1|Page

Audit theory and practice

“Assurance services can add credibility by providing an independent report on

subject matter, ranging from the design of a system of controls to a company’s
financial statements and beyond.”( ICAEW, 2013)
2|Page

The аudit prоcеss plays a key role for organisations and improves the decision-

making process. It can also be regarded as an assessment which provides

assurance of the truth and fairness of the financial information presented by the

directors. According to the HMRC Enquiry Manual audit can be defined as “the

independent examination of, and expression of opinion on the financial

statements of an entity by a duly appointed auditor’’. The intention of this essay

is to reach a conclusion with a view of determining the gains arising from the

audit process in the United Kingdom and the expectations of the stakeholders in

respect of it.

Audit and assurance services have a fundamental part to the success of financial

markets as they are essential features which companies adopt, in order to

improve the quality of their information. Meanwhile, there are various

stakeholders that have expectations from an audit, but the main focus of the

purpose of an audit is mainly concerned with the relationships between

shareholders, manager and auditors. Quality and reliable financial information is

pursued by all stakeholders, in order to make smart and well-informed decisions.

Audits are one form of assurance and the purpose for the latter is to offer

competent and independent opinions and decrease the risk of misleading

information. For instance, the assessment of the truth and fairness of financial

information and the reflection on a company`s financial position at a given date

is an assurance service and the gold standard for this remains audit

(ICAEW,2013).

The lack of knowledge of the shareholders, since they are not engaged in the

day-to-day affairs of the business, may be minimized by the auditor`s report аs

it acts as а link bеtwееn both the sharеholdеrs and the management. However,

the auditors’ expert opinion is intended to benefit the shareholders, as well as

3|Page

the public, so that the various stakeholders can make decisions on the basis of

the audit reports. While the financial statements may contain estimates and

judgments, there may, therefore, be a range of true and fair opinions, but the

audit should ensure that shareholders that no material errors exist. Material

misstatements can be described as the difference between an amount, balance

or disclosure and the correct treatment in compliance with the financial reporting

standards. Since there is a time lapse between the financial year and the audited

financial statements given to the shareholders there can be subsequent events

which would be reviewed only briefly. Inconsistencies can also be caused by a

genuine mistake and errors or fraud, and auditors should try to reduce the risk

of the audit to an acceptably low level. In result the financial statements will be

helpful to a broad range of users in decision-making as they serve as an

instrument to present the financial position of an enterprise.

Statutory external audits are essential because they increase and improve the

credibility and legitimacy of the financial information and, therefore, shareholders

can rely on the accuracy of the information given. In exchange for shareholders

to invest money in a company, they require the financial information about the

company so the success of their investment and the achievements of the

enterprise can be monitored. Consequently, directors must prepare certain

information that must be given to the shareholders annually in compliance with

the Companies Act 2006. Since the financiаl statements should dеmonstratе the

financial performance of the enterprise an audit must be conducted, in order to

prevent the directors from deliberately or unintentionally providing the

shareholders with deceitful and inaccurate information. The auditor must be

trained in auditing and independent from the company. With the purpose of

ensuring that the shareholders` rights are retained and no advantage is taken,
4|Page

the auditors are regarded as agents acting on their behalf. Once the audit is

complete, an audit report must be prepared to reflect the auditors ' view and

judgement as regards the accuracy and honesty of the financial statements.

(Rulund & Lindblom, 1992). In cases where the requirements are not fulfilled in

the view of the auditors, this must be stated in the report. In the opinion of Lord

Oliver of Aylmerton ’’it is the auditors` function to ensure , so far as possible, that

the financial information as to the company`s affairs prepared by the directors

accurately reflects the company`s position in order, first to protect the company

itself form the consequences of undetected errors or, possibly, wrongdoing (by,

for instance, declaring dividends out of capital) and, secondly, to provide

shareholders with reliable intelligence for the purposes of enabling them to

scrutinize the conduct of the company`s affairs and to exercise their collective

power to reward or control or remove those to whom that conduct has been

confided.’’

