schelluch & gay

Accounting and Finance 46 (2006) 653–676

©

The AuthorsJournal compilation

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2006 AFAANZ

Blackwell Publishing, Ltd.Oxford, UKACFIAccounting and Finance0810-5391Accounting and Finance Association of Australia and New Zealand464

ORIGINAL ARTICLE

P. Schelluch, G. GayP. Schelluch, G. Gay

Assurance provided by auditors’ reports on prospective financial information: implications

for the expectation gap

Peter Schelluch, Grant Gay

Department of Accounting and Finance, Monash University, Melbourne, 3168, Australia

Abstract

The results of this study indicate significant differences in beliefs between auditors,users and preparers of prospective financial information, concerning forecastreliability and the role and responsibilities of auditors and management. Contraryto the usual published studies on expectation gap, it was found that auditors believethat forecasts are more reliable than users or preparers. Auditors also believe thatthey have a higher level of responsibility and accountability than is attributed to themby users or preparers. Beliefs were affected by the type of report issued by the auditorand subjects were able to discriminate between the level of assurance providedby positive and negative assurance opinions. However, based on the responsesof shareholders, it appears that the negative assurance opinion on assumptionsfor an audit might confuse users and might not meet the demands of the market.

Key words

: Assurance; Expectation gap; Prospective financial information

JEL classification

: M42

doi

: 10.1111/j.1467-629x.2006.00187.x

1. Introduction

Forecast disclosures are prepared extensively for the use of management,potential investors, shareholders, lenders, regulatory bodies and other interestedparties. Such disclosures might be intended for general or limited distribution anduse. The increasing reliance on such forecast disclosures has raised a number ofconcerns about the reliability of such prospective financial information and theability of the auditor to enhance the credibility of such

ex ante

disclosures. Theconcerns have emerged as a consequence of differences in perceptions of differentgroups of financial report users concerning messages conveyed by audited financialinformation and a professional acknowledgement of this audit expectation gap.

Received 18 February 2005;

accepted 2 September 2005 by Robert Faff (Editor).

654 P. Schelluch, G. Gay/Accounting and Finance 46 (2006) 653–676

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2. Expectation gap

The audit expectation gap refers to differences between the public’s percep-tions of the role and responsibilities of the auditor and the auditor’s perceptionof these roles and responsibilities. Humphrey

et al

. (1992, 1993) indicate thatthe gap relates directly to the uncertainty associated with the purpose, value,nature and effect of the audit. As a result, they indicate that the potential causesof the audit expectation gap are many and varied, including: unreasonableexpectations of non-auditors; hindsight evaluation of audit performance; corpo-rate crises that lead to new expectations and accountability requirements; andthe profession attempting to control the direction and outcome of the expecta-tion gap debate to maintain the status quo.

Although a consensus as to the cause of the audit expectation gap has notbeen achieved, its persistence has been acknowledged.

1

The Australian Societyof Certified Practicing Accountants (now CPA Australia) and the Institute ofChartered Accountants in Australia (1993, 1996) in their Expectation GapReports made a number of recommendations to reduce the expectation gap infinancial reporting and auditing. However, the Institute of Chartered Accountantsin Australia (2003) acknowledged that attempts to reduce the gap by movingcommunity expectations in line with the audit product have largely failed andconsequently there is a need to expand the scope of audit and assurance servicesto meet market expectations.

The audit expectation gap debate has consistently centred on a number ofperennial issues,

2

including:• The role and responsibilities of auditors• The quality of the audit function• The structure and regulation of the profession• The nature and meaning of audit report messages• The auditor’s ability to communicate different levels of assurance to users.

3. Prospective financial information

Part of the motivation of this study is concern about the impact that the pro-vision of prospective financial information might have on the audit expectationgap. This concern stems partly from the continuing existence of the expectationgap and the conflicting evidence concerning the utility and reliability of pub-licly available prospective financial information. According to Berlinger andRobbins (1986), the external use of prospective information was discouragedfor a long time because of fears ‘that forecasts would fall far short in reliability’.

1

See, for example, Gay and Schelluch (1993) Gay

et al

. (1998), Humphrey

et al

. (1992,1993), Monroe and Woodliff (1994) and Porter (1993).

2

Ibid.

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Dev and Webb (1972) point out that it has often been argued that as forecastsare impossible to verify on an

ex ante

basis, they are of little value. However,Berlinger and Robbins (1986, p. 347) suggest that there has been an acceptancethat ‘estimates of the future from those most knowledgeable about the businessare as reliable as a historical accounting of what happened in the past’.

Blair and Taylor (1989) point out that for initial public offerings, equityissuers have an incentive to provide optimistic forecasts to make the investmentopportunity appear more attractive. Although theory suggests that managersmight be motivated to bias their earnings forecasts, empirical studies haveyielded conflicting results. McDonald (1973) finds an average overprediction inUS profit forecasts of over 10 per cent. However, in a later US study, Imhoff (1978)finds actual earnings to be approximately 1 per cent below forecast earnings.Blair and Taylor (1989) also note that there might be disincentives to providingoptimistic forecasts. McNichols (1989) finds little support for the hypothesisthat management forecasts are biased systematically. Similarly, in Australia,Goodwin (1989) conducts a study of forecasts of newly listed companiesbetween 1982 and 1986 and finds that the profit forecasting was inaccurate,although there was no obvious bias towards over-optimistic forecasting. Lee

et al

. (1993) conduct a study of public offerings from 1976 to 1989 and findthat the forecasts that were included were inaccurate and upwardly biased.Lee

et al

. (2002) examine initial public offerings from 1991 to 1998 and findthat the distribution of forecast errors was strongly suggestive of earningsmanagement to avoid reporting earnings below the forecast figure. Coulton andTaylor (2003) investigate 240 stand-alone earnings forecasts by Australianlisted companies and find that good news forecasts are more specific than badnews forecasts. They also find that the shorter the time before the release of theannual earnings statement, the more confident management are of the outcomeand so the more specific is the forecast. Chapple

et al

. (2005) find that therevised funding regime and increased disclosure introduced by the

CorporateLaw Economic Reform Program

(

CLERP

)

Act 1999

was associated with areduction in forecast frequency since 2000 and an increase in forecast valuerelevance, but not with any change in forecast error or bias.

