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Page 1: Bridging the expectations gap

Regulators andothers firstbegan immortal-

izing the term expec-tations gap in the1970s (e.g., AmericanInstitute of CertifiedPublic Accountants[AICPA], 1977; Liggio, 1974) as a wayto describe the differencebetween financial statementusers’ ideas of a financial state-ment audit and what auditingstandards require in a financialstatement audit. Thirty years, anuntold number of new auditingstandards, and at least a dozenaccounting scandals later, westill appear to be no closer toclosing the gap.

Recent efforts to close thegap include the Public CompanyAccounting Oversight Board’s(PCAOB’s) recently issuedAuditing Standard (AS) No. 6,Evaluating the Consistency ofFinancial Statements, intendedto improve communication whenfinancial statements are restated(PCAOB, 2008), and the Sub-committee on Firm Structureand Finances of the TreasuryAdvisory Committee on theAuditor Profession’s final rec-ommendation that the auditor’srole in detecting fraud under

current auditing standards beclarified in the auditor’s report(Advisory Committee on theDepartment of the Auditing Profession, 2008).

CLARIFYING WHAT AUDITORS DO

Unfortunately, the communi-cation tool that the professionuses to describe a financial state-ment audit is three paragraphslong and a little under 250 words.In this article, we attempt to bet-ter clarify what auditors do. Inaudits of the largest corporations,backing up those 250 wordsentails fees of millions of dollarsand thousands of hours of profes-sional labor.1 We hope by betterexplaining the auditing standardsthat underlie the meaning of theauditor’s report that we can helpreduce the expectations gap.

Explaining the role of theaudit is important for several

reasons. First, a lack ofunderstanding betweenthe public and auditorshas long been consid-ered a source of litiga-tion risk. Research indi-cates that jury poolshave very differentexpectations of audi-tors’ roles than auditors

do (Frank, Lowe, & Smith,2001). These business risks ofaudit firms are necessarilypassed onto clients in the formof higher audit fees. Further, theconfidence of the capital mar-kets in the assurance role of theauditor is undermined when therole of the auditor is poorlyunderstood. This is perhapsespecially true in the case offraudulent financial reporting.The auditor’s responsibility forthe detection of fraud continuesto be one of the biggest contrib-utors to the expectation gap.

In this article, we identifyissues that we believe—andothers have reported—contributeto the gap between financialstatement users’ beliefs andauditors’ processes (e.g.,McEnroe & Martens, 2001). Wediscuss these issues in the con-text of the auditors’ communi-cations tool, the auditor’sreport. Topics covered include:

The term expectations gap describes the differ-ence between investors’ ideas of a financial state-ment audit and what standards actually require.Despite many changes in auditing standards,investors still misunderstand the auditor’s report.

© 2009 Wiley Periodicals, Inc.

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© 2009 Wiley Periodicals, Inc.Published online in Wiley InterScience (www.interscience.wiley.com).DOI 10.1002/jcaf.20547

Bridging the Expectations Gap

Denise Dickins and Julia L. Higgs

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what is meant by an unqualifiedopinion; what is the auditor’sresponsibility for the detectionof fraud; how does an auditordetermine materiality; what ismeant by a financial statementrestatement; when does an audi-tor issue a going-concern opin-ion; what does it mean when acompany reports a materialweakness in internal control; andhow does a review of quarterlyfinancial data differ from anaudit of the annual financialstatements?

THE AUDITOR’SCOMMUNICATION TOOL: THEAUDITOR’S REPORT

The auditor is limited inwhat may be communicated toreaders of financial statements tohis or her report. As thereport is required to bestandardized, the auditorhas limited ability to mod-ify or to provide additionalexplanation about the con-duct of the audit or thejudgment that is part of theauditing process. Thesejudgments include anassessment of materiality,an assessment of goingconcern, a determination ofthe existence of errors and fraud,and a determination of whetherinternal control violations meetthe criteria of being materialweaknesses, among other things.The AICPA and the PCAOBcarefully vet the standard word-ing of the auditor’s report tocommunicate to readers whatresponsibility the auditor takesfor the audit of the financialstatements.

