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1-1994

Investor Views of Audit Assurance: RecentEvidence of the Expectation GapMarshall A. GeigerUniversity of Richmond, mgeiger@richmond.edu

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Recommended CitationGeiger, Marshall A. "Investor Views of Audit Assurance: Recent Evidence of the Expectation Gap." Journal of Accountancy, January1994, 60-66.

CPE DIRECT

INVESTOR VIEWS OFAUDIT ASSURANCE:RECENT EVIDENCE OFTHE EXPECTATION GAP

What do investors expect from an audit?

by Marc J. Epstein and Marshall A. Geiger

nvestors and financial statement users longhave agi'eed on the usefulness of the auditin financial reporting. Over time, however,auditors have been expected to provide as-surance in varying degi-ees and for differ-ent purposes. Differences in perception—especially regarding assurances provid-ed—between users, preparers and auditorshave been termed the "expectation gap."This article provides some startling evi-dence of the existence of such a gap in in-vestor perceptions of the assurance provid-ed by an audit.

EVOLUTION OF THE AUDITIn the early years of the U.S. auditing pro-fession—from 1850 to the early 1900s—au-ditors primarily were engaged to providealmost absolute assurance against fraudand intentional mismanagement. As corpo-rate America gi'ew and the auditing pro-fession developed, the early 1900s saw a

MARC J. KPSTEIN. PhD. is a vu^iting professor ofbusiness admi.nistration at the Graduate School ofBusiness Administration. Harvard University, Cam-bridge, Massachusetts. He is a member of the Ameri-can Accounting Association and the Institute of Man-agement Accountantn. MARSHALL A. GEIGER.CPA, PhD, is associate, professor of accountuig at theUniversity of Riiode Inland, Kingston. He is a mem-ben- of the Awsrican Institute of CPAs, the Pe7insyliKt-nia Institute of CPAs ami tiie AAA.

shift away from verifying all transactionsand amounts for purposes of fraud detec-tion to determining fairness in financialstatement reporting. This shift partly wasa response to the burgeoning volume ofbusiness activity (making fraud detectionless feasible) and the appearance and in-creased imi)ortance of a new business play-er—the shareholder. Corporate sharehold-ers and other outside parties became in-creasingly reliant on auditors to attest tomanagement-provided information, neces-sitating a shift in the primary audit objec-tive to providing assurance on externallyreported financial information.

Current practice has not strayed farfrom that of early corporate America, withthe primary audit focus on financial state-ment reasonableness. Current standardsstill reflect the matenal misstatement fo-cus and increasingly have relied on the con-cept of "reasonable assurance" in de})ictingthe level of reliance to be placed on auditedinformation. One need only skim currentauditing standards to find pervasive evi-dence of the reasonable assurance con-cept's use as the foundation for reliance onaudited financial statements. Statement onAuditing Standards no. BI, EvidentialMatter, SAS no. 39, Audit Sampling, andSAS no. 53, The Auditor's Respoiisibilitifto Detect and Report Errors and Irregu-

6 0 JOURNAL OF ACCOUNTANCY, JANUARY 1994

larities, all I'ely on the concept of reason-able assurance.

Regardless of professional standards,however, an important question for theprofession is, What assurance does thepublic currently expect auditors to pro-vide? As a profession, CPAs continuallymust assess public reaction to their statedrole in financial reporting as well as deter-mine the public's perception of the typeand level of assurances believed or desiredto be provided by auditors.

THE ASSURANCE PROBLEMThe expectation gap has plagued the publicaccounting profession almost from incep-tion. Yet the profession has tried to mini-mize the disparity. From 1945 to 1950, theAmerican Institute of Accountants (anAmerican Institute of CPAs predecessor)undertook an active campaign to enlightenthe public to the public accountant's "true"responsibility. Around this time, the pro-fession began to clarify communications tothe public regarding its self-pei'ceived re-

sponsibility. Specifically, the standard au-ditor's report was modified in 1948 to com-municate better to the public what an auditwas and to present the auditor's opinionmore clearly. In 1950, over 70,000 co])ies ofa pamphlet describing an audit, audit re-ports and auditor responsibilities were dis-tributed to banks and other groups inter-ested or involved in financial reporting.