The ability of the auditor to enhance the credibility of forecast financialinformation has also been studied. Corless and Norgaard (1974) find that areport by an auditor on a profit forecast would only slightly increase the users’confidence in the forecast data, because of the users’ overriding concern regard-ing the tentative nature of forecast data. Conversely, Johnson and Pany (1984)find that both auditors and bank loan officers believe that auditor associationwould increase the likelihood that the forecast would be free of clerical errorsand would be accurate. However, auditors have a higher expectation than loanofficers as to the auditor’s effectiveness of detecting clerical errors on forecasts.Mak (1990) points out that in some cases, concerns about the reliability ofprofit forecasts have been dealt with by legislation requiring independentchecks of forecast information by an auditor to ensure their integrity and provide


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assurance to users as to their reliability. Therefore, this study is also concernedwith the level of assurance that an auditor can provide on forecast informationand the impact of different types of audit reports on the assurance provided.

4. Assurance

In Australia, Auditing and Assurance Standard AUS 106.10 defines assuranceas ‘the satisfaction as to the reliability of information provided’ (Auditing andAssurance Standards Board, 2001). It points out that the level of satisfactionis determined by the nature, extent and results of audit procedures and theobjectivity of the evidence obtained. Auditing and Assurance Standard AUS108, issued in June 2004, recognizes two types of assurance (Auditing andAssurance Standards Board, 2004):

1 Reasonable level of assurance

, which is a reasonable (previously defined ashigh) but not absolute level of assurance, recognizing that it is not possible toachieve absolute assurance because of the inherent limitations of an audit andcontrol systems. A reasonable level of assurance is provided through the auditorissuing a positive expression of opinion about an accountability matter.

2 Limited level of assurance

, which is a limited (previously defined as moderate)level of assurance provided by the auditor that the subject matter is plausible inthe circumstance by stating that nothing has come to the auditor’s attention toindicate that the information is not presented fairly in accordance with identifiedcriteria.

Although the assurance services framework adopted in AUS 108 has receivedwidespread general support, several aspects still remain unresolved and/or sub-ject to debate. These include:• Whether the assurance framework should offer a continuous level of assur-

ance or as is argued in the standard, only a reasonable or limited level ofassurance

• The impact of the subject matter in determining the level of assurance (forexample, whether a reasonable level of assurance can be provided on bothhistorical and prospective information)

• The best way to communicate the different levels of assurance particularlythe limited level of assurance.An important issue is whether the user comprehends the level of assurance

that is intended by the assurance provider. Corless and Norgaard (1974) exam-ine whether the wording differences between a positive and negative assurancereport made any difference to the user’s interpretation of the role that theauditor played in generating the forecast and the responsibility assumed by theauditor. They find that the majority of respondents believed that the auditorhad reviewed the underlying assumptions of the forecast. With a positive assur-ance report, 88 per cent of respondents indicated that the auditor had

reviewedthe assumptions

, and 82 per cent of respondents believed this to be the casewith a negative assurance report. Of those respondents indicating that the


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auditor had reviewed the assumptions, a greater proportion of positive assur-ance report respondents indicated that a thorough review was undertaken, ratherthan only a cursory review for inconsistencies. With respect to the accuracy ofcomputations, a majority of report users believed that the auditor had verifiedthe accuracy of computations inherent in the forecast and there was little differ-ence between positive and negative assurance reports for this matter. Withrespect to the accuracy of the forecast, a majority of report users did not believethat the auditor was attesting to the accuracy of the forecast.

In Canada, the Ontario Securities Commission has permitted the inclusion ofan earnings forecast in prospectuses for initial public offerings since 1983.Before July 1989, auditors were required to provide only review-level or limitedassurance for these forecasts. As a result of dissatisfaction with the quality ofthe earnings forecasts, the regulators encouraged the Canadian Institute ofChartered Accountants in 1989 to introduce revised auditing guidelines thatincreased the level of assurance required for earnings forecasts to audit-level orreasonable assurance. McConomy (1998) compares the accuracy and bias ofearnings forecasts before and after this 1989 requirement that forecasts beaudited rather than reviewed. He finds a significant reduction in optimistic bias,but relatively little improvement in accuracy resulting from the audit require-ment. While Clarkson (2000) similarly finds a reduction in forecast bias, healso finds an improvement in forecast accuracy as measured by averageabsolute forecast error associated with the shift from review to audit-levelassurance.

Using subjects from different backgrounds, Gay

et al

. (1998) find that usersof financial information in Australia have different perceptions of the degree ofreliability of financial information and the levels of assurance provided byreview and audit reports. Results indicate that users found financial informa-tion to be less reliable compared to auditors. Although all groups recognizedthat an audit report with a positive assurance opinion provided greater assurancethan a review report with a statement of negative assurance, auditors had sig-nificantly stronger beliefs as to the extent of assurance being provided than userand preparer groups. The findings also suggest that audit and review reportswere used in the form of a ‘clean bill-of-health’ stamp or symbol, rather thancontaining information for the reader from the description of work performed.

Roebuck

et al

. (2000) manipulate first the subject matter of the work under-taken (historical (internal control) versus prospective (prospective informa-tion)), and second the level of work undertaken (higher work level

vs

moderatework level). They examine the level of assurance conveyed by the assurancereport and find that shareholders perceive a higher level of work for historicalcompared with prospective information. However, shareholders did not changetheir perception of the level of assurance from the report as a result of thedescription of the work performed by the assurance provider (for which stand-ard wording suggested for assurance reports and already used for audit andreview reports was used).


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Forecast disclosures are based on assumptions about future events thatmanagement expects to take place and actions that management expects totake. Although audit evidence might be available to support these underlyingassumptions, such evidence is itself generally future orientated and, therefore,speculative in nature. Consequently, Australian Auditing Standard AUS 804advocates that the auditor provide a statement of negative assurance on thereasonableness of management’s best-estimate assumptions (i.e. a limited levelof assurance that the assumptions are free from material misstatement) (Auditingand Assurance Standards Board, 2002). The requirements of AUS 804 aregenerally consistent with International Standard on Auditing ISA 810. AUS804.34 does, however, permit the auditor to express a positive assurance on theassumptions when the auditor has obtained an appropriate level of satisfactionthat the assumptions are free from material misstatement. Such a positive opinionwas originally proposed in exposure draft ED 49 and AUP 36, which were thepredecessors to AUS 804 (Australian Accounting Research Foundation, 1992).

