The purpose of the auditor's report and the audit expectation gap

A company collapses six months after the auditors signed a clean report. Shareholders say they relied on the audit and ask why the auditor did not stop the fraud. The audit report said no such thing. But the public thought it did.

That gap between what the public expects of auditors and what auditors actually do is called the expectation gap. It is one of the most persistent issues in the profession. The audit report is the single way the auditor speaks to users, so it is also the main tool for closing the gap.

This topic covers the purpose of the auditor's report and the standards that govern it, the expectation gap, its three elements, examples of public misunderstandings, how the gap is addressed, and the criticism of those responses. The previous topic covered the overall review, and the next covers the unmodified report under ISA 700.

Key terms in plain English

Syllabus check

This topic is in syllabus area C, audit evidence, completion and reporting (25% of marks). It covers:

• the purpose of the auditor's report
• the audit expectation gap
• ISA 700 and related standards

CAMA 2020 and the audit report

The Companies and Allied Matters Act 2020 (CAMA 2020) is the company law of Nigeria. The sections below apply to this topic.

The rules in more depth

Purpose of the auditor's report

The auditor's report is the end product of the external audit. It is the document in which the auditor gives a professional judgement on whether the financial statements give a true and fair view. The content is usually regulated by national legislation. In addition, the auditor is governed by:

• ISA 700, Forming an Opinion and Reporting on Financial Statements;
• ISA 701, Communicating Key Audit Matters in the Independent Auditor's Report;
• ISA 705, Modifications to the Opinion in the Independent Auditor's Report; and
• ISA 706, Emphasis of Matter Paragraphs and Other Matter Paragraphs.

ISA 705 and ISA 706 are outside the scope of the syllabus, though the syllabus asks about going concern and the way the report is modified, which later topics cover.

The report serves several users. Shareholders use it to judge the reliability of the information on which they decide whether to hold or sell, and to hold directors to account. Lenders rely on it for credit decisions. Regulators use it for supervision and tax authorities for assessment. Employees, suppliers and customers use it to judge the stability of the entity. The report is the auditor's only direct communication with these users.

The expectation gap

The auditor's report is the only direct means of communication between the auditor and the users of the financial statements, who are mostly, but not only, the shareholders. Auditing has suffered from an expectation gap, because the role of the auditor in law does not match what users expect.

The term means that the public perception of the role and responsibilities of the external auditor is different from the auditor's statutory role and professional responsibilities. Public expectations are often higher than the level at which the auditor actually works. Examples of the misunderstandings:

• The public believes that the audit opinion is a certificate that the statements are correct and can be relied on for all decisions, including takeover decisions.
• The public believes that the auditor has a duty to prevent and detect fraud and that this is a reason for an audit.
• The public assumes that the auditor tests 100% of transactions.

One result of these beliefs is a growing tendency in some countries to take legal action against auditors, sometimes on a frivolous basis, in the belief that the auditor should have prevented misstatements or fraud.

The reality is different. The opinion gives reasonable assurance, a high but not absolute level of assurance, that the statements are free from material misstatement. The primary responsibility for preventing and detecting fraud is with management and those charged with governance. The auditor is responsible for reasonable assurance that the statements are free from material misstatement, whether from fraud or error.

The audit is based on sampling, on testing and on risk assessment, because of cost and time and because of the inherent limits of controls. The opinion applies to the statements, not to the future viability of the business or the quality of management.

Elements of the expectation gap

The standards gap and the performance gap are those most often cited, with the liability gap as the third.

Responses to the expectation gap

Responses have varied by country:

• Corporate governance codes have been changed in some countries to strengthen the role and responsibilities of directors for good internal control and accounting systems, so that responsibility is placed with management.
• The standard auditor's report has been expanded to clarify what an audit involves and the relative responsibilities of the directors and the auditors. The long-form report with sections on the basis for opinion, management's responsibilities, the auditor's responsibilities and key audit matters is the result.

Other ways of narrowing the gap include:

• public education, by professional bodies, on what an audit is and is not;
• clearer wording of standards and of the engagement letter, so clients know what they are buying;
• reports on fraud risks, going concern and internal controls, such as the going concern statement and the key audit matters;
• strengthening the independence of the auditor, through audit committees, rotation and limits on non-audit services;
• a high quality of audit and strong regulation, such as the inspection work of the Financial Reporting Council of Nigeria; and
• limited liability arrangements that make the position of auditors clearer to users.

Critics argue that these moves are unlikely to be effective, because the groups that promote the expectation gap may not understand the attempts to remedy it, and because a longer report may simply not be read. Others argue that the gap will remain as long as the public wants a guarantee that an audit cannot give.

There is also a view that part of the gap is for the profession to close, by extending the scope of the audit, for example to require more work on fraud, and not only by explaining the limits.

How the audit report helps

The report states that the audit was done under the ISAs, that the auditor is independent, that management and those charged with governance are responsible for the preparation of the statements and for internal control, and that the auditor's responsibility is to give an opinion on the statements.

It says that reasonable assurance is not a guarantee, that the auditor uses sampling and professional judgement and that fraud and error are both possible. It also tells readers what the auditor regarded as most significant, in the key audit matters. Each section answers part of the public misunderstanding.

An auditor can also help to narrow the gap through the engagement letter, communication with those charged with governance, a clear explanation at the annual general meeting and in the management letter, and by carrying out the audit with scepticism, since a failure of performance feeds the belief that auditors do not do their job.

Worked examples

1. The opinion is reasonable assurance, not a certificate.
2. The statements can contain immaterial errors, and some material ones may be undetected because of the limits of testing.

1. The primary duty to prevent and detect fraud is with management.
2. The auditor is responsible for reasonable assurance. The question is whether the audit was performed to the ISAs, which would then be a performance gap issue and not a standards gap one.

1. This is the liability gap: users do not understand to whom the auditor is liable.
2. The auditor's duty is generally owed to the company and its members, and to third parties only in limited circumstances.

1. That is an explanation that tackles the belief that 100% of transactions are tested.
2. It reduces the standards and performance gap misunderstanding but may not reach the readers who need it.

How to score full marks

• Define the gap in one line.
• Give the three beliefs: certificate, fraud, 100% testing.
• Name the three elements and explain each.
• Give four ways to close the gap, with a short reason.

Common mistakes in the exam

• Saying the auditor is responsible for preventing fraud.
• Mixing up the standards gap and the performance gap.
• Giving only the problem and no remedies.
• Forgetting that the report itself is a response.

Quick revision

• Gap between public expectation and statutory role.
• Standards, performance, liability.
• Certificate, fraud, 100% testing.
• Responses: governance codes, expanded report, education, independence, regulation.

Practice questions

Questions 1 to 10 are multiple choice. Questions 11 to 13 are written. Try each before opening the answer.

Model answers

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