The Role of Auditing and Audit Markets

In the U.S., there are approximately 13,000 publicly traded companies registered with the Securities and Exchange Commission (SEC) and approximately 6,000,000 private companies. These companies conduct transactions with other companies or customers. In order for companies, or customers, to determine if they want to conduct such transactions, they nee to gather information to assess the financial health and risk of their present and potential trading partners. To satisfy this need for information, companies publish their financial statements that represent their report card on performance. Demand for Auditing: These financial statements are prepared by a companys own management. Readers of these statements may be skeptical because there may be incentives for managers to report optimistic or false performance. To reduce the possibility of intentional or unintentional errors and to add credibility to managements self-reported financial performance, the SEC required in 1934 that all publicly traded companies must engage a certified public accountant (CPA), an auditor, to verify and report on the fairness of these financial statements. Many private companies also seek added error-detecting controls and enhanced credibility for their financial statements and voluntarily engage an auditor. Responsibilities of Auditors: In order for a CPA to conduct an audit, he/she must be totally independent from the client, and competent to evaluate the clients industry and environment. Independence and competence represent the foundation for auditors, given that auditing is not an exact science but requires vast degrees of professional judgment. Auditors must plan and conduct their audits based primarily on their judgments given that the auditing profession has prepared only some broad-based guidelines called Generally Accepted Auditing Standards (GAAS). Examples of GAAS are that auditors should observe a clients inventory and send confirmation letters to verify a clients accounts receivable. Auditors Report: The auditor conducts the audit with the intention of reporting that the financial statements present fairly the financial position of the client. Financial statements are deemed to present fairly the true financial position if they are prepared in accordance with Generally Accepted Accounting Principles (GAAP). The auditors report is attached to the companys financial statements that describes the scope and results of the audit. The auditors report is addressed to the Board of Directors and to the stockholders. Clients that have prepared financial statements that are in accordance with GAAP receive an unqualified (sometimes called a clean) audit report. Clients desire such audit reports and approximately 75% of the companies in the U.S. receive unqualified reports. However, auditors will mention in their reports any departures in reporting. Departures from an unqualified opinion

arise when the client has questionable longevity (e.g., near bankruptcy), is involved with uncertainty (e.g., litigation), has changed their accounting procedures, has limited the auditors scope of examination, or has prepared financial statements in violation of GAAP. Types of Opinions: (i) Unqualified opinion with explanatory paragraph: (a) if there are uncertainties affecting the financial statements (e.g. litigation outcome), (b) if there is substantial doubt about the companys going concern status (e.g. financial distress), or (c) if the statements are not consistent with previous years due to changes in accounting principles. (ii) Qualified opinion subject to: if there is a departure from GAAP which is material but does not overshadow financial statements as a whole. (iii) Adverse opinion: if there is a departure from GAAP which is so material that overall fairness is in question. (iv) Disclaimer of opinion (no opinion): (a) if the auditor lacks independence, (b) for specific statements that are not audited, e.g. quarterly financial statements, or (c) if there are scope limitations such that the auditor is unable to verify certain items. In essence, departures from unqualified reports represent the auditors signaling to financial statement readers that there are material issues of concern. Research has shown that this is often an important signal in that clients stock prices have significantly declined when the auditor issues something other than an unqualified report. The Expectations Gap There is a vast difference in the perceived role of the auditor by financial statement readers and the actual role of the auditor. This perception difference is called the Expectations Gap. This gap relates to the users interpretation that an auditor verifies the total accuracy of the statements while the audit is actually based upon testing small samples, estimates, and is intended to discover only material misstatements. Also, the audit is not structured to detect management fraud or collusion. The auditing profession has attempted to bridge the gap by more carefully reporting their procedures and educating the public on their role. While the client engages the auditor to verify their financial statements, the auditor is charge to act in the best interest of the users of the financial statements. In 1984, the U.S. Supreme Court reiterated this issue when they called auditors the public watchdogs for society. This causes a potential dilemma for auditors in that they are hired by the client, paid by the client, interact with the client, and report to the client, but are expected to act in the best interest of a large, often unknown, diverse group of users with diverse needs.

Legal Liability: This dilemma has contributed to the most pressing issue facing the auditing profession, legal liability. The six largest audit firms recently claimed that they spend 9% of their gross revenues defending and settling legal claims. These costs have become so large that in 1994 many auditing firms restructured their organizations from partnerships to Limited Liability Partnerships (LLPs) which restricts their liability exposure to the wealth of the audit partnership, but not the partners individual wealth.
The auditors assertions in legal liability claims are often that they are being unjustly held responsible for the losses of shareholders and creditors because of their deep pockets and the legal doctrine of joint- and-several liability. Joint-and-several liability holds the auditor liable to pay for all the damages to the investors or creditors, even if the auditor was responsible for a small fraction of the misstatement, if the other parties who were primarily responsible for the misstatement are unable to provide compensation for the damages.

The users assertions in legal liability claims are that they made poor decisions based upon inaccurate financial statements. The users file lawsuits claiming that the financial statements contained material misstatements that the auditor should have detected and corrected. In 1988, the U.S. Supreme Court ruled that investors need not have even read the materially misstated financial statements to be involved in litigation against the auditor, because an efficient market would have impounded the inaccurate information for the investors.