In advocating the use of a negative assurance opinion, AUS 804 recognizesthat it might be difficult, if not impossible, for the auditor to obtain a level ofsatisfaction sufficient for the expression of a positive opinion because:• By their very nature, not all assumptions are capable of independent substantiation• The reasonableness of assumptions is assessed on presently available information• The auditor cannot be certain that all the expectations, intentions and plans of

management are reflected in a forecast and that the present expectations ofmanagement will not change in response to changing circumstances

• The reasonableness of the assumptions cannot be compared to a reportingframework with the rigour necessary to allow for a positive assurance.The use of a statement of negative assurance alleviates concerns that a positive

assurance opinion on the reasonableness of the assumptions would result in agreater level of credibility (assurance) being attached to the underlying assump-tions than that intended. However, the use of a statement of negative assurancein relation to the reasonableness of forecast assumptions raises concerns aboutusers’ ability to distinguish between the levels of assurance communicated bynegative assurance opinions when compared to positive assurance opinions.

In the light of previous research studies dealing with the expectation gapand messages conveyed by audit reports, it would appear that there is uncer-tainty about the ability of positive and negative assurance reports to convey thedesired level of assurance to users. In addition, these previous expectation gapstudies emphasize concerns about the ability of audit reports to clearly commu-nicate the role and responsibilities of auditors and management in the reportingprocess, while remaining neutral about the effectiveness of management and thefuture prospects of the reporting entity.

3

This study tests the validity of theseconcerns.

3

See, for example, Gay and Schelluch (1993), Gay

et al

. (1998), Hatherly

et al

. (1991) andMonroe and Woodliff (1994).


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The wording of the positive and negative assurance reports provided to par-ticipants in previous studies differ from the current wording. Therefore, thisstudy has used the wording suggested in AUS 804 and its predecessor exposuredraft ED 49 to address:• The effect of positive and negative assurance reports on user/preparer beliefs

concerning forecast reliability• The effect of positive and negative assurance reports on user/preparer beliefs

about the auditor’s and management’s role and responsibilities• The effect of positive and negative assurance reports on user/preparer beliefs

about the forecast entity’s prospects.

5. Research method

5.1. Research instrument

Several studies have examined the measurement of meaning of audit reportmessages. Houghton and Messier (1990) examine the effect of wording changeson the meaning of audit reports using the general semantic differential scales ofOsgood

et al

. (1957), adapted for accounting by Haried (1972, 1973) andenhanced by Houghton (1987a,b, 1988). Houghton and Messier (1990) useadjectives in their semantic differential scales, whereas Holt and Moizer (1990)use adjectival phrases.

In the present study, a semantic differential instrument was developed tomeasure the messages communicated through audit reports on prospectivefinancial information, following the steps outlined by Malhotra (1981), Monroeand Woodliff (1993, 1994) and Gay

et al

. (1998).The academic and professional literature was reviewed to identify messages

that were intended to be conveyed by audit reports on prospective financialinformation. This resulted in the identification of 45 unique statements, whichwere then reviewed for completeness by five audit academics, one audit partnerand two audit managers. This resulted in two additional statements beingincluded in the study.

As a pilot study, two pretest instruments were developed and mailed to 200auditors. One instrument contained a negative assurance report and the othercontained a positive assurance report on prospective financial information eachfollowed by 47 bipolar adjectival statements separated by a 7 point Likert scale.The auditors were asked to respond to the instrument and also to review it toensure that their perceptions coincided with the views expressed in publishedreports. This did not result in any additions to the existing bipolar adjectivalstatements, although minor modifications to the wording of a number of statementswere made as a consequence. Useable responses were received from 76 of the200 auditors participating in the pilot study (a response rate of 38 per cent).

To identify the underlying dimensions of the messages communicated, aprincipal components analysis, together with varimax rotation, was performed.


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This was supported by a factor comparability analysis, using a split halvestechnique (Everett, 1983; Monroe and Woodliff, 1993, 1994; Gay

et al

., 1998),which resulted in three stable factors: (i) Reliability; (ii) Responsibility; and(iii) Prospects, with coefficients of factor comparability of 0.98, 0.97 and 0.91.

4

The split-halves technique involves splitting the respondent group into two.

5

The data from each group of respondents are subjected to identical factor ana-lyses. The two sets of factor score coefficients are used to calculate a duplicateset of factor scores for each respondent. A cross-correlation of duplicate factorscores for each factor provides a measure of factor comparability and is referredto as the coefficient of factor comparability. Everett (1983) points out that it isimportant that the same procedures should provide stable factors when appliedto different sets of respondents, if the factors are to be used as summarymeasures.

Reliability analysis utilizing Cronbach coefficient alpha was used to reducethe statements with factor loadings greater than 0.50 to 15 for the final instrument(Cronbach, 1951). The first factor, Reliability, was reduced to 11 statementswith factor loadings greater than 0.50, with an alpha of 0.75 suggesting onlyslight information loss. Similarly, the second factor, Responsibility, was reducedto two statements with an alpha level of 0.74, while the third factor, Prospects,was reduced to two statements with an alpha level of 0.70.

Two versions of the final research instrument were used. One version con-tained the statement of negative assurance report recommended by AUS 804(Appendix I), while the second version contained the positive assurance auditreport derived from its predecessor exposure draft ED49 (Appendix II). Thedifferences in wording between the two reports are highlighted in bold forthe purpose of this article, so that readers can easily identify the differences.Each version of the research instrument contained one of the two audit reports,without any bolding, followed by the words ‘This audit report indicates to methat . . .’ and each of the selected bipolar adjectival statements separated by a7 point scale. The first phrase was treated as the ‘1’ end of the scale and the sec-ond phrase was treated as the ‘7’ end of the scale. The selected statements andtheir related factors are shown in Table 1. The order and direction of the bipolarstatements was randomly assigned and then fixed for all subjects. In addition,demographic details of subjects were also sought in the final instrument.

