Minimizing the expectation gap.

Bostick, Lisa N. ; Luehlfing, Michael S.

ABSTRACT

Given the growing list of financial reporting scandals (Enron, WorldCom, Parmalat, etc.), financial reporting is once again at a crossroad (Sutton, 2002, 319). Similarly, the auditing "expectation gap" continues to exist (McEnroe & Martens, 2001) and the investing public is again challenging the auditing profession to develop mechanisms to increase audit effectiveness and thus restore confidence in independent audits (Sutton, 2002). Thus the auditing profession again finds itself amidst a crisis and again it needs to look inward to restore confidence in financial reporting, in general, and the independent audit, specifically. In this regard, we analyze the expectation gap with respect to illegal acts in an effort to improve audit effectiveness.

The analysis is grounded in the expectation gap paradigm developed by Porter (1993). In turn, the results of the analysis suggest two broad findings. First, in addition to unreasonable public expectations, deficiencies in the professional standards may have also contributed to the results of McEnroe and Martens (2001). That is, deficiencies in the professional standards may be contributing to the expectation gap. Second, the current professional guidance regarding illegal acts may need to be revisited in order to improve audit effectiveness and, in turn, narrow the expectation gap with respect to illegal acts.

INTRODUCTION

Given the growing list of financial reporting scandals (Enron, WorldCom, Parmalat, etc.), financial reporting is once again at a crossroad (Sutton, 2002, 319). Predictably, both the government and the auditing profession have reacted to these scandals (see Luehlfing, 1995). For example, the government passed The Sarbanes-Oxley Act of 2002. Additionally, the American Institute of Certified Public Accountants (AICPA) issued Statement on Auditing Standards (SAS) No. 99 (AICPA, 2002a), Consideration of Fraud in a Financial Statement Audit, and has also issued a proposed SAS (AICPA, 2002b), Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement. While we believe that these recent actions have addressed many of the issues underlying these scandals, we also believe that more can and should be done. In particular, we believe that, in order to improve audit effectiveness, the auditing profession (1) must revisit the auditors' responsibility to detect illegal acts. As summarized below, the logic underlying this notion is grounded in McEnroe and Martens (2001), as well as, Porter (1993).

McEnroe and Martens (2001) report that expectation gaps continue to exist in six dimensions of the audit--including fraud, internal controls, and illegal acts. As suggested by Porter (1993), we analyze these expectation gaps in order to identify possible remedial actions, that is, actions that may narrow the expectations gaps identified by McEnroe and Martens (2001). The analysis initially focuses on actions of the AICPA (2)--subsequent to McEnroe and Martens (2001)--regarding fraud and internal controls. Thereafter, the analysis focuses on the current professional guidance regarding illegal acts. Two broad findings are suggested by the results of the analysis. First, in addition to unreasonable public expectations, deficiencies in the professional standards may have also contributed to the results of McEnroe and Martens (2001). Second, the current professional guidance regarding illegal acts may need to be revisited in order to improve audit effectiveness and, in turn, narrow the expectation gap with respect to illegal acts.

BACKGROUND

Sutton (2002, 321) believes that the auditing profession needs to do three things in order to restore and maintain confidence in the independent audit:

* Embrace a role that is fully consistent with high public expectations;

* Tackle fraudulent financial reporting as a distinct issue with a distinct goal--zero tolerance; and,

* Accept and support necessary regulatory processes that give comfort to investors and the public that the profession is doing all that it can do to prevent future episodes of failed financial reporting.

In essence, the above thoughts of Sutton (2002, 321-322) are grounded in the auditing "expectation gap" literature. In this regard, McEnroe and Martens (2001, 345) provide the following parsimonious definition: (3)

The auditing "expectation gap" refers to the difference between (1)
what the public and other financial statement users perceive
auditors' responsibilities to be and (2) what auditors believe
their responsibilities entail.

