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Bridging the Expectations Gap

Denise Dickins and Julia L. Higgs

R
egulators and reasons. First, a lack of
others first The term expectations gap describes the differ- understanding between
began immortal- ence between investors’ ideas of a financial state- the public and auditors
izing the term expec- ment audit and what standards actually require. has long been consid-
tations gap in the Despite many changes in auditing standards, ered a source of litiga-
1970s (e.g., American investors still misunderstand the auditor’s report. tion risk. Research indi-
Institute of Certified © 2009 Wiley Periodicals, Inc.
cates that jury pools
Public Accountants have very different
[AICPA], 1977; expectations of audi-
Liggio, 1974) as a way tors’ roles than auditors
to describe the difference current auditing standards be do (Frank, Lowe, & Smith,
between financial statement clarified in the auditor’s report 2001). These business risks of
users’ ideas of a financial state- (Advisory Committee on the audit firms are necessarily
ment audit and what auditing Department of the Auditing passed onto clients in the form
standards require in a financial Profession, 2008). of higher audit fees. Further, the
statement audit. Thirty years, an confidence of the capital mar-
untold number of new auditing CLARIFYING WHAT kets in the assurance role of the
standards, and at least a dozen AUDITORS DO auditor is undermined when the
accounting scandals later, we role of the auditor is poorly
still appear to be no closer to Unfortunately, the communi- understood. This is perhaps
closing the gap. cation tool that the profession especially true in the case of
Recent efforts to close the uses to describe a financial state- fraudulent financial reporting.
gap include the Public Company ment audit is three paragraphs The auditor’s responsibility for
Accounting Oversight Board’s long and a little under 250 words. the detection of fraud continues
(PCAOB’s) recently issued In this article, we attempt to bet- to be one of the biggest contrib-
Auditing Standard (AS) No. 6, ter clarify what auditors do. In utors to the expectation gap.
Evaluating the Consistency of audits of the largest corporations, In this article, we identify
Financial Statements, intended backing up those 250 words issues that we believe—and
to improve communication when entails fees of millions of dollars others have reported—contribute
financial statements are restated and thousands of hours of profes- to the gap between financial
(PCAOB, 2008), and the Sub- sional labor.1 We hope by better statement users’ beliefs and
committee on Firm Structure explaining the auditing standards auditors’ processes (e.g.,
and Finances of the Treasury that underlie the meaning of the McEnroe & Martens, 2001). We
Advisory Committee on the auditor’s report that we can help discuss these issues in the con-
Auditor Profession’s final rec- reduce the expectations gap. text of the auditors’ communi-
ommendation that the auditor’s Explaining the role of the cations tool, the auditor’s
role in detecting fraud under audit is important for several report. Topics covered include:

© 2009 Wiley Periodicals, Inc.

Published online in Wiley InterScience (www.interscience.wiley.com).
DOI 10.1002/jcaf.20547 51
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52
what is meant by an unqualified
opinion; what is the auditor’s
responsibility for the detection
of fraud; how does an auditor
determine materiality; what is
meant by a financial statement
restatement; when does an audi-
tor issue a going-concern opin-
ion; what does it mean when a
company reports a material
weakness in internal control; and
how does a review of quarterly
financial data differ from an
audit of the annual financial
statements?
THE AUDITOR’S
COMMUNICATION TOOL: THE
AUDITOR’S REPORT
The auditor is limited in
what may be communicated to
readers of financial statements to
his or her report. As the
report is required to be
standardized, the auditor
has limited ability to mod-
ify or to provide additional
explanation about the con-
duct of the audit or the
judgment that is part of the
auditing process. These
judgments include an
assessment of materiality,
an assessment of going
concern, a determination of
the existence of errors and fraud, “Interim Standards”; thus, audits
and a determination of whether
internal control violations meet
the criteria of being material
weaknesses, among other things. ASB has adopted 16 additional
The AICPA and the PCAOB
carefully vet the standard word-
ing of the auditor’s report to
communicate to readers what
responsibility the auditor takes
for the audit of the financial
statements.
Until 2002, auditing stan-
dards were set by the Auditing
Standards Board (ASB) of the
AICPA. Standards set by the
ASB are called Statements of
Auditing Standards (SASs).2
DOI 10.1002/jcaf
The Journal of Corporate Accounting & Finance / November/December 2009
Because of the events culminating
in the signing of the Sarbanes-
Oxley Act of 2002 (SOX), the
profession was deemed to be
incapable of self-regulation with
respect to setting auditing stan-
dards and monitoring the quality
of auditors of publicly-traded
companies, so the PCAOB was
created. The PCAOB’s primary
functions are standard setting
and the registration and inspec-
tion of auditors of publicly
traded companies.3 Thus, the
ASB now sets auditing standards
for audits of privately held com-
panies, and the PCAOB sets
auditing standards for audits of
public companies.4 The
PCAOB’s rules of auditing are
called Auditing Standards
(ASs).5 SASs 1 to 100 were
adopted by the PCAOB as
The AICPA and the PCAOB carefully
vet the standard wording of the
auditor’s report to communicate to
readers what responsibility the audi-
tor takes for the audit of the finan-
cial statements.
