed changes and with a few minor adjustments believed they would be affective, “in general, the suggested improvements are appropriate”( ACCA, 2012), so in the near future one may see the suggestions made put in to effect.
To conclude my research suggests that audit reports need to evolve and improve to keep up with the changing business and social environment and the IAASB’s proposals are a step in the right direction. Although the suggestions made could have an inverse impact the potential for benefit vastly outweighs this. The proposals target a number of issues such as transparency and usefulness and have the capability to be operated internationally. However one may be concerned by users misunderstanding comments which would then widen the expectations gap.
Word count: 1541
McEnroe & Martens, JEM & SCM, 2001. Auditors’ and Investors’ Perceptions of the “Expectation Gap”. American Accounting Association Accounting Horizons, Vol 15 No. 4 , 345-358.
Journal Article with two authors
Bussiere & Fratzscher, MB & MF, 2006. Towards a new early warning system of ¬nancial crises. Journal of International Money and Finance, vol 25 issue 6, 953-973.
Journal Article with three or more authors
Bailey, Bylinski & Shields, KEB, JHB & MDS, 1983. Effects of Audit Report Wording Changes on the Perceived Message. Journal of Accounting Research, vol 21 No. 2, 355-370.
Electronic Journal Article
Morris & Thomas, JTM & CWT, 2011. Clarified Auditing Standards: The Quiet Revolution Redrafting brings both significant and subtle changes. Journal of accountancy, [Online]. vol 212 no. 6, 1-5. Available at: http://www.journalofaccountancy.com/Issues/2011/Jun/20113792.htm?action=print [Accessed 21 December 2012].
Book with two authors
Sherer & Turley, MS & ST, 1997. Current Issues in Auditing . 3rd ed. SAGE.
ACCA. 2012. IFAC. [ONLINE] Available at: http://www.ifac.org/sites/default/files/publications/exposure-drafts/comments/TECH-CDR-1134.pdf. [Accessed 24 December 12].
Court of Appeal. 1896. in Re Kingston Cotton Mill Company. [ONLINE] Available at:https://docs.google.com/viewer?a=v&q=cache:es7g__ZhMQcJ:oxcheps.new.ox.ac.uk/new/casebook/cases/Cases%2520Chapter%25203/In%2520Re%2520Kingston%2520Cotton%2520Mill%2520Company.doc+&hl=en&gl=uk&pid=bl&srcid=ADGEESi-yvPPgWKz2uXlc1x-nczMt8_8SwD5LS3GUKqD91xzDPjpel3Wb3jz5wuRb–cvvLuSbU0n-hrVB219b2nbSDucvGe6M1_zbbPDznPNgySGRthAbob0hPvSfUxDOxNyqw7joD4&sig=AHIEtbSArCbzy46PFrwiGFwW9sR4r4_q_Q. [Accessed 20 December 12].
WESTWORTH KEMP. 2012. IFAC. [ONLINE] Available at: http://www.ifac.org/sites/default/files/publications/exposure-drafts/comments/%20Response%20to%20IASB%20cover%20letter.pdf. [Accessed 24 December 12].
PCAOB. 2011. Auditor’s Reporting Model. [ONLINE] Available at: https://docs.google.com/viewer?a=v&q=cache:zgMg6vjULngJ:pcaobus.org/Rules/Rulemaking/Docket034/Concept_Release.pdf+&hl=en&gl=uk&pid=bl&srcid=ADGEEShbtsssuJKbqau2HByCha6ceGn0TerZkO2rSZIgCwab7oP3VrEKByouZvO5KNp9GelZwSr4yKTLA0ifzzYvyCaUZqC5io_C4hw_kIFbqFRqW0B0-VZD-BRfFPv4BXPWyp30WLq4&sig=AHIEtbSRPJv8F4PlAwjESC9_dYMb5zV2hA. [Accessed 21 December 12].
Robert Mednick. 2012. IFAC. [ONLINE] Available at:http://www.ifac.org/sites/default/files/publications/exposure-drafts/comments/Bob%20Mendick.pdf. [Accessed 24 December 12].
Roger Harrington. 2012. IFAC. [ONLINE] Available at:http://www.ifac.org/sites/default/files/publications/exposure-drafts/comments/IAASB%20auditor%20reporting_BP%20final%20letter.pdf. [Accessed 24 December 12].
The Institute of Chartered Accountants in Australia. 2008. The role and function of external auditors . [ONLINE] Available at: https://docs.google.com/viewer?a=v&q=cache:-a3oYjL5QZMJ:www.charteredaccountants.com.au/~/media/Files/Students/Educators/The%2520role%2520and%2520function%2520of%2520external%2520auditors.ashx+purpose+of+external+audit+report&hl=en&pid=bl&srcid=ADGEESjNR071rP0bdpjegrZugcckMQf624dKlOBe-5k2KXxKGtEIrcAzex4Tu9z9SCvvTW940KbpqVjrb5AEk6dCGHv1y5yirgdDrDKbnnP2OSuT3p89CjCFN7TPDlCQuIxIam7VQjCx&sig=AHIEtbT1FCvNCrztdhXarps3bxYVpP3b2w. [Accessed 19 December 12].