4

Houghton (1986) points out that a common benchmark for factor comparability is a cor-relation of factor scores of 0.9 or better. This cut-off point is also used as an example inEverett (1983).

5

It is acknowledged that the use of the split-halves factor analysis, although a valid, objec-tive and reliable method, is mainly taxonomic and other methods could have been used toreduce the number of statements to a level where a reasonable response rate would beobtained. The result is an in-depth analysis of the three factors selected, rather than exploringa number of diverse issues.


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Table 1Belief statements

Reliability factor1 Extent of assurance The extent of assurance provided by the auditor is clearly

communicated.

The extent of assurance provided by the auditor is not clearly communicated.

2 Basis of assumptions The forecast is properly prepared on the basis of the assumptions.

The forecast is not properly prepared on the basis of the assumptions.

3 Reasonable assumptions The assumptions are reasonable for the preparation of the forecast.

The assumptions are not reasonable for the preparation of the forecast.

4 Material misstatements Users can have absolute assurance that there are no material misstatements in the forecast.

Users can have no assurance that there are no material misstatements in the forecast.

5 Forecast achieved Users can have absolute assurance that the forecast will be achieved in all material respects.

Users can have no assurance that the forecast will be achieved in all material respects.

6 Assumptions approved The auditor did not approve the assumptions.

The auditor approved the assumptions.

7 Accounting standards The forecast does not comply with applicable accounting standards.

The forecast complies with applicable accounting standards.

8 Significant errors The forecast contains significant errors.

The forecast contains no significant errors.

9 Review assumptions The auditor did not review the assumptions.

The auditor did review the assumptions.

10 True and fair The forecast gives a true and fair view.

The forecast does not give a true and fair view.

11 Auditor satisfaction The auditor is satisfied with the forecast.

The auditor is not satisfied with the forecast.

Responsibility factor12 Underlying assumptions Management is responsible for the assumptions underlying the

forecast.

The auditor is responsible for the assumptions underlying the forecast.

13 Audit quality and accountability

The shareholders (addressee) can hold the auditors accountable for the quality of their work.

The shareholders (addressee) cannot hold the auditors accountable for the quality of their work.

Prospects factor14 Well managed The entity is not well managed.

The entity is well managed.

15 Continue operating The entity will cease operating next year.

The entity will continue operating next year.


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5.2. Subject details

Subjects were chosen from groups that would be associated with the prepara-tion, use and audit of prospective financial information (i.e. company secretaries/accountants, shareholders and auditors). The subjects were mailed a copy of thequestionnaire, a covering letter, and a prepaid return envelope. The auditors (AUD)were randomly selected from members of the Institute of Chartered Accountantsin Australia (ICAA). The ICAA provided a national list of members who areeither engaged in, or have an interest in, the auditing profession. Shareholders(SH) were selected from members of the Australian Shareholders’ Association,which provided a national list of its membership and foreshadowed the surveyin its newsletter prior to the questionnaire being mailed out to a random selectionof members. Company secretaries/chief accountants (CS) were randomly selectedfrom the top 500 business entities. The number of questionnaires distributed toeach subject group and the subsequent responses for each report are shown inTable 2.

Although the response rates were good (36–59 per cent) and the Mann–Whitney

U

-tests of differences between early and late subject responsesrevealed no significant differences in responses for each type of audit report forall subjects as well as for each class of subject for each report type, the usualcaveats about a potential non-response bias apply to the reported results. Also,the subjects chosen might not reflect the views held by similar subjects whomight have been chosen from other professional/special interest organizationsor other corporate mailing lists. In addition, the external validity of the studymight be questioned if users do not read the audit reports in detail, but treatthem as a symbol representing a clean bill of health (Gay and Schelluch, 1993).

Table 2Subject distributions and response rates

Group AUD CS SH

Distributeda 580 301 496Less unuseable responsesb and returned mail 7/573 5/296 5/491Useable responses

Negative assurance 162 42 99Positive assurance 176 63 111

Total 338 105 210Response rate (%) 59 36 43

Respondent groups include auditors (AUD), company secretaries and chief accountants (CS) and shareholders(SH). aHalf of the subjects on the mailing lists were randomly assigned one of the two versions of the questionnairein equal proportion. bUnuseable responses consisted of blank or partially completed returns. Non-responseswere followed up; however, some subjects could not be located or had died or retired, or their firms hadmerged, been taken over or gone into liquidation at the time of mailing. Note: Mann–Whitney U-testsof differences between early and late subject responses revealed no significant differences in responsesfor each type of audit report for all subjects as well as for each class of subject for each report type.


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5.3. Demographic characteristics of subjects

To obtain a profile of subject group characteristics, subjects were asked torespond to demographic questions as part of the questionnaire. Auditors werecharacterized by an average of 13 years of auditing experience and 5 years ofother business experience, 49.5 per cent were employed by the ‘Big Four’ pub-lic accounting firms, 69.3 per cent invested in shares, 97.8 per cent had a terti-ary qualification, while 35.4 per cent were partners, 39.9 per cent managers,and the remaining 24.7 per cent were supervisors or below.

Company secretaries revealed that 89.8 per cent had a tertiary qualification,their average business experience was 15.8 years, 29.6 per cent were designatedcompany secretaries, 20.4 per cent were designated executive/managing directors,while 50 per cent were chief accountants. Shareholder characteristics revealedthat 68.6 per cent held a tertiary qualification. Only 15 per cent indicated that theywere unfamiliar, or very unfamiliar with financial reports, while 61 per cent statedthey were familiar or very familiar (12 per cent) with financial reports.

Responses of subject groups to the two report types were analysed by demo-graphic characteristics.

χ

2

-tests revealed no demographic differences betweensubject groups receiving the statement of negative assurance report and thosereceiving the positive assurance report. Also, no significant differences werefound in responses within groups based on demographic characteristics thatcould not be attributed to chance at

p

≤

0.05.

