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Instructor’s Manual

Auditing: An International Approach

Bahram Soltani

ISBN: 978-0-273-68541-8 Pearson Education Limited 2008 Lecturers adopting the main text are permitted to download and photocopy the manual as required.

Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies around the world Visit us on the World Wide Web at: www.pearsoned.co.uk ---------------------------------- First Published 2008 © Pearson Education Limited 2008 The right of Bahram Soltani to be identified as author of this work has been asserted by him in accordance with the Copyright, Designs and Patents Act 1988. ISBN: 978-0-273-68541-8 All rights reserved. is hereby given for the material in this publication to be reproduced for OHP transparencies and student handouts, without express permission of the Publishers, for educational purposes only. In all other cases, no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise without either the prior written permission of the Publishers or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6-10 Kirby Street, London EC1N 8TS. This book may not be lent, resold, hired out or otherwise disposed of by way of trade in any form of binding or cover other than that in which it is published, without the prior consent of the Publishers.

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Contents

Chapters Pages 1. An introduction to auditing and assurance 6 2. Demand for and supply of external audit services 14 3. Auditing, organization and governance 23 4. The audit committee, internal and external auditing 34 5. International auditing and assurance services 43 6. Auditing in the European context 52 7. Auditor independence and professional ethics: international issues 63 8. Audit risk, materiality and business risk management 75 9. Audit sampling techniques 86 10. Evidence and decision making in auditing 97 11. Internal control over financial reporting and IT environment 106 12. Audit reporting 118 13. Information technology and auditing 137 14. Continuous auditing and continuous reporting 146 15. Quality control and oversight systems in auditing: international issues 156 16. Auditor liability in a changing environment 163 17. The independent auditor, stock markets and lending decisions 173 18. Corporate fraud, corporate scandals and external auditing 181 19. Auditing: looking ahead 190

Bahram Soltani, Auditing: An International Approach, Instructor’s Manual


INSTRUCTOR GUIDANCE AND SUGGESTIONS

This book discusses auditing concepts for a changing environment and how auditing responds to public expectations. It analyzes the role of external auditors today as a vital part of decision making in the market economy and the need to expand their role beyond traditional financial statement audits. It treats auditing as a whole discipline – the theory and the practice – rather than discussing only auditing techniques. This approach raises the essential question of what auditing ‘ought to be’ and how it should keep pace with change.

This book is organized around four fundamental areas in auditing: international issues including international standards, theoretical as well as practical aspects of auditing, major research work in auditing and multidisciplinary topics. It views the audit process in a changing environment, and in this respect, it concerns the examination of the financial statements information relating also to an organization’s ability to effectively manage strategic and business process risks.

This textbook is different from many others available in the market in a number of ways. Firstly, the book reflects on auditing as a discipline emphasizing its theoretical foundation and issues as a basis, rather than discussing only the practices of auditing. It presents auditing as a complex judgement and decision process affected by real-world behavioural and environmental factors, rather than just as a mechanical, standard-driven process. Second, Auditing: An International Approach emphasizes the international aspects of auditing covering the International Standards on Auditing (ISA) issued by IFAC and IAASB as well as the US auditing standards and regulations. This is a significant feature of this textbook compared with the other major textbooks in auditing, which cover mainly the US approach to auditing and financial reporting. Thirdly, this book differs significantly from other texts in terms of philosophical approaches, as it presents auditing as a field of knowledge. This difference is reflected in the discussions in several chapters focusing on the expectation gap in auditing, audit judgement, decision making, bounded rationality and heuristic in auditing, personal ethics, professional ethics, legal liability etc. This innovative approach, which considers the audit process as judgement-based rather than a standards-driven process, provides a much broader vision than the merely technical aspects of this field discussed in most auditing textbooks. Moreover, the multidisciplinary approach taken in this book provides a significant difference when compared to other texts. In several chapters, the relationships between auditing and organization, auditing and finance with regard to corporate governance and financial market, and auditing and information technology systems have been highlighted.

This does not seek to undermine the importance of practical aspects of auditing – indeed they are extensively covered in the book – but to understand and explain them better, and even to look ahead into the future. However, in a changing world, the move away from the traditional role of an auditor as simply an attestor of historical financial statements reflects the shift in the audit process from a detail-driven substantive approach to a strategic risk approach to audit planning and execution. Although the detailed discussion on audit planning and execution is not the major objective of this book, it provides extensive coverage of major topics in audit practices. These include the discussions on auditing standards, evidence gathering, audit committee, internal control, auditor independence, audit reporting, strategic and business process risks, audit testing, auditing and IT, quality control and legal liability.



Special note to instructors

The questions at the end of the chapters in this book are designed to promote deeper thought about the auditing issues. The answers given in this instructor’s manual are provided in a summarized form. They are intended to provide the highlights and major elements related to the review and discussion questions. Since the questions are general and are not always related to a specific point, the answers can be found not only in the related chapter but in other chapters also.

Instructors are encouraged to provide their own opinions and perceptions when discussing the questions. As the instructors may notice, there are not always specific answers to the questions, and this opens the door to further discussions around the topics raised in the chapters. The students should be encouraged to express their opinions on the topics raised in the questions even if their points of view are not specifically related to the chapter under discussion.


