Expectation Gap

So I mentioned this thing called the expectation gap in auditing. As you may have guessed it is the gap between what the client and/or public in general expect from an audit and what the auditors are delivering.

Auditors must work hard to narrow the gap as much as possible, so I'll do what I can by explaining what it is that the auditors provide.

Auditors do NOT prepare the financial statements of their clients. The clients themselves do that. The auditors come in and examine the financial statements that have been prepared, checking to make sure the accounting standards (e.g. Generally accepted accounting principles -- GAAP) have been applied properly and that everything is fairly presented.

The second part of an auditors job is to provide an opinion (unqualified, qualified, adverse, and I can't even recall the 4th one because it is rarely even used -- you will generally see unqualified or qualified opinions) on the statements. If everything looks great and any potential issues were cleared up (adjusted) with management, then an unqualified opinion will be issued (as weird as it sounds, this is the best opinion a company can hope for).

Notice, though, that the auditor does NOT go through every single transaction and balance to ensure they are 100% correct and free of error. They use sampling methods to test them. This means that the auditors do NOT provide 100% assurance (i.e. they are not providing insurance on the financial health of the company). There will be some small percentage of misstatements that are not caught by the auditors.

So, does that mean if I'm an investor and I invest in the company based on the audited financial statements and lose money due to the misstatement then I can sue the auditor for negligence? Well, it depends. It depends if they followed GAAS (generally accepted auditing standards) or not. If the auditor followed GAAS, then they provide reasonable assurance that the statements are fairly presented and have sufficiently done their job. If the auditor failed to comply with GAAS, then an investor could sue them!

This is a good place to explain the difference between business failure and audit failure. Business failure is where a business fails to make it's debt payments and could result in bankruptcy. Audit failure, on the other hand, is the failure of the auditor to comply with GAAS. They are NOT the same. As was explained above, business failure could occur while there was no failure in audit.

So do we want 100% assurance from the auditors? It would sure be nice, but it just means that it will cost the company more money in audit fees. More assurance = more work for the auditor = higher fees. The level of assurance that is currently provided is sufficient enough that investors can have confidence in it and make informed decisions based on the audited financial statements. It's currently cost-effective.