These early efforts were the profes-sion's attempts to hring public perceptionin line with the profession's notion of itsrole. Recent efforts have focused on bothpublic opinion and changing professionalstandards to bridge the gap.

THE NEW SASsA battery of expectation gap SASs were is-sued in 1988 partly to address public criti-cism of the auditing profession and partlyto provide increased levels of service to au-dit clients and the public. Although severalof the SASs depict auditor responsibility interms of the reasonable assui-ance concept,two are especially germane. SAS no. 58,

JOURNAL OF ACCOUNTANCY, JANUARY 1994 61

EXPECTATION GAP

Reports on Audited Fmancial Statements,requires a new standard audit report in-cluding an explicit statement that an auditprovides reasonable assurance for relianceon the fairness of the financial statements.SAS no. 53 increases the auditor's respon-sibility to design an audit to provide rea-sonable assurance that material errors andirregularities will be detected.

The statement added to the new auditreport is a culmination of almost 20 yearsof effort to establish reasonable assuranceas a basis for the standard report. In 1972,the AICPA committee on auditing proce-dure proposed a modified audit report toaddress what its members believed weredifferences in intended and perceived au-dit report messages. The proposed reportincluded the notions of materiality, test-ing and reasonable assurance, but it even-tually was withdrawn due to anticipatednegative public reaction. Several intermit-tent attempts to alter the standard auditreport also tried to include reasonable as-surance in a new report. SAS no. 58 em-bodies the intent of these early proposalswith an explicit reference that communi-cates to readers that an audit providesreasonable assurance of financial state-ments' material accuracy.

While SAS no. 58 communicates moreexplicitly the level of assurance an audit isintended to provide, SAS no. 53 says audi-tors have a responsibility to design auditsto provide reasonable assurance that allmaterial misstatements will be detected.

Former standards had required auditors toplan an audit to search for material errorsand irregularities. Together, these SASsI'einforce both internally and externally theconcept of reasonable assurance and the in-tention that an audit provide such a level ofassurance to users.

SHAREHOLDER VIEWSWe recently conducted a national surveyof investors to gather information on theirviews of various aspects of financial re-porting issues. F^articipants were selectedif they owned 100 or more shares of astock listed on the American or New Yorkstock exchanges. In total 24() responseswere obtained, representing individualsfrom all 50 states.

Two separate questions asked investorswhat level of assurance they believed audi-tors should provide for detecting materialmisstatements as a result of error (unin-tentional misstatements) and as a result offraud (intentional misstatements). The an-ticipated typical response was reasonableassurance. However, investors held audi-tors to a much higher level of assurance.The exhibit on page 64 gives the results ofboth questions.

For material misstatement due to er-I'ors, only about 51% of the investors be-lieved they should receive reasonable as-surance. Approximately 47% wanted ab-solute assurance financial statements arefree of material misstatements due to er-rors. This unexpected result clearly is in

EXECUTIVE SUMMARY• FOR MANY YEARS A GAP HASexisted between the assurances auditorsprovide on management-compiled finan-cial information and the expectations ofinvestors and other financial statementusers.• RECENT EFFORTS TO CLOSE theexpectation gap have focused on influ-encing public opinion and changing pro-fessional standards to ensure an audit isdesigned to provide reasonable assur-ance that material errors, irregularitiesand misstatements in financial state-ments will be detected.• A SURVEY OF INVESTORS foundthey held auditors to a high level of as-surance. Almost half expected completeor absolute assurance that material fi-nancial statement errors would be de-

tected. Over 70% expected absolute as-surance that material misstatement dueto fraud would be detected.• IF INVESTORS EXPECT AND thecourts begin to uphold a standard of ab-solute assurance, audit liability in-evitably will increase. As a result, theprofession should devote substantial re-sources to increasing public understand-ing of an audit's nature and its inherentlimitations.• WHILE A VARIETY OF MEANSare available for bridging the expecta-tion gap, including increased publicawareness and education, the most im-mediate is through ailherence to currentaudit standards. Auditors should bemore sensitive to the possible existenceof fraud in every audit they conduct.

