Taxation case study: Sole trader to limited company

Question

James fish, a management consultant, has been advised by his accountant to continue his unincorporated trade through a company. The business has been trading for around 10 years and has 30th April year end. The company will be wholly owned by James and he will be the sole director. The business profits before James’ drawings have historically been around £50000 and it is expected that these will continue at this level. The business is registered for VAT and James wants to retain his VAT number when the company takes over the trade. The business uses a motor car which is owned by James but no other material business assets.

Discuss the following in relation to income tax, corporation tax, capital gains tax, value added tax, and National insurance:

1.      What special need to be considered at the end of the sole trader business?

2.      What special issues need to be considered at the start of the limited company business?

3.      What tax reliefs could be used to minimise any tax liabilities following the change in business ownership?

4.      From a tax-only viewpoint what method(s) of personal cash extraction from the company would benefit James (illustrate any potential tax savings or increase compared to his profits as a sole trader)?

5.      Should the company own the car or should James retain it outside the company?

 Ans:

INTRODUCTION

Mr James Fish is a sole trader who has been advised by his accountant to change his sole proprietorship business which has been trading for ten years in to a limited company. James Fish is a high income earner (his profit being around £50,000) and after the change to a limited company he will be the only director and therefore he will be entitled to the whole profit of the business. This change from sole trader to a limited company will surely have an impact on James’s tax liability due to different tax rates and rules between sole trader and limited company.
Therefore this report will be discussing issues which James should consider at the end of the sole trade and at the start of the limited company. Moreover, this report will assess the tax savings or increase due to the change and any possible tax relief which James could use to reduce his tax liability. Furthermore, it will advice James on whether he should retain the car outside the business or let the company own it. After discussion of all important matters in relation to income tax, capital gains tax, corporation tax, National insurance and value added tax (VAT), recommendation will be given on whether James should incorporate his business or not and if yes, what he can do to reduce his tax liability.

ISSUES TO BE CONSIDERED AT THE END OF THE SOLE TRADER

At the end of the sole proprietorship, there are issues which need to be considered such as overlap profit, overlap relief, trading losses, and capital allowance, VAT and Capital Gain Tax. According to Melville, (2011) an overlap profit arises when the business accounting period ends not on 5^th April. However, any business with accounting period ending between 31^st March and 4^th April will be treated as if the accounting period ends on 5^th April in order to avoid very small overlap period and profit. Overlap profit results when profit at some point is charged tax twice on one tax assessment. In James’s case, it is clear that there must be an overlap profit due to the fact that his business accounting period ends on 30^th April. Therefore at some point James’s profit was charged twice in one tax assessment (see appendix 1).

The presence of an overlap profit in the opening years raises another issue called overlap relief. The business will be relieved through deduction of the amount of the overlap profit raised in the opening years from the business trading profit of which tax is to be charged in the final year of the business. The aim of this relief is to make sure that the total amount of tax charged on trading profit is equal to the one charged in each accounting period on adjusted trading profit. Since it was concluded that James’s business has got an overlap profit, therefore his business will be entitled to an overlap relief at the end of the business (during incorporation). If this overlap profit is higher than his trading profit then the loss will be eligible for the tax relief, however in James’s case this will be unlikely due to his high trading profit compared to 11 months (see appendix 1) of overlap profit. However, an overlap profit may increase or decrease during the trading period due to change in accounting date. This happens when the business decides to change from one ending accounting date to another. Therefore an overlap profit from the earlier years may either be relieved by subtraction from the profit or more overlap profit come up during the change.

Another issue to be considered is cessation of trade. This happens when the sole trader decide to sell his/her business or dies or retire from the business (Melville, 2011). Incorporation is treated as a cessation due to the fact that owner of the business is the one who is charged income tax and not the business, therefore, it is an ending of one business and starting another. If the business ceases in the same year which trade commenced, then tax will be charged on the whole period of the business. If the business in the second year ceases its trading, then the basis period for taxation will start from 6^th April to cessation date. If the business ceases it’s trading in third or more years, then the tax chargeable in final year will be charged from the end of the previous tax year to the date of the cessation which may be shorter, equal or longer than twelve month period. In James’s case, it is clear from the question that he has been trading for ten years; therefore he will be charged tax from the end of the previous tax year to the cessation date.