C H A P T E R 1

AN INTRODUCTION TO AUDITING AND ASSURANCE

Instructor guidance

This chapter discusses the conceptual development of auditing and some fundamental theoretical aspects of auditing as a field of knowledge, and its philosophical background. It is desirable that the instructors put sufficient emphasis on the questions on p. 3. As indicated in the introduction of the chapter, the major objective here is ‘to adopt a critical approach to auditing’ and try to build up an appropriate framework for the fundamental areas of auditing that will be discussed in the following chapters.

The following is the suggested outline for the instructors when teaching this introductory chapter. Most of the learning objectives include the major topics that need to be emphasized by the instructors when teaching this introductory chapter.

• Reflections on the core questions indicated on p. 3 about the critical role of auditors;

• Discussion about the demand for assurance services (pp. 14–18). It is desirable to provide a brief definition of an audit of financial statements and how recent changes affect the audit environment and its framework (pp. 4–7), including the changes in auditors’ evaluation of companies’ internal control systems (pp. 20–22);

• Emphasis on the theoretical approach to auditing by discussing the philosophy of auditing (pp. 7–14). Reference should be made to the seminal works of Limperg (1930s), Mautz and Sharaf (1961), Flint (1988) and Power (1990).


SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS

Review Questions

1-1 What types of assurance services are provided by the public accounting profession? What factors create a need for assurance services?

Answer 1-1 The public accounting firm can provide three major professional services: assurance, tax and consulting. Assurance can be categorized into attestation and non-attestation services. In general, there is a broad range of assurance engagements which includes any combination of the following:

• Engagements to report on a large number of subject matters covering financial and non-financial information.

• Engagements intended to provide high (examinations) and moderate (reviews) levels of assurance. Examinations which provide decision makers with a high level of assurance as to the reliability of information are related to all financial statement audits. Reviews which provide only a moderate level of assurance to decision makers concerning the reliability of information are substantially narrower in scope than examinations.

• Attestation and direct reporting engagements.

• Engagements to report internally and externally.

• Engagements in the private and public sector.

The need for assurance services is mainly affected by the desire of different interested parties (investors, managers, regulators, financial institutions, employees etc.) for high-quality corporate financial information. Not only are the assurance services provided by independent auditors determinant in the decision-making process, they provide credibility to information quality. The concept of credibility is directly related to the reliability of financial information as an essential characteristic of information quality.

1-2 What is an attestation function? What major factors create a demand for the performance of attestation services by public accounting firms?

Answer 1-2 An attestation is the process of providing assurance service in which the public accountant issues a report about the reliability of any information provided by one party to another. The examples of attestation are a financial statement audit and the auditor’s attestation on management’s assessment of the effectiveness of the company’s internal control over financial reporting. The audit of financial statements is mostly demanded by the investors and creditors who are seeking an independent opinion on a company’s financial statements. The auditor’s report provides the external users with the reliable financial information they need in their decision-making process.



1-3 What is the essence of the ‘theory of inspired confidence’ developed by Professor Limperg in 1930s.

Answer 1-3 The ‘theory of inspired confidence or rational expectations’ basically tries to link a society’s need for reliable financial information and the auditor’s performance. It emphasizes the extent to which the auditing techniques and the content of audit report meet the users’ satisfaction for high-quality financial statements. In a general sense, the independent auditor acts as an intermediary agent providing confidence to economic agents making business decisions in the society.

1-4 What are the main objectives of audits of financial statements? How does an audit enhance the quality of financial statements?

Answer 1-4 In a financial statement audit, the auditor attests to the fairness of a company’s financial statements by expressing an opinion about whether the statements are in conformity with generally accepted accounting principles or other recognized criteria. The financial statements are assertions by management regarding the financial performance and financial condition of the company.

The objective of the audit is to assist users of accounting information and financial reporting in determining the quality of information being received. The audit function ought to add to the credibility of information because the user of the information needs to have confidence in it when making decisions.

1-5 How do assurance services differ from audit services? How have these differences developed in recent years?

Answer 1-5 Assurance services can be categorized into attestation services and non-attestation services. Audit services are typically forms of attestation services involving a report that goes to a third party. Assurance is a much broader concept than auditing. In contrast to attest engagements, non-attest assurers either improve the relevancy of information that originates with other parties, or create entirely new information for the use of interested parties. Assurance also applies limited specific audit procedures to the examination of one or more specified accounts or elements of the financial statements, rather than conducting the complete audit of financial statements. Audit services usually provide a high level of assurance, whereas other forms of assurance services provide limited assurance.

The changes due to financial markets, information technology and a greater demand for continuous reporting probably affect the audit function more than other forms of assurance services. Several developments in recent years have considerably affected financial information users’ perceptions of audit services and the manner in which these differ from other assurance services. These mainly include real-time reporting, the need to put more emphasis on attestation of internal control over financial reporting, reports on prospective financial statements and demand for continuous auditing.

1-6 What are the main differences between reasonable and limited levels of assurance engagements?

Answer 1-6 These terms are mainly discussed in the IFAC auditing standards (2005). Accordingly, the objective of a reasonable assurance engagement is a reduction in assurance engagement risk to an acceptably low level. The objective of limited assurance engagement is to reduce this risk to a level that is acceptable in the circumstances of the engagement, but where that risk is greater than for the former type of engagement. The nature, timing and extent of procedures for gathering sufficient appropriate evidence in a limited assurance engagement are deliberately limited relative to a reasonable assurance engagement.



