This document has once again stressed the importance of the audit function in financial reporting and its efficient functioning in capital markets and its impact on cost of capital. In reviewing audit quality the discussion paper examined various ‘drivers’ of audit quality: the regulatory framework; audit review processes; audit firm arrangements and processes; the reliability and usefulness of audit reporting; and other factors outside the control of auditors that affect ‘audit quality’.
You are required to:
- Describe briefly what might be regarded as ‘audit quality’ and how ‘audit quality’ might be assessed.
- Outline and discuss how auditor’s independence might impact ‘auditquality’.
- Outline and discuss how the audit expectations gap might impact ‘audit quality’.
Auditing is the method of investigating the financial records of a business organisation for ascertaining if they are correct and they are in line with the applicable regulations, rules and laws. For maintaining accuracy, audit quality is considered as an important phenomenon while evaluating the financial records of the organisations (Abbott et al. 2016). The current essay would focus on elaborating the concept of audit quality and the ways through which such audit quality could be assessed from the perspective of the auditors. The second segment of the essay would focus on highlighting the effects of auditor’s independence on the overall audit quality. Finally, the essay would shed light on evaluating the impact of audit expectations gap on audit quality.
Audit quality and ways of assessing audit quality:
Audit quality is a difficult term to be defined from the accounting perspective. However, from theoretical viewpoint, the audit quality could be described as a general standard used for measuring the capability of the auditors in performing their obligations (Bell, Causholli and Knechel 2015). The audit regulators have defined audit quality as the understanding level, which the auditors possess regarding the major risks that could affect the financial statements and the effective ways through which they could devise out an audit plan for mitigating those risks.
The audit quality above is defined from the theoretical perspective; however, in reality, the definition is different. According to Cahan and Sun (2015), audit quality in practice describes the actions undertaken by the auditors for accomplishing greater audit quality. The issue here is to determine the indicators of greater audit quality and the ways through which it could be evaluated. In this instance, it is noteworthy to mention that the Sarbanes-Oxley Act of 2002 played a significant role in depicting audit quality. This act is considered as the major player in improving audit quality with the help of its regulations. The act mandates the audit committees to be responsible for all dealings about the external auditors that take into consideration oversight as well (Cameran, Prencipe and Trombetta 2016).
As per the “Concept Release on Audit Quality Indicators” of PCAOB, 28 potential indicators are present through which the audit quality could be assessed and they lie within three groups. The initial group comprises of the audit professionals that denote competence, availability and focus of the individuals conducting the audit work. The second group involves the audit procedure, which is associated with the tone at the top, incentives, independence, leadership and other aspects of the audit firm. The last group takes into account the audit outcomes, which is viewed to be the group associated with the technical parts of the audit engagements. These engagements include going concern, financial statements, litigation, internal controls, communication between audit committees and auditors and enforcement (DeFond, Erkens and Zhang 2016).
All these indicators emphasise on enhancing and providing a way for the individuals in analysing the audit quality. Moreover, these indicators intend to improve discussions among interested parties and thus, competition could be stimulated unintentionally from the end of the audit firms depending on quality. Furthermore, along with these stated goals, such indicators might enhance the reliability and credibility of audits. Thus, the improvement of audit quality would play a crucial role in enhancing the feasibility and resilience of the audit profession (Eshleman and Guo 2014). Finally, it could be stated that all these aspects taken together would help in assessing the overall audit quality.
Impact of auditor’s independence on audit quality:
It has been argued by various scholars that the auditor’s independence have direct effect on the quality of audit by putting forward a number of theories. There are four significant threats to the independence of the auditor arising from client-auditor relationship. They include client importance, non-audit services, auditor tenure and affiliation of the client with the audit firm (Ettredge, Fuerherm and Li 2014).
For client importance, when there is failure of audit, the auditor might be subject to legal actions raised from the end of the associated stakeholders, which mainly include the investors or regulatory agencies. When such event happens, the goodwill of the auditor would fall eventually and this would result in loss of fees of the auditors from the other clients as well. Hence, this increased risk of litigation might be an incentive for the audits to stay independent, instead of economic dependence. However, majority of research associated with economic dependence emphasises a significant concern on the part of the auditors and from the perspective of the client, adequate research has not been conducted (Goodwin and Wu 2016).
