A Critical View of the Audit Expectation Gap and Audit Rotation

The audit of financial statements is mandatory for publically listed entities throughout the world. The auditor conducts various tests and based on the results forms an opinion on the truthfulness and fairness of the financial statements of the company and whether or not they are prepared in accordance with the financial reporting standards and are free from any material misstatement (Freedman, 2013). The purpose of auditing is to enhance the confidence of investors and to add credibility to the truthfulness of company 's true financial performance. However, there are some dos ' and don 'ts that an auditor must take care of. For instance, anything that threatens the independence of the auditor must be avoided as it adversely affects the truthfulness and objectivity of the opinion formed.

An important decision for any shareholder is deciding whether or not to do business with that company. When a business is audited, the operations are reviewed to make sure that nothing is being hidden. An auditor will review the company’s financial statement and practices to confirm that each are direct and correct. The financial statements are the business’s way of representing them and showing that they are following the Generally Accepted Accounting Principles. The audit process is an important one because it provides a platform for the auditor’s opinion concerning the financial statements of the company. As part of the audit process the auditor will conduct an audit plan that outlines a number of actions that he or she will be perform while also detailing the reason for those actions. With every audit, the business’s management is in charge of handing over the financial statements that the auditor will review; while the auditor will review the statements for any material or immaterial misstatements.

WUCHUN CHI, National Chengchi University HUICHI HUANG, Syracuse University YICHUN LIAO, National Taiwan University HONG XIE, University of Kentucky 1. Introduction Mandatory audit partner rotation has existed in the United States since the 1970s, when the American Institute of Certified Public Accountants (AICPA) required that audit partners in charge of Securities and Exchange Commission (SEC) audits be rotated at least once every seven years. The Sarbanes-Oxley Act of 2002 (SOX) further strengthens this requirement by mandating a five-year rotation for the lead and concurring partners. An implicit assumption in a policy of mandatory partner

In October 2001, Enron Corporation which was one of the world major energy, commodities and service companies with claimed revenues of nearly 111 billion dollars during 2000 collapsed under the weight of massive fraud in that it has become largest bankruptcy recognition in the US economy. Enron’s earning report was extremely skewed that losses were not represented in their entirety, prompting more and more wishing to participate in what seemed like a profitable company. After collapse of Enron, Auditor independence has become a social issue that weather auditor has to be independent or not. In addition, while auditing must consider matters objectively with dispassion, there were still doubts whether it implemented well. Further, there has been much speculation about the need for the mandatory rotation of auditors or audit firm rotation to warn false accounting between audit firm and client. By examining Enron case, this essay will discuss about advantages and drawbacks of the mandatory rotation of

This title consists of 9 sections that instruct in the behavior of auditing firms and establish guidelines for external auditor independence. It also sets restrictions for clients outside of auditing boundaries and requirements for audit partner rotation.

Sec. 207. Study of mandatory rotation of registered public accounting firms, requires the Comptroller General of the United States to conduct a study on the potential effects of the mandatory rotation of auditors and submit a report within one year to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of the study and review required by this

Part two, entitled auditor independence, helped create a statutory code of ethics for public accounting firms. New, specific regulations were set up to dissuade ethic violations. A list was created of consulting services that audit companies cannot perform for companies that they audit and senior management conflicts were resolved by not allowing audit firms to audit if a senior manager was a former employee of the audit company. Auditors were required to rotate the companies that they audit every five years and auditors must report to an audit committee. Laws and regulations for accounting firms were encouraged. (Jennings, 2012)

The audit risk model has provided a conceptual framework for auditing practice for more than 40 years. Despite practical difficulties in implementation and criticisms of its theoretical foundation, the model has been fairly effective in helping auditors analyze risks and use that analysis to determine the nature, timing, and extent of audit procedures (especially substantive procedures) in audits of financial statements. The audit risk model provides a conceptual framework for the risk assessment standards.

● enhance the independence of the audit partner in charge by a system of rotation and is not compatible with consulting and auditing services ;

If these standards are not followed there are strict consequences that could cause the loss of designation and even criminal charges. Also, small accounting firms with few clients that make up a large percentage of their income may face an even greater power imbalance between client and auditor. Recommendations such as rotating audits periodically or rotating partners within a firm every 5 years have suggested as ways of keeping independence and ensuring that the auditors are focused on job quality versus keeping the audit and getting paid. However, the best method would be if a special board were set up to investigate why auditors have been fired. If during the investigation it is revealed that disagreement occurred between management and auditors over financial statements and presentation then a third party should be involved. Although there are new accounting policies and bodies in place to restrict this power imbalance; it will never be fully eliminated.

The consensus of the committee was that the expectations from audits were too high. They went on to elaborate on the lack of precision and exactness of financial statements and that the public was demanding a degree of certainty in their audits that could not be achieved. This has historically been labeled the “expectations gap”

In response to the wave of corporate crises, the Sarbanes-Oxley Act includes a provision regarding mandatory audit partner rotation for firms auditing public companies. This should not be confused with audit firm rotation and it is important to make the distinction. The Act requires the lead audit partner and audit review partner (or concurring reviewer) to be rotated every five years on all public company audits. The Act requires a concurring review of all audits of issuers (as defined in the Act). The focus of this document is audit partner rotation. However, it also discusses the circumstances in which audit partner rotation can be tantamount to audit firm rotation.

Auditors are required by GAAS to understand their clients’ incentives and to search for differences between actual and expected performance that may indicate misstatements, so the auditors who participated in our study were relatively well positioned to identify specific instances of earnings management. Because respondents provided transaction-level data about attempts covering a range of financial accounting transactions, including attempts that are purely judgmental as well as attempts that involve transaction structuring, these data allow us to examine how attempts are affected by the precision of financial accounting standards2 and by other characteristics of attempts. Unlike studies that focus on only postaudit information, we consider separately managers’ decisions about how to attempt earnings management and auditors’ decisions about whether to require adjustments.3 Thus, our study provides evidence about how a key feature of accounting standards (precision of rules) and a key feature of the financial reporting process (activity of external auditors) influence earnings management. Results of descriptive analyses indicate that the earnings management attempts in our sample occurred in numerous accounting areas, including revenue recognition, business combinations, intangibles, fixed assets, investments and leases, but by far the most frequently identified attempts involve reserves. Respondents believe that managers’ attempts were motivated

Neutrality is the essence of unbiased scepticism. According to CICA handbook (2003), an auditor is required to perform with a questioning attitude, having in mind that there may be the existence of financial misstatement. It also indicated that being skeptical requires critical thinking upon evidence obtained through the auditing process, and is alert for questionable documents regarding the entity representations. However, it does not mean an auditor should be obsessively suspicious about anything. Instead, it is suggested to have the capability to reach the balance without speculated dishonesty or unquestioned trust. An objective evaluation should always be guaranteed, and a neutral auditor should always present a suspension of judgement until having evidence or proving the otherwise.

The lack of independence for external auditors will lead to the neglect of auditing risks (William R.K., 2003), which are the main reasons for the failure of certified accountants and professional accounting organizations. The consequence of the external auditors deprived of independence would be very serious. And there are many cases, which aroused by the failure of external auditors and most are related to the lack of independence. One famous example is the bankruptcy of Enron and the role played by its external auditor, Arthur Andersen (Todd, S., 2003). Arthur Andersen was once one of the biggest accounting companies in the world, and was canceled for the involvement in the Enron bankruptcy scandal.