Until 2002, auditing stan-dards were set by the AuditingStandards Board (ASB) of theAICPA. Standards set by theASB are called Statements ofAuditing Standards (SASs).2

Because of the events culminatingin the signing of the Sarbanes-Oxley Act of 2002 (SOX), theprofession was deemed to beincapable of self-regulation withrespect to setting auditing stan-dards and monitoring the qualityof auditors of publicly-tradedcompanies, so the PCAOB wascreated. The PCAOB’s primaryfunctions are standard settingand the registration and inspec-tion of auditors of publiclytraded companies.3 Thus, theASB now sets auditing standardsfor audits of privately held com-panies, and the PCAOB setsauditing standards for audits ofpublic companies.4 ThePCAOB’s rules of auditing arecalled Auditing Standards(ASs).5 SASs 1 to 100 wereadopted by the PCAOB as

“Interim Standards”; thus, auditsof privately held and publiclytraded companies are identical inmany ways. Since 2002, theASB has adopted 16 additionalSASs and the PCAOB hasadopted six ASs, some of whichmodify Interim Standards. AllASs must be approved by theSEC prior to becoming law forpublicly traded companies.6

Auditors of privately heldcompanies generally only reporton the financial statements. AS5, An Audit of Internal ControlOver Financial Reporting ThatIs Integrated with An Audit ofFinancial Statements (PCAOB,

2007), supersedes AS 2, AnAudit of Internal Control OverFinancial Reporting Performedin Conjunction With an Audit ofFinancial Statements (PCAOB,2004), and requires that auditorsof publicly traded companiesreport on the financial state-ments and on the effectivenessof internal control over financialreporting. Internal control overfinancial reporting is anyprocess or procedure considerednecessary to ensure that externalfinancial reports are accurate,complete, and timely. As anexample, the timely preparationand review of bank reconcilia-tions is necessary to ensure thatthe amounts reported as “cash” inthe financial statements are validand, hence, part of a company’ssystem of internal control over

financial reporting. On theother hand, the recruitmentof sales personnel is aprocess that likely has littledirect impact on the finan-cial statements and thereforeis not a part of a company’ssystem of internal controlover financial reporting.

These required tests ofinternal controls for largepublicly traded companiesmay magnify the expecta-

tion gap for small public compa-nies and for privately held com-panies,7 as readers of auditreports of privately held compa-nies generally believe that audi-tors do a lot more testing ofinternal controls than is required(McEnroe & Martens, 2001).For audits where AS 5 is notmandated, the auditing standardsonly require that the auditor gainand document their understand-ing of the system of internalcontrol in order to assess the riskof material misstatement in thefinancial statements, whetherdue to error or fraud. Only if theauditor determines that it is more

52 The Journal of Corporate Accounting & Finance / November/December 2009

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The AICPA and the PCAOB carefullyvet the standard wording of theauditor’s report to communicate toreaders what responsibility the audi-tor takes for the audit of the finan-cial statements.

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effective and efficient to rely oninternal controls is testing ofinternal controls required. If theauditor believes that either (1) itis more efficient to only performtests of details and analyticalreview to support his or herreport on the financial state-ments or (2) that a company’ssystem of internal control is notsufficiently effective to ensurethat if material errors or fraudoccur, they will be detected in atimely manner, the auditor wouldlikely opt to place no reliance ona company’s system of internalcontrol. In such instances, notesting of internal controls isrequired. Further, if the auditorconcludes the company’s systemof internal control is inadequate,this conclusion is not required tobe documented or reported in theauditor’s report on financialstatements. The auditor’s reporton the financial statementsmakes no representation aboutthe quality or effectiveness ofinternal controls.

UNQUALIFIED REPORTS

There are four types ofreports that an auditor may issueon the financial statements:unqualified, qualified, adverse,and disclaimer. As the Securitiesand Exchange Commission (SEC)will not accept the last three typesof auditor’s reports—which basi-cally say that the auditor eitherbelieves that the financial state-ments are not presented in accor-dance with generally acceptedaccounting principles (GAAP) orthe auditor was unable to com-plete all of the procedures neces-sary to be able to form an opinionabout the fairness of the financialstatements—we focus our discus-sion on the various types ofunqualified reports typicallyaccompanying financial state-ments filed with the SEC.

The basic, unqualified reporton the financial statementsincludes three paragraphs. Thelanguage attempts to clearlycommunicate some things thathistorically have contributed tothe gap between readers offinancial statements and audi-tors. The standard unqualifiedopinion without modification ispresented in Exhibit 1. It hasthree standard paragraphs: intro-ductory, scope, and opinion.

Introductory Paragraph

The introductory paragraphdescribes which financial state-ments are audited (i.e., name of

company and period covered bythe financial statements) andaffirms that the financial state-ments are the responsibility ofmanagement, while the auditors’responsibility is the expressionof an opinion on the financialstatements. The report’s emphasis on management’sresponsibility for the financialstatements is intended as areminder that management hasprimary responsibility for thedetection of error and irregulari-ties (fraud) in the financial statements.

One of the largest sources of the expectations gap is theauditor’s responsibility for the

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© 2009 Wiley Periodicals, Inc. DOI 10.1002/jcaf

Independent Auditor’s Report

We have audited the accompanying consolidated statements of financialposition of ABC Company as of December 31, 2XXX and 2XXX, and therelated consolidated statements of operations, shareholders’ equity, andcash flows for each of the three years in the period ended December 31,2XXX. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these finan-cial statements based on our audits.

