An Empirical Study of Audit Expectation Gap in Nigeria

An Empirical study of Audit Expectation Gap in Nigeria

By

Muhammad Tanko (PhD, ACA)

Kaduna State University

0802-915-1213; 0807-726-2667

[email protected]

1

1. Introduction

The act of record keeping keeps the track of transactions in an organization and this in a way

serves as the basis upon which information is passed to the end users. But before it reaches them

there is the need for someone to authenticates the correctness of such records, and that is exactly

what the auditing procedure is all about. Rostami (2009), opined that it is the auditor that

authenticates the correctness of financial information that is passed to the end users, and he does

that based on his professional code of ethics and regulation. Therefore, auditors occupy the

central role in bridging the communication gap between the management of an enterprise, and

the end-users of the published financial reports.

The term audit is a word that is derived from the latin word ‘to hear’ and the term auditor means

‘hearer’. These terms follow the function of the auditor as it is expected that the preparers of

financial statements need to go through some impartial and experienced persons, normally

judges who used to hear the accounts prepared by the persons in charge and express their

opinion. (2009) opined that in the early 1990s auditors were primarily engaged to provide almost

absolute assurance against fraud and intentional

The role of the auditor is generally understood by the general public to be the detection of fraud

and error in the financial statements. This is because it is the auditor that comes to light in any

matter that effects the investigation of fraud or misappropriation in companies. Not until 1989

when the LJ Lopes of the appeal court stated in the case of Re Kingdom cotton mills (1896) that

the auditor was a watchdog not a bloodhound. Clearly, this decision brought to light the primary

role of the auditor to exclude the decision of fraud detection. Therefore, the definition of what an

audit is by the user’s of financial statements, the general public and the auditors, is what

cumulates to bring about the term “audit expectation gap“. The concept can better be understood

when we have a close look at the following issues: The audit profession’s expectation of an

audit; the auditor’s perception of an audit; and the general public/user’s of financial statements

perception of the audit

2

Marianne (2007) observes that, if users of financial statements and the general public were

educated to think that the auditor's role embraces the detection and prevention of fraud,

especially in relation to material items, the fraud and error detection role of an audit could be

relatively objective. However, absolute objectivity cannot be guaranteed since “materiality” and

“material significance” are subjective concepts which require further clarification by the

Auditing Practices Board. A return to the primary role of detection and prevention would also be

welcomed since there are at present, not sufficient measures to hold the auditor liable for

negative consequences of his actions. Some sources of academic literature assume that the

meaning of an audit is not ‘objective’ that is not ‘fixed’ whilst other sources such as contents of

audit reports assume that the meaning of an audit is ‘fixed’. In relation to the latter assumption,

there is the belief that the expectations gap could be significantly reduced –if not possible to

eliminate.

Pierce and Kilcommins (1996) using the external auditors as their bench mark as against the

bench mark of the audit profession tried to define the audit expectation gap. To them when the

external auditors’ understanding of their role and duties is compared against the expectations of

user groups and the general public then we expects to see audit expectation gap. Liggio (1974),

on the other hand, defined the audit expectation gap as the difference between the levels of

expected performance as interpreted by the independent accountant and the user of financial

statements. On the other hand, where we try to look at the expectation gap with the audit

profession in mind or as bench mark, there will be less subjectivity in the understanding and

definition of the expectation gap and which will narrow the expectation gap.

Much has been written about the possibility of an audit expectations gap. In an attempt to

address the problem, especially as to do with the role and responsibilities of auditors, have led to

the establishment of several government and professional investigations, which form an

important part of the expectation gap literature. These include the Cohen Commission (1978);

Metcalf Committee (1976); and Treadway Commission (1987); in the United States, the Cross

Committee (1977); and Greenside Committee (1978); in the United Kingdom and the Adams

Committee (1977) and MacDonald Commission (1988) in Canada.

3

While Cohen Commission in 1978 considered whether a gap might exist between what the

public expected and what auditors could reasonably expect to accomplish, poter (1993), in his

empirical study of the audit expectation gap, sees the definition of the gap as failing to mention

the possibility of sub-standard performance by auditors. It is against this backdrop that it is

imperative to study the issue of expectation gap. The next section explains the objective of this

paper.

1.1 Objective of the Research

The objective of this paper as stated above is to establish that there exist the expectation gap at

least in Nigeria, and that those areas of concern, (areas that brought about the creation of

misunderstanding between the public and the audit profession) could be identified and measures

could be taken to either eliminate them or reduce them to the bearest minimum. Furthermore, the

research intends to identify the effect of social framework on the definition of the audit

perception. The paper will make policy recommendations based on the outcome of the research.