6. Results

The results for the 15 bipolar adjectival statements are presented in Tables 3–5.The results are analysed under the appropriate factor headings, rather than theorder the questions were presented in the research instrument. The tables showthe relevant statements and the mean responses for each of the subject groups,together with the results of Mann–Whitney

U

-tests of comparison betweengroups, and between negative and positive assurance reports for each subjectgroup.

6

A review of the distribution of responses for each question was alsoundertaken and no unusual responses were found.

7. Reliability statements

As would be expected, the responses by auditors indicate that they believethat the level of assurance provided by each form of audit report is clearly com-municated to users (Question 1). However, it is surprising that the extent oftheir belief is not stronger. Furthermore, the view of auditors about the clarity

6

The normality of the distribution of responses was tested by the Kolmogorov–Smirnovtest. The responses are not normally distributed and transformation of the data does notresult in normality. Hence, non-parametric statistics are used for analysis purposes.


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of the communication is not shared by company secretaries and shareholders.For the negative form of assurance, non-audit subject responses are signifi-cantly different to auditors and indicate that the level of assurance is not clearlycommunicated, although this view is not strongly held as the mean response isclose to the mid-point of the range. For the positive assurance report non-audit

Table 3Reliability statements mean responses and tests of differences

Group meansBetween group

differences

StatementReporttype

AUD CS SH AUD versusCS

AUD versusSH

CS versusSH

1 Extent of assurance provided by the auditor is clearly communicated.

–ve 2.85 4.05 4.35 b c+ve 3.03 3.60 3.77 a

2 Forecast is properly prepared on the basis of the assumptions.

–ve 1.32 1.65 1.99 c+ve 1.34 1.55 1.69 a

3 Assumptions are reasonable for the preparation of the forecast.

–ve *2.67 *3.40 *4.00 a c+ve *1.58 *1.95 *2.08 a bp < 0.001 0.001 0.001

4 Users can have absolute assurance that there are no material misstatements in the forecast.

–ve *4.55 *4.75 *5.29 c a+ve *3.94 *4.27 *4.81 cp < 0.01 0.05 0.05

5 Users can have absolute assurance that the forecast will be achieved in all material respects.

–ve *6.05 *6.43 *6.33+ve *5.62 *5.90 *5.97 ap < 0.01 0.05 0.05

6 Auditor did not approve assumptions. –ve *3.91 3.18 *2.97 c+ve *5.21 3.94 *5.01 c cp < 0.001 0.001

7 The forecast does not comply with applicable accounting standards.

–ve 6.59 6.28 6.07 a+ve 6.58 6.53 6.48

8 Forecast contains significant errors. –ve *5.41 5.05 4.73 c+ve *5.88 5.24 5.08 c cp < 0.001

9 Auditors did not review assumptions. –ve *6.45 5.80 *5.53 c+ve *6.69 6.13 *6.09 a ap < 0.05 0.05

10 Forecast gives a true and fair view. –ve *3.71 *3.83 *3.97+ve *3.03 *3.37 *3.14p < 0.001 0.05 0.01

11 Auditor is satisfied with forecast. –ve *3.07 *3.83 *4.79 a c c+ve *1.82 *2.44 *2.75 b cp < 0.001 0.001 0.001

Respondent groups include auditors (AUD), company secretaries and chief accountants (CS) and shareholders(SH). a, b, c: Mann–Whitney Z score significantly different between groups as indicated, at p < 0.05, 0.01, 0.001.*Mann–Whitney Z score between negative and positive audit reports significantly different at levels indicated by p.Report type is indicated by ‘–ve’ for the negative assurance opinion and ‘+ve’ for the positive assurance opinion.


© The AuthorsJournal compilation © 2006 AFAANZ

subject responses indicate that they believe that the extent of assurance isclearly communicated. However, this belief is not strong and for shareholders issignificantly less than for auditors.

This suggests that there is some confusion in the minds of the non-audit subjectgroups as to the extent of assurance communicated by the positive and negativeform of audit reports. The responses from auditors might also indicate that, althoughthey understand the forms of the two reports, their less-than-strong beliefs indicatethat they are also uncertain about the relative levels of assurance communicated byeach type of report. Therefore, there is a need to amend the wording of the reportsto ensure that the level of assurance provided by the auditor in both reports ismore clearly communicated, particularly for the negative assurance report.

Table 4Responsibility statements mean responses and tests of differences

Table 5Prospects statements mean responses and tests of differences

Reporttype

Group means Between group differences

StatementAUD CS SH AUD

versus CSAUD versus SH

CS versus SH

12 Management is responsible for the assumptions underlying the forecast.

–ve 1.38 1.25 *1.26 a+ve 1.39 1.42 *1.65p < 0.01

13 The shareholders (addressee) can hold the auditor accountable for the quality of their work.

–ve *2.74 3.70 *4.29 c+ve *2.46 3.23 *3.44 a bp < 0.05 0.05

Respondent groups include auditors (AUD), company secretaries and chief accountants (CS) andshareholders (SH). a, b, c: Mann–Whitney Z score significantly different between groups as indicated,at p < 0.05, 0.01, 0.001. *Mann–Whitney Z score between negative and positive audit reportssignificantly different at levels indicated by p. Report type is indicated by ‘–ve’ for the negativeassurance opinion and ‘+ve’ for the positive assurance opinion.

Reporttype

Group means Between group differences

StatementAUD CS SH AUD

versus CSAUD versus SH

CS versus SH

14 The entity is not well managed.

–ve 4.21 4.45 4.10+ve 4.17 4.21 4.39

15 The entity will cease operating next year.

–ve 4.98 4.58 4.97+ve 5.02 4.74 5.33 a

Respondent groups include auditors (AUD), company secretaries and chief accountants (CS) and shareholders(SH). a, b, c: Mann–Whitney Z score significantly different between groups as indicated, at p < 0.05, 0.01, 0.001.*Mann–Whitney Z score between negative and positive audit reports significantly different at levels indicated by p.Report type is indicated by ‘–ve’ for the negative assurance opinion and ‘+ve’ for the positive assurance opinion.