Capital allowance is another issue to be considered at the end of the sole trader business. According to hmrc.gov.uk capital allowance is the tax relief on capital expenditure in form of standardised depreciation allowance. In James’s case the only business asset is the motor car. Even though it is not clear when the car was bought, James can claim for capital allowance for the car of 20% if the car falls under main pool (cars acquired after 6^th April or with CO2 emissions of 160g/km or less) or 10% if it falls under special pool (cars with CO2 emission over 160g/km) and this allowance should be calculated with respect to the period of accounts (chargeable period). This is because capital allowance is given in respect of period of account (chargeable periods). Moreover if James did not claim the maximum written down allowance during the previous years, then his written down value brought forward will be higher and at the same time his allowance available for this chargeable period (the last one) will be higher as well.

Another thing which James should consider is if there are any trading losses in the final year. If there is any trading losses then James will able to claim for the terminal trade loss relief even though it does not look to be the case in James’s business due to his average profit of around £50000 per annum. Next issue to be considered is Value added tax. “VAT is an indirect tax which is charged on the supply of a wide variety of goods and services” (Melville, (2010). Traders who are registered with VAT suffer nothing due to the fact final consumer are the one bearing the burden of VAT. Therefore James as a registered VAT trader can recover the VAT he paid to his suppliers from the HMRC.

 One more issue which should be considered is Capital gain tax. This gain arises if there is a chargeable person (individual or companies), chargeable disposal (sale or gift of whole or part of assets, and chargeable asset (property, etc regardless of their location). In James’s case, the transfer of the business into a limited company will be treated as the sale of his business assets in return for shares wholly or partly plus cash. Therefore he should consider the capital gain tax since he will be charged 28% or 18% depending on his income level after being exempted £10100. However this tax liability can be reduced if James has met conditions to claim for capital gain tax relief such as entrepreneurs’ relief.

Furthermore, James could claim for a transitional overlap relief if his business existed before 6^th April 1994 (before this date, tax was assessed on the preceding year basis), however in James’s case this is not possible due to the fact his business was established 10 years from now (2011).

ISSUES TO BE CONSIDERED AT THE START OF THE LIMITED COMPANY

When starting a limited company there are issues such as requirements under the company Act 2006, classification of the company, the duties of the directors, the scale of the corporation tax, VAT registration and rates of the corporation tax which should be considered. At the start of the limited company, registrar of the companies should be provided with the memorandum and articles of association with the name, objectives, address of the company, directors, company secretary ( not necessary for private company) and the type of liability. Moreover the company under the Company Act 2006 is required to keep statutory books to record its constitution and books of accounts to record its transactions according to financial reporting standards, international accounting standards or international financial report standards. However for small companies, they may adopt financial reporting standards for smaller entities which they are within the UK GAAP. The company can be classified as small due to its turnover being less than £6.5m, its balance sheet balance being less than £3.26m or having less than 50 employees. However medium Size Company will have a turnover of less than £25.9m, a balance sheet balance of less than £12.9m, or less than 250 employees. Another issue to be considered is director’s duties under the Company Act 2006 which are duty to act within powers, duty to promote the company’s success, exercise independent judgement, exercise reasonable care, skill and diligence, avoid conflicts of interest, duty to not accept benefit from third parties, and duty to declare interest in proposed transactions. Since limited company will be charged corporation tax, the scope of the tax should be considered at the start of the company. For the tax purpose, the company is a UK resident if it is incorporated in UK or if it is controlled and managed from UK. All UK companies are charged Corporation Tax regardless of where or how they earn their profit. One more issue which should be considered at the start of the limited company is the rate of tax. Corporation tax is charged on all company’s profit and gains (capital gain) at the rate of 21% for the profit less or equal to £300000, then 29.75% for the profit between £300001 and £1499999 and 28% for the profit more or equal to £1500000. However, the company will be able to save on capital gain by using indexation allowance which aims at ensuring that the company gains which are caused by inflation are not charged to tax. The company can pay dividend to its owners after tax or it can pay salary before corporation tax of which it will have to pay national insurance class 1B. Final issue is VAT registration, James since he has already registered with the VAT when he was trading as a sole trader, then he can either apply for a new registration number for his limited company by completing an application form, or asks to retain the previous number. Since it is clear that James wants to retain his old VAT number then he will have to complete an application form plus form VAT68. Moreover he may also have to complete form VAT2 Partnership details.