We conducted our audits in accordance with auditing standards generallyaccepted in the United States (or standards of the PCAOB). Those standardsrequire that we plan and perform the audit to obtain reasonable assuranceabout whether the financial statements are free of material misstatement.An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presenta-tion. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of ABC Com-pany of December 31, 2XXX and 2XXX, and the results of their opera-tions and their cash flows for each of the three years in the periodended December 31, 2XXX, in conformity with accounting principlesgenerally accepted in the United States of America.

Exhibit 1

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detection of fraud. Over theyears, the AICPA has made sev-eral attempts to bridge the expec-tation between what the publicperceives an auditor’s responsi-bility is for the detection of fraudand what auditors are actuallyable to do in the context of thedetection of financial statementfraud. The AICPA’s most recentattempt is SAS 99 (AICPA,2002a). This standard, written inconjunction with the Associationof Certified Fraud Examiners, isunique among auditing standards.In addition to audit requirements,it has an appendix to help audi-tors identify fraud risk factorsand also has an appendix to assistmanagement in developing fraud-prevention programs.

Under SAS 99, man-agement and those chargedwith governance areresponsible for setting theproper tone, creating andmaintaining a culture ofhonesty and high ethicalstandards, and establishingappropriate controls to pre-vent, deter, and detectfraud (paragraph 4). Audi-tors have a responsibility toplan and perform the auditto obtain reasonable assuranceabout whether the financial state-ments are free of material mis-statement whether due to error(unintentional misstatements) orfraud (intentional misrepresenta-tions) (paragraph 12). As mightbe expected, intent is often diffi-cult to prove. Nevertheless, theaudit must include audit testsdesigned to detect both. Theauditor must conclude whether ornot the financial statements arefree of material errors and fraud.

Materiality is described inAU Section 312A (AICPA, 1983)and references the FASB Con-cepts Statement 2 (FASB, 1980)definition: “the magnitude of anomission or misstatement of

accounting information that, inthe light of surrounding circum-stances, makes it probable that thejudgment of a reasonable personrelying on the information wouldhave been changed or influencedby the omission or misstatement.”AU 312A describes the qualitiesof a reasonable person that wouldbe relying on financial statementsand presumes that readers offinancial statements “(1) have anappropriate knowledge of busi-ness and economic activities andaccounting and a willingness tostudy the information in thefinancial statements with anappropriate diligence; (2) under-stand that financial statements areprepared and audited to levels of

materiality; (3) recognize theuncertainties inherent in themeasurement of amounts basedon the use of estimates, judgment,and the consideration of futureevents; and (4) make appropriateeconomic decisions on the basisof the information in the financialstatements.”

For public companies, theSEC further clarified the conceptunder Staff Accounting Bulletin(SAB) No. 99, Materiality (SEC,1999). SAB 99 requires that theauditor consider both quantitativeand qualitative factors whendetermining materiality. Thismeans that materiality judgmentsmay not solely be based onthresholds of financial data. They

must also consider qualitativefactors such as the impact ofchanges in the financial state-ments on debt compliance, andthe company’s ability to meetanalysts’ expectations. SAB 99reminds auditors that adjustmentsto the financial statements thatchange earnings per share by apenny may be considered mate-rial, as they could translate to bil-lions of dollars in changes in acompany’s market capitalization.Materiality and risk are closelytied together in the auditor’sjudgment process.

While it would be nice tohave a bright-line measure ofmateriality—and while as apractical matter auditors fre-

quently start their evalua-tion of materiality usingmeasures like a percentageof net income, revenues, orassets—ultimately, materi-ality comes down to thejudgment of the auditor.The following exampleserves to highlight theexchange between quantita-tive and qualitative assess-ments of materiality.

Suppose a company has$10 million in income and

the auditor sets a materialitythreshold at 5 percent of income.The auditor can tolerate a mis-statement in income up to$500,000. Suppose the companyunderestimated the allowance forbad debts by $350,000, whichcaused net accounts receivable tobe overstated by the same amount.This overstatement caused thecurrent ratio to be higher, whichin turn caused the company tomeet a debt covenant it wouldhave otherwise missed. Althoughthe $350,000 is within the materi-ality guidelines, the $350,000would be considered a materialerror because it would mean thedifference between meeting andnot meeting the debt covenants.

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Under SAS 99, management and thosecharged with governance are responsi-ble for setting the proper tone, creat-ing and maintaining a culture ofhonesty and high ethical standards,and establishing appropriate controlsto prevent, deter, and detect fraud.

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The auditor will evaluatesome high-risk aspects of theengagement such as related-partytransactions or transactionsinvolving management with lowermateriality thresholds than mis-statements due to errors. Forexample, even if the auditor hasestablished an initial definition ofmateriality of $500,000, a$50,000 loan to the CEO wouldbe considered material becauseloans to CEOs, regardless of size,are not allowed under the law(SOX Section 402a). Althoughregular audits are not designed tofind immaterial frauds, if they aredetected as part of the audit theymust be reported to managementand the audit committee of theboard of directors.