1-7 Explain the objective of agreed-upon procedures engagement and provide five examples of such procedures.

Answer 1-7 Agreed-upon procedures engagement is related to the examination of one or more specified accounts or elements of the financial statements using limited but specific audit procedures, without conducting an audit of the entire financial statements. By definition, these procedures are narrower in scope than an audit or review of financial statements. The examples of such procedures include examining the detailed accounts-receivable data used in loan agreements, narrative description of a company’s compliance with specific laws, regulations, rules or contracts, the debtor’s compliance with certain financial covenant provisions stated in a loan agreement, a representation by management in the case of trading of a company’s investment securities based on its investment policies and an auditor’s attestation regarding the information contained in a company’s forecasted financial statements.

1-8 To what extent is it reasonable to view the external auditor as a guarantor in the capital market economy? Explain.

Answer 1-8 The external auditor as an intermediary economic agent helps to reduce the information asymmetry between management and shareholders. The audit also contributes to alleviating the conflicts of interest between the information preparers and users of information. The external auditor adds to the credibility of financial reports, facilitating the regulatory bodies’ attempts to protect public interest. However, external auditors cannot be viewed as a guarantor in a capital market involving numerous risk factors.

1-9 In your opinion, what are the potential threats facing an external auditor when conducting all types of assurance services?

Answer 1-9 The potential threats mainly relate to the lack of auditor independence and professional competence and training, as well as not attaching sufficient importance to environmental factors including business risk. The developments of these elements and other related matters are mainly presented in chapter 7 of the textbook.

1-10 What are the major aspects of the relationship between the structure of the audit market and its regulation?

Answer 1-10 The relationship between the audit market and regulatory bodies is significantly affected by the increasing number of statutory entities requiring audit, a new pattern of governance, advances in information technology and developments of the capital market economy. This requires the increasing involvement of regulatory bodies in the audit market by proposing several reforms for the better protection of investors and avoiding further corporate financial scandals.

Public oversight of the audit market, which was mainly in the hands of professional bodies, has been recently passed over to market regulators. In the United States, the Securities and Exchange Commission (SEC) and Public Company Accounting Oversight Board (PCAOB) have recently proposed several important measures affecting the structure of the audit market and its relationship with the capital market.

1-11 What is the primary rationale for market regulatory bodies to require mandatory reporting on internal accounting controls and the auditor’s involvement in this respect?

Answer 1-11 Due to the importance and effect of the assessment of internal control in the audit of financial statements, external auditors should attest to management’s assertion about the effectiveness of internal control over financial reporting. Several important elements, such as the reliability of financial reporting, the effectiveness of management decision making, compliance with applicable laws and regulations and safeguarding of assets, depend to a great extent on an efficient internal control system of the company.



Discussion Questions

1-12 To what extent do the factors such as: (a) economic developments;

(b) globalization and internationalization of capital markets;

(c) the complexity of financial operations and

(d) information technology advances affect the demand for and the performance of auditing services?

Answer 1-12 All these environmental factors affect the demand for and the performance of external auditors.

(a) Economic developments affect the demand for audit as a result of an increasing number of companies and/or higher volume of activities.

(b) The globalization and internationalization of the capital market affect the competition among audit firms and may create a higher concentration in the audit market. It may result in a higher quality of audit if the auditors acquire the necessary competency, training and specialization. However, the concentrated audit market may also impair auditor’s independence and the auditor’s performance.

(c) The increasing number of financial instruments and financial operations which require more sophisticated accounting standards and auditing techniques significantly affect the audit scope and auditor performance. These also create the demand for specialized audit and high level of competency and training in different related domains.

(d) The rapid advance of online technologies and the World Wide Web (W W W) and other forms of IT systems considerably affect the auditor’s performance and demand for audit. As part of the audit process, the auditor should make an assessment of company’s information system and different types of risks. When IT systems are used extensively within an organization, the auditor should also obtain an understanding of the IT environment and the extent to which this influences the company’s financial reporting and the quality of information disclosed to third parties.

1-13 Discuss the historical perspective of auditing with regard to Limperg (1930s) and Mautz and Sharaf (1960s).

Answer 1-13 The seminal works of Limperg and Mautz and Sharaf are discussed on pp. 8–14. However, for an in-depth historical discussion, refer to the original sources. In the case of Mautz and Sharaf (1961), it would be interesting to read particularly Chapter 1 (Toward an Auditing Philosophy), Chapter 2 (the Methodology of Auditing), Chapter 8 (Independence), Chapter 9 (Ethical Conduct) and Chapter 10 (Auditing in Perspective). For the work of Limperg, it would be interesting to refer to the end-of-chapter references (Carmichael 2004, Flint 1988 and Blokdijk et al 1995).

1-14 Discuss the arguments supporting the idea that auditing is a field of knowledge. What are the contributions of Mautz and Sharaf in this area?

Answer 1-14 This topic, which is briefly discussed on pp. 11–12 of the chapter, is well developed in Chapter 1 (Toward an Auditing Philosophy) and Chapter 10 (Auditing in Perspective) of Mautz and Sharaf (1961). They defined the structures of auditing as a field of knowledge (see pp. 243–248 of their book) on the basis of five essential elements (philosophical foundation, postulates, concepts, precepts and practical applications).