of privately held and publicly
traded companies are identical in
many ways. Since 2002, the
SASs and the PCAOB has
adopted six ASs, some of which
modify Interim Standards. All
ASs must be approved by the
SEC prior to becoming law for
publicly traded companies.6
Auditors of privately held
companies generally only report
on the financial statements. AS
5, An Audit of Internal Control
Over Financial Reporting That
Is Integrated with An Audit of
Financial Statements (PCAOB,
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2007), supersedes AS 2, An
Audit of Internal Control Over
Financial Reporting Performed
in Conjunction With an Audit of
Financial Statements (PCAOB,
2004), and requires that auditors
of publicly traded companies
report on the financial state-
ments and on the effectiveness
of internal control over financial
reporting. Internal control over
financial reporting is any
process or procedure considered
necessary to ensure that external
financial reports are accurate,
complete, and timely. As an
example, the timely preparation
and review of bank reconcilia-
tions is necessary to ensure that
the amounts reported as “cash” in
the financial statements are valid
and, hence, part of a company’s
system of internal control over
financial reporting. On the
other hand, the recruitment
of sales personnel is a
process that likely has little
direct impact on the finan-
cial statements and therefore
is not a part of a company’s
system of internal control
over financial reporting.
These required tests of
internal controls for large
publicly traded companies
may magnify the expecta-
tion gap for small public compa-
nies and for privately held com-
panies,7 as readers of audit
reports of privately held compa-
nies generally believe that audi-
tors do a lot more testing of
internal controls than is required
(McEnroe & Martens, 2001).
For audits where AS 5 is not
mandated, the auditing standards
only require that the auditor gain
and document their understand-
ing of the system of internal
control in order to assess the risk
of material misstatement in the
financial statements, whether
due to error or fraud. Only if the
auditor determines that it is more
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The Journal of Corporate Accounting & Finance / November/December 2009 53

effective and efficient to rely on The basic, unqualified report company and period covered by
internal controls is testing of on the financial statements the financial statements) and
internal controls required. If the includes three paragraphs. The affirms that the financial state-
auditor believes that either (1) it language attempts to clearly ments are the responsibility of
is more efficient to only perform communicate some things that management, while the auditors’
tests of details and analytical historically have contributed to responsibility is the expression
review to support his or her the gap between readers of of an opinion on the financial
report on the financial state- financial statements and audi- statements. The report’s
ments or (2) that a company’s tors. The standard unqualified emphasis on management’s
system of internal control is not opinion without modification is responsibility for the financial
sufficiently effective to ensure presented in Exhibit 1. It has statements is intended as a
that if material errors or fraud three standard paragraphs: intro- reminder that management has
occur, they will be detected in a ductory, scope, and opinion. primary responsibility for the
timely manner, the auditor would detection of error and irregulari-
likely opt to place no reliance on Introductory Paragraph ties (fraud) in the financial
a company’s system of internal statements.
control. In such instances, no The introductory paragraph One of the largest sources
testing of internal controls is describes which financial state- of the expectations gap is the
required. Further, if the auditor ments are audited (i.e., name of auditor’s responsibility for the
concludes the company’s system
of internal control is inadequate,
this conclusion is not required to
be documented or reported in the Exhibit 1
auditor’s report on financial
statements. The auditor’s report
on the financial statements Independent Auditor’s Report
makes no representation about
the quality or effectiveness of We have audited the accompanying consolidated statements of financial
internal controls. position of ABC Company as of December 31, 2XXX and 2XXX, and the
related consolidated statements of operations, shareholders’ equity, and
UNQUALIFIED REPORTS cash flows for each of the three years in the period ended December 31,
2XXX. These financial statements are the responsibility of the Company’s
There are four types of management. Our responsibility is to express an opinion on these finan-
reports that an auditor may issue cial statements based on our audits.
on the financial statements:
unqualified, qualified, adverse, We conducted our audits in accordance with auditing standards generally
and disclaimer. As the Securities accepted in the United States (or standards of the PCAOB). Those standards
and Exchange Commission (SEC)
require that we plan and perform the audit to obtain reasonable assurance
will not accept the last three types
of auditor’s reports—which basi- about whether the financial statements are free of material misstatement.
cally say that the auditor either An audit includes examining, on a test basis, evidence supporting the
believes that the financial state- amounts and disclosures in the financial statements. An audit also includes
ments are not presented in accor- assessing the accounting principles used and significant estimates made by
dance with generally accepted management, as well as evaluating the overall financial statement presenta-
accounting principles (GAAP) or tion. We believe that our audits provide a reasonable basis for our opinion.
the auditor was unable to com-
plete all of the procedures neces- In our opinion, the consolidated financial statements referred to above
sary to be able to form an opinion present fairly, in all material respects, the financial position of ABC Com-
about the fairness of the financial pany of December 31, 2XXX and 2XXX, and the results of their opera-
statements—we focus our discus- tions and their cash flows for each of the three years in the period
sion on the various types of ended December 31, 2XXX, in conformity with accounting principles
unqualified reports typically generally accepted in the United States of America.
accompanying financial state-
ments filed with the SEC.