In looking for materialfraud, the auditor willdesign tests to look forboth misappropriation ofassets and fraudulent finan-cial reporting. SAS 99requires that the auditoridentify (through brain-storming, analytical proce-dures, and discussions withmanagement and the boardof directors) and documentfraud risks. The audit planmust address plans to man-age the identified fraud risks inthe conduct of the audit throughadditional testing. Each memberof the team is reminded to main-tain a mental attitude of profes-sional skepticism, which, whenproperly used, can significantlyadd to the overall judgment qual-ity of the audit process.

As a practical matter, forpublicly traded companies, it isnot likely that the most commonfraudulent transaction—theft ofcash or other assets—will rise toa level of materiality such that itwould be detected by the auditor.More likely, material fraud willoccur through fraudulent finan-cial reporting. The detection of

fraudulent financial reportinghas to be understood through thelens of risk-based auditing inwhich audit effort is concentratedwhere risk of misstatement isperceived to be highest. Whenthe auditor plans the audit, he orshe identifies the financial state-ment items with the highest riskof material misstatement byjointly considering the areaswhere controls are weakest andwhere the account is inherentlyrisky.8 The auditor then concen-trates the audit effort on thesehigher-risk areas. SAS 99 specif-ically requires that the auditorconsider how the financial state-ments might be misstated due tomisstatements of revenues, the

most common type of fraudulentfinancial reporting.

Despite auditors’ efforts, it is still likely that immaterialinstances of fraud will go unde-tected, such as employee theft ofinventory. Further, despite excel-lent audit planning and execution,when perpetrated by collusion ormanagement override of controls,fraud is difficult to detect.

Scope Paragraph

The second, or scope, para-graph describes the nature of anaudit and its limitations. Thereport emphasizes that the audi-tor is giving only “reasonable

assurance” regarding whether thefinancial statements are free ofmaterial misstatements resultingfrom errors or fraud. What theauditor’s report implicitly statesis that the financial statementsmay still contain immaterial mis-statements arising from error orfraud. This paragraph of theauditor’s report also points outthat the auditor relies on sam-pling, implying that samplingerror (i.e., the risk that a sam-ple’s characteristics are not rep-resentative of a population)could arise as part of the auditprocess. Finally, although finan-cial statements are based onnumerical amounts, the reportpoints out to readers that imbed-

ded in those numbers are anumber of estimates.9 Col-lectively, these statementscommunicate to the readerthat auditing the financialstatements is not an exactprocess, that the audit isdesigned only to providereasonable assurance thatthe financial statements arenot materially misstated,and that given the numberof estimates included in thefinancial statements (i.e.,the allowance for doubtful

accounts), the financial state-ments are likely not free of mis-statements. What financial state-ment users are left with islimited assurance that if discov-ered by the auditor, materialadjustments will be reflected inthe financial statements.

Today with the strongerrules of corporate governance inplace as a result of SOX, howmaterial audit adjustments arehandled is different from thepast. All adjustments that meetthe auditor’s level of materiality,whether or not recorded by thecompany, must be discussedwith the audit committee. If theadjustment was discovered by

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Despite auditors’ efforts, it is stilllikely that immaterial instances offraud will go undetected, such asemployee theft of inventory. Further,despite excellent audit planning andexecution, when perpetrated by collu-sion or management override of controls, fraud is difficult to detect.

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the auditor, not by managementas a part of the company’s sys-tem of internal control, the audi-tor must decide whether thecompany has a material weak-ness in internal control overfinancial reporting. Materialweaknesses are reported in theauditor’s Report on the Effective-ness on Internal Control overFinancial Reporting, which wediscuss later.

If the company disagreeswith the auditor’s proposedadjustment to the financial state-ments, there are other considera-tions. Most importantly, the audi-tor must make a determinationabout whether the unrecordedadjustment rises to the levelof making the financialstatements materially mis-leading. If so deemed, theauditor would be required toqualify his or her report. Aspreviously mentioned, sincethe SEC will not allow apublicly traded company tofile a qualified report, theauditor’s only other alterna-tive would be to withdrawfrom the engagement.10 Theother determination that the audi-tor must make when clientsrefuse to record the auditor’s pro-posed adjustments is whethermanagement (and the board) areintentionally (fraudulently) tryingto misrepresent the company’sfinancial results or financial posi-tion. Again, if this is deemed tobe the case, the auditor is likelyto withdraw from the engage-ment. SAS 99 requires that theauditor continuously update thefraud risk associated with anaudit, making adjustments forthings like the company’s postureon aggressive accounting posi-tions. The cost of failing to adjustthe financial statements, if thosefinancial statements are laterfound to be materially mislead-ing, is substantial. Management,

the board of directors, and theauditor all potentially face severecriminal, reputational, and finan-cial consequences.

