The audit expectation gap in the capital markets

 

Auditing

Question 1

1. Discuss the main components of the audit expectation gap in the capital markets.

Several scholars have tried to describe the audit expectation gap from a different perspective. Liggio describes the audit expectation gap as the difference in users’ and auditors’ perception of the auditors’ performance level during the auditing process. Porter defines the audit expectation gap as the gap that exists between auditors’ society expectation and auditors’ performance. Association of Chartered Certified Accountants (ACCA) defines the audit expectation gap as the difference between what society thinks the auditors do and what they want them to do. Therefore, the auditing expectation gap in the capital market refers to the difference in auditing perception from the public and auditors’ perspectives.

From Porter’s school of thought, the components of the audit expectation gap are reasonable gap and performance gap. The reasonable gap component relates to the difference in what the public expects the auditors to achieve and what the auditors are reasonably expected to accomplish. Performance gap refers to the difference in what the public reasonably expects auditors to accomplish and what the auditors are perceived to achieve. The performance gap component is divided into deficient standard and deficient performance. Deficient standard is the gap between what is reasonably expected of auditors and the auditors’ stipulated duties within the laws and professional standards. Deficient performance refers to the difference in the expected standards of performance of auditors’ existing duties and the auditors’ perceived performance by the public.

From the Association of Chartered Certified Accountants (ACCA), the components of the audit expectation gap include knowledge gap, performance gap, and evolution gap. Knowledge gap refers to the difference between what the public thinks the auditor does what they do, and it considers the cognizance that the public can misunderstand the scope of work of the auditors. The performance gap focuses on auditors’ failure to comply with the regulations and standards.  Therefore, the performance gap occurs due to inadequate concentration on audit quality, variation in the interpretation standards, the complexity of certain auditing standards, and overzealous regulation requirements between practitioners and regulators. Finally, the evolution gap concentrates on auditing areas that require evolution based on the public demand, technological changes, and overall auditing process.

1. LDF Co’s bad debt provision audit
2. Discuss the difference between the modified and unmodified audit reports.

A modified audit report is a type of audit opinion issued on an entity’s financial statements when the auditing process finds that the statements are not prepared according to the accounting standards, and the presentation does not fairly reflect the accounting framework in use. An unmodified audit report is a type of audit opinion that auditors issue on financial statements prepared in all material respect and compliant with the accounting standards and applicable regulations.

The auditor gives a modified opinion when the firm’s financial statements do not reflect a true and fair view of the company’s materials. On the other hand, the auditors give an unmodified opinion when the financial statement reflects a true and fair view of the firm’s current financial position. The auditors use different methods, techniques, and procedures to evaluate the financial statement for material misstatement. The unmodified opinion will be given when the evaluation ascertains that the information in the financial statement is materially correct; however, when the information shows incorrect information, a modified opinion would be given.

The modified opinion is classified into three sub-audit opinions depending on the level of modification, which bases the classification on the level of misstatement, pervasiveness, and sufficiency of audit evidence. The sub-audit opinion categories include qualified audit opinion, adverse audit opinion, and disclaimer audit opinion. Unmodified opinion, on the other hand, lacks sub-audit opinions.

Modified auditing report occurs when the auditor adds or deletes any information to the suggested financial statement report format and content. In contrast, an unmodified auditing report occurs when the auditor releases an audit report with the same format or content as the suggested financial statement report.

2. Discuss the above issue and describe the impact of this issue on the auditors’ report, if any, should this issue remain unresolved.

The issue in the case relates to material misstatement. The auditor’s evaluation shows that LDF Co included £500,000 into the provision of bad debts, which did not qualify for the provision for bad debts according to the applicable accounting standards. Inclusion of the amount to the provision of bad debts would increase the firm’s provision of bad debts that would impact the firm’s income statement and balance sheet, reducing the profit and value of trade receivables, respectively.

Since the inclusion of the amount to the provision of bad debt fails to adhere to the applicable accounting standards, the auditor will issue a modified report indicating the amount and reasons why its inclusion in the materials in the provision of bad debts categories is inappropriate. Moreover, since the management deems the provision of bad debts appropriate for the firm, the auditor will have no option but to issue a modified opinion stating that the financial statement does not reflect a true position of the firm since the profits have been reduced by £500,000.

The issue should be resolved since the inclusion of the £500,000 unnecessarily increases the firm’s expenses reducing the company’s profitability. Moreover, issuing a modified opinion by the auditor will reduce the investor-attractiveness of the firm since receiving a modified audit report negatively affects the firm’s cash flow investment sensitivity.

Question 2

1. Discuss the above statement by explaining the differences between the evidence sufficiency and appropriateness. Your answer should include a discussion of two types of audit evidence.

Sufficient appropriate evidence in auditing is evidence that is of quantity, quality, and reliability. Evidence of the required quantity is considered sufficient, while reliable and high-quality evidence is considered appropriate. Therefore, evidence sufficiency relates to the quality of evidence, while evidence appropriateness relates to the quality and reliability of evidence.

Auditor’s conclusion should be based on sufficient evidences. Auditing evidence is considered sufficient when evidence is in line with material misstatement risk, item’s materiality, internal control systems and nature of accounting, auditors knowledge and business experience, control test results, population size tested, and evidence reliability.

Auditing evidence is considered appropriate when they are reliable and relevant. To achieve evidence reliability, the auditors should focus on obtaining auditing evidence from trustworthy and dependent sources. Evidence is considered reliable when obtained from an independent external source, internally generated, obtained by the auditor, and in original and documentary forms. For audit evidence to be relevant, the evidence must address the objective and purpose of the auditing procedure.

The type of audit evidences that relates to evidence sufficiency and appropriateness is documentary evidence and confirmation, respectively. Documentary evidence is a type of audit evidence that focuses on gathering documents regarding different auditing processes. Confirmation entails sending circularization to independent external sources to confirm the information in the financial statement.

1. You are an auditor manager of Earl & Co and are planning the audit of Darjeeling Co.

Issue	Audit Risk	Auditors Response
Including the $0.9m expenses on new product line development to intangible assets	Accounting for all the expenses as intangible assets may lead to the risk of over-recognizing and under-recognizing intangible assets	Perform a cost analysis and classify various costs correctly. Ensure that company’s cost recognition is consistent with IAS 38
The company intends to undertake a stock exchange listing in the next 12 months.	Managers may be tempted to distort the company’s financial statements to show that the company is on the right performance track.	The auditing team should maintain professionalism and be skeptical of manipulation threats. The auditing team should carefully analyze the material estimate and assessment.
Establishing promise price to compete with the competitors and customers encouraged to claim the difference if any firm offers the products at a lower price.	Since payables are subjective and highly judgmental, their evaluation requires numerous requirements that the company’s directors may not accurately estimate; therefore, the company risk overstating revenue and under or over recognizing profits and liabilities.	The auditing team should review the accounting documents to confirm the reasonableness of the assumptions. Ensure the accounts payable are recognized and valued appropriately.
Stopping further sales and recalling the faulty paint products.	The company risks over-recognizing revenue, under-recognizing liabilities, and misrepresenting inventory value.	Ensure that the sales are properly reviewed, and the recalled products are removed from general sales and inventory.
Purchase and installation costs of the new manufacturing line asset are included in the property plant and equipment.	The company risk including maintenance and servicing costs, which are not part of the fixed asset costs	Review the new manufacturing line documents to extract maintenance and servicing costs.

 

Question 3

1. Describe the steps that Salt & Pepper should take in relation to Cinnamon prior to accepting the audit.

Salt & Pepper Company should consider the compliance with ACCA’s code of ethics and conduct and the local legislation issues such as conflict of interest, which is a threat to the auditing process.

Salt & Pepper should ascertain whether they have the competence, resources, skills, and knowledge to perform the auditing processes adequately.

Salt & Pepper need to gather adequate information on the Cinnamon director’s reputation and integrity.

The organization should consider the level of risk attached to Cinnamon’s auditing process and whether the audit fee is sufficient to carry out the auditing process.

The organization should gather the necessary information regarding the auditing process, such as obtaining information from the previous auditors on why they should accept or not accept the audit invitation.

1. Identify and explain five ethical threats which arise from the above actions

Issue	Ethical Threat	Auditor’s response
The company is running an advertisement that its auditing process will not last longer than two weeks, thus minimizing company disruption.	Lack of compliance with ACCA’s code of ethics and standards	Stop the new advertising strategy since it is not in accordance with the code of ethics and standards
Offering all new clients free accounts preparation service for the first year of the engagement	Overworking of the auditing team	Ensure that the auditing process is undertaken by separate auditing teams
Failure to update the engagement letters of existing clients	Lack of compliance with the ISA 210 on the agreement to auditing engagement terms	The company should update the engagement letters to comply with ISA 210
The proposal of an existing client basing the year’s auditing fee on their final pre-tax profit percentage.	The proposal creates a contingent fee, which results in a self-interest threat that is irreducible to any adequate level	The company should decline the proposal since it breaches the ACCA’s code of ethics and conducts.
The company intends to use junior staff in the auditing process of Cinnamon	The use of junior staff will result in incompetency in assessing the adequacy of the work performed, which may result in the risk of giving incorrect audit opinion	The company should review the auditing staff for Cinnamon to include experienced members.

 

References

Olojede, P., Erin, O., Asiriuwa, O., & Usman, M. (2020). Audit expectation gap: an empirical analysis. Future Business Journal, 6(10). https://doi.org/10.1186/s43093-020-00016-x

Andersson Manglaris, A., & Brewitz, T. (2020). The Audit Expectation Gap: Exploring the auditor’s roles and responsibilities from knowledge, performance, and evolution gap perspectives.

Marden, R. E., & Brackney, K. S. (2009). Audit risk and IFRS. The CPA Journal, 79(6), 32.

Ilemona, S. A., & Nwite, S. (2021). Accounting Code of Ethics: Severity Analysis of Threats to Compliance of Auditors in Nigerian Business Environment. Journal of Finance and Accounting, 9(1), 16–22. https://doi.org/10.11648/j.jfa.20210901.13

 

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