Although all subject groups believe that both reports communicate themessage that the forecast is properly prepared on the basis of the assumptions(Question 2), auditors have a significantly higher belief than shareholders. Thedifference may be explained by a lower familiarity with the role of the under-lying assumptions in forecasts held by shareholders or their greater scepticism.As both reports provide a positive opinion for this question, it is not surprisingthat there were no significant differences between reports.

The responses to this question indicate that all groups perceive that the auditopinion must be related to a defined reporting framework. The profession hasbeen attempting to educate users that the audit opinion, whether expressed interms of ‘truth and fairness’ or ‘presents fairly’, must be seen in the context ofa particular framework identified within the financial report.7 In the case ofprospective financial information, it is information prepared on the basis of aset of identified assumptions.

As the wording of the two audit reports is very different in relation to thereasonableness of the underlying assumptions, one would expect the extent ofbeliefs of subject groups to differ between the two reports as to whether theassumptions are reasonable for the preparation of the forecast (Question 3). Allgroups had significantly stronger beliefs about the reasonableness of assump-tions for the positive assurance report than for the negative assurance report.This appears to reflect an understanding of the differing levels of assuranceprovided by the two reports in relation to the reasonableness of underlyingassumptions by the respective user/preparer groups. However, the strength ofbeliefs differed significantly between auditors and the other subject groups forboth audit report types.

The non-audit subject groups’ beliefs about the reasonableness of the under-lying assumptions are significantly less than that of the auditor for both reporttypes. For the positive assurance report, the closeness of responses to the end-point, however, indicates that subject groups believe in the reasonableness ofthe underlying assumptions. For the negative assurance report, significant dif-ferences in responses between auditors and the other subject groups indicatethat the wording of the negative opinion on the reasonableness of the assump-tions has tempered the beliefs of all subject groups. This again might reflectsubjects’ beliefs about the inability of the auditor to obtain the kind of evidencenecessary to form a positive opinion (provide a reasonable level of assurance)in relation to management’s assumptions, which is explicitly outlined in the lastparagraph of the scope section of the negative assurance report. It might alsoreflect difficulties experienced by company secretaries and shareholders ininterpreting the wording of the negative assurance report.

The level of responses to both reports indicates that all subject groups areaware that an audit cannot provide absolute assurance that there are no material

7 Refer to AUS 702.17 (g) and AUS 702.21–22, which require reference to the identifiedreporting framework in both the scope and opinion sections of the audit report.



misstatements (Question 4). The level of responses further indicates that allsubject groups believe that the negative assurance report provides a lower levelof assurance than the positive assurance report. This is particularly the case forauditors. While company secretaries’ and auditors’ beliefs are similar, share-holders are significantly more sceptical about the level of assurance than theother subject groups, indicating the possible existence of an expectation gap.

The responses indicate that all subject groups are aware that little, if any,assurance can be provided by the auditor that the forecast will be achieved(Question 5). As with the previous question, all users clearly distinguishedbetween the level of assurance that can be obtained from the negative andpositive assurance reports, believing that the negative assurance report providesless assurance than the positive assurance report that the forecast will beachieved. This may be expected as the wording of the positive assuranceopinion makes explicit reference to the reasonableness of the underlyingassumptions, while both forms of audit report also make explicit reference tothe fact that the forecast may not be achieved and that the auditor does notexpress any opinion as to whether the forecast will be achieved.

All subject groups believe that the auditor does not approve the assumptions(Question 6) for the negative assurance report, although these beliefs are notstrong. However, shareholders’ beliefs are significantly stronger than those ofauditors. The level of responses of subjects, particularly auditors in relation tothe negative assurance report, highlights a degree of uncertainty about the audi-tor’s role in relation to the assumptions. For the positive assurance report, allsubjects other than company secretaries believe that the auditor does approvethe assumptions, although again such beliefs are not strong. The contrary beliefsheld by company secretaries might be due to the use of the term ‘approve’, asit might be argued that the auditor only forms an opinion on the reasonablenessor otherwise of the assumptions, but does not actually approve them.

Subjects’ beliefs about approval levels vary significantly between report type forboth auditors and shareholders. These subject groups associate the positive assurancereport with auditor approval of the assumptions, whereas the negative assurancereport is viewed as not leading to auditor approval, again showing an ability todiscriminate between the assurance levels provided by the respective reports.

Both audit report types make explicit reference in the audit opinion sections tofair presentation in accordance with applicable accounting standards (Question 7).As a result, one would expect to find a consensus in beliefs between subjectgroups and also within groups between the two report types. This was the case,although company secretaries’ beliefs are significantly weaker than those of theauditors for the negative assurance report. However, the responses of subjectgroups in general are consistent and are approaching the end-point of the scale.

Although for both reports subjects in general believe that the forecast didnot contain significant errors (Question 8), both non-audit subject groups aresignificantly less confident than auditors that the forecasts are free of significanterrors for the positive assurance report. For the negative assurance report,



shareholders are significantly less convinced than auditors that the forecast con-tained no significant errors. Subjects’ beliefs are influenced by report type assubjects hold stronger beliefs that no significant errors existed in relation to thepositive assurance report than the negative assurance report, particularly inthe case of auditors where the difference is significant. The level of responsesof non-audit groups and the fact that they differ significantly from the beliefs ofthe auditors in all but one case indicate that they have less faith in the ability ofthe auditor to detect and require management to correct significant errors thando the auditors themselves.

The level of subject responses suggests that all subjects believe that theauditor reviewed the assumptions (Question 9) for both report types. However,non-audit subjects’ beliefs were significantly lower than auditor’s beliefs (withthe exception of company secretaries for the negative assurance report). Asexpected, all subjects’ beliefs that the assumptions are reviewed are stronger forthe positive assurance report than for the negative assurance report, particularlyin the case of auditors and shareholders.

The direction of subject responses indicates that all subject groups believethat both audit reports communicate that the forecasts give a true and fair view(Question 10). Subject groups’ beliefs as to the truth and fairness of the forecastare significantly stronger for the positive assurance report than for the negativeassurance audit report. The fact that subject responses in general are not strongmight be because of subjects’ beliefs that forecasts, because of their inherentnature, might not be able to achieve the degree of truth and fairness that mightbe expected for historical cost financial information. Alternatively, it mightreflect uncertainty about the meaning of ‘truth and fairness’.