Opinion Paragraph

The third, or opinion, para-graph includes the auditor’s con-clusion about whether the finan-cial statements present fairly thefinancial position and results ofoperations of the company. Againthe language emphasizes that thefinancial statements presentfairly, in all material respects.

In certain circumstances, theauditor’s report may be modified,yet still be considered unqualified.

The two most frequent modifica-tions are when prior financialstatements have been changed asa result of a company adopting anew accounting standard, orchanging from one generallyaccepted accounting principle toanother generally acceptedaccounting principle; and whenthe auditor wants to emphasize a matter like the risk that thecompany may be unable to continue as a going concern.

COMMUNICATING ABOUTCONSISTENCY

Communicating about con-sistency is important enough thatit is included in one of the tengenerally accepted auditing stan-dards (GAAS). Users of financial

statements can assume that thefinancial statements are presentedon a consistent basis (sameGAAP, same reporting structure),unless the auditor states other-wise. The auditing standards gointo some amount of detail as towhat is meant by consistency.First, consistency is concernedwith how a company reports fromyear to year. It is not related tothe concept of comparability,which relates how Company A is compared to Company B. Consistency modifications willonly be present in the report ifthey materially impact the financial statements.

An important type of consis-tency modification is achange in the application ofGAAP such as the changefrom straight-line to accel-erated depreciation forproperty and equipment, orthe change from first-in,first-out (FIFO) to last-in,first-out (LIFO) accountingfor the cost of inventories.These types of changes areconsidered voluntary. Onthe other hand, the adoption

of a newly implemented account-ing principle, like the adoption ofSFAS 123R (FASB, 2004), whichrequires the expensing of stockoptions, would be considered aninvoluntary change.

Prior to the adoption ofSFAS 154 (FASB, 2005), whencompanies changed theiraccounting principles, the effectof the change was reflected inthe financial statements as acumulative effect in the incomestatement in the year of adop-tion. Cumulative effects ofaccounting changes were pre-sented below income from con-tinuing operations, but above netincome. SFAS 154 now requirescompanies, absent any require-ment to do otherwise, to revisethe financial statements for all

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SAS 99 requires that the auditorcontinuously update the fraud riskassociated with an audit, makingadjustments for things like the company’s posture on aggressiveaccounting positions.

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prior periods to reflect theperiod-specific effects of apply-ing the new accounting princi-ple. In other words, the historicalfinancial statements are nowrestated. When these types ofretrospective adjustments weremade, auditors modified theirreports to alert the reader thatthe financial statements hadbeen restated. As might beexpected, there was likely someconfusion among readers ofauditors’ reports as to whetherrestatements were “bad,” result-ing from corrections or errors, orwere the result of changing oradopting new accounting stan-dards. The ability to distin-guish the type of changegiving rise to restatedfinancial statements isimportant, as research hasgenerally found that whilethe market does not reactto changes in accountingmethods with no economiceffects (e.g., Dawson, Neu-pert, & Stickney, 1980;Vigeland, 1981), the mar-ket does react negativelywhen financial statementsare restated due to previ-ously unidentified errorsand irregularities (Hribar &Jenkins, 2004).

In an effort to help reducethis confusion and, again, narrowthe expectations gap, AuditingStandard 6 was submitted by thePCAOB and approved by theSEC in 2008. It addresses whenand how auditors’ reports are tobe modified for consistency whenpublic companies adopt newaccounting standards. It requiresthat the language in the auditor’sreport distinguish betweenretroactive changes resultingfrom changes in or adoptions ofaccounting principles, andrestatements resulting from cor-rection of errors. If a companyadopts a new accounting princi-

ple, or changes from another gen-erally accepted accounting princi-ple, the auditor’s report mustinclude an explanatory paragraphsimilar to the following:

As discussed in Note X tothe financial statements,the company has changed(or elected to change) its method of accountingfor ABC in YEAR due tothe adoption of Account-ing Pronouncement (ifapplicable).

On the other hand, if thefinancial statements have been

restated due to a previouslyundisclosed error, resulting fromeither errors or fraud, theexplanatory paragraph wouldread as follows:

As discussed in Note Xto the financial state-ments, the YEAR finan-cial statements havebeen restated to correct amisstatement.

The other frequentlyobserved modification to theunqualified auditor’s reportoccurs when the auditor wants toemphasize a matter. This is anarea where the auditor has a fair

amount of latitude in decidingwhether to discuss something thathe believes the reader of thefinancial statement should payparticular attention to, such as,when there exists an unusualamount of litigation risk, asset-realization uncertainties, extrac-tive industries uncertainties, con-tingent liabilities, andrelated-party transactions (Butler,Leone, & Willenborg, 2004). Byfar the most common matter thatauditors emphasize is the risk thata company may be unable to con-tinue as a going concern. AuditAnalytics reported that in 2006,16.6 percent (2,318) of auditor

reports of publicly tradedcompanies included para-graphs emphasizing going-concern issues.