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54 The Journal of Corporate Accounting & Finance / November/December 2009

detection of fraud. Over the accounting information that, in must also consider qualitative
years, the AICPA has made sev- the light of surrounding circum- factors such as the impact of
eral attempts to bridge the expec- stances, makes it probable that the changes in the financial state-
tation between what the public judgment of a reasonable person ments on debt compliance, and
perceives an auditor’s responsi- relying on the information would the company’s ability to meet
bility is for the detection of fraud have been changed or influenced analysts’ expectations. SAB 99
and what auditors are actually by the omission or misstatement.” reminds auditors that adjustments
able to do in the context of the AU 312A describes the qualities to the financial statements that
detection of financial statement of a reasonable person that would change earnings per share by a
fraud. The AICPA’s most recent be relying on financial statements penny may be considered mate-
attempt is SAS 99 (AICPA, and presumes that readers of rial, as they could translate to bil-
2002a). This standard, written in financial statements “(1) have an lions of dollars in changes in a
conjunction with the Association appropriate knowledge of busi- company’s market capitalization.
of Certified Fraud Examiners, is ness and economic activities and Materiality and risk are closely
unique among auditing standards. accounting and a willingness to tied together in the auditor’s
In addition to audit requirements, study the information in the judgment process.
it has an appendix to help audi- financial statements with an While it would be nice to
tors identify fraud risk factors appropriate diligence; (2) under- have a bright-line measure of
and also has an appendix to assist stand that financial statements are materiality—and while as a
management in developing fraud- prepared and audited to levels of practical matter auditors fre-
prevention programs. quently start their evalua-
Under SAS 99, man- tion of materiality using
agement and those charged Under SAS 99, management and those measures like a percentage
with governance are charged with governance are responsi- of net income, revenues, or
responsible for setting the assets—ultimately, materi-
proper tone, creating and ble for setting the proper tone, creat- ality comes down to the
maintaining a culture of ing and maintaining a culture of judgment of the auditor.
honesty and high ethical The following example
standards, and establishing
honesty and high ethical standards, serves to highlight the
appropriate controls to pre- and establishing appropriate controls exchange between quantita-
vent, deter, and detect to prevent, deter, and detect fraud. tive and qualitative assess-
fraud (paragraph 4). Audi- ments of materiality.
tors have a responsibility to Suppose a company has
plan and perform the audit $10 million in income and
to obtain reasonable assurance materiality; (3) recognize the the auditor sets a materiality
about whether the financial state- uncertainties inherent in the threshold at 5 percent of income.
ments are free of material mis- measurement of amounts based The auditor can tolerate a mis-
statement whether due to error on the use of estimates, judgment, statement in income up to
(unintentional misstatements) or and the consideration of future $500,000. Suppose the company
fraud (intentional misrepresenta- events; and (4) make appropriate underestimated the allowance for
tions) (paragraph 12). As might economic decisions on the basis bad debts by $350,000, which
be expected, intent is often diffi- of the information in the financial caused net accounts receivable to
cult to prove. Nevertheless, the statements.” be overstated by the same amount.
audit must include audit tests For public companies, the This overstatement caused the
designed to detect both. The SEC further clarified the concept current ratio to be higher, which
auditor must conclude whether or under Staff Accounting Bulletin in turn caused the company to
not the financial statements are (SAB) No. 99, Materiality (SEC, meet a debt covenant it would
free of material errors and fraud. 1999). SAB 99 requires that the have otherwise missed. Although
Materiality is described in auditor consider both quantitative the $350,000 is within the materi-
AU Section 312A (AICPA, 1983) and qualitative factors when ality guidelines, the $350,000
and references the FASB Con- determining materiality. This would be considered a material
cepts Statement 2 (FASB, 1980) means that materiality judgments error because it would mean the
definition: “the magnitude of an may not solely be based on difference between meeting and
omission or misstatement of thresholds of financial data. They not meeting the debt covenants.

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The Journal of Corporate Accounting & Finance / November/December 2009
The auditor will evaluate
some high-risk aspects of the
engagement such as related-party
transactions or transactions
involving management with lower
materiality thresholds than mis-
statements due to errors. For
example, even if the auditor has
established an initial definition of
materiality of $500,000, a
$50,000 loan to the CEO would
be considered material because
loans to CEOs, regardless of size,
are not allowed under the law
(SOX Section 402a). Although
regular audits are not designed to
find immaterial frauds, if they are
detected as part of the audit they
must be reported to management
and the audit committee of the
board of directors.
In looking for material
fraud, the auditor will
design tests to look for
both misappropriation of
assets and fraudulent finan-
cial reporting. SAS 99
requires that the auditor
identify (through brain-
storming, analytical proce-
dures, and discussions with
management and the board
of directors) and document
fraud risks. The audit plan
must address plans to man-
age the identified fraud risks in
the conduct of the audit through
additional testing. Each member
of the team is reminded to main-
tain a mental attitude of profes-
sional skepticism, which, when
properly used, can significantly
add to the overall judgment qual-
ity of the audit process.