Although all subjects for both audit reports (with the exception of shareholdersfor negative assurance reports) believe that the auditor is satisfied with theforecast (Question 11), the degree of satisfaction is significantly less for all non-audit subject groups when compared to that of the auditors. All subject groupshold significantly stronger beliefs about auditor satisfaction with the forecast forthe positive assurance report than the negative assurance report. The responsesto this statement indicate that subjects are able to discriminate between the twoforms of audit report with respect to the level of assurance. However, shareholdersbelieve that the auditor is not satisfied with the forecast with respect to the neg-ative assurance report. This belief might stem from the wording of the negativeassurance opinion in relation to the underlying assumptions, as well as the lastparagraph of the scope section of the audit report that details the inherent natureand limitations of prospective financial information, the underlying assumptionsand the type of audit evidence available to assess these assumptions.

8. Responsibility

The level of responses towards the strongly agree end-point indicate that allsubject groups believe that management is responsible for the underlying



assumptions of the forecast (Question 12). Management’s responsibility for theassumptions should not be affected by the type of audit report. Only shareholdersperceive a difference in responsibility between the two different audit reports byattributing a lower level of responsibility to management for the positive assurancereport than for the negative assurance report. This difference might be a result ofthe fact that the auditor expresses a positive opinion on the reasonableness of theassumptions in the positive assurance report, which could imply that a detailed auditand evaluation process is undertaken by the auditor rather than merely a review ofthe assumptions. However, it could be implied from a negative assurance opinionthat only a review has taken place, even though an audit is conducted in each case.Shareholders have significantly stronger beliefs about management’s responsibilityfor the underlying assumptions than auditors do for the negative assurance report.

For the negative assurance report, the shareholders believe that the auditor is notaccountable to the addressee of the report for the quality of their work (Question13), whereas the auditors and company secretaries believe there is a degree ofaccountability, indicating that an expectation gap might exist between shareholdersand the other subject groups. For the positive assurance report, all groups believethe auditor to be accountable, even though non-audit subject groups held a sig-nificantly lower level of beliefs about accountability than the auditors did.

Auditors and shareholders believe that there is a significant difference inaccountability for audit quality between the two report types, believing that theauditor is significantly more accountable in respect of the positive assurancereport than the negative assurance report.

The results indicate that an expectation gap may exist between auditors andother subject groups with respect to beliefs about accountability of the auditorfor the quality of their work. The beliefs held by shareholders are consistentwith previous shareholder responses indicating confusion about the nature andlevel of assurance provided by the negative assurance report, as well as thescepticism expressed towards the profession and reporting process.

9. Prospects

The mean responses of all subject groups around the mid-point on the scaleindicates uncertainty among subjects concerning whether any message is com-municated about the entity being well managed (Question 14). There were nosignificant differences between responses for the positive and negative assur-ance reports, as respondents did not believe that either of the reports told themmuch about the way the entity was managed. This is consistent with professionalpronouncements, which indicate that the auditor’s opinion is on the financialinformation and not the efficiency of management.

All subjects believe that the entity will continue operating next year(Question 15) for both audit report types, although the level of responsesindicates that these beliefs are not very strong. Given the level and direction ofresponses of subjects, there appears to be no expectation gap between auditors



and other subject groups, although company secretaries’ beliefs are signifi-cantly weaker than those of shareholders that the entity will continue operatingnext year, in relation to the positive assurance report.

10. Summary and conclusion

This study investigated beliefs about messages communicated by both nega-tive and positive assurance audit reports on prospective financial information.Beliefs were assessed with respect to the reliability of prospective financialinformation, the responsibilities of auditors and management, and the futureprospects of the entity.

With respect to the reliability statements, there appear to be significantdifferences in responses for both reports between auditors and shareholders andbetween auditors and company secretaries, with auditors deriving a greaterdegree of assurance about the reasonableness of the assumptions and that theforecast has been properly prepared. In general, the expectation gap appearsto be greatest between auditors and user subjects (i.e. shareholders). Where asignificant difference is found between report types for the subject groups, it isgenerally found that greater reliability is placed on the positive assurance reportthan the negative assurance report by subject groups, which is consistent withexpectations and highlights the ability of subjects to distinguish between thelevels of assurance provided by each report. Nevertheless, the results relating tothe reliability statements indicate that there is considerable room for improve-ment by modifying the wording of the two reports and/or further educatingusers. In particular, responses indicated some doubt about the appropriatenessof the wording of the negative assurance report.

With respect to the responsibility statements, the results also indicate thatsignificant differences in beliefs exist between auditors and shareholders andbetween auditors and company secretaries. In general, where there are signifi-cant differences in the beliefs of subject groups about responsibilities betweenreport types, subject groups tended to attach greater responsibility to the auditorwith respect to the positive assurance report than the negative assurance report.Although all groups recognize that management is responsible for the assumptionsused in the forecast, auditors have a significantly stronger view that auditors areaccountable for the quality of their work on the forecast.

With respect to the future prospect statements, there is little difference inbeliefs between subjects or reports.

There are several implications of this study. First, the profession’s fearsabout the existence of an expectation gap with respect to audit opinions onprospective financial information appear to be justified, although the extent ofthe gap is not as pronounced as might have been expected given the results ofprevious studies and the extensive public discussion of the audit expectationgap. In general, the expectation gap appears to be greater between auditors andshareholders than between auditors and company secretaries. Of particular



significance is that the results indicate that the current expectation gap in respectof prospective financial information is in the opposite direction to that indicatedin published reports on expectation gap. Auditors believe that forecasts aremore reliable than user or preparer groups do. Auditors also believe that theyhave a higher level of responsibility and accountability than is attributed to themby users or preparers. The sceptical attitude of shareholders, in particular, isprobably a result of the recent corporate scandals and audit failures of the late1990s and early 2000s. Therefore, an area of future research will be to see if thechanges to auditors’ responsibilities and independence requirements under theCLERP 9 amendments to the Corporations Act 2001 have done anything to redressthis perception and restore user and preparer confidence in the audit function.

Second, the profession should re-examine the wording used in the auditreport. Even auditors showed some uncertainty as to the messages being com-municated. In addition, users, preparers and auditors are uncertain about apply-ing the term ‘true and fair’ to prospective financial information, which supportsthe continued use of the current wording ‘presents fairly’ in the audit report.The wording of audit reports needs to be simplified and enhanced so that theybecome more understandable to users and preparers and the level of assuranceis more clearly communicated. These results support the view put by JusticeOwen in the HIH Royal Commission Report (2003), when he called for plainEnglish audit reports. This study also indicates that there is scope for furtherresearch on the wording used for different types of audit reports and that thisshould be considered by the Australian Auditing and Assurance StandardsBoard in any revisions they make to auditing standards.

Third, auditors, users and preparers can differentiate between positive andnegative forms of audit reports. In general, they all attach greater forecast reliabilityto the positive assurance report than to the negative assurance report.

Fourth, in general, subject groups are able to distinguish between manage-ment and auditor responsibilities for both report types in a manner that isconsistent with professional expectations. Where subject group beliefs aboutauditor/management responsibilities differed significantly between reports thiswas in general consistent with professional expectations.

Finally, as the underlying assumptions of forecasts are crucial to the fairnessof prospective financial information, it could be argued that based on theresponses of shareholders, the current negative assurance opinion on suchassumptions for an audit might confuse users and might not meet the demandsof the market.

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Appendix I

Negative assurance report

(Bold type has been used to highlight differences between reports in Appendix Iand Appendix II)

http://ssrn.com/



INDEPENDENT AUDIT REPORT

To [addressee]

ScopeWe have audited the forecast of [entity] for the [period] as set out on pages . . .

to . . . The [members of the governing body] are responsible for the preparationand presentation of the forecast and the information contained therein, includ-ing the assumptions as set out in note . . . on which the forecast is based. Wehave conducted an independent audit of the forecast in order to express an opin-ion on it to [addressee].

The forecast has been prepared for distribution to [addressee] for the purpose . . . We disclaim any assumption of responsibility for any reliance on this reportor on the forecast to which it relates to any person other than to [addressee] orfor any purpose other than that for which it was prepared.

Our audit has been conducted in accordance with Australian Auditing Stand-ards. Our procedures included examination, on a test basis, of evidence sup-porting the assumptions, amounts and other disclosures in the forecast and theevaluation of accounting policies. These procedures have been undertaken toform an opinion as to whether anything has come to our attention which causesus to believe that management’s assumptions as set out in note . . . do not pro-vide a reasonable basis for the preparation of the forecast, and whether, in allmaterial respects, the forecast is properly prepared on the basis of the assump-tions as set out in note . . . and is presented fairly in accordance with . . . (and ona basis consistent with the accounting policies adopted and disclosed by theentity in its audited financial report for the [period] ended [date]) so as topresent a view of the entity which is consistent with our understanding of the[entity’s] past, current and future operations.

Prospective financial information relates to events and actions that havenot yet occurred and may not occur. While evidence may be available tosupport the assumptions on which prospective financial information isbased, such evidence is generally future orientated and therefore specula-tive in nature. Given the nature of the evidence available in assessing thereasonableness of management’s assumptions, we are not in a position toobtain the level of assurance necessary to express a positive opinion onthose assumptions. Accordingly, we provide a lesser level of assurance onthe reasonableness of management’s assumptions.

The audit opinion expressed in this report has been formed on the above basis.

Audit OpinionBased on our examination of the evidence supporting the assumptions,

nothing has come to our attention which causes us to believe that theassumptions as set out in note . . . do not provide a reasonable basis for thepreparation of the forecast.



In our opinion,(a) the forecast is properly prepared on the basis of the assumptions as set

out in note . . . ; and(b) the forecast is presented fairly in accordance with

(i) . . . applicable accounting standards; and(ii) on a basis consistent with the accounting policies adopted and dis-

closed by the entity in its audited financial report for the [period] ended[date]

Actual results are likely to be different from the forecast since anticipatedevents frequently do not occur as expected and the variation may be material.Accordingly, we express no opinion as to whether the forecast will be achieved.

Date FirmAddress Partner

Appendix II

Positive assurance report

(Bold type has been used to highlight differences between reports in Appen-dix I and Appendix II)

INDEPENDENT AUDIT REPORT

To [addressee]

ScopeWe have audited the forecast of [entity] for the [period] as set out on pages

. . . to . . . The [members of the governing body] are responsible for the prepar-ation and presentation of the forecast and the information contained therein,including the assumptions as set out in note . . . on which the forecast is based.We have conducted an independent audit of the forecast in order to express anopinion on it to [addressee].

The forecast has been prepared for distribution to [addressee] for the purpose . . . We disclaim any assumption of responsibility for any reliance on this reportor on the forecast to which it relates to any person other than to [addressee] andfor any purpose other than that for which it was prepared.

Our audit has been conducted in accordance with Australian Auditing Standards.Our procedures included examination, on a test basis, of evidence supportingthe assumptions, amounts and other disclosures in the forecast and the evaluationof accounting policies. These procedures have been undertaken to form anopinion as to whether the assumptions as set out in note . . . are reasonable for the



preparation of the forecast, and whether, in all material respects, the forecast isproperly prepared on the basis of the assumptions as set out in note . . . and ispresented fairly in accordance with . . . (and on a basis consistent with theaccounting policies adopted and disclosed by the entity in its audited financialreport for the [period] ended [date] so as to present a view of the [entity] which isconsistent with our understanding of the [entity’s] past, current and futureoperations.

Audit OpinionIn our opinion,(a) the assumptions as set out in note . . . are reasonable for the prepara-

tion of the forecast;(b) the forecast is properly prepared on the basis of the assumptions as set

out in note . . . ; and(c) the forecast is presented fairly in accordance with:

(i) applicable accounting standards; and(ii) on a basis consistent with the accounting policies adopted and disclosed

by the entity in its audited financial report for the [period] ended [date]Actual results are likely to be different from the forecast since anticipated

events frequently do not occur as expected and the variation may be material.Accordingly, we express no opinion as to whether the forecast will be achieved.

Date FirmAddress Partner

schelluch & gay

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