1-15 A company’s management, shareholders and creditors (mainly financial institutions) are directly concerned with the auditors’ function and performance, particularly in the case of publicly traded companies.

(a) Briefly discuss who among the above groups is the most important beneficiary of an auditor’s report on a company’s financial statements.

(b) Describe the circumstances in which there are potential conflicts of interest between these groups. How should auditors resolve such conflicts in the needs of the above parties?

Answer 1-15

(a) Shareholders are the main recipients of the financial statements and reports of corporations. The audited financial statements are an essential part of investors’ information for their decision-making process. However, the audited financial statements may substantially benefit the company’s management when evaluating its performance and facilitating the conflictual shareholder–manager relationship.

(b) The critical areas such as investment, financing, dividend policies as well as management remuneration are some examples in which there may exist conflicts of interest between shareholders and managers and also between both of these groups and creditors. Many of these conflicts result from the information asymmetry between these groups. The presence of independent auditors not only contributes to the reduction of information asymmetry, it also provides credibility to the company’s financial statements disclosed to various interested parties, provided that the auditor performs his/her function perfectly.

1-16 Market concentration has been a feature of auditing in the past few decades. Large accounting firms have come to dominate audit and assurance services. Discuss the effect of market concentration on audit quality in the context of capital market efficiency.

Answer 1-16 Audit market concentration and mergers among top audit firms in the 1990s are critical issues in the capital market economy. The market regulatory agencies have recently shown some concerns over this matter. It would be interesting to discuss this by putting forward both the for and against arguments, as the impact of market concentration on audit quality is a controversial topic. Audit quality may benefit from audit market concentration because of increasing specialization and competency of auditors in charge of publicly listed companies. On the other hand, it may impair auditor independence and credibility in some respects.

1-17 What is the role of regulatory bodies such as the SEC and PCAOB in the US and the European Commission in the audit market? Discuss this in terms of:

(a) setting audit standards;

(b) monitoring and performing the quality control reviews.

Answer 1-17 The SEC and PCAOB have played an important role in the US audit market, particularly since the approval of the Sarbanes-Oxley Act (SOX Act) in 2002. The PCAOB has been designated by US regulators as the major body in establishing audit standards and oversight of audit quality control. The audit profession has been playing a major role in both areas, but important changes have taken place since the SOX Act. Although the role of the European Commission in these areas is not as significant as that of the US regulators, this has evolved in recent years and the EU Commission has also adopted several recommendations concerning auditor independence, audit quality control and auditors’ responsibilities.



1-18 Discuss the following statement with regard to internal control over financial reporting within publicly traded companies. Evaluate the importance of this issue from the viewpoint of various interested parties (shareholders, managers, external auditors, regulators, potential investors, etc.).

The PCAOB notes in its release (Auditing Standard March 2004 United States) that: ‘The primary benefit [of an effective internal control structure]…is to provide the company, its management, its board and audit committee, and its owners and other stakeholders with a reasonable basis on which to rely on the company’s financial reporting’.

Answer 1-18 The SOX Act requires management’s assessment and the auditor’s opinion to address whether company’s internal control was effective as of the end of the company’s most recent fiscal year. To make decisions, a company’s management and its owners – public investors – and others must be able to rely on the financial information reported by companies. As part of the audit function, the independent auditor has to express an opinion about whether management’s assessment, or conclusion, on the effectiveness of internal control over financial reporting is stated fairly, in all material respects.

Evaluating a company’s internal control over financial reporting is sometimes costly, but there are also many far-reaching benefits. Some of the benefits of a company developing, maintaining, and improving its system of internal control include identifying cost-ineffective procedures, reducing the costs of processing accounting information, increasing productivity of the company’s financial function and simplifying financial control systems. It may also result in fewer financial statement restatements and less litigation. Effective internal control contributes to the better functioning of the company and promotes reliable financial reporting, which in return adds value and also can offset risks in a cost-beneficial manner. In that sense, the interested parties benefit from effective internal control and reliable financial reporting.

1-19 Discuss the following statement.

Michael Power (1997)∗ states that the rise of auditing has its roots in political demands for accountability and control. He argues that the new demands and expectations of audits live uneasily with their operational capabilities. Not only is the manner in which they produce assurance and accountability open to question but also, by imposing their own values, audits often have unintended and dysfunctional consequences for the audited organizations.

Answer 1-19 Many aspects of the corporate failures resulting from fraudulent financial reporting raise concerns about auditing practices, auditors’ independence, their social responsibilities and duties to third parties (including stakeholders) who rely on their reports. The question of auditors’ duties to report fraud to regulators has long been an issue of concern in many developed countries and remains so, particularly when news about corporate misbehaviour becomes public. External auditors are increasingly coming under critical scrutiny. This raises important social and political questions about the responsiveness and accountability of the auditing profession and auditors’ role within the capital market economy.

To provide fair and objective answers to these questions requires further reflection on the role, objectives and responsibilities of external auditors. The auditing profession has faced unprecedented challenges, particularly during the last decade. Severe pressures have caused a re-examination of the auditors’ role and their place in the economy. Auditors are often portrayed as public watchdogs but according to the current rules and standards, their public obligations remain fairly limited. They do not owe a ‘duty of care’ to participants in the market economy such as employees, individual shareholders and/or bank depositors. Moreover, external auditors

∗ The Audit Society: Rituals of Verification (1997, Oxford University Press).



are themselves economic agents who try to maximize profit, and this does not always conform to the responsibilities attributed to them by public opinion.