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EXPECTATION GAP

Investor perceptions of audit assurance

The auditor should do whatever investigation is necessary so he orshe can provide assurance the audited financial statements are freefrom material misstatements. This assurance should be described asfollows:

No assurance necessary

Reasonable assurance

Absolute assurance

Error

1.67%

51.05

47.28

Fraud

2.51%

26.36

71.13

opposition to the levels of assurance statedin the auditor's report and in current pro-fessional standards.

As surprising as these results are, theypale in comparison with the high assurancelevels sought for fraud detection. Over TO'̂of investors believe auditors should be heldto absolute assurance for detecting maten-al misstatement due tu fraud. The profes-sion, in SAS no. 53, formally recognizesthat frauds and intentional misrepresenta-tions, even if material, are more difficult todetect than misstatements due to errors.

Nevertheless, investors seemingly setthe assurance standard for detection offraud higher than that for detection of er-rors—both of which exceed current profes-sional standards. Hence, the profession'sperception that an audit should providereasonable assurance of financial state-ment accuracy is held by only a minority ofinvestors. In sum, the majority of investorswant from an audit absolute assurance thefinancial statements are fi'ee of all types ofmaterial misstatement.

BRIDGING THE GAPThe findings unmistakably reveal an ex-pectation gap between auditors and in-vestors on the level of assurance an auditprovides. The evidence suggests investorsseek very high levels of financial state-ment assurance. Auditors should not onlybe interested in but also be aware of theseshareholder perceptions. The litigious en-vironment in which CPAs operate man-dates that we. intlividually and as a pro-fession, monitor public opinion and atti-tudes toward the level of services and as-surance provided.

If investors expect, and courts begin touphold, a standard of absolute assurance,

audit liability inevitably will increase sub-stantially. Thus, it is necessary from bothsocietal and professional perspectives thatCPAs try to narrow the expectation gap.To do so, however, both groups need to be-come active agents for change.

The gap may be narrowed partlythrough increased public understanding ofan audit's nature and its inherent limita-tions. The AICPA should devote substan-tial resources to explaining to the publicthe auditor's current role in the financialreporting process and an audit's inevitablelimitations. Increased educational effortswith clients and audit committees, atshareholder meetings, in professional andcivic organizations and at every availablejuncture should be used to communicate anaudit's merits and limitations. Our surveyfound that, in general, the more educatedan investor was regarding accounting, fi-nance and investment analysis—includingthe use of the auditor's report—the lesslikely he or she was to require absolute au-ditor assurance. Hence, increased aware-ness and education seem to be viable waysto bridge the gap.

Accordingly, an additiitnal way of edu-cating the public is through continued useof the new audit report explicitly indicat-ing reasonable assurance. Since the reporthas been used for a relatively short periodof time, it may take longer for the newmessages to affect public perception suffi-ciently. Standard setters should continu-ously evaluate the autlit report's commu-nicative effectiveness by testing wordingchanges on investors, bankers, educators,government and court officials to learnhow the audit repoit affects perceptions ofthe assurances provided and not providedby an audit. However, reliance on the au-dit report alone to educate report userswill not be sufficient to have an impact onuser perceptions.

A supplemental educational mediumthat may be used is the 1989 AICPA pam-phlet. Understanding Aiuiita and the Au-ditor's Report: A Guide for FinaiicinlStatement Users. Unfortunately, the pam-phlet has not attained widespread distribu-tion and, accordingly, its educational im-pact has been minimal. Substantially in-creased dissemination would be advanta-geous in presenting auditor views and pro-viding a foundation for discussion thateventually might lead to a nai-rowing of thegap. Hut individual shai-t'luilders are notlikely to read this publication unsolicited.