POSSIBLE TAX RELIEFS

There are some tax relief which James could use to minimise his tax liability following the change in business ownership such as Terminal Trade Loss relief, incorporation relief and entrepreneurs’ relief. Terminal trade loss relief can be claimed when the incorporated business suffer a loss in their last 12months of trading. This loss can be set against the profit earned by the business in the year of cessation or within the previous three years starting with the latest first. Moreover, if there is still a loss which has not been relieved, then that loss can be set against income (salary, dividend and interest) received by directors or shareholder of the company. However, in James’s situation this may not be the case because it is clear that, his profit has been around £50000 and this will continue. Therefore there will be no loss relief to be claimed by James.

Another relief which James could use to minimise his tax liability is incorporation relief. Incorporation relief arise when there is a gain earned due to transfer of an unincorporated business to a limited company in return for that company’s shares. This gain is held over until the day where the transferor sells those shares and then he or she can claim for the relief. For the transferor to be able to claim for this relief he or she must meet certain conditions such as, the business transferred to limited company as a going concern, all assets (except cash) has been transferred to the company and the transferor has received shares wholly or partly as part of the consideration. In James’s situation, since he is willing to be the only owner, this means that he will transfer the whole business into a limited company in return for shares, therefore he will be able to claim for this relief as long as there is any gain earned due to this transfer. This relief applies automatically and therefore there will be no need for James to claim for it, however he can decide not to apply for the relief.

Another relief is entrepreneurs’ relief which arise due to material disposal of assets of the business. According to Melville, (2011) Material disposal of assets means whole or part disposal of sole trader/partnership business assets owned during the period of one year to the day of disposal, disposal on cessation of trade of assets used in the business, or disposal of the company’s securities or shares where the seller is the owner of the company. In James’s situation, James will be able to claim for this relief since he has met all the conditions and therefore he will be charged 10% on the gain earned during this disposal, however there is a lifetime limit of £5million of gains which he can claim. Therefore if James has not exceeded this lifetime limit then he has to claim for the relief before a year 31^st Jan after the end of the tax year of disposal.

POSSIBLE TAX SAVING/INCREASE DUE TO CHANGE

One question James’s would ask himself is what is the impact of the change in relation to tax? This question will be answered in this section of the report.

There are possible tax saving and possible tax increase due to incorporation depending on James’s decisions after incorporation. One of the decisions which will affect James’s tax liability is the decision of being paid salary by the company since he is the only director of the company. This decision will help James’s company to reduce the amount of the corporation tax liability since salary is an allowable expense, therefore it will reduce the amount of profit chargeable to tax. This may lead to smaller amount of chargeable trading profit compared to when James was operating as a sole trader since he was not receiving salary for working in his company (self employed and hence receive profit only). However, this decision will not only increase James’s employment income and hence PAYE tax but also National Insurance contribution. James will be paying National insurance both class 1 primary and secondary since he is acting as both employee and employer (his company). Therefore after deducting an exemption of £5715 James will be charged 11% as employee up to £43875 and 1% for the remainder and 12.8% as employer. This is different from the sole trader who pays national insurance class 2 for the fixed sum of £2.40 per week provided earnings are above £5075 per annum and class 4 based on the taxable profit where after exempting £5715 he pays 8% up to £43875 and 1% for the remainder. Therefore James’s decision to receive salary as the director of the company will increase his tax liability compared to when he was a sole trader. Another decision James can make is to receive dividend instead of salary. This will result into a high corporation tax due to the fact that dividend is chargeable to investment income. Moreover, James will not receive salary and instead receive dividend, therefore the amount of salary which would decrease the taxable profit will be zero and hence no decrease in taxable profit. However, James would be able to save on the investment income by paying 10% of tax for the first £37400 of his dividends, and then 32.5% for the extra amount up to £112600 and 42.4% for the remainder. This decision will save James a huge amount of tax compared to when he was a sole trader.