As a practical matter, for
publicly traded companies, it is
not likely that the most common
fraudulent transaction—theft of
cash or other assets—will rise to
a level of materiality such that it
would be detected by the auditor.
More likely, material fraud will
occur through fraudulent finan-
cial reporting. The detection of
© 2009 Wiley Periodicals, Inc.
fraudulent financial reporting
has to be understood through the
lens of risk-based auditing in
which audit effort is concentrated
where risk of misstatement is
perceived to be highest. When
the auditor plans the audit, he or
she identifies the financial state-
ment items with the highest risk
of material misstatement by
jointly considering the areas
where controls are weakest and
where the account is inherently
risky.8 The auditor then concen-
trates the audit effort on these
higher-risk areas. SAS 99 specif-
ically requires that the auditor
consider how the financial state-
ments might be misstated due to
misstatements of revenues, the
Despite auditors’ efforts, it is still
likely that immaterial instances of
fraud will go undetected, such as
employee theft of inventory. Further,
despite excellent audit planning and
execution, when perpetrated by collu-
sion or management override of
controls, fraud is difficult to detect.
most common type of fraudulent
financial reporting.
Despite auditors’ efforts, it
is still likely that immaterial
instances of fraud will go unde-
tected, such as employee theft of
inventory. Further, despite excel-
lent audit planning and execution,
when perpetrated by collusion or
management override of controls,
fraud is difficult to detect.
Scope Paragraph
The second, or scope, para-
graph describes the nature of an
audit and its limitations. The
report emphasizes that the audi-
tor is giving only “reasonable
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55
assurance” regarding whether the
financial statements are free of
material misstatements resulting
from errors or fraud. What the
auditor’s report implicitly states
is that the financial statements
may still contain immaterial mis-
statements arising from error or
fraud. This paragraph of the
auditor’s report also points out
that the auditor relies on sam-
pling, implying that sampling
error (i.e., the risk that a sam-
ple’s characteristics are not rep-
resentative of a population)
could arise as part of the audit
process. Finally, although finan-
cial statements are based on
numerical amounts, the report
points out to readers that imbed-
ded in those numbers are a
number of estimates.9 Col-
lectively, these statements
communicate to the reader
that auditing the financial
statements is not an exact
process, that the audit is
designed only to provide
reasonable assurance that
the financial statements are
not materially misstated,
and that given the number
of estimates included in the
financial statements (i.e.,
the allowance for doubtful
accounts), the financial state-
ments are likely not free of mis-
statements. What financial state-
ment users are left with is
limited assurance that if discov-
ered by the auditor, material
adjustments will be reflected in
the financial statements.
Today with the stronger
rules of corporate governance in
place as a result of SOX, how
material audit adjustments are
handled is different from the
past. All adjustments that meet
the auditor’s level of materiality,
whether or not recorded by the
company, must be discussed
with the audit committee. If the
adjustment was discovered by
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56
the auditor, not by management
as a part of the company’s sys-
tem of internal control, the audi-
tor must decide whether the
company has a material weak-
ness in internal control over
financial reporting. Material
weaknesses are reported in the
auditor’s Report on the Effective-
ness on Internal Control over
Financial Reporting, which we
discuss later.
If the company disagrees
with the auditor’s proposed
adjustment to the financial state-
ments, there are other considera-
tions. Most importantly, the audi-
tor must make a determination
about whether the unrecorded
adjustment rises to the level
of making the financial
statements materially mis-
leading. If so deemed, the
auditor would be required to
qualify his or her report. As
previously mentioned, since
the SEC will not allow a
publicly traded company to
file a qualified report, the
auditor’s only other alterna-
tive would be to withdraw
from the engagement.10 The
other determination that the audi-
tor must make when clients
refuse to record the auditor’s pro-
posed adjustments is whether
management (and the board) are
intentionally (fraudulently) trying
to misrepresent the company’s
financial results or financial posi-
tion. Again, if this is deemed to
be the case, the auditor is likely
to withdraw from the engage-
ment. SAS 99 requires that the
auditor continuously update the
fraud risk associated with an
audit, making adjustments for
things like the company’s posture
on aggressive accounting posi-
tions. The cost of failing to adjust
the financial statements, if those
financial statements are later
found to be materially mislead-
ing, is substantial. Management,
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The Journal of Corporate Accounting & Finance / November/December 2009
the board of directors, and the
auditor all potentially face severe
criminal, reputational, and finan-
cial consequences.
Opinion Paragraph
The third, or opinion, para-
graph includes the auditor’s con-
clusion about whether the finan-
cial statements present fairly the
financial position and results of
operations of the company. Again
the language emphasizes that the
financial statements present
fairly, in all material respects.
In certain circumstances, the
auditor’s report may be modified,
yet still be considered unqualified.