What can perhaps contribute to this debate is first to provide some clear definitions about the objectives of external auditing, the nature of auditing services and auditors’ social responsibilities. The next step is to consider the other technical issues regarding the conduct of audits and the processes used to serve companies. The integrity of corporate financial information must take priority over a desire for cost efficiencies or competitive advantages in the audit process. High-quality auditing requires well-trained, well-focused and well-supervised auditors.

1-20 Visit the website of the AICPA (www.aicpa.org), IFAC (www.IFAC.org) and PCAOB (www.pcaobus.org). Identify attestation services that have been recently defined by these accounting bodies. Prepare a report describing the nature of those services, and include a brief description of the criteria that have been developed for auditors to use in providing those services. Indicate significant differences between US and international approaches in terms of definitions for assurance and attestation services.

Answer 1-20 This question requires the search by students on the web sites of auditing bodies in the US (AICPA and PCAOB) and at international level (IFAC and the International Auditing and Assurance Standards Board ‘IAASB’ in charge of developing auditing standards). The students must be encouraged to do this as a case study in order to identify the major differences between US and international approaches. They can refer to the discussions in Chapters 1 and 5 (international auditing and assurance services) for further information. However, it would be interesting to search for the most recent and update information including the changes made since the publication of the book.

www.aicpa.org

www.IFAC.org

www.pcaobus.org


C H A P T E R 2

DEMAND FOR AND SUPPLY OF EXTERNAL AUDIT SERVICES

Instructor guidance

This chapter discusses the importance of auditing in corporate financial reporting. It provides a discussion on the implications of the economics of information, the needs of various users of financial statements, the issue of the expectation gap and the role of external auditors in reducing the problem of information asymmetry.

The following is the suggested outline for instructors when teaching this chapter:

• Emphasize the importance of the economics of information and insist on the theoretical elements (e.g. information asymmetry);

• Discuss the expectation gap in auditing and its evolution with a changing environment;

• Emphasize the role of external auditors in corporate financial reporting and major features of this relationship;

• Provide the theoretical explanations for the demand for auditing.


SUGGESTED SOLUTIONS TO END-OF-CHAPTER REVIEW AND DISCUSSION QUESTIONS

Review Questions

2-1 What are the main aspects of the communication process by which accounting information reaches the potential users of this information?

Answer 2-1 Corporate financial reporting and communication processes are essential to a company’s strategy. The major aspect of the process is the quality of information transmitted to various users of financial information and the presence of independent auditors adds credibility to this information. It is important to refer to the qualitative characteristics of accounting and financial reporting discussed on p. 15 of Chapter 1. The worth of the financial communication process depends, to a great extent, on its utility for the decision making of potential users and its impact on their perceptions.

2-2 Why is there a need for regulation of disclosure in capital markets? What types of disclosures should be regulated and which should not?

Answer 2-2 The market regulators play an important role in capital markets by regulating the type of information which must be disclosed by publicly listed companies. This oversight role is required to protect the investors and various stakeholders, and also to provide confidence and credibility as major factors in the better functioning of financial markets. This cannot be achieved without regular monitoring of the quality of information disclosed by listed companies and a demand for efficient control mechanisms.

The market regulatory bodies are generally concerned with mandatory financial information such as financial statements, notes to the accounts, and periodic reporting (annual, quarterly reports). Although the regulators are interested in the quality of the information voluntarily transmitted by companies to users of information, it would be rather difficult to exercise any direct control on disclosures of this type (public releases on earnings, share prices, investment and financing policies etc.).

2-3 Explain the role of the independent audit function in the communication of corporate accounting information.

Answer 2-3 The company’s management is responsible for preparing and implementing the appropriate financial accounting and reporting systems and communicating reliable financial information to interested parties. The presence of independent auditors is an essential factor in adding credibility to the information disclosed by companies. The recent regulations require the active presence of external auditors in the company’s reporting process in the areas of internal control over financial reporting and financial information needed for business decision making. Moreover, the external auditors are increasingly considered by market participants as an independent intermediary in corporate financial reporting for reducing the information risk, efficient resource allocation and market control mechanisms.

2-4 Discuss the importance of the notions of ‘expectation gap’ and ‘credibility gap’ in the corporate financial reporting process.

Answer 2-4 The expectation gap is the shortfall between the amount of information that a decision maker possesses, and the amount of information required or he/she expects to have for a given decision. This gap can be filled by an independent auditor. The independent auditor backs up the financial statements prepared by the company’s management, thereby lending



credibility to the company’s financial reporting process. It is also expected that the presence of an external auditor adds to the credibility of information and mitigates the credibility gap caused by conflicts of interest between the users of a company’s financial information. Changes in society’s expectations and in information technology have significantly affected the demand for auditing, and the expectation gap in this field has become much wider and the implications much more complex.

2-5 Discuss the factors influencing the mandatory and voluntary disclosures of financial information.

Answer 2-5 The need for better protection of potential users of corporate financial information, efficient monitoring of a company’s reporting process, better functioning of financial markets, a higher level of transparency of financial data and increasing demand for reliable financial communication systems are among the major factors affecting the financial disclosure of publicly listed companies. Efficient monitoring of financial reporting and the information disclosed by publicly listed companies requires the active presence of market regulatory bodies in the capital market economy. Above all, efficient control mechanisms such as internal and external auditing and effective internal control over a company’s financial information are necessary for efficient resource allocation in a market economy.