The financial statementsare prepared under theassumption that the com-pany will continue into theforeseeable future, based onthe idea that an entity willbe a going concern. Thismeans that the company’sassets will be realized andits liabilities will be settledin the normal course ofbusiness. Contrast this witha company that is going out

of business and must liquidate itsassets and settle its liabilitieswithin a short time frame. Obvi-ously, the value that the companycan be expected to receive for itsassets, and the amounts that credi-tors may be willing to take inexchange for settlement of debts,most likely will be less. Inaccounting jargon, we call this thedifference between reportingassets and liabilities on a goingconcern versus a liquidation basis.

AN ERRONEOUS BELIEF

When the auditor believesthat there is substantial doubtthat a company will fail in less

When the auditor believes that thereis substantial doubt that a companywill fail in less than one full yearfrom the date of the financial state-ments, AU 341 requires that theauditor include an explanatory para-graph in his or her report emphasiz-ing this uncertainty.

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than one full year from the dateof the financial statements, AU341 requires that the auditorinclude an explanatory para-graph in his or her reportemphasizing this uncertainty(AICPA, 1988a). According toMcEnroe and Martens (2001),investors erroneously believethat in the absence of a going-concern opinion, the businesswill likely succeed. This popularopinion is contrary to explicitlanguage in AU 341 (p. 622),which states that “the absence ofreference to substantial doubt inan auditor’s report should not beviewed as providing assurance asto an entity’s ability to continueas a going concern.”

The auditor bases thegoing concern assessmentconsidering both financialmatters (e.g., reporting netlosses or negative cashflows, or violating of debtcovenants) and operationalmatters (e.g., financial dis-tress of a major supplier orcustomer, labor difficul-ties) known as of the dateof the auditor’s report; andnot all of which may beapparent to the reader ofthe financial statements.The assessment of goingconcern also considers manage-ment’s plans for overcoming anyconcerns that the auditor hasidentified (e.g., ability to cutcosts, obtain new financing, dis-pose of assets).

Ultimately, the assessment ofwhether management’s plans canbe successful is a matter of judg-ment. The decision of whether ornot to issue a going-concernopinion is difficult. On onehand, failing to emphasizegoing-concern issues exposes theauditor to litigation risk if theclient ultimately fails. On theother hand, some believe that theissuance of a going-concern

opinion is self-fulfilling, becausesuppliers may be less willing toextend credit. Research hasdemonstrated that the going-concern opinion is informative.The market reacts negatively togoing-concern opinions, and forcompanies declaring bankruptcy,the market’s reaction to a bank-ruptcy announcement is less nega-tive when the company previouslyhad a going-concern opinion (e.g.,Firth, 1978; Holder-Webb &Wilkins, 2000). Unfortunately,auditors have historically notbeen very good at predictingwhen companies will be unableto survive at least one full year(e.g., Menon & Schwartz, 1986),

perhaps because relevant infor-mation becomes known after thedate of the auditor’s report.

The Auditor’s Report onInternal Control Over Financial Reporting

SOX Section 404 and relatedSEC rules describe internal con-trol over financial reporting asprocesses and proceduresdesigned to provide reasonableassurance for the reliability offinancial reporting and thepreparation of financial state-ments for external purposes inaccordance with generally

accepted accounting principles.11

The rules as originally draftedunder AS 2 were broad andlacked direct guidance on thesufficiency of controls andrelated tests of controls. In 2007,AS 5 was issued to supersedeAS 2, in part to reduce confu-sion and better direct controlstesting.

Managers (CEOs and CFOs)of large publicly traded compa-nies must attest to the adequacyof a company’s system of inter-nal control over financial report-ing. In case there was previouslyany confusion regarding theparty responsible for establish-ing, maintaining, and evaluating

a company’s system ofinternal controls, SOX pro-vides that managers nowexplicitly state that theyhave primary responsibil-ity. Auditors make an independent evaluation of internal controls.

Two forms of the audi-tor’s report are proscribed:unqualified and adverse.12

Unqualified reports con-clude that the system ofinternal control over finan-cial reporting is operatingeffectively, in all materialrespects, as of the date of

the balance sheet. An adversereport indicates the presence ofone or more, or a combinationof, controls is not operatingeffectively, and as a result amaterial misstatement of thefinancial statements may occurand go undetected. Typical mate-rial weaknesses include failureto follow generally acceptedaccounting principles (e.g.,recording the cost of a lease thatincludes a rent abatement periodover the period of the paymentsrather than over the full term ofthe lease), and insufficient orimproperly trained accountingpersonnel. The reporting of

SOX Section 404 and related SECrules describe internal control overfinancial reporting as processes andprocedures designed to provide rea-sonable assurance for the reliability offinancial reporting and the prepara-tion of financial statements for exter-nal purposes in accordance with gen-erally accepted accounting principles.