More specifically the paper will address the following issues:

(i) Whether the expectation gap exists in Nigeria

(ii) Whether the areas of the gap could be identified

(iii) Whether it is possible to eliminate the gaps

(iv) whether it could be reduced in cases where it could not be eliminated

(v) Examine and differentiate the fixed and variable definition of the audit

(vi) Determine the extent which the social framework affects audit definition and

perception.

(vii) Make policy recommendations as to ways of improving the reduction of the

expectation gap

The next section contains the theoretical framework and the literature review that were employed

in the research.

4

Literature Review

The literature has explicitly accepted the existence of the problem of expectation gap. This can

be seen by the definition of the term by pierce and kilcommins (1996), who observe that the

audit expectation gap exist when the external auditor’s understanding of their role and duties is

compared against the expectations of user group and the general public. Tricker (1982) viewed

the expectation gap as the result of a natural time lag in the auditing profession identifying and

responding to continually evolving and expanding public expectations. Other authors argued that

it was the consequence of the contradictions in a self-regulated audit system operating with

minimal government intervention as evidenced in Hopwood (1990) and Humphrey (1991).

Loggio (1974) further sees the expectation gap as the difference between the levels of expected

performance as interpreted by the independent accountant and the user of financial statements.

The two definitions above have established the existence of the problem of the expectation gap.

This has been echoed by the recent happenings in the financial reporting scandals of the Enron,

WorldCom, and Parmalat. Furthermore, Sutton (2002) observe that financial reporting is once

again at the cross road. Incidentally, both government and the auditing profession have reacted to

these developments. The Sarbanes Oxley act of 2002, the American institute of certified public

accountants statements of 2002 (AICPA, 2002a; SAS 99; AICPA, 2002b) are testimonies.

The next area of concern is to identify the areas of those expectation gaps as identified in the

literature. McEnroe and Martins (2001) have identified several expectation gaps between the

“audit partners” and the investor’s perception of the auditors’ responsibilities involving various

dimensions of the audit. They observe that the investing public does not want auditors to issue an

unqualified audit opinion unless every item of importance to investors and creditors have been

reported or disclosed, the financial statements are free of misstatements resulting from

management fraud, auditors have been public watchdogs, internal controls are effective, the

financial statements are free of misstatements intended to hide the firm, and has not engaged in

illegal operations. They therefore, identified the following areas of the expectation gap as:

i. Full Disclosure

ii. Public Watchdog

iii. Effective internal controls

iv. Management Fraud

5

v. Employee fraud and

vi. Illegal acts

The expectation gap generally, stems from the differing expectations of the function of

independent audit between the auditors and the public. Sweeney (1997) listed out the areas

where difference in expectations mostly arises: going concern, fraud and illegal acts,

independence, and duty of care.

The empirical study by Humphrey (1991) with reference to England is an extension of first

studies and the main conclusions include expectations gap in auditors’ role in fraud detection; the

extent of auditors’ responsibility to this party; the nature of balance sheet valuation; threats to

auditors’ independence; and auditors’ ability to cope up with risk and uncertainty. He also adds

“If any topic can be classified as going to the heart of the audit expectations debate, it is the issue

of auditor independence.” Humphrey et al. (1992) stated that the “auditor independence is a key

element of the audit expectation gap”.

In an attempt to find solution to the issue of the expectation gap McEnroe and Martins (2001),

suggested that “the appropriate action to reduce these expectations might be in public education”

They suggested two approaches to the public education. First, the inclusion of a uniform

explanation of what the attest function is designed to accomplish in the annual report. This is

expected to include a condensed summary of the authoritative guidance regarding auditors’

responsibility. Secondly, auditors provide a similar explanation at the annual shareholders’

meeting. This might include a question and answer session regarding the nature and scope of the

audit. Therefore, it is expected that educating stakeholders on what an audit is designed to

accomplish and communicating what the auditor’s responsibilities are, will reduce the gap

between what stakeholders expect the auditor to achieve and what they can reasonably achieve.

Porter (1993) opined that the two strategies are appropriate corrective actions for the

reasonableness gap component of the expectation gap.