Moreover James by incorporating his business he will increase his capital gain tax liability since the gain earned from the sale of business assets will be charged as part of the business profit in corporation tax under Taxation of Chargeable Gains Act 1992 at the rate of either 21%, 28% or 29.75% depending on profit level while if he was a sole trader, the gain earned from selling his business assets will be charged 18% or 28% depending on his income level after deducting the annual allowance (£10100). Furthermore, James by incorporating his business he will increase his running expenses since he will have to example employ an accountant to prepare his accounts, etc, therefore these cost since they are tax allowable expenses, they will help James to reduce his corporation tax liability, however the employment of an accountant will increase his PAYE and National Insurance contribution.

CAR OWNERSHIP

Another question which James will be asking himself is whether to retain the car outside the company or should the company own it. Either of the decision will have an impact on tax, therefore James should go with the decision which will reduce his tax liability. As a sole trader, James was using his own car for the business purpose. This was saving him a lot of money on tax since using your own car for business purpose is an allowable expense, this means James will be charging the expenses incurred from the use of the car against his trading profit. This reduces his taxable profit and hence pays less income tax. Moreover, this saves James on the amount to be paid for National insurance. This is due to the fact that, National insurance class 2 is paid out of the self employed person’s total earning, therefore in James’s case, he will have less total earning due to deduction of allowable expenses incurred due to the use of his own car for business purpose.

On the other hand, if James decides to leave the company own the car; he will be charged tax on benefit in kind since James is a P11D employee. Therefore, he will be charged benefit in kind tax depending on the level of CO2 emissions. If the CO2 emission is less than 75g/km then the applicable percentage will be 5%, if it is between 76g/km and 130g/km then the percentage will be 10% and if it is 121g/km to 130g/km then the percentage will be 15% and each additional 5g/km will result into a 1% increase. These percentages will be applied to the lower of either the price of the car less any contribution made by James on the car’s cost up to £5000 or £80000. Moreover the company as James’s employer will be charged National insurance class 1A. This is due to the fact that the company’s car used by James is treated as a benefit in kind. Therefore the company will be charged 12.8% of the total amount assessed for income tax purposes on James as a benefit in kind. However, James can leave the car as his personal car and charge the company on mileage. For the first 10000 miles in the tax year James will be able to charge 40p per mile and 25p per mile for each mile over 10000 miles. This will reduce his corporation tax due to the fact that this is an allowable expense.

CONCLUSION AND RECOMMENDATION

After discussion of all important matters in relation to Income tax, Value added tax, Capital gain tax, National Insurance and Corporation tax, it can be concluded that, at the end of the sole trader business James should consider his overlap profit and claim an overlap relief if there was an overlap profit at the start or during the business. Moreover he should claim for his VAT paid to suppliers since he is a trader and not a final consumer. Furthermore, James can claim for the capital allowance and should take into consideration capital gain tax since he is exchanging business assets with shares in his limited company. Before the start of the company, James will be required to provide memorandum and articles of association with names of directors and address of the company. Moreover, since his company falls under small size company category, he will be required to prepare his accounts in accordance with the UK GAAP and it will be taxed corporation tax on all of company’s profit including capital gains at the rate of 21% if the profit is less than £300000, 28% for profit above £1500000 and 29.75% for profit between £300001 and £1499999.