2-6 How and to what extent do regulatory bodies (such as SEC in the US and the European Commission) affect the supply of financial statement information by publicly held corporations?

Answer 2-6 The market regulatory bodies such as SEC in the United States and similar bodies in other countries are responsible for the protection of the public interest and better functioning of capital markets. The regulatory bodies are mainly exercising their oversight role with regard to mandatory financial information and control mechanisms needed for high-quality financial reporting within corporations. The importance of protecting public interest and implementing effective market control mechanisms requires the direct intervention of regulatory bodies concerning the mandatory supply of financial information, and it does not very much concern the voluntary disclosure of information. However, the regulatory market bodies are also concerned with any irregularities and fraudulent financial reporting resulting from voluntary disclosures by publicly listed companies.

2-7 ‘A Statement of Basic Auditing Concepts’ (American Accounting Association, 1973) explains different conditions creating demand for auditing. Discuss these conditions.

Answer 2-7 These conditions (conflict of interest, consequences, complexity and remoteness) are discussed on pp. 46–49 of Chapter 2. In spite of the fact that the Statement of Basic Auditing Concepts was released more than thirty years ago, it deals clearly with major issues facing the current audit market and demand for auditing. It is important that the instructors emphasize the validity of the theoretical foundation of this statement, even if the current demand for auditing is mainly characterized by environmental changes and not only concerns the auditor-client and/or auditor-manager-shareholder relationships.

2-8 What are the major hypotheses with regard to the sources of demand for audit services? Explain each of these hypotheses.

Answer 2-8 These hypotheses are explained on pp. 49–55 of Chapter 2 and provide the theoretical explanations of the demand for audit services. It is essential that the students grasp the main points of this discussion to be able to analyze the role of external auditors in the capital market economy. To define the role of the auditor with regard to the economics of information not only supports the increasing demand by market regulatory bodies for high-quality audit services, but it also helps us to understand better the major issues such as auditor independence



(Chapter 7), quality control (Chapter 15), auditor liability (Chapter 16), the role of the external auditor in the financial market (Chapter 17) and several other topics discussed in the following chapters.

2-9 How effective are auditors in enhancing the credibility of financial statements? What factors influence their effectiveness?

Answer 2-9 The effectiveness of external auditors depends very much on how the major users of financial information perceive the quality of the audit. The presence of independent auditors is an integral part of reliable financial reporting. However, the increasing demand of stakeholders for high-quality information and real-time reporting requires the move from annual assurance to continuous assurance. The effectiveness of auditors also depends on their ability to satisfy the users’ expectations for high-quality financial information. It relates to the auditors’ capabilities to respond to increasing environmental changes and complex information systems by expanding the audit scope and improving audit quality control mechanisms.

2-10 What is the relationship between financial disclosure, corporate governance and management incentives? What role do boards of directors and audit committees play in the disclosure process?

Answer 2-10 Management is responsible for preparing and communicating high-quality financial information. Corporate governance mechanisms, particularly the audit committee, play a central role in the financial reporting process. The evaluation of management’s performance and its incentives should logically be based on a company’s financial statements. The audited financial statements should help the owners to link the company’s financial performance and management’s performance. However, factors such as temptation to manage earnings, big bath accounting operations and irrational market expectations make this evaluation difficult. The more efficient the control mechanisms and accountability systems within the company are, the better the management evaluation system and incentive policies will be. High quality and transparent financial reporting significantly contributes to achieving this.

2-11 How effective are accounting standards (e.g. US GAAP, IFRS (or IAS)) in facilitating credible communication between corporate managers and outside investors? What factors determine their effectiveness?

Answer 2-11 Financial reporting includes financial statements and other forms of communication that provide accounting information (corporate annual reports, prospectuses, annual reports filed with the market regulatory agencies, news releases and management forecasts). The financial statements and attached notes are the essential components of the financial reporting of companies, and their preparation is essentially based on generally accepted accounting standards (IFRS or US GAAP) established by recognized bodies such as the International Accounting Standards Board (IASB) or the US Financial Accounting Standards Board (FASB). The accounting standards are officially recognized as authoritative by the market regulatory agencies and professional accounting bodies. Such standards are essential to the efficient functioning of the economy because investors, creditors, auditors and others rely on credible, transparent and comparable financial information.

There are a number of limitations of accounting standards in areas such as the evaluation of immaterial assets, intellectual capital, internally generated goodwill and financial derivatives. The discretionary nature of income statements and earnings management are the other areas in which the lack of clear-cut accounting standards and guidelines allow the managers to produce fraudulent financial reporting. Many aspects of recent corporate failures are directly related to ineffective accounting standards and financial reporting. In order to contribute to the credibility of the communication process of companies, particularly those listed on financial markets, the standard-setters should develop high-quality accounting standards that are relevant to the business decision-making process, easy to understand and facilitate comparability of financial information.



2-12 In what way is the globalization of capital markets affecting the globalization of financial reporting?

