Centre for Economic Policy Research

3.3
The value of the audit opinion
It is probably not an exaggeration to state that audited financial statements are
central to the efficiency of the capital market and that these statements are broad-
ly relied upon as the key information source in assessing both past stewardship
and expected future use of capital provided to firms.
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The current audit opinion
is expressed in a report attesting to whether the financial statements provide a
‘fair presentation’ or ‘true and fair view’ of the financial performance and finan-
cial position of the entity at a point in time or over a period of time. The form and
content of the report, and thus the nature of the opinion, has evolved from
detailed reviews and comments when audits were a result of private demand to
the often ‘boiler-plate’ versions we see today.
By reducing the information asymmetry between management and investors,
Accounting: Conflicts of Interest in Auditing and Consulting 29

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the certification provided by an audit should have a measurable value. Favourable
opinions issued by audit firms with a strong reputation should be valued more
than those issued by firms with weaker reputations. The available empirical 
evidence confirms that if the top firms have the strongest reputations, obtaining
opinions from them lowers the required rate of return on issuing company
bonds.
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The standard presumption is that a ‘clean’ or unqualified audit opinion 
represents a certification of quality and reliability of the information being report-
ed. Studies suggest, however, that there is a large difference between the percep-
tion of what an audit opinion is intended to convey and what it actually does
(McEnroe and Martens, 2001). Results of the Commission on Auditors’
Responsibilities (1978) sponsored by the AICPA revealed that some users believe
that an unqualified audit opinion indicates that the entity is financially sound.
Users also expected auditors to have performed audit functions to penetrate into
the company’s operations and management and detect any illegal acts or fraud.
(McEnroe and Martens 2001) These expectations are widely held in spite of the
fact that in the United States the audit opinion only indicates that management’s
presentation of the financial information is a fair presentation of the financial
position and performance of the company is in conformity with generally accept-
ed accounting principles (GAAP). This difference in perception versus reality is
known as the ‘expectations gap’. An expectations gap exists in Europe also but
may not be as great. In the United Kingdom and in many European countries
since the 4th Directive of the European Commission, an auditor’s opinion refers
to whether the financial statements present a ‘true and fair view’ of the compa-
ny’s financial position and performance.
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In these countries the audit process
arguably has a focus more aligned with users’ expectations than in the United
States, although in many countries (like France) ‘true and fair’ has no simple 
translation and has made little impact on the nature of the opinion. 
One possible cause of the expectations gap is from the difference between what
auditors report to the company versus what they report to the public. As in 
earlier times when audits were driven by private demand, auditors still provide
management (and audit committees where they exist) with a post-audit report
that details a number of accounting, internal control and even business issues
they discovered during their audit. Yet, these issues are inevitably ‘resolved’ to the
point where the regular ‘clean’ opinion on the published financial statements can
be made. Thus, market participants may presume that large-scale problems do not
exist.
In the face of this large and perhaps growing expectations gap, it is important
to emphasize that despite perceptions that accounting is a precise measurement
system, there is no system of rules that can be written to eliminate the need for
judgement in accounting decisions that are required for periodically reporting on
a company’s financial position and performance (Wallman, 1996). The external
auditor’s primary role is to provide an unbiased opinion on a company’s financial
information provided by management to the financial markets. 
Given the complexity and subjectivity of many accounting decisions, it is 
necessary for an auditor to have both the professional expertise to evaluate 
management’s judgements, and independence from management (Ryan et al.,
2001). Auditor independence is the key factor in ensuring there is no actual or 
perceived conflict of interest with the managers of the firms supplying the 
information (Wallman, 1996). If expertise and independence are the two primary
attributes of a professional auditor, reputation is the primary asset of value to the
auditor and especially the audit firm. Thus, we would expect all the auditor’s
actions to be guided by an overriding desire to avoid damage to this critical asset. 
30 Conflicts of Interest in the Financial Services Industry

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The current crisis of confidence in capital markets, arising from widespread
massive business failures, is clearly exacerbated by the perceived failure of the
auditors to enforce accurate reporting of companies’ true performance and to
identify fraudulent activities in several cases. Many of the companies that failed
spectacularly had unqualified audit opinions prior to their demise. While audit
failures are not a new occurrence, the growing list of assumed audit failures at
large companies has damaged all auditors’ reputations, and brought into question
the auditor’s primary role as an independent expert and monitor of financial
statement information. 
There are three interrelated potential explanations for the perceived audit 
failures: 
1. The expectations gap of the auditor’s role may have increased. The rise of 
class action lawsuits against audit firms on behalf of shareholders may 
reflect this rising expectations gap. 
2. The bull market of the late 1990s, propelled perhaps by overly optimistic 
investor sentiment, may have increased the incentives for management to 
manage earnings, increasing the difficulty of audits. The post-bull market 
catharsis revealed the intense accounting management that attempted to 
meet earnings expectations to sustain high stock valuations. 
3. There were systemic problems from the lack of auditor independence, 
creating conflicts of interest that were exploited. 
All the explanations have some validity and interacted to create a crisis of 
confidence, tarnishing the reputations of the largest audit firms.