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material weaknesses in internalcontrol is discussed.

INTERNAL CONTROLREPORTING

Early evidence suggests thatfinancial markets’ interest ininternal control reporting is neg-ligible. For example, Cheng, Ho,and Tian (2006) find that com-panies generally suffer signifi-cant negative abnormal marketreturns when material weak-nesses are announced; however,the negative market reaction ismitigated for companies withcomplex business structures,suggesting the possibility thatthe market expects such compa-nies to have weaker inter-nal controls. Ogneva,Raghunandan, and Subra-manyam (2005) report thatthe cost of capital of com-panies reporting materialweaknesses is only margin-ally higher than that ofcompanies without materialweaknesses; and such dif-ferences disappear aftercontrolling for economiccharacteristics of compa-nies disclosing materialweaknesses.

As of the date of this writ-ing, companies with less than$75 million market capitalizationare not yet required to evaluateand report on their systems ofinternal control over financialreporting. This is somewhatironic given that research to datesuggests that smaller companies(measured as market capitaliza-tion, among other ways) aremore likely to report materialweaknesses in internal control(e.g., Ge & McVay, 2005).

It is important to note thatthe absence of material weak-nesses reported in connectionwith a company’s annual finan-cial statements does not mean

that a company had no materialweaknesses during the year. Incompanies’ quarterly reports,managers are required to reporton any identified material weak-nesses and any significantchanges in internal control. Ifweaknesses are identified as partof the company’s own processesand controls, and are remediatedprior to the end of the year, audi-tors may conclude that the com-pany’s system of internal controlis effective, and that as of theend of the year, there are nomaterial weaknesses impactingthe company’s ability to produceand report its financial results.

The absence of reportedmaterial weaknesses also does

not mean there are no significantdeficiencies in internal control.AS 2 defines a significant deficiency as a condition in thedesign or operation of an internalcontrol that results in a morethan remote likelihood that amore than inconsequential mis-statement of a company’s financialstatements will occur and goundetected on a timely basis. Inother words, all material weak-nesses are significant deficien-cies, but a significant deficiencyneed not be a material weakness.

The following example isintended to illustrate the differ-ence between a material weak-ness in internal control and a sig-nificant deficiency. A company

requires that credit checks be performed for all customers towhom credit in excess of $10,000is extended. This process isintended to reduce the company’scredit risk and acts as a control toensure that accounts receivableare stated at their net realizablevalue. A comparison of theaccounts receivable trial balancesand credit checks identifies threecustomers with receivable bal-ances in excess of $10,000 forwhom credit checks were not performed. Company A has totalreceivables of $50,000, totalassets of $200,000, and netincome of $100,000. Company Bhas total receivables of $500 mil-lion, total assets of $2 billion, and

net income of $100 million.In the case of Company A,the failure of the internalcontrol is most likely con-sidered a material weak-ness. In the case of Com-pany B, it would likely beconsidered a significantdeficiency. As is obviousfrom this example,whether a breech in inter-nal control is characterizedas a significant deficiencyor a material weakness is

largely a matter of judgment.Different auditors may come todifferent conclusions based upontheir judgment of the likelihoodthat the control deficiency wouldresult in a material misstatementof the company’s financial statements.

REDEFINING “MATERIALWEAKNESS”

In addition to attempting toreduce confusion and ease thecost (both in terms of manpowerand dollars) of compliance withSection 404, AS 5 redefines theterm material weakness. Prior toAS 5, a material weakness ininternal control was defined as a

It is important to note that theabsence of material weaknessesreported in connection with a com-pany’s annual financial statementsdoes not mean that a company had no material weaknesses duringthe year.

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control deficiency that resulted ina more than remote likelihood thata material misstatement of thefinancial statements could occurand go undetected on a timelybasis. AS 5 changed the “morethan remote likelihood” criteriato a “reasonable possibility.”Although the change is subtle,the threshold for a control defi-ciency rising to the level of areportable material weakness hasbeen raised.

AS 5 also coins the term anintegrated audit to describe anaudit that jointly considers theresults of testing of the effective-ness of a company’s system ofinternal control over financialreporting (i.e., SOX 404 proce-dures), and the nature, extent,and timing of audit tests ofdetails and analytical review pro-cedures. In its early inspectionsof post-SOX audits, the PCAOBfound that auditors tended totreat the tests of internal controlsconducted to comply with SOXSection 404 and AS 2 as sepa-rate from the “regular” audit(PCAOB, 2005). AS 5 specifi-cally addresses the need to inte-grate the audit and attempts toreduce the inefficiencies thatmay arise from conducting anaudit in this manner.