Answer 2-12 The globalization of capital markets has been accompanied by calls for the globalization of financial reporting. This requires a common set of high-quality accounting standards which will enhance the consistency, comparability and efficiency of the financial statements of publicly listed companies, enabling global markets to move with less friction. High-quality financial reporting is an imperative of orderly and efficient globalized capital markets. They require appropriate accounting standards and adequate financial disclosure at a world-wide level. The IASB is committed to developing, in the public interest, a single set of high quality, global accounting standards that require transparent and comparable information in general purpose financial statements. In pursuit of this objective, the IASB co-operates with the FASB and other national accounting standard-setters to achieve convergence in accounting standards around the world.

2-13 To what extent, in your opinion, do the current format and content of audit reports respond to the needs and expectations of investors and lenders in capital markets?

Answer 2-13 The audit report is the most common and highest level of assurance provided by an independent auditor to those interested in a company’s financial information. The audit report in its current form is based on historical financial statements. Users of financial information are no longer satisfied with annual reports and conventional ‘backward-looking’ audit reports on companies’ financial statements. Several factors are leading to a higher expectation gap between what the public expects or needs and the information content of audit reports. These include the ever-increasing expectations of various interested parties for real-time reporting, market expectations for value relevance of audit reports, information technology advances and problems relating to earnings management.

Discussion Questions

2-14 Comment on and discuss the following statement and the related questions.

‘Notwithstanding the efforts made by regulatory bodies and accounting policymakers in disclosure and corporate reporting, there is still some ambiguity surrounding several important topics in this area’. Consider the following questions regarding the informational role of mandatory financial reporting:

(a) What information about a company’s financial conditions should be released to investors and other stakeholders in a financial report?

(b) Where should the information be released? Should it be recognized explicitly in the body of the financial statements, disclosed in notes or revealed in some other fashion?

(c) When should the information be disclosed?

Answer 2-14 The market regulatory agencies are responsible for protecting public interest. This requires monitoring of the financial reporting process of publicly listed companies. With regard to mandatory disclosure of financial information, the following points are important.



(a) The financial reports should include the information useful for business decision making. This primarily includes the information regarding the company’s economic resources, obligations, owners’ equity, economic performance and earnings, liquidity, solvency and fund flows.

(b) Corporate annual reports, quarterly financial reports, management forecasts and other types of information filed with market regulatory bodies should include this information. The company’s financial statements and the attached notes should generally include all the necessary information useful for business decision making.

(c) The users of a company’s financial information generally require timely and reliable information. However, because of the difficulties surrounding the company’s disclosure in real-time reporting, companies currently disclose the mandatory information on a periodic basis and supply the additional information on a voluntary basis, for example, in the area of earnings management. As a result of market expectations and the regular demand for information, voluntary disclosure becomes part of the company’s reporting and communication process. The financial market may sanction the companies who do not respect the voluntary disclosure of information on scheduled dates. This sanction is mainly exercised on the company’s share prices since the absence of regular disclosure may be considered as a negative sign in terms of company’s performance.

2-15 ‘Managers generally have superior information to outside investors about their company’s expected future performance’.

Discuss the above statement in a theoretical context. How does the managers’ superiority in information affect the efficiency of the financial market? To what extent does this affect the attitude of managers in terms of voluntary disclosures?

Answer 2-15 It is essential to discuss the problem of information asymmetry (pp. 37–39), the economics of information (p. 39) and the supply and demand for financial information. The fact that the management is responsible for preparing corporate information inevitably puts them in a privileged position of having access to more information than those interested parties outside the company. At the same time, part of this information may be used to evaluate the managers’ performance. If a manager tries to benefit from his/her position in this respect, this will have a negative impact on the company’s performance and shareholders’ interest.

Managers’ misconduct and abuses of power are more likely when they do not establish the appropriate control mechanisms (internal control, internal audit, etc.) within the company, and they are reluctant to disclose information. The temptation to manage earnings in an unreasonable manner, the disclosure of financial statements that contain misrepresentations, producing fraudulent financial statements and unrealistic future cash flows are good examples of the cases in which the management’s actions would unfavourably affect market efficiency in the long term. Although fraudulent financial reporting may be disclosed both on a mandatory and voluntary basis, management abuses in the area of financial reporting are mostly revealed through voluntary disclosures, especially to satisfy market expectations. The best way to avoid managers’ misconduct in producing and communicating biased information is to implement effective and appropriate internal and external control mechanisms over the company’s financial reporting. The presence of oversight systems implemented by market regulatory bodies also contributes significantly to controlling managers’ actions.

2-16 Discuss the question of whether investors, when pricing a security (e.g. in the case of initial public offerings (IPO)), value the auditor’s ability to provide an insurance role. Discuss this in the context of the relationship between the insurance hypothesis and auditor liability status (limited liability). Explain the link with securities’ prices in the flotation.



Answer 2-16 To discuss this question, it would be interesting to suggest to students to read the research conducted by O’Reilly (2000), Menon and Williams (1994) and Kothari et al. (1988) (see references at the end of chapter). The literature on the audit market has suggested that a valued attribute of audits is implicit insurance. The insurance stems from the investor’s right to recover from auditors, the losses sustained by relying on audited financial statements that contain misrepresentations. For example, Menon and Williams (1994) examined the effect on stock prices of the clients of Leventhol & Horwath (L&H) of two related events (L&H was the seventh largest accounting firm in the United States. It was agreed to file for bankruptcy in November 1990): firstly, the disclosure of their auditor’s bankruptcy, and second, the appointment of a successor auditor. The disclosure of L&H’s bankruptcy was found to have a negative impact on L&H clients’ stock prices. No corresponding increase in stock prices on the announcement of a replacement auditor was observed. The paper suggested that the value of the expected insurance coverage included in the price of the stock was hypothesized to vary with the magnitude of the losses previously sustained by the security and with the security’s classification either as an IPO or as a seasoned security. Evidence suggests that investors in IPOs take advantage of the protection provided under the securities’ laws and file suit when they sustain investment losses. This protection includes the right to recover from auditors the losses resulting from misstatements of a company’s financial statements which have been audited. Investors appear to be willing to pay a premium for the right to recover potential investment losses from auditors through litigation.