SAS 99 requires that the auditor
continuously update the fraud risk
associated with an audit, making
adjustments for things like the
company’s posture on aggressive
accounting positions.
The two most frequent modifica-
tions are when prior financial
statements have been changed as
a result of a company adopting a
new accounting standard, or
changing from one generally
accepted accounting principle to
another generally accepted
accounting principle; and when
the auditor wants to emphasize
a matter like the risk that the
company may be unable to
continue as a going concern.
COMMUNICATING ABOUT
CONSISTENCY
Communicating about con-
sistency is important enough that
it is included in one of the ten
generally accepted auditing stan-
dards (GAAS). Users of financial
10970053, 2009, 1, Downloaded from https://onlinelibrary.wiley.com/doi/10.1002/jcaf.20547 by Mahmoud Ali - Egyptian National Sti. Network (Enstinet) , Wiley Online Library on [28/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
statements can assume that the
financial statements are presented
on a consistent basis (same
GAAP, same reporting structure),
unless the auditor states other-
wise. The auditing standards go
into some amount of detail as to
what is meant by consistency.
First, consistency is concerned
with how a company reports from
year to year. It is not related to
the concept of comparability,
which relates how Company A
is compared to Company B.
Consistency modifications will
only be present in the report if
they materially impact the
financial statements.
An important type of consis-
tency modification is a
change in the application of
GAAP such as the change
from straight-line to accel-
erated depreciation for
property and equipment, or
the change from first-in,
first-out (FIFO) to last-in,
first-out (LIFO) accounting
for the cost of inventories.
These types of changes are
considered voluntary. On
the other hand, the adoption
of a newly implemented account-
ing principle, like the adoption of
SFAS 123R (FASB, 2004), which
requires the expensing of stock
options, would be considered an
involuntary change.
Prior to the adoption of
SFAS 154 (FASB, 2005), when
companies changed their
accounting principles, the effect
of the change was reflected in
the financial statements as a
cumulative effect in the income
statement in the year of adop-
tion. Cumulative effects of
accounting changes were pre-
sented below income from con-
tinuing operations, but above net
income. SFAS 154 now requires
companies, absent any require-
ment to do otherwise, to revise
the financial statements for all
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The Journal of Corporate Accounting & Finance / November/December 2009
prior periods to reflect the
period-specific effects of apply-
ing the new accounting princi-
ple. In other words, the historical
financial statements are now
restated. When these types of
retrospective adjustments were
made, auditors modified their
reports to alert the reader that
the financial statements had
been restated. As might be
expected, there was likely some
confusion among readers of
auditors’ reports as to whether
restatements were “bad,” result-
ing from corrections or errors, or
were the result of changing or
adopting new accounting stan-
dards. The ability to distin-
guish the type of change
giving rise to restated
financial statements is
important, as research has
generally found that while
the market does not react
to changes in accounting
methods with no economic
effects (e.g., Dawson, Neu-
pert, & Stickney, 1980;
Vigeland, 1981), the mar-
ket does react negatively
when financial statements
are restated due to previ-
ously unidentified errors
and irregularities (Hribar &
Jenkins, 2004).
In an effort to help reduce
this confusion and, again, narrow
the expectations gap, Auditing
Standard 6 was submitted by the
PCAOB and approved by the
SEC in 2008. It addresses when
and how auditors’ reports are to
be modified for consistency when
public companies adopt new
accounting standards. It requires
that the language in the auditor’s
report distinguish between
retroactive changes resulting
from changes in or adoptions of
accounting principles, and
restatements resulting from cor-
rection of errors. If a company
adopts a new accounting princi-
© 2009 Wiley Periodicals, Inc.
ple, or changes from another gen-
erally accepted accounting princi-
ple, the auditor’s report must
include an explanatory paragraph
similar to the following:
As discussed in Note X to
the financial statements,
the company has changed
(or elected to change)
its method of accounting
for ABC in YEAR due to
the adoption of Account-
ing Pronouncement (if
applicable).
On the other hand, if the
financial statements have been
When the auditor believes that there
is substantial doubt that a company
will fail in less than one full year
from the date of the financial state-
ments, AU 341 requires that the
auditor include an explanatory para-
graph in his or her report emphasiz-
ing this uncertainty.
restated due to a previously
undisclosed error, resulting from
either errors or fraud, the
explanatory paragraph would
read as follows:
As discussed in Note X
to the financial state-
ments, the YEAR finan-
cial statements have
been restated to correct a
misstatement.
The other frequently
observed modification to the
unqualified auditor’s report
occurs when the auditor wants to
emphasize a matter. This is an
area where the auditor has a fair
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57
amount of latitude in deciding
whether to discuss something that
he believes the reader of the
financial statement should pay
particular attention to, such as,
when there exists an unusual
amount of litigation risk, asset-
realization uncertainties, extrac-
tive industries uncertainties, con-
tingent liabilities, and
related-party transactions (Butler,
Leone, & Willenborg, 2004). By
far the most common matter that
auditors emphasize is the risk that
a company may be unable to con-
tinue as a going concern. Audit
Analytics reported that in 2006,
16.6 percent (2,318) of auditor
reports of publicly traded
companies included para-
graphs emphasizing going-
concern issues.