A more direct approach to increasing

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EXPECTATION GAP

user awareness of the audit function wassuggested by Robert Mednick. (See "TheAuditor's Role in Society: A New Ap-proach to Solving the Perception Gap,"JofA, Feb.86, page 70.) He proposed asupplemental "report" to accompany theaudit report describing in plain English anaudit's usefulness, the assurances provid-ed and the limitations. Such a report es-sentially would summarize the informa-tion in the AICPA pamphlet but would besubstantially condensed and much morevisible and useful to all fmancial informa-tion users.

Since messages of this type, no matterhow positively worded, could becometainted if promulgated by the AICPA, theSecurities and Exchange Commissionshould be encouraged to develop a similarunbiased report to be presented with reg-istrants' fihngs and financial statements.An SEC communication regarding the au-dit function and the assurances providedmay be more convincing to financial state-ment users than one emanating from audi-tors. A SEC requirement, however, willnot be effective for smaller and nonpub-licly traded entities.

The profession lacks an easily accessiblefraud database. Development and dissemi-nation of a national database on perpetrat-ed frauds and the effective and efficientmethods of detecting various frauds wouldincrease audit effectiveness. Since financialstatement users seek high levels of assur-ance, fraud-detection techniques and theirappropriate use should be readily availableto all auditors. If they were, fraud auditsmight become more prevalent or even rou-tine as part of the service package offeredby auditors.

The audit risk model in SAS no. 47, Au-dit Risk and Materiality in Conducting anAudit, suggests overall audit risk (in termsof the overall level of assurance providedby an audit) can be reduced through in-creased substantive testing. Another wayto address the gap is to offer a range of au-dit services (including fraud audits) withvarious levels of assurance. During theshareholders' meeting, investors could beoffered an array of applicable services andapproximate costs. They then could decidefor themselves what level of assurancethey are willing to pay for each year. Thiswould serve not only to educate investorsto an audit's inherent limitations but alsoto enlighten them to the relative costs forincreased audit work that would lead to in-creased levels of assurance.

The most immediate means of bridgingthe gap is simply through adherence tocurrent audit standards. The importantmessage behind SAS no. 53 is auditorsshould be more sensitive to the possibleexistence of material irregularities(frauds) in every audit. Heightened auditsensitivity to management honesty and in-tegrity not only will affect overall auditperformance but also will produce auditsthat provide the highest levels of assur-ance currently possible for the detection ofall misstatements.

In the long term, to move toward bridg-ing the expectation gap the audit profes-sion needs to expand services and undergoa fundamental change in attitude from self-defense-self-preservation to meeting soci-ety's expectations. This shift is beginningto take place already. Such a reorientationalso means an expansion of services, in-cluding more work to detect frauds andmore internal control audits and disclo-sures. It also means more opportunities to

• Increase the quality and diversity ofaudits.

• Increase the scope of services provid-ed and, accordingly, firm revenues.

• Decrease liability exposure due to notmeeting existing user demands.

To close the gap more completely, how-ever, the audit profession and financialcommunity need to reexamine the funda-mental role of an audit in society and to besure financial statement preparers, usersand auditors all are in agreement. As longas users and auditors continue to have dif-ferent understandings of what "presentfairly" according to generally accepted ac-counting principles really means, the ex-pectation gap will remain and auditors willcontinue to be faced with lawsuits.

HARP TO IMPLEMENTSome of these suggestions may be hard toimplement. However, until substantialchanges occur the expectation gap will per-sist and the litigation explosion will contin-ue to plague CPAs as injured shareholdersargue accountants "should have known" astock's price was going to fall or a fraudhad been committed.

Investor views should serve as a re-minder to the profession and individual au-ditors that professional audit standards donot dictate public opinion. Misconceptionsand differences in expectations—not tomention the current litigious environ-ment—will persist unless effectively andtimely addressed. •

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