Expectation Gap – What is it?

CaseWare IndiaAuditing

Tesco, a multinational grocery chain from the UK is now awaiting for final reports from three authorities while drafting this report – the Groceries Code Adjudicator, Serious Fraud Office and the financial reporting council. It all started in September 2014 when an information was brought to the Board’s attention which indicated that the recognition of UK commercial income was being accelerated and the accrual of the costs were delayed (it simply means overstating of profits). The board appointed Deloitte, to carry out an independent investigation on the matter. Deloitte report said, due to the pulling forward of income and deferral of costs resulted in an estimated Euro 208 million overstatement of revenue relating to prior periods. It shows clearly that this practice was followed for long and over period it snowballed to such an amount. The newly appointed chairman to the group, Mr John Allan states that ” the pulling forward of commercial income from suppliers that was more appropriately attributed to future periods was clearly a management failure within the UK division. The fact that it remained undiscovered has been a matter of deepest concern”. Subsequent to this announcement, the share prices for Tesco fell and started underperforming – an obvious reaction by the market.

Let us think from a common investor point of view to start with. The following may be some of the questions which comes to their mind reading these events, I guess.

  • The results in the prior year were audited and the auditors gave a clean report for those years!!
  • How come they never found such an irregularity? How can I believe those reports to make an informed decision?
  • What is the value addition can someone expect as an investor or simply as the user of the financial statement, from an external audit?

Let me explain what exactly is the auditor/s wants to convey to the users of financial statements, in simple terms (hope it is simple):

  • We have audited the financial statements and tried our best to give optimised benefits under the circumstances.
  • The external audit is an effort to provide a reasonable assurance (readers, please stress this word) about the truth and fairness of accounts and not a certification of the numbers presented as true and correct.
  • To achieve the above, we have fixed a threshold limit whereby any error below that, if we don’t see any reason that it will affect your decision, for example buy or sell the shares, will not be drilled down too much.
  • Finally, don’t worry, the threshold is fixed based on relevant benchmarks like revenue, net worth of the company etc. and you will be informed of any fraud or error which we think is important for your decision making based on our expertise and industry knowledge.

During a recent interview in the press, Dennis Nally, the chairman of PWC International Limited said that he thinks the investor community at large expects more from the auditors in terms of quality, reporting etc. He said the auditing profession should look at the issue and also warned that more extensive investigation requires more time and cost.

The viewpoints and landscape at which an auditor and the user of the financial statements look at an external audit of financial statements is quite different as we can see from the above. This means that the auditor preconceives the user to know every intricacy and the user expects the auditor to do a complete penny to penny investigation. This is called as an “Expectation Gap” (technical jargon for people who like it)
Various studies were conducted by professional and government bodies and they all conclude that expectation gap can be divided into three elements as depicted below:

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Even though it seems easy as it sounds, in reality it is a difficult task. Active and continuous efforts will only help reducing the gap.

Efforts from the Government and ICAI

Recent developments like introducing the brand new Companies Act 2013 by the Ministry of Corporate Affairs and release of exposure drafts on revised and new auditing standards by ICAI is set to reduce the gap. Let me share some of it for the reader’s benefit.

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The restructuring of the Companies Act in India is an appreciable step from the lawmaker towards the goal of transparent conduct of business and financial reporting. The regulator of accounting profession in India, the ICAI is also improving and revising standards, issuing guidance notes etc to increase the professional awareness of its members. Also peer review of the professional work done is a good yardstick which ICAI uses as an appraiser tool to regulate the conduct of various attesting functions.