The financial statements
are prepared under the
assumption that the com-
pany will continue into the
foreseeable future, based on
the idea that an entity will
be a going concern. This
means that the company’s
assets will be realized and
its liabilities will be settled
in the normal course of
business. Contrast this with
a company that is going out
of business and must liquidate its
assets and settle its liabilities
within a short time frame. Obvi-
ously, the value that the company
can be expected to receive for its
assets, and the amounts that credi-
tors may be willing to take in
exchange for settlement of debts,
most likely will be less. In
accounting jargon, we call this the
difference between reporting
assets and liabilities on a going
concern versus a liquidation basis.
AN ERRONEOUS BELIEF
When the auditor believes
that there is substantial doubt
that a company will fail in less
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58 The Journal of Corporate Accounting & Finance / November/December 2009

than one full year from the date opinion is self-fulfilling, because accepted accounting principles.11
of the financial statements, AU suppliers may be less willing to The rules as originally drafted
341 requires that the auditor extend credit. Research has under AS 2 were broad and
include an explanatory para- demonstrated that the going- lacked direct guidance on the
graph in his or her report concern opinion is informative. sufficiency of controls and
emphasizing this uncertainty The market reacts negatively to related tests of controls. In 2007,
(AICPA, 1988a). According to going-concern opinions, and for AS 5 was issued to supersede
McEnroe and Martens (2001), companies declaring bankruptcy, AS 2, in part to reduce confu-
investors erroneously believe the market’s reaction to a bank- sion and better direct controls
that in the absence of a going- ruptcy announcement is less nega- testing.
concern opinion, the business tive when the company previously Managers (CEOs and CFOs)
will likely succeed. This popular had a going-concern opinion (e.g., of large publicly traded compa-
opinion is contrary to explicit Firth, 1978; Holder-Webb & nies must attest to the adequacy
language in AU 341 (p. 622), Wilkins, 2000). Unfortunately, of a company’s system of inter-
which states that “the absence of auditors have historically not nal control over financial report-
reference to substantial doubt in been very good at predicting ing. In case there was previously
an auditor’s report should not be when companies will be unable any confusion regarding the
viewed as providing assurance as to survive at least one full year party responsible for establish-
to an entity’s ability to continue (e.g., Menon & Schwartz, 1986), ing, maintaining, and evaluating
as a going concern.” a company’s system of
The auditor bases the internal controls, SOX pro-
going concern assessment SOX Section 404 and related SEC vides that managers now
considering both financial rules describe internal control over explicitly state that they
matters (e.g., reporting net have primary responsibil-
losses or negative cash financial reporting as processes and ity. Auditors make an
flows, or violating of debt procedures designed to provide rea- independent evaluation
covenants) and operational sonable assurance for the reliability of of internal controls.
matters (e.g., financial dis- Two forms of the audi-
tress of a major supplier or financial reporting and the prepara- tor’s report are proscribed:
customer, labor difficul- tion of financial statements for exter- unqualified and adverse.12
ties) known as of the date Unqualified reports con-
of the auditor’s report; and nal purposes in accordance with gen- clude that the system of
not all of which may be erally accepted accounting principles. internal control over finan-
apparent to the reader of cial reporting is operating
the financial statements. effectively, in all material
The assessment of going respects, as of the date of
concern also considers manage- perhaps because relevant infor- the balance sheet. An adverse
ment’s plans for overcoming any mation becomes known after the report indicates the presence of
concerns that the auditor has date of the auditor’s report. one or more, or a combination
identified (e.g., ability to cut of, controls is not operating
costs, obtain new financing, dis- The Auditor’s Report on effectively, and as a result a
pose of assets). Internal Control Over material misstatement of the
Ultimately, the assessment of Financial Reporting financial statements may occur
whether management’s plans can and go undetected. Typical mate-
be successful is a matter of judg- SOX Section 404 and related rial weaknesses include failure
ment. The decision of whether or SEC rules describe internal con- to follow generally accepted
not to issue a going-concern trol over financial reporting as accounting principles (e.g.,
opinion is difficult. On one processes and procedures recording the cost of a lease that
hand, failing to emphasize designed to provide reasonable includes a rent abatement period
going-concern issues exposes the assurance for the reliability of over the period of the payments
auditor to litigation risk if the financial reporting and the rather than over the full term of
client ultimately fails. On the preparation of financial state- the lease), and insufficient or
other hand, some believe that the ments for external purposes in improperly trained accounting
issuance of a going-concern accordance with generally personnel. The reporting of

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The Journal of Corporate Accounting & Finance / November/December 2009
material weaknesses in internal
control is discussed.