James can claim for entrepreneurs’ relief, incorporation relief or terminal trade loss relief if his business suffered a loss in the final year which will help him to minimise his tax liability due to change of ownership. After changing the business into limited company, James can receive salary which will reduce his corporation tax liability and increase his national insurance contribution and PAYE or receive dividend which will increase his investment income and reduce his corporation tax liability and National insurance contribution. Moreover he can decide to leave the car owned by the company which is more expensive compared to when he decides to leave it as a personal car and charge the company on mileage.

From this conclusion, James can be recommended to go ahead with the transfer of the business into a limited company if he thinks that this will help him to maintain his profit or expand his business; however he should consider the possibility of increasing cost of administration and compliance. Moreover, he should claim for any relief available to him such as entrepreneurs’ relief and incorporation relief since these will minimise his tax liability. Furthermore, after the transfer of business, he should receive dividend instead of salary since by receiving dividend he will be saving on tax compared to receiving salary. One more thing is that, James is recommended not to leave the car owned by the company since this will increase his tax liability and instead own it as his personal car and charge the company on mileage.

REFERENCES

Alpha business services (2011) start your own business. Available at: http://www.alphalimited.co.uk/guides/start-your-own-business~8/form-of-company-limitedcompany/  (07/02/2011)

Combs, A., Dixon, S. & Rowes, P. (2010) Taxation: Incorporating the 2010 Finance Act. 29^th Ed. Birmingham: Fiscal Publications

HM Revenue and Custom (2011) Capital gain tax on business assets. Available at: http://www.hmrc.gov.uk/cgt/businesses/reliefs.htm (07/02/2011)

HM Revenue and Custom (2011) capital allowances. Available at: http://www.hmrc.gov.uk/businesses/capital-allowances.htm (03/02/2011)

HM Revenue and Custom (2011). What if I change my legal entity? Available at: http://customs.hmrc.gov.uk/channelsPortalWebApp/channelsPortalWebApp.portal?_nfpb=true&_pageLabel=pageExcise_ShowContent&id=HMCE_CL_000086&propertyType=document#P521_56861 (23/2/2011)

Link for business (2010). Tax issues for sole trader. Available at:http://link4business.info/2010/11/tax-issues-for-sole-traders/ (31/01/2011)

Melville, A. (2011) Taxation: Finance Act 2010. 16^th Ed. England: Pearson Education Limited.

Taxation web: sole trader to limited company. Available at:http://www.taxationweb.co.uk/forum/sole-trader-ltd-company-t12.html (31/01/2011)

Audit Expectation Gap

1.     INTRODUCTION

Expectation gap is “the gap between the role of an auditor as perceived by the auditor, and the expectations of the users of financial statements” (Hussey, 1999). Expectation gap is an important current auditing issue because it involves two important groups in an audit which are stakeholders and auditors. Moreover, expectation gap worth discussing because its continuous existence would lead to the public not being capable to recognise auditor’s contribution to the public and this may weaken the significance of audit purpose. Therefore, this report will aim to look at the reasons as to why the expectation gap still exists and any possible solution which can be taken to solve this problem. In order to conclude on the reasons as to why the gap still exists, this report will critically discuss causes of the gap and suggested solution put forward by other researchers. After critical discussion of the causes, possible solution to the gap and conclusion of the reasons as to why the gap still exists, this report will provide recommendation on how the gap can be bridged.

2.     BACKGROUND

The name “expectation gap” was firstly used in United States in the auditors’ responsibilities commission famous as the Cohen Commission formed by AICPA in early 1974. This commission was established due to the increase in public criticisms regarding the quality of auditors’ performance; it had one specific task of recommending on the responsibilities of auditors. The commission concluded that stakeholders expectation towards auditors' abilities were reasonable. Nevertheless, many stakeholders misunderstood the nature of the auditor’s role, especially in the situation of an unqualified opinion.

In 1975 the US government decided to establish the senate subcommittee famous as the Metcalf Committee due to failure of auditors to report on failures in public companies. This committee was formed to look into and recommend ways in which the accountability of auditors and public companies management can be improved. This was followed by the House commerce committee known as Moss Committee which was formed in 1976 to investigate on the corporate accountability standards. In 1977 comparable issues led to the establishment of the special committee known as Adams Committee by CICA to investigate on auditor’s roles.