Furthermore, in the search for a solution to solving the problem of the expectation gap, Sikka et.

al., (1992) identified independence as the main cause to reduce the expectation gap. He stated

“as a first step towards reducing the expectation gap, auditing standards and hence audit

objectives should be shaped by open, democratic, accountable bodies, independent of the

6

accountancy profession”. Continuing arguments on reducing audit expectation gap, he

recommends one of the steps to be taken by the profession to reduce the expectation gap as

reform relating to auditor independence. Directly related to the independence issue is auditor

appointment and the role of directors and senior management in that appointment.

Sutton (2002) suggest that the auditing profession has, in the past, taken the following

chronological approach to addressing expectation gaps

i. Deny the existence of deficiencies (as it relates to deficient standards)

ii. Entertain suggestions for improvements

iii. Agree to accept some proposed suggestions

In the empirical literature, Garcia-Benau and Humphrey (1992) investigated the expectation gap

in both the UK and Spain. Auditors, finance directors and users were asked, inter alia, whether

audit firms should not provide NAS to their audit clients. In both countries, the average response

was close to neutral for all groups except UK auditors who expressed strong disagreement.

The Beattie et al., (1988; 1999) study examined a large set of 45 economic and regulatory factors

that could impair or enhance auditor independence, using questionnaire surveys of UK audit

partners, finance directors and financial journalists. At a level of 50 per cent of audit fee, the

corresponding threat rankings were firth, tenth and seventeenth and at the level of 25 per cent of

audit fee they dropped to fourteenth, eighteenth and twentieth ranks. NAS fees also increased

economic dependence generally, and all groups ranked various measures of economic

dependence among the top threat factors. A survey taken up by Lin (2004) in China with respect

to audit objectives, auditor's obligation to detect and reporting frauds and third party liability of

auditors. The study evidenced the emergence of the expectation gap in China and the majority of

audit independence by reducing governmental control or intervention and moving towards self-

regulation of the profession. This study has a limitation in the sense that it should cast light on

understanding of the institutional setting and updated development of independent audits in

China and may also serve as an annotation to the recent accounting reform debates in the western

world. This study investigated the views of natural shareholders regarding the role of the effects

on independence due to the audit firm also providing non-audit services to their audit client. A

total of 615 questionnaires were received with an overall response rate of 37.50 per cent.

7

Shareholders were asked whether they agreed that the independent audit enabled them to rely on

financial information of profits, dividend yield/payout ratios and assets/liabilities. The responses

of shareholders generally confirmed that the independent audit was important in their use of

financial accounting information. Similarly, the reliability factors for the audit report of the

independence of auditors and audit firm reputation were tested. Both were believed to add

credibility to the auditors’ report.

Further discussion involved shareholder perception of audit independence in three separate

instances: audit firm receiving substantial consultancy fees; the auditor holding shares in the

audit client and the same auditor had been retained for over seven years. Shareholder opinions

revealed that auditor independence was perceived to have been impaired by the substantial

consultancy fees paid, but to a lesser extent by share ownership. Long-term audit contracts were

not perceived to impair auditor independence. This study also refutes the idea that auditors could

maintain their independence when receiving substantial consultancy fees. Overall, the findings of

this research suggest that natural shareholders place a strong reliance on regulatory matters such

as the accounting standards and the corporation’s law for accounting information.

Alleyne et al., (2006) investigated the appearance standard by empirically exploring both

auditors’ and users’ perceptions of auditor independence in Barbados. Firstly, the study

contributed to the existing body of knowledge in terms of providing a better understanding of the

nature of auditor independence in small developing countries. Secondly, this study could inform

policy makers, governments and professional accounting bodies as to how auditor independence

policies and frameworks could be structured to ensure adequate regulation of the capital market.

Thirdly, their study would serve to educate users and auditors about the contextual factors

surrounding the role of auditor as well as the possible threats and enhancements factors affecting

auditor independence. The survey instrument was divided into two sections: section one dealt

with demographic factors and section two focused on 39 audit-related issues categorized under a

number of generic factors. The sampling respondents identified comprised several groups such

as auditors, financial directors, credit managers, investment analysts, fund managers,

shareholders and government departments. The sample respondents comprised 66 auditors and

148 users. The findings of the study revealed that economic dependence of auditor on the client,

8

the provision of non audit services, high competition, small firm size, being a sole practitioner,

lengthy tenure and the size and closeness of Barbadian society were found to negatively affect

perceptions.

Conclusively, we can understand from the literature that the problem of audit expectation gap is

a phenomenon that has been widely recognized. Therefore, an attempt to document the extent of

its existence and the way forward for its correction in Nigeria will be a welcome idea. The

methodology to be used in the research will be explained in the next section of this paper.

2. Methodology

The main objective of this research is to establish whether there exist the audit expectation gap

and that those areas of concern, (areas that brought about the creation of misunderstanding

between the public and the audit profession) could be identified and measures could be taken to

either eliminate them or reduce them to the beeriest minimum. In order to achieve the above

aforementioned objective the following procedure is followed.

3.1 Research design

The paper develops questionnaire based on the method used in Best et al (2001) who studied the

expectation gap in Singapore, Nazri et al (2004) in Malaysia, Chowdhury et al. (2005) in

Bangladesh and the study of Salehi et al. (2009) in Iran. The process ensures that data is

collected for the public’s expectation on the issues of the expectation gap and subsequently and

side by side we shall compare the issues with the audit authorities required or expected

perspective.

In collecting the data for the research the questionnaire method will be used; specifically the

questionnaire contains three parts namely;

Part A, which contains the respondents’ bio-data, this will help in measuring the

competence of those respondents to the questionnaire and in a way depicting the

reliability of the outcome of the research.

Part B, which contains questions on areas of the audit gap. They are targeted at

establishing the major reasons why the gap exists. Therefore issues such as the

importance of the audit are raised. Furthermore, the sections ask questions on the

9

importance of financial reports, directors and company profile, and the level of auditor

independence.

Part C, the conceptualization of the social framework and the definition the audit is

analyzed here. The section tries to see the issue of the fixed and variable aspects of the

audit definition.

The distribution of the questionnaire will cover the following respondents that comprised of

several groups such as the auditors, financial directors, credit managers, investment analysts,

fund managers, shareholders and government departments. The sample respondents will

therefore cover almost all the facets of the expected areas of the audit expectation gap.

3.2 Methods of data analysis

The measure instrument of the statements is a five-point likert type scale anchored by a five scale

from “strongly disagrees” to “strongly agree”. To test for the significant expectation gap between

the two parties of respondents, both the parametric and non parametric statistical tests would be

used. In terms of the distribution of the questionnaire, we shall use both the mailing approach

and direct approach. We shall make two tests for non-response bias via the “wave technique” as

it treats the two approaches as separate waves of responses (Stanley 2001; Kanuk and Berenson

1975; and Hawkins 1975). In the analysis the Mann-Whitney U test using a two tailed test would

be used as a non parametric statistical tool which is considered appropriate for ordinal

measurement, such as the likert scales that will be employed in this study. It tests whether the

two independent samples are from the same population. The parametric test of t-test is also used

as a compliment to test for the efficiency and reliability of the outcome of the study.

3.3 Justification for the use of the techniques

The method that will be used is quit adequate to allow for a conclusion on the investigation as is

scientific and ensures the capture of all variables in the study. The method ensures the inclusion

of all possible behavior expected from the variables and subjects used in the investigation.

3. Conclusion

The objective of this paper as stated earlier is to establish that there exist the audit expectation

gap in Nigeria and that those areas of concern could be identified and measures could be taken to

10

either eliminate them or reduce them to the bearest minimum. Furthermore, the research intends

to identify the effect of social framework on the definition of the audit perception. To achieve

this, the paper develops questionnaire based on the method used in the literature. The process

ensures that data is collected for the public’s expectation on the issues of the expectation gap on

the one hand. Subsequently and side by side we compare the issues with the audit authorities

required or expected perception.

The data collected is analyzed using a five-point likert type scale anchored by a five scale from

“strongly disagrees” to “strongly agree”. To test for the significant expectation gap between the

two parties of respondents both the parametric and non parametric statistical tests would be used.

In terms of the distribution of the questionnaire we shall use both the mailing approach and direct

approach. The Mann-Whitney U test using a two tailed test would be used as a non parametric

statistical tool which is considered appropriate for ordinal measurement, such as the likert scales

that will be employed in the study. It tests whether the two independent samples are from the

same population. The parametric test of t-test is also used as a compliment to test for the

efficiency and reliability of the outcome of the study. It is expected that whatever the outcome of

the research would be, policy recommendations based on the outcome of the research will help

policy makers, government and the general public in shaping their taught on how to specifically

forward the audit profession forward and generally the accounting profession to higher heights.

The accounting profession can benefit from the research work by developing either a manual that

will guide the operation of the auditors or promulgate enactments and policies that will make

auditors more responsive to their work, by so doing, it will help the auditors to protect them the

more against litigation and the public from the negligent performance of the auditors in the

discharge of their duties.

References

Adams A. C. and Evans R. (2004): Accountability, Completeness, Credibility and the Auditing

Expectation Gap. Greenleaf Publishing, JCC 14 Summer.

Adams Committee. (1977): Role of the Auditor, Toronto: Canadian Institute of Chartered

Accountants.

11

Beattie, v., Brandt, R. & Fearnley, S. (1999): “‘Perceptions of Auditor Independence: UK

Evidence”, Journal of International Accounting, Auditing and Taxation, Vol.8, No.1, pp: 67-107.

Best P J, Buckby S & Tan C. (2001): “Evidence of The Audit expectation Gap in Singapore”

Managerial Auditing Journal, Vol .16, No .3 pp: 134-144.

Carey,L. (1970): The Rise of the Accounting Profession: To Responsibility and Authority, 1937-

1969 (New York,).

Chenok, P.B. (1994): Perception vs. Reality, Journal of Accountancy. pp: 47-51.

Chowdhury, R, Innes,J and Kouhy, R. (2005): “The Public Sector Audit Expectation Gap in

Bangladesh”, Managerial Auditing Journal,Vol.20, No.8,pp: 893-908.

Chowdhury,R ,Jnnes , J & Kouhy , R. (2005): “The Public Sector Audit Expectation Gap in

Bangladesh”, Managerial Auditing Journal.Vol.20,No.8,pp:893-908.

Cohen Commission. (1978): Report of the Commission on Auditor Reasonability’s: Conclusions

and Recommendations. New York: American Institute of Certified Public Accounts.

Cross Committee. (1977): Report of the Committee Under the Chairmanship R1. Hon the Lord

Cross of Chelsea, Accountancy, 160, pp: 80-86.

DeAngelo, L.E. (1981): “Auditor Size and Audit Quality”, Journal of Accounting and

Economics, Vol.3, August, pp: 183-199.

Dunmore P.V Z & Falk, H. (2001): Joint Provision of Audit and Non-audit Services, Audit

Pricing and Auditor Independence, WP.

12

Fadzly ,M. Z & Ahmad,Z (2004): Audit Expectation Gap: The case of Malaysia. Managerial

Auditing Journal, Vol. 19. No. 7.

Fadzly ,M & Ahmad,Z (2003): “The Perceived Value of Financial Statement Audit” , Proceeding

of The International Conference on Quality Financial Reporting Corporate Governance, kuala

Lumpur,Malaysia.

FEE :( 1995): Auditor Independence and Objectivity, Position Paper. Bruseels.

Flint, D. (1988): Philosophy and Principles of Auditing, An Introduction. Macmillan. London

Fried, D, & Schiff, A. (1981): “CPA Switches and Associated a Market Reactions”, The

Accounting Review, April, pp. 326-341.

Gill G, and Cosserat G.. (1996): Modern Auditing in Australia, Fourth Edition Wiley and Sons

Australia.

Greenside Committee, (1978): “Report of the Joint Committee Appointed to Consider the Cross

report and related Matters”, journal of Accountancy. Vol. 161, pp; 124-132

Guy. D. & Suilivan, J. (1988): “The Expectations Gap in Auditing Standards”, Journal of

Accountancy.Vol.165, pp: 36-46.

Hille. (1993): “Expanding the New Zealand Audit report”, Accountants Journal, pp: 59-61.

Hopwood, A.G.. (1990): “Ambiguity, Knowledge and Territorial Claims: Some Observations on

the Doctrine of Substance over Form-S Review essay”, British Accounting Review, Vol. 22, No.1

Humphrey, C., Moizer, P., and Turley, S. (1992): The Audit Expectation Gap in the United

Kingdom, Report prepared for the Auditing Research Foundation of the research board of the

institute of chartered accountants in England and Wales, London, ICAEW.

13

Liggio, C.D. (1974): “The Expectation Gap: The Accountant’s Legal Waterloo”. Journal of

Contemporary Business, Vol.3, No.3, pp: 27-44.

McEnroe, J. E., Martens, S. C. (2001): Auditor’s and Investors’ Perception of the “Expectation

Gap. Accounting Horizons, Vol. 15 no. 4

Macdonald Commission. (1988): Report on the Commission to Study the Public’s expectation of

Audits, Canada, Canadian Institute of Chartered Accountants.

Mtcalf Committee. (1976): The Accounting Establishment, Washington D C: United States

Government Printing Office.

Mahdi S., Mansoury A., Azary Z. (2009): Audit Independence and Expectation Gap: Empirical

evidences from Iran. International Journal of Economics and Finance Vol. 1, No. 1

14