INTERNAL CONTROL
REPORTING
Early evidence suggests that
financial markets’ interest in
internal control reporting is neg-
ligible. For example, Cheng, Ho,
and Tian (2006) find that com-
panies generally suffer signifi-
cant negative abnormal market
returns when material weak-
nesses are announced; however,
the negative market reaction is
mitigated for companies with
complex business structures,
suggesting the possibility that
the market expects such compa-
nies to have weaker inter-
nal controls. Ogneva,
Raghunandan, and Subra-
manyam (2005) report that
the cost of capital of com-
panies reporting material
weaknesses is only margin-
ally higher than that of
companies without material
weaknesses; and such dif-
ferences disappear after
controlling for economic
characteristics of compa-
nies disclosing material
weaknesses.
As of the date of this writ-
ing, companies with less than
$75 million market capitalization
are not yet required to evaluate
and report on their systems of
internal control over financial
reporting. This is somewhat
ironic given that research to date
suggests that smaller companies
(measured as market capitaliza-
tion, among other ways) are
more likely to report material
weaknesses in internal control
(e.g., Ge & McVay, 2005).
It is important to note that
the absence of material weak-
nesses reported in connection
with a company’s annual finan-
cial statements does not mean
© 2009 Wiley Periodicals, Inc.
that a company had no material
weaknesses during the year. In
companies’ quarterly reports,
managers are required to report
on any identified material weak-
nesses and any significant
changes in internal control. If
weaknesses are identified as part
of the company’s own processes
and controls, and are remediated
prior to the end of the year, audi-
tors may conclude that the com-
pany’s system of internal control
is effective, and that as of the
end of the year, there are no
material weaknesses impacting
the company’s ability to produce
and report its financial results.
The absence of reported
material weaknesses also does
It is important to note that the
absence of material weaknesses
reported in connection with a com-
pany’s annual financial statements
does not mean that a company
had no material weaknesses during
the year.
not mean there are no significant
deficiencies in internal control.
AS 2 defines a significant
deficiency as a condition in the
design or operation of an internal
control that results in a more
than remote likelihood that a
more than inconsequential mis-
statement of a company’s financial
statements will occur and go
undetected on a timely basis. In
other words, all material weak-
nesses are significant deficien-
cies, but a significant deficiency
need not be a material weakness.
The following example is
intended to illustrate the differ-
ence between a material weak-
ness in internal control and a sig-
nificant deficiency. A company
10970053, 2009, 1, Downloaded from https://onlinelibrary.wiley.com/doi/10.1002/jcaf.20547 by Mahmoud Ali - Egyptian National Sti. Network (Enstinet) , Wiley Online Library on [28/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
59
requires that credit checks be
performed for all customers to
whom credit in excess of $10,000
is extended. This process is
intended to reduce the company’s
credit risk and acts as a control to
ensure that accounts receivable
are stated at their net realizable
value. A comparison of the
accounts receivable trial balances
and credit checks identifies three
customers with receivable bal-
ances in excess of $10,000 for
whom credit checks were not
performed. Company A has total
receivables of $50,000, total
assets of $200,000, and net
income of $100,000. Company B
has total receivables of $500 mil-
lion, total assets of $2 billion, and
net income of $100 million.
In the case of Company A,
the failure of the internal
control is most likely con-
sidered a material weak-
ness. In the case of Com-
pany B, it would likely be
considered a significant
deficiency. As is obvious
from this example,
whether a breech in inter-
nal control is characterized
as a significant deficiency
or a material weakness is
largely a matter of judgment.
Different auditors may come to
different conclusions based upon
their judgment of the likelihood
that the control deficiency would
result in a material misstatement
of the company’s financial
statements.
REDEFINING “MATERIAL
WEAKNESS”
In addition to attempting to
reduce confusion and ease the
cost (both in terms of manpower
and dollars) of compliance with
Section 404, AS 5 redefines the
term material weakness. Prior to
AS 5, a material weakness in
internal control was defined as a
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60
control deficiency that resulted in
a more than remote likelihood that
a material misstatement of the
financial statements could occur
and go undetected on a timely
basis. AS 5 changed the “more
than remote likelihood” criteria
to a “reasonable possibility.”
Although the change is subtle,
the threshold for a control defi-
ciency rising to the level of a
reportable material weakness has
been raised.
AS 5 also coins the term an
integrated audit to describe an
audit that jointly considers the
results of testing of the effective-
ness of a company’s system of
internal control over financial
reporting (i.e., SOX 404 proce-
dures), and the nature, extent,
and timing of audit tests of
details and analytical review pro-
cedures. In its early inspections
of post-SOX audits, the PCAOB
found that auditors tended to
treat the tests of internal controls
conducted to comply with SOX
Section 404 and AS 2 as sepa-
rate from the “regular” audit
(PCAOB, 2005). AS 5 specifi-
cally addresses the need to inte-
grate the audit and attempts to
reduce the inefficiencies that
may arise from conducting an
audit in this manner.
Reviews of Interim Financial
Information
SAS 100, Interim Financial
Information (AICPA, 2002b),
describes the requirements that
the auditor must follow when a
company produces and distrib-
utes for public use financial
statements covering less than a
full year, as when publicly traded
companies file quarterly finan-
cial statements with the SEC on
Form 10-Q. Under Rule 10-01(d)
of Regulation S-X, interim
financial information included in
Form 10-Q (or Form 10-QSB) is
DOI 10.1002/jcaf
The Journal of Corporate Accounting & Finance / November/December 2009
required to be reviewed by an
accountant prior to being filed
with the SEC. Unlike an audi-
tor’s report, the SEC generally
does not require that the accoun-
tant’s review report accompany
the interim financial statements.