Even though the word Expectation Gap was originated in United States, this gap has been around for more than 100 years (Lee, et al. 2009) and similar issues regarding the auditor’s roles and accountability were at the same time being expressed in other countries such as United Kingdom, Australia, Malaysia, and Singapore.

3.     REASONS FOR THE GAP

This section of the report will critically discuss the reasons for the existence of the expectation gap.

3.1.          Auditor’s Deficient Performance

Auditor’s deficient performance is one of the causes of the expectation gap. Deficient performance includes lack of experience, knowledge and care. This is associated with the way audit firms arrange their day to day work which mostly is carried out by people with less or no experience and qualification (See appendix 2). Lee et al (2007) in Malaysia and Porter in New Zealand found that some of the audit duties done by non-auditor respondents were poorly performed. According to Humphrey et al. (1992) one of the reasons for the incompetence is the Level of audit fees. This means the lower the audit fee the lesser time spent on the company and less experienced staff involved due to cost of equating them being low. Moreover, audit fees may force auditors to limit their performance in order to maximise their interest at client’s expense as it happened in the Grays building Society. (See appendix 3 and 5). Furthermore, Lee et al. (2009) argued competition for human capital is another factor causing incompetence. This means skilled and experienced auditors prefers to move to countries where they will be offered high wages and benefits. Commercial life complexity is another reason for incompetence as argued by Gray and Manson (2000). For example Bank of Credit and Commercial International where their complicated interest around the world with complex financial arrangements plus fraudulent activities by their management made a toxic combination which many auditors might find hard to manage.  However it can be argued that lack of competence is no longer the reason for the gap due to the introduction of “rules regarding issuing of practising certificates by the audit professional bodies, post-qualifying educational requirements of the professional bodies, monitoring of audit activity by professional bodies following the company Act 1989 and disciplinary procedures by the accounting bodies following investigation of apparent audit failures” (Gray and Manson, 2000 pg.521).

3.2.          Lack of Auditor’s Independence

Auditor Independence is the way in which auditors show that they can perform their responsibilities in an objective way, (Salehi, M. Et al. (2009)). Auditor’s independence is important since it adds creditability to the report and is the basis of an audit work and its inadequate can lead to the auditor’s opinion to be questioned. Society observation of auditor independence is vital because the clear independence depends on public view of things which could damage the genuine auditor independence. Therefore auditors should make sure that the performance and quality of the audit will not be settled below standards. Inadequate auditor’s independence can arguably be caused by closeness between auditors and clients, blood or marriage relationship between auditors and clients, and auditors looking to pay favour to the board of directors due to re-appointment. Beattie, et al (1999) in their survey in UK argued provision of non audit services to be another factor for auditor’s inadequate independence since it increases auditor’s economic dependency to his clients. For example, in 2000 Andersen received from Enron $25 million as audit fees and $27million as non audit fees. However, it can be argued that auditor dependence has been decreased by the introduction of Company Act 1985 sections 384-394 which regulate ways in which auditors can be appointed, removed, resigned and remunerated.

3.3.          Deficient standards

Lee et al. (2009) defined deficient standard gap as the gap arising due to difference between what auditors can reasonably be expected to do and what they are required to do by the current standards. This report will discuss deficient standards in relation to fraud detection and going concern.

3.3.1.     Fraud

Fraud can be defined to mean the following,

v  theft or misappropriation of assets,

v  Intentionally accountants not applying the accounting principles in relation to classification, disclosure, presentation or amounts.

v  Intentionally omitting amounts from the financial statements and accounting records.

v  Deception which includes manipulation or giving false accounting records for the purpose of getting financial benefit illegally.