Porter (1993, 50) states that the expectation gap should more appropriately be entitled "the audit expectation-performance gap" and "be defined as the gap between society's expectations of auditors and auditors' performance, as perceived by society." Furthermore, Porter (1993, 50) decomposes the expectation gap into two major components--a reasonableness gap and a performance gap. She defines the reasonableness gap as "a gap between what society expects auditors to achieve and what they can reasonably be expected to accomplish." In turn, she defines the performance gap as "a gap between what society can reasonably expect auditors to accomplish and what they are perceived to achieve."

Continuing, Porter (1993, 50) further decomposes the performance gap into two categories--a deficient performance gap and a deficient standards gap. She defines the deficient performance gap as "a gap between the expected standard of performance of auditors' existing duties and auditors' perceived performance, as expected and perceived by society." In turn, she defines a deficient standards gap as "a gap between the duties which can be reasonably expected of auditors and auditors' existing duties as defined by the law and professional promulgations." Significantly, Porter (1993, 66) concludes ...

... that once a discrepancy between society's expectations of
auditors and auditors' perceived performance is detected (that is,
once auditors' performance of, or failure to perform, a duty is
criticized by a significant proportion of society, or of an
interest group), the duty in question should be analysed to
identify which component of the gap it represents. Once a duty is
associated with a specific component of the gap, appropriate
corrective action is almost self-evident.

Thus Porter (1993, 66) suggests the following approach to narrowing the expectation gap:

* Detect expectation gaps;

* Categorize each expectation gap;

* Take appropriate corrective action.

McEnroe and Martens (2001, 345) identify several expectation gaps between "audit partners' and investors' perceptions of auditors' responsibilities involving various dimensions of the audit." Specifically, McEnroe and Martens (2001, 356) report that the investing public does not want auditors to issue an unqualified opinion unless:

1. every item of importance to investors and creditors has been
reported or disclosed;

2. auditors have been "public watchdogs;" (4)

3. the internal controls are effective;

4. the financial statements are free of misstatements resulting
from management fraud;

5. the financial statements are free of misstatements intended to
hide employee fraud; and,

6. the financial statements are free of misstatements intended to
hide the firm has not engaged in illegal operations. (5)

As a result of these findings, McEnroe and Martens (2001, 354-356) conclude that an expectation gap exists in each of the above dimensions of the audit. Specifically, McEnroe and Martens (2001, 357) state that:

The areas of the attest function cited as evidence of the
expectation gap are, with the exception of the Supreme Court's
"public watchdog" function, required in the course of the audit by
the authoritative guidance (SASs). Therefore, it might well be the
case that the public has unreasonable expectations of the nature
and scope of the attest function. According to Porter's (1993)
classification scheme, this would be categorized as a
"reasonableness gap."

McEnroe and Martens (2001, 357) suggest that the "appropriate action to reduce these expectations might be in public education." In summary, they suggest two public education strategies. First, include as part of the annual report, a uniform explanation of what the attest function is designed to accomplish. This might include a condensed summary of the authoritative guidance regarding auditors' responsibilities. Second, have auditors provide a similar explanation at the annual shareholders' meeting. This might include a question and answer session regarding the nature and scope of the audit.

In the best of all worlds, educating stakeholders on what an audit is designed to accomplish and communicating what the auditor's responsibilities are, will reduce the gap between what stakeholders expect the auditor to achieve and what they can reasonably achieve, that is, the reasonableness gap. Thus, the two public education strategies delineated above are appropriate corrective actions for the reasonableness gap component of the expectation gap as defined by Porter (1993). However, deficient standards may have also contributed to the findings of McEnroe and Martens (2001). We explore this notion immediately below.