Reviews of Interim FinancialInformation

SAS 100, Interim FinancialInformation (AICPA, 2002b),describes the requirements thatthe auditor must follow when acompany produces and distrib-utes for public use financialstatements covering less than afull year, as when publicly tradedcompanies file quarterly finan-cial statements with the SEC onForm 10-Q. Under Rule 10-01(d)of Regulation S-X, interimfinancial information included inForm 10-Q (or Form 10-QSB) is

required to be reviewed by anaccountant prior to being filedwith the SEC. Unlike an audi-tor’s report, the SEC generallydoes not require that the accoun-tant’s review report accompanythe interim financial statements.This lack of explicit reportingmay create confusion regardingthe level of assurance providedby the accountant.

Most importantly, the objec-tive of a review is not to expressan opinion on the fairness of thefinancial statements. Instead, theauditor performs analytical pro-cedures (e.g., ratio analysis andtrend analysis), makes inquiriesof managers, reads the financialstatements, and considers theresults of prior audits as a basisfor communicating whether heor she is aware of any materialmodifications necessary to con-form with GAAP. A review doesnot contemplate tests of transac-tions through inspection or con-firmation, or other procedurestypically performed in the courseof an audit. A review is notdesigned to provide any level ofassurance with respect to inter-nal controls. So what reliancecan users place on interimfinancial statements? Only that,based on these procedures,accountants are not aware of anymaterial adjustments necessaryto make the statements conformwith GAAP.

CLOSING THE GAP

In this article, we attemptedto reduce the gap between finan-cial statement users’ expecta-tions of the role of the auditor,and auditors’ procedures underGAAS and standards of thePCAOB. Specifically, we hopeto enhance users’ understandingof unqualified opinions, theauditor’s responsibility for thedetection of fraud, materiality,

financial statement restatements,going-concern opinions, materialweaknesses in internal control,and how a review of interimfinancial statements differs from an audit. Deepening users’understandings of these topicsreduces investor risk andenhances market efficiency by reducing information asymmetry.

NOTES

1. According to data from Audit Analytics,in 2006, 94 companies had audit fees ofover $20 million, and 2,796 companiesexceeded $1 million.

2. These can be found at www.aicpa.org.The codification of SASs is arranged bycodification section number, which per-tains to topic areas. For example, AuditReports is Codification Section AU 508.

3. As of January 2009, auditors of nonpub-lic broker-dealers are required to registerwith the PCAOB. See http://www.pcaob.org/News_and_Events/News/2009/01-07.aspx, accessed February 26, 2009.

4. The Government Accountability Officesets auditing standards for audits of stateand local governments and for entitiesthat fall under the Single Audit Act(those that receive certain amounts offederal financial assistance). These stan-dards are found in what has commonlybeen called “The Yellow Book.” Afourth entity that sets auditing standardsis the International Auditing and Assur-ance Standards Board.

5. Auditing standards can be found athttp://www.pcaob.org.

6. Our discussion does not cover foreignregistrants or companies that trade onU.S. stock exchanges as AmericanDepository Receipts. We do not attemptto describe expectations gap issuesrelated to non-U.S.-based generallyaccepted auditing standards.

7. Currently only companies with marketcapitalizations of more than $75 millionare required to provide reports on inter-nal control over financial reporting.

8. The audit risk model requires the audi-tor think about audit risk from the perspective of three components of risk:inherent risk, control risk, and detectionrisk. Inherent risk cannot be changed bythe action of either the auditor or theclient. Control risk can be reduced if theclient is willing to invest in internal controls. The only risk factor under thecontrol of the auditor is detection risk.

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9. AU Section 342 (AICPA, 1988b) specifies the procedures for auditingaccounting estimates.

10. Examples of this can be seen in the 8-K,where reasons for auditor terminationsand resignations must be disclosed.

11. This description is intended to includethe internal controls discussed by AU319 (AICPA, 1989), the Foreign CorruptPractices Act, and the internal controlsaddressed by the Committee of Sponsor-ing Organizations (COSO).

12. Reports on internal control can alsoinclude scope limitations. For example,when a company acquires another business entity, management may electto exclude that entity from the evalua-tion of the effectiveness of the system ofinternal control (see paragraph B16 ofAS 5).

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Denise Dickins, PhD, CPA, is an assistant professor at East Carolina University and teaches auditing. Shewas formerly a partner with Arthur Andersen and currently serves on the boards of three public companies.Dr. Dickins has published extensively on auditing topics. Julia L. Higgs, PhD, CPA, is an associate profes-sor at Florida Atlantic University. She teaches auditing and financial accounting and was formerly an audi-tor. She is active in the auditing section of the American Accounting Association and has published innumerous outlets on the topic of auditing.

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