This lack of explicit reporting
may create confusion regarding
the level of assurance provided
by the accountant.
Most importantly, the objec-
tive of a review is not to express
an opinion on the fairness of the
financial statements. Instead, the
auditor performs analytical pro-
cedures (e.g., ratio analysis and
trend analysis), makes inquiries
of managers, reads the financial
statements, and considers the
results of prior audits as a basis
for communicating whether he
or she is aware of any material
modifications necessary to con-
form with GAAP. A review does
not contemplate tests of transac-
tions through inspection or con-
firmation, or other procedures
typically performed in the course
of an audit. A review is not
designed to provide any level of
assurance with respect to inter-
nal controls. So what reliance
can users place on interim
financial statements? Only that,
based on these procedures,
accountants are not aware of any
material adjustments necessary
to make the statements conform
with GAAP.
CLOSING THE GAP
In this article, we attempted
to reduce the gap between finan-
cial statement users’ expecta-
tions of the role of the auditor,
and auditors’ procedures under
GAAS and standards of the
PCAOB. Specifically, we hope
to enhance users’ understanding
of unqualified opinions, the
auditor’s responsibility for the
detection of fraud, materiality,
10970053, 2009, 1, Downloaded from https://onlinelibrary.wiley.com/doi/10.1002/jcaf.20547 by Mahmoud Ali - Egyptian National Sti. Network (Enstinet) , Wiley Online Library on [28/05/2023]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License
financial statement restatements,
going-concern opinions, material
weaknesses in internal control,
and how a review of interim
financial statements differs
from an audit. Deepening users’
understandings of these topics
reduces investor risk and
enhances market efficiency
by reducing information
asymmetry.
NOTES
1. According to data from Audit Analytics,
in 2006, 94 companies had audit fees of
over $20 million, and 2,796 companies
exceeded $1 million.
2. These can be found at www.aicpa.org.
The codification of SASs is arranged by
codification section number, which per-
tains to topic areas. For example, Audit
Reports is Codification Section AU 508.
3. As of January 2009, auditors of nonpub-
lic broker-dealers are required to register
with the PCAOB. See http://www.pcaob.
org/News_and_Events/News/2009/01-07.
aspx, accessed February 26, 2009.
4. The Government Accountability Office
sets auditing standards for audits of state
and local governments and for entities
that fall under the Single Audit Act
(those that receive certain amounts of
federal financial assistance). These stan-
dards are found in what has commonly
been called “The Yellow Book.” A
fourth entity that sets auditing standards
is the International Auditing and Assur-
ance Standards Board.
5. Auditing standards can be found at
http://www.pcaob.org.
6. Our discussion does not cover foreign
registrants or companies that trade on
U.S. stock exchanges as American
Depository Receipts. We do not attempt
to describe expectations gap issues
related to non-U.S.-based generally
accepted auditing standards.
7. Currently only companies with market
capitalizations of more than $75 million
are required to provide reports on inter-
nal control over financial reporting.
8. The audit risk model requires the audi-
tor think about audit risk from the
perspective of three components of risk:
inherent risk, control risk, and detection
risk. Inherent risk cannot be changed by
the action of either the auditor or the
client. Control risk can be reduced if the
client is willing to invest in internal
controls. The only risk factor under the
control of the auditor is detection risk.
© 2009 Wiley Periodicals, Inc.
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The Journal of Corporate Accounting & Finance / November/December 2009
9. AU Section 342 (AICPA, 1988b)
specifies the procedures for auditing
accounting estimates.
10. Examples of this can be seen in the 8-K,
where reasons for auditor terminations
and resignations must be disclosed.
11. This description is intended to include
the internal controls discussed by AU
319 (AICPA, 1989), the Foreign Corrupt
Practices Act, and the internal controls
addressed by the Committee of Sponsor-
ing Organizations (COSO).
12. Reports on internal control can also
include scope limitations. For example,
when a company acquires another
business entity, management may elect
to exclude that entity from the evalua-
tion of the effectiveness of the system of
internal control (see paragraph B16 of
AS 5).
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62 The Journal of Corporate Accounting & Finance / November/December 2009

Denise Dickins, PhD, CPA, is an assistant professor at East Carolina University and teaches auditing. She
was formerly a partner with Arthur Andersen and currently serves on the boards of three public companies.
Dr. Dickins has published extensively on auditing topics. Julia L. Higgs, PhD, CPA, is an associate profes-
sor at Florida Atlantic University. She teaches auditing and financial accounting and was formerly an audi-
tor. She is active in the auditing section of the American Accounting Association and has published in
numerous outlets on the topic of auditing.

DOI 10.1002/jcaf © 2009 Wiley Periodicals, Inc.