Fraud detection is one of the reasons for expectation gap since investors are expecting auditors to detect fraud while auditors are trying to suggest to investors that their duty to detect fraud is limited. Lack of fraud detection has played a huge part in many of the accounting scandals such as PARMALAT and has resulted into investors losing their money. However, Cosserat, (2004) argued that the auditing standards have been improved after fall of big organisations in order to put emphasis on auditors responsibility in detecting fraud. He argued that before Enron Scandal Auditors were required to report only on fairness and truth of the financial statements without regarding if the misstatement was accidental or fraudulent. The fall of Enron showed that the approach used by auditors did not take into account management intention when producing falsified financial statements. This led to the introduction of new standards such as ISA 240 which requires auditors to take more positive steps in fraud searching such as question reasons for rise of matters such as unusual and unreasonable transactions which lacks business underlying principle, any figure of accounting estimates which is unjustifiable and uncertainty in correcting errors exposed by an audit which are immaterial. Another standard is ISA 315 where auditors are required to assess management risk framework of an entity as the proper way to prevent misstatements.

3.3.2.     Going Concern

Going concern “is the assumption that the enterprise will continue in operational existence for the foreseeable future” (Gray and Manson, 2000). This means, the financial statements show no intention or need to liquidate or reduce the level of operation. Auditors mostly come into criticism after there has been a failure of the company and in its Annual report by auditors or directors has been no suggestion that the organisation had any problems with going concern. This causes expectation gap since investors expects auditors to suggests any problems regarding going concern while auditors are limited by the standard only to be attentive to the likelihood that the concept of going concern was not valid. However this problem has been minimised after the introduction of the ISA 570 and SAS 130 which requires directors to decide whether the company does not have going concern problems. Moreover, it requires auditors to discuss with directors on how they decided that there is no going concern problem and look at the appropriate financial statements.

3.4.          Unreasonable expectation

Unreasonable expectation is when public is expecting auditors to do what they are not required by the standards to do or may not be capable of doing it due to cost-beneficial issues, (Lee and Azham, 2008). Unreasonable expectation is mostly caused by the public ignorance and inexperience on the auditor’s duties. (See appendix 4). The community is the free audit function attacker; therefore it may be adamant that auditors should take on duties which in reality cannot be performed by auditors due to cost-beneficial issues. This cannot be avoided because public is not paying for the cost of the audit. Moreover, there are confusions concerning auditor’s duties in fraud detecting and reporting. This is because the public assume that auditors check every transaction during audit function which is in contrast with the actual audit function where an auditor uses sampling techniques. Lee et al. (2009) argued that unreasonable expectation may have a negative impact on audit profession because community may possibly not be capable to recognize the auditor’s contribution to the public and may weaken the significance of the audit purpose. He argued that the only solution to unreasonable expectation is by making the public contributing to the cost of performing an audit function. However, this may lead to more expectation since the public will expect more from the auditors than before.

4.     SUGGESTED SOLUTION

 After the critique discussion of the reasons for expectation gap, this section of the report will discuss the possible solution to the expectation gap.

4.1.          Expansion of auditors’ duties and responsibilities

Gray and Manson (2000) argued that expansion of auditor’s duties will help to reduce the gap. Humphrey, et al (1993) argued that it is impossible for the community to discard their expectation that auditor is a fraud detective through modification of auditor’s report length or education. Therefore it is the responsibility of the auditing bodies to introduce/improve auditor’s duties and responsibilities. Knutson (1994) suggested that auditing bodies should introduce a standard to deal with the expectation gap which will hold auditors liable for what they must have known and not for what they might have known. Moreover, Sherer, et al (1997) suggested that standards should be introduced to limit number of services auditor can offer in order to limit his economic interest. However, these suggested solutions might be expensive to implement and therefore cost benefit issues should be assessed before the implementation.

4.2.          Awareness of the Public

Epstein and Geiger (1994) discovered that investors with some knowledge in accounting, investment or finance will be likely to demand lower audit assurance compared to ignorant investors. Therefore the only way to reduce expectation gap is through explanation of the audit function and limitations to the public. This communication of audit function and limitations can be done in Annual General Meeting or be included as part of the audit report. This will help to reduce the unreasonable expectation gap since the public will be aware that their expectations are unrealistic.