2-17 ‘Improving the quality of financial reporting necessarily involves the imposition of certain burdens and costs on publicly listed companies. Despite these costs, it is believed that a more transparent and reliable financial reporting process ultimately results in a more efficient allocation of resources and in a lower cost of capital. Nevertheless, in terms of cost and benefit, these additional costs need to be offset against the impact of reduction of outright fraud and other practices that result in lower quality financial reporting’.

Discuss the following questions with regard to the conflicts of interest between companies’ shareholders and management, and corporate lenders such as bankers:

(a) Provide some examples of actions the company’s shareholders and management can take that are at variance with the interests of corporate lenders.

(b) Give examples of actions management can take that are at variance with the interests of shareholders.

(c) What mechanisms might serve to reduce potential conflicts between the various parties involved in corporate financial reporting (e.g. between shareholders and corporate lenders and/ or management and shareholders)?

Answer 2-17 A company’s financial reporting must be useful to be beneficial to the users. The provision of transparent and useful information is an essential component of business decision making. However, internal financial information users have superior information compared to outside parties, such as bankers and analysts. Additionally, several aspects of corporate strategy may be the sources of conflicts between various interested parties. Good quality information must reflect all the necessary details including those relating to conflicts of interest. The following brief responses provide examples of such conflicts and how the useful financial information helps to solve the conflicts.

(a) The areas such as the company’s investment and dividend policies and the forecasted cash flows may be the source of conflicts between the management and corporate lenders when a company seeks financing. Company shareholders defending their interests may also support management actions against the lenders. The disclosure of reliable and transparent financial information and the existence of



effective control mechanisms can lessen the conflicts. In this respect, the predictive value of disclosed information is an essential qualitative characteristic of information.

(b) There may be conflicts of interest between the shareholders and management over dividend policy, investment decisions using internal financing and management remuneration. Once again, the principles of reliable and transparent information and accountability are determinant factors in resolving a part of the conflict between the related parties.

(c) An adequate reporting policy, effective internal control mechanisms, respect of transparency and accountability principles, selection of appropriate accounting standards and high-quality independent audit are among the most important factors contributing to the resolution of conflicts of interest between various interested parties.

2-18 The expectation gap usually refers to what the public expects or needs and what auditors can reasonably do. Users of financial reports expect auditors to provide assurances concerning material fraud, irregularities and the viability of the business and its management. Discuss the following questions with regard to the expectation gap: (a) In your opinion, what are the major factors affecting the expectation gap

between users of financial statements and auditors?

(b) Auditors’ responsibilities have increased over recent years. In your opinion, to what extent has public pressure affected the developments in auditor responsibilities?

(c) Discuss the role and performance of external auditors in detecting corporate fraud, one of the areas in which they are subject to continuing public criticism due to society’s ever-increasing expectations of auditors.

(d) What type of solutions and/or strategies would you recommend to reduce the expectation gap in auditing?

(e) What is the role of market regulators in reducing the expectation gap in auditing?

Answer 2-18 This question discusses the development of expectation gap in auditing and the role of external auditors in the capital market economy.

(a) Several factors have significantly contributed to widening the gap between what the public expects or needs and what auditors can and should reasonably be expected to do. These include rapid economic growth, the bubble economy, unexpected advances in information technology, the globalization and internationalization of capital markets, the complexity of financial products and operations and the high profile financial crises of recent years. The audit profession and accounting firms have not always been successful in responding to the increasing demands of users of financial information arising from such factors.

(b) Public pressures and financial market expectations have had an important impact on the market regulatory bodies’ decisions to develop new rules with regard to the responsibilities of the auditors in charge of publicly held companies. This also affects the audit market and the perception of auditors regarding their social responsibilities.



(c) This question has been widely discussed in Chapter 18 (corporate fraud, corporate scandals and external auditing). The active involvement of external auditors in corporate fraud detection, adopting the preventive approach and the appropriate auditing techniques, widening the scope of the auditor’s evaluation of a company’s internal control over financial reporting and the requirement to report on these issues are the most important changes with regard to the auditor’s role.

(d) Emphasizing auditor independence and ethics as an imperative, considering as a central issue the auditor’s knowledge about the company’s financial and business activities, widening the audit scope and increasing the quality of the auditors’ training are important steps in reducing the expectation gap. It is essential that the audit profession and the accounting firms play a more active role in developing reflection on the social responsibilities of independent auditors in the capital market economy.

(e) Market regulatory bodies have recently increased their level of oversight in the audit market. A more active co-operation between the regulatory bodies and accounting profession, adopting a transparent evaluation policy of external auditors’ performance, and adequate quality control mechanisms in auditing provide more confidence to potential users of financial information, which in turn contributes to the reduction of the expectation gap in the audit market.

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