RECENT ACTIONS OF THE AICPA

For convenience, we summarize the expectation gaps noted by McEnroe and Martens (2001, 356) as follows:

1. Full disclosure;

2. Public watchdog;

3. Effective internal controls;

4. Management fraud;

5. Employee fraud; and,

6. Illegal acts.

While recent actions of the AICPA have not directly addressed items 1. and 2. above, such is not the case with respect to items 3. through 5. Specifically, since the publication of McEnroe and Martens (2001), the AICPA has issued SAS No. 99 (AICPA 2002a), Consideration of Fraud in a Financial Statement Audit, and has also issued a proposed SAS (AICPA 2002b), Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement. SAS No. 99 provides additional guidance on the auditor's responsibility for assessing risk of material misstatement whether due to error or fraud. The AICPA issued this SAS as the cornerstone to its Anti-Fraud Program to improve the likelihood that misstatements due to fraud will be detected. Thus SAS No. 99 relates to improving professional standards directly relating to items 4 and 5. While not yet approved, the proposed SAS provides additional guidance to the auditor for obtaining a sufficient understanding of the entity and its environment, including its internal controls, for assessing the risks of material misstatement (a theme also stressed in SAS No. 99). The AICPA issued this proposed SAS to increase the rigor and specificity of the auditing procedures to improve audit effectiveness. Thus the proposed SAS relates to improving professional standards directly relating to item 3.

Specifically, both SAS No. 99 and the proposed SAS emphasize the auditors' responsibility to expand their understanding of the entity and its environment beyond the accounting and financial aspects of the entity. Auditors are encouraged to make inquiries of others within the entity, including production, marketing, sales, and other personnel. In other words, to assess the risk of material misstatement of the financial statements whether due to error or fraud, the auditor should not only obtain an understanding of the accounting and financial aspects of an entity, but also the operational aspects of an entity.

With respect to restoring confidence in independent audits, Sutton (2002, 321) concludes with the following:

In the past, the auditing profession responded to challenges to its
performance with arguments that, on the whole, audits are effective
and that public expectations of the independent audit are
unrealistic. As the dialogue continued, attention inevitably turned
to the standards that govern financial reporting and auditor
performance. After extended debate, some changes were proposed and
some were adopted.

Thus Sutton (2002, 231) suggests that the auditing profession has, in the past, taken the following chronological approach to addressing expectation gaps.

* Deny the existence of deficiencies-specifically deficient standards.

* Entertain suggestions for improvements.

* Agree to accept some, but not all, proposed suggestions.

In this regard, we believe that the recent actions of the AICPA (noted above) represent prima facie evidence that a deficient standards gap (as defined by Porter 1993) not only existed at the time of McEnroe and Martens (2001), but also contributed to the findings of McEnroe and Martens (2001). Significantly, we believe deficient standards continue to exist with respect to illegal acts (i.e., item 6). As discussed immediately below, SAS No. 99 currently relates to some, but not all, illegal acts.

DETECTING ILLEGAL ACTS

SAS No. 54, Illegal Acts by Clients (AICPA 1988b), as well as SAS No. 99, provide the current professional guidance with respect to detecting illegal acts. SAS No. 54 classifies illegal acts as either those with a direct effect on the financial statements (AICPA 2003, AU 317.05) or those with an indirect effect on the financial statements (AICPA 2003, AU 317.06). Those with a direct effect on the financial statements generally relate to the financial and accounting aspects of an entity. Those with an indirect effect on the financial statements generally relate to the operational aspects of an entity. (6) Significantly, the auditor's responsibilities for considering "direct" illegal acts are delineated in SAS No. 99 while the auditor's responsibilities for considering "indirect" illegal acts are delineated in SAS No. 54. (7)

SAS No. 99 indicates that the responsibility of the auditor to detect direct illegal acts is the same as their responsibility to detect errors or fraud (AICPA 2003, AU 316.01, footnote 1). Stated otherwise, the "auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused from error or fraud" (AICPA 2003, AU 110.02) or whether caused by illegal acts "having a direct and material effect on the determination of financial statement amounts" (AICPA 2003, AU 316.01, footnote 1). In contrast, SAS No. 54 (AICPA 2003, AU 317.07) states that "an audit made in accordance with generally accepted auditing standards provides no assurance that [indirect] illegal acts will be detected or that any contingent liabilities that may result will be disclosed." (8) In turn, we believe that the current auditing standards continue to be deficient with respect to illegal acts especially in view of the requirements of Statement of Financial Standards (SFAS) No. 5, Accounting for Contingencies (Financial Accounting Standards Board, 1975).