In case of non-audit services, the auditors have an economic interest of providing non-audit services to the audit clients. The non-audit services are deemed to be more profitable. In the research work of Guan (2014), it has been studied whether there has been loss of objectivity of the auditors because of non-audit service provision. As per the findings of the research, no significant evidence of negative impact of non-audit services on propensity could be identified for issuing the opinion of going concern. However, the issuance of audit report of going concern is more probable at the time the non-audit service level increases, which are obtained from industry analysts (He et al. 2017).
In case of auditor tenure, the incentive of the audit partner might conflict with that of the audit firm. According to the work of Krishnan, Krishnan and Song (2016), the increased audit partner tenure with the client raised the identification of the auditor with the client, which raise the probability of the auditor acquiescing to the preference of the client. This implies that the auditors dealing with the clients might become associated with the client, which could result in substandard audit. Therefore, it is necessary for the auditing firm to maintain their reputation by remaining independent of its audit client. Moreover, it is noteworthy to mention that when the tenure of the auditor is more than five years, the users of the financial statements perceive that the auditor’s independence is not minimised. In fact, higher tenure is related to improved earnings quality, according to the perceptions of the investors in the equity market. This implies that the impact of earnings on share rankings and forecast of the analysts rises with the tenure of the auditor. However, according to the perception of the non-professional investors, the auditor’s independence could be strengthened with the presence of strong audit committee.
In case of affiliation of clients with the audit firms, there might be three reasons that would result in impairing the auditor independence in relation to client employment issue. The first reason is that the auditors might see their clients as the employers. Secondly, the closeness with the management might lead to a distance between the shareholders and auditors and thirdly, the audit team might encounter difficulties to maintain its independence at the time of dealing with their previous colleagues (He et al. 2017). When the independence of the auditor is affected in such a situation, favourable audit opinion would be issued to the client, if even there is presence of material misstatements in the financial reports. Therefore, this aspect could affect the audit quality adversely.
Impact of audit expectations gap on audit quality:
The audit expectations gap takes place at the time there is a variation between the users of the financial statements and the expectations of assurance providers. If any gap is identified, it implies that the notions of the users are not in line with the performance of the auditor in the auditing process. A gap generally takes place when the users of the financial statements need more information than those provided by the auditors (Lamoreaux 2016). However, the users sometimes have unrealistic views. Some unrealistic demands include complete assurance of the auditor, ensuring the future viability of the organisation, unmodified audit opinion, detection of fraud and checking each business transaction. However, in reality, the auditors do not perform these functions. Instead, they provide reasonable assurance, unmodified audit opinion when there are no material misstatements, testing a sample of transactions. The auditors do not ensure the financial viability of the business organisations and they do not provide guarantee about the existence of fraud.
The auditors could not fulfil the demand of the users due to the fact that the expectations of the users are not reasonable. However, it is to be noted that reasonableness could be found in the expectations of the users beyond the need of the current standards. This implies that there is scope of improvement for auditing standards and they could be strengthened to fulfil the expectations of the users in future. Moreover, it is probable that there are some auditors not providing the users with adequate information. This is due to the fact that they are not adhering to the necessary auditing standards (Lennox, Wu and Zhang 2014). Under such situation, the auditors could be obliged to face prosecution or they could be sued for such acts. The outcome is that the auditors performing beyond the approved standard are still thought to be performing ineffectively. Thus, the audit expectation gap could be attributed partly to ineffective performance from the end of the auditors.
The quality gap is a sub-element to the expectations gap in audit. The auditing standards fetch a significant foundation aiding audit quality. More precisely, the “International Standards on Auditing (ISA)” issued from the end of IASB emphasise on the objectives of the auditors by setting minimum requirements (Tepalagul and Li 2015). However, maximum requirements in ISA provide a framework for judgements made in audit or require judgement for effective application of the same. Finally, the declining quality of professional work in audit is one of the significant causes for the occurrence of the expectations gap. Therefore, it is taken into consideration the improvement of audit service quality as a method of minimising the audit expectations gap.
It is prominent from the above discussion that audit quality is a significant aspect while determining the financial accuracy of an organisation. This is because the absence of effective audit quality would provide inaccurate valuation of the financial statements of the organisation. It has been evaluated that as per PCAOB, there are 28 potential indicators through which the audit quality could be assessed. Moreover, client importance, non-audit services, auditor tenure and affiliation of the client with the audit firm are identified as the four threats to auditor’s independence that could have impact on audit quality. Finally, it has been found that the audit expectations gap occurs due to a variation between the users of the financial statements and the expectations of assurance providers. If any gap is identified, it implies that the notions of the users are not in line with the performance of the auditor in the auditing process.
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