The Agency theory provides an explanation both on the purpose and significance

of the relationship between the principal-the shareholders and the agents-the

directors and the management. The agents are employed on the behalf of the

shareholders in an attempt to maximise their wealth, however different issues

may arise as their objectives, priorities and interests may not be always in

alignment. In order to measure and evaluate the stewardship of the directors and

their performance, the opinion and judgement of an auditor is used. Choosing a

skilled external auditor will be beneficial since this is the most cost-efficient way

to monitor that the agents do not act in their own best interest which may be

contrary to the principles and objectives of principals (Gray, Manson &

Crawford,2019).
5|Page

Even though the key statutory objective of an audit is to provide shareholders with

an independent opinion, in reality, there are also other parties who are often

referred to as stakeholders who can also take advantage of this process. Those

are the people who are affected by the organization’s actions, objectives and

policies (Freeman,1984). As explained by Evan and Freeman (1993) companies

have to ensure that the rights of the various stakeholders such as its shareholders,

directors, management, audit regulators, regulators of organisations, creditors

and lenders, auditors, employees and others are considered and safeguarded, as

those groups are crucial to the success of the company. There are likely to be a

number of sеvеrаl cоntrаsting and evеn cоntrаdictоry rеquirеmеnts and

expectations within each stakeholder`s group. If all requirements of the

stakeholders are taken into consideration the volume of the information, for

instance, would probably increase dramatically. The reason for this is that various

stakeholders have different criteria, which can lead to problems regarding the

clarity and relevance of the information. Nevertheless, any benefit or value to the

stakeholders derived from the audit process must be regarded not as the main

and primary purpose but as a by-product and consequence (ICAEW,2006).

The expectation gap is an undoubtedly extensive and wide-ranging issue existing

for many years that emerges between the stakeholders and the auditors. It can

be defined as the gap between the perceptions of the public and what an audit

can actually achieve (Liggio,1974). The expectations and value of the individual

stakeholder also may shift during the years as a result of the level of information

provided in the financial statements. The more valuable the stakeholder is based

on the relationship and its ability to influence decisions on a particular enterprise.

Sinсе the аudit еxpеctаtions wеrе first еstаblishеd, thе mаrkеt climаtе hаs

chаngеd significаntly, with the cоrpоrаtе crisis аffеcting finаnciаl rеpоrting,

6|Page

corporate governance, auditing procedures and audit regulations. Although the

audit itself has significantly changed, the gap in the expectations has remained as

the perceptions developed as the audit evolves. In line with the Association of

Chartered Certified Accountants (ACCA,2019), the audit expectation gap can be

broken down into 3 smaller categories: knowledge gap, performance gap and

evolution gap.

The difference between what the public thinks auditors do and what actually they

do can be described as the knowledge gap. The studies of Humphrey et al (1992)

showed the main substantial misunderstanding gap is to the expectations of the

auditor`s roles rather than the perceptions relating to the compliance of the

accounts to the laws and the general accepted accounting standards. For instance,

there is a common public misconception that auditors check all transactions and

their role is to prevent the company failure rather than actually check a sample.

Audits may identify some conditions that could lead to company failure in relation

to the going concern concept or any deficiencies but there are risks and issues

that may not be addressed. The audit cannot be regarded as absolutely correct

but as a reasonable assurance. Thus, this responsibility remains with the

management of the company. In agreement with ACCA (2019) view, reducing the

knowledge gap will require all the involved parties in the audit process to minimize

this gap as they ensure that the public is aware of audit legislation and

requirements in a fair, consistent, transparent and understandable manner.

According to Defliese et al. (1988) the public should have realistic expectations

about auditors’ duties and the outcomes from the audit process. Over expectations

and lack of awareness of the limitations of the audit can increase the gap and it is

important to improve and develop the knowledge of the audit users. One way to

do this would be creating strategies to improve communication between updates

7|Page

to existing audit requirements and regulation or standards that need to be

available to the general public in order to decrease it. Media could provide further

aid in educating the public by clearly defining the audit requirements about

changes made to current audit legislation to allow the public to have a better

understanding about the audit.

The performance gap reflects on the expectations that arise when auditors do not

comply with auditing regulations and standards due to lack of focus on audit

quality. With a view to ensure that quality audit is performed by audit firms, they

are required to establish systems and processes which has to be in line with the

legal requirement and regulations. Global organisations such as the International

Federation of Accountants (IFAC) and International Auditing and Assurance

Standards Board (IAASB) ensure that accountants and audit practitioners serve

the public interest. Moreover, the standard setters must strive to define the

standards as clearly as possible and avoid creating requirements hard to

implement in an objective manner, as this can increase and reinforce bias.

(ACCA,2017). Audit companies must ensure that audit reliability is reached and

sustained by identifying and reacting to areas of persistently low performance.

The modern world is constantly changing and new advances are being developed,

which can be used to enhance the audit process and create additional benefits to

the public`s demands. The evolution gap arises between what the auditors are

supposed to do and what the public wants them to do. The recognition of

knowledge and performance gaps is a major milestone to understand and identify

what needs to me improved and developed in audit, in order to prevent

overregulation or unreasonable changes in auditing practices where lack of

knowledge and poor performance could be the real problem. Reasonable

assurance (ISA 240) also must be obtained ensuring that the financial statements
8|Page

are free from material misstatements cause by fraud or error while the public

expects far more from auditors on fraud.

To conclude, over the last few years, auditing is becoming more and more

essential for companies and the stakeholders’ demands are increasing. Due to

financial scandals (Enron, WorldCom, Parmalat, etc.) and audit failures, the value

of the audit process has increased in recent years (Dewing and Russel, 2002). The

main aim of auditing is to provide the shareholders an independent choice with

regard to the truth and fairness of the company`s financial statement. There are

requirements to be fulfilled if the audit report is to be considered credible and the

concept of independence is vital criteria. The audit opinion would be fundamentally

flawed if the auditor is not independent of the company and the purpose of the

audit would be void, which would leave shareholders unassured that the

organisation has provided them with true and honest financial statements about

the company`s financial position. Regulations enforcing the legitimacy of audit are

of upmost importance, and they are the best way of keeping companies from

committing fraud and lie about their financial statements. The audit process

involves not only the auditor's assessment but also prооf of cоmpliаncе with thе

finаnciаl reporting standards. The assessment of audit literature and empirical

studies illustrates and indicates that there is a real gap in existing expectations

since the various users of the financial statements would use them for different

purposes. Stakeholders should be able to base their decisions and seek solutions

to the issues that are affecting them by using and relying in the audited financial

statements.
9|Page

References:

ACCA,2017. Banishing bias? Audit, objectivity and the value of professional

scepticism. London. ACCA : Available
from:[Link]
-[Link] [Accessed 06/10/19]

ACCA, 2019. Closing the expectation gap in audit. London: ACCA: Available from:
[Link]
insights/Expectation-gap/[Link][Accessed
04/10/19]

Defliese PJ, Murray B, Jaenicke, Henry R., O’Reilly Hirch P (1988). Auditing.
Eleventh Edition. John Wiley & Sons

Dewing IP, Russell P (2002). UK Managers, Audit Regulation and the New
Accountancy Foundation: Toward a Narrowing of the Audit Expectation Gap?
Manage. Audit. J., 17(9): 537-545

EVAN, W. M. and FREEMAN, R. E. (1993). “A Stakeholder Theory of Modern

Corporation: Kantian Capitalism”. In Beauchamp and Bowie, Ethical Theory and
Business, Prentice Hall.

Epstein MJ, Hill J (1995). The Expectation Gap between Investors and Auditors,
Greenwich, Connecticut, JAI Press Inc

Freeman, R. E. (1984). Strategic Management: A Stakeholder Approach. Boston,

MA: Pitman.

Friedman, A.L and Miles, S. Stakeholders: theory and practice, Oxford: Oxford
University Press, 2006. Available from:
[Link]
[Link]?subformat=pdfa [Accessed 28/09/19]

GRAY, I., MANSON, S. and CRAWFORD, L., 2019. The audit process 7th ed.
London: Cengage
10 | P a g e

HMRC. (2016). Examining Accounts: Accountants and Auditors: What is an

Audit? (EM2778). Available from: [Link]
manuals/enquiry-manual/em2778 [ Accessed 25/09/19]

Humphrey CG, Moizer P, Turley WS (1992). The Audit Expectation Gap in the
United Kingdom. Account. Bus. Res., Winter: 83-84

ICAEW, 2013. Credibility Counts. [online]. London: ICAEW. Available from:

[Link]
beyond/audit-and-beyond-2013/audit-and-beyond-sept-2013/credibilitycounts
[Accessed 26/09/19]

ICAEW,2006. Fundamentals- Audi purpose. [online]. London: ICAEW .Available

from:[Link]
assurance/audit-quality/audit-quality-forum-fundamentals/fundamentals-audit-
[Link] [Accessed 02/10/19]

ICAEW,2008. Stakeholder expectations of audit [online]. London: ICAEW.

Available from : [Link]
and-assurance/audit-quality/audit-quality-forum-evolution/evolution-
[Link] [Accessed 02/10/19]

Liggio C.D. (1974), ‘The Expectation Gap: The Accountant’s Waterloo’, Journal of
Contemporary Business, 3 (3) pp.27-44.

Mackie A. Addressing misconceptions about the role of audit. Deloitte. Available

from: [Link]
[Link][Acessed29/09/19]

Mahdi, S. (2011). Audit expectation gap: Concept, nature and trace. African
Journal of Business Management, 5(21),pp.8376-8392.

Rulund RG, Lindbom C (1992). Ethic and Disclosure: An Analysis of Conflicting

Duties. Crit. Perspect. Account., 3: 259-272.