REPORTING ILLEGAL ACTS

Loss contingencies can result when an entity engages in illegal operations. SFAS No. 5 provides management with the authoritative guidance for reporting material loss contingencies. In contrast to both SAS 54 and SAS No. 99, SFAS 5 does not differentiate between illegal acts with a direct effect on the financial statements or those with an indirect effect on the financial statements. Thus, with respect to illegal acts, a disparity exists between the auditing authoritative guidance and the reporting authoritative guidance. In other words, management has a responsibility under SFAS No. 5 to report all material loss contingencies, while the auditor has limited responsibility to detect loss contingencies arising from illegal acts than have an indirect effect on the financial statements. Again, we believe that this disparity represents prima facie evidence that a deficient standards gap also contributed to the findings of McEnroe and Martens (2001).

Additional evidence of an existing expectation gap resulting from deficient standards regarding auditing indirect illegal acts lies in the reporting (or lack thereof) of environmental liabilities. There have been numerous studies that document a pattern of underreporting environmental liabilities (See Ingram & Frazier, 1980; Wiseman, 1982; Rockness, 1985; Freedman & Wasley, 1990; Price Waterhouse, 1992; Cormier & Magnan, 1997; Freedman & Stagliano, 1995; Gamble et al., 1995; Stanny, 1998).

Significantly, environmental liabilities lie within the gap between the reporting requirements of SFAS No. 5 and the auditing requirements of SAS No. 54.

MINIMIZING THE EXPECTATION GAP

As previously stated, Porter (1993, 66) concludes that once auditors' performance is criticized by a significant proportion of society (that is, once an expectation gap exists) it is important to identify which component of the expectation gap exists. Once the specific component is identified the "appropriate corrective action is almost self-evident." McEnroe and Martens (2001, 357) suggest that the expectation gaps they found resulted from the reasonableness gap component of Porter's (1993) classification scheme. However, as described above, it could be that the deficient standards gap component of Porter's (1993) classification scheme could also be contributing to the McEnroe and Martens (2001) expectation gaps. In this regard, we offer two possible options that should be explored as the appropriate corrective action to reduce the expectation gap with respect to illegal acts.

First, adopt the McEnroe and Martens (2001) educational strategies. SAS No. 54 (AICPA 2003, AU 317.06) indicates that an auditor ordinarily does not have sufficient basis for recognizing possible violations of operational laws and regulations. Thus, the investing public may have unreasonable expectations of the auditor for identifying these types of illegal acts. However, this option only addresses the reasonableness gap and thus may not be sufficient to reduce the expectation gap with respect to indirect illegal acts.

Second, in addition to public educational strategies, amend SAS No. 54 to require the auditor to take a more active approach to detecting indirect illegal acts. The amendment could provide specific guidance for detecting indirect illegal acts while still emphasizing the inherent limitations regarding the auditor's ability to detect indirect illegal acts. Significantly, much of the specific guidance in the proposed SAS (AICPA, 2002b), Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement, and SAS No. 99 (AICPA, 2002a), Consideration of Fraud in a Financial Statement Audit, can be extrapolated to indirect illegal acts. Thus, a foundation for the amendment already exists. Additionally, the amendment can reiterate the inherent limitations concerning detecting indirect illegal acts as SAS No. 54 currently describes. In summary, the auditor would employ a more active approach for considering indirect illegal acts without compromising the spirit of SAS No. 54.

Significantly, this second option addresses both the reasonableness gap (education strategies) and the deficient standards gap (amendment to SAS No. 54). Thus, it would be consistent with the AICPA's efforts for improving audit effectiveness as evidenced by its recent actions on internal controls and fraud (items 3-5). Additionally, amending SAS No. 54 could eliminate or at least reduce the disparity between this auditing standard and SFAS No. 5. Finally, amending SAS No. 54 would be consistent with Sutton's (2002) suggestions for restoring and maintaining confidence in the audit of financial statements.

CONCLUSION

McEnroe and Martens (2001) found that an expectation gap exists in six dimensions of the audit. They recommended that public education may reduce the expectation gap in the areas they found, with the exception of the "public watchdog" function, thus suggesting that the reasonableness gap component was the contributing factor to the expectation gaps they found. However, as discussed above, the recent actions of the AICPA and the disparity between the reporting and auditing requirements of indirect illegal acts indicate that a deficient standards gap may also be contributing to these expectation gaps.

Given the pressures on the auditing profession to increase audit effectiveness and thus reduce audit failures, the profession should once again look inward. As Porter (1993) suggests, the profession should categorize each expectation gap in order to determine the appropriate corrective action. Amending SAS No. 54 to include additional guidance for assessing the risk of material misstatement due to indirect illegal may be the needed appropriate correction action to reduce the expectation gap regarding illegal acts (item 6). As Sutton (2002) suggests, the profession should embrace a role that is consistent with the high public expectations.

ENDNOTES

(1) The Sarbanes-Oxley Act of 2002 (The Act) created the Public Company Accounting Oversight Board (PCAOB), a private sector non-profit corporation to oversee the auditor of public companies. Specifically, Section 101 of The Act provides that the PCAOB shall establish auditing, quality control, ethics, and independence standards to be used by registered public accounting firms in the preparation and issuance of audit reports. However, given that the promulgatory domain of the PCAOB is currently limited to audits of public companies, the AICPA continues to promulgate generally accepted auditing standards (GAAS) with respect to audits of non-public companies. Thus the term auditing profession encompasses not only auditors, but also the two promulgating bodies (i.e., the PCAOB and the AICPA).

(2) As discussed in endnote 1, there are two promulgating bodies that establish GAAS. Initially, the PCAOB decided not to exercise its authority to designate or recognize any professional group of accountants to propose standards for audits of public companies (PCAOB, 2003a). Subsequently, the PCAOB adopted GAAS, as promulgated by the AICPA, as the interim PCAOB standards (PCAOB, 2003b). However, on December 17, 2003 the PCAOB announced its intentions to supercede, or effectively amend the existing professional standards as promulgated by the AICPA for public companies (PCAOB, 2003c).

(3) Please see the following references for additional definitions and related background information regarding the expectation gap: Commission on Auditors' Responsibilities, 1978; Guy and Sullivan, 1988; AICPA, 1993; Epstein and Geiger, 1994; U.S. Government Accounting Office, 1996; Sweeney, 1997; and, Wolf et al, 1999.

(4) In United States v. Arthur Young & Co., the U.S. Supreme Court portrayed the independent audit as a "public watchdog" function.

(5) An illegal operation is an illegal act. The professional standards define illegal acts as violations of laws or governmental regulations (AICPA 2003, AU 54.03).

(6) For example, indirect illegal acts may arise from violations of operational laws and regulations relating to, for example, securities trading, occupational safety and health, food and drug administration, equal employment, and price-fixing and other antitrust violations (AICPA 2003, AU 317.06).

(7) SAS No. 54 originally referred the auditor to SAS No. 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities (AICPA, 1988a) with respect to considering direct illegal acts. In 1997, SAS No. 53 was superseded by SAS No. 82, Consideration of Fraud in a Financial Statement Audit (AICPA, 1997). Thereafter, SAS No. 82 was superseded by SAS No. 99 in 2002.

(8) Carmichael (1988, 40) reports that the "ASB believed it simply isn't feasible to design an audit to provide reasonable assurance of detecting all illegal acts that could have a material effect on the financial statements." Additionally, Carmichael (1988, 41) suggests that auditors "usually aren't trained to spot" indirect illegal acts.

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Lisa N. Bostick, The University of Tampa

Michael S. Luehlfing, Louisiana Tech University