However, educating the public is not an easy solution since not all shareholders attend the Annual General Meeting. Therefore those ones who miss the meeting will still be expecting unrealistic auditor’s duties and responsibilities.

4.3.          Provision of more Clarity Auditing Standards

Sherer, M. et al 1997 suggested that in order to solve the problem of expectation gap, auditing standards should be adjusted to make rules and regulations clearer to both Public and Auditors. For example, SAS 130 and ISA 240, from the titles of these standards (see Appendix 1) it can be suggested that duties and responsibilities of auditors are clear however they are not clear when reading them especially to the public with no auditing background. According to Lee, et al (2007) SAS 130 raises the problem of who is responsible to report going concern, directors or auditors? In ISA 240 Directors of the company have the primary responsibility to detect fraud and auditors have the secondary responsibility with limitations. The standard agrees with the fact that detecting fraud is more difficult than detecting an innocent error since efforts have been made to hide the misstatement. This standard limits auditors’ efforts to find material misstatements since they have a secondary responsibility in detecting fraud. Therefore, auditing standards should be clearer with situations where auditors will and won’t have duties and responsibility to deal with issues such as going concern and fraud.

4.4.          Technological Change

Technological change is another solution suggested by Gray and Manson (2000). This solution may help to reduce the problem of unreasonable expectation. This is because, public assume auditors verify all transaction during an audit while in reality is not true, therefore an introduction of the new technology might let this happen. The introduction of the sophisticated auditing techniques would allow an auditor to set parameters for testing every transaction and for transactions which do not meet the parameters should be subjected to further examination. This technology will make the impossible possible and hence solve the problem of unreasonable expectation. However, this new technology will cost money to develop and run it, therefore cost beneficial issues should be measured before the implementation.

4.5.          Independent Audit Office

Humphrey, et al (1993) argued that, auditing bodies should introduce an independent auditing office which will examine the appointment of auditors, the level of audit fees paid and review the audit done by auditors in order to improve auditor’s independence. Furthermore, introduction of the regulatory pressure on the performance of the auditor will help to improve the auditor’s actual performance. This means, audit office by monitoring all auditing firms will have a positive effect on the auditor’s performance. However this solution would lead to dishonest from some members when reviewing auditing firms they have interest in.

5.     REASONS AS TO WHY THE GAP STILL EXISTS

After looking at reasons for the gap and suggested solution, this section of the report will look at the reasons as to why the gap still exists.

 It has been suggested in the solution (independent audit office) that by having audit office monitoring all auditing firms will have a positive effect on the auditor’s performance. This solution has some limitation in implementing it since it is time consuming and members will have to be trained in order to perform the annual reviews. Moreover if members are interested in one audit firm, then there is a possibility that they will try to favour that firm by performing the reviews dishonestly just to get their employees cleared to perform audits.

Moreover, level of audit fees is another contributing factor as to why the gap still exists. According to Lee et al (2007) it will not be cost beneficial for the audit firms to send their best, experienced and most expensive auditors to perform audits on small companies which will pay small audit fees. This will result to smaller companies not getting the same level of service compared to larger more wealthy companies. This means the less skilled auditors might fail to spot mistakes or fraud within the smaller companies which a more skilled and experienced auditor might pick up.

Furthermore, difficulties in educating the public are another reason as to why the gap still exists. It has been suggested in one of the solution (awareness of the public) that public should be given education on audit functions and its limitation through annual general meeting (Epstein and Geiger 1994). However this solution has some limitation in implementing since not all shareholders attend annual meeting. Moreover, since each shareholder will have his/her own interest, he/she may not be interested in listening to the audit functions and limitations during the meeting.

Another reason as to why the gap still exists is changing in accounting and auditing standards. According to Lee, Et al (2007), auditing standards have been changing within short period which gives no time for auditors to learn and gain experience in applying them. This is one of the reasons for continuing problem of lack of auditor’s competence since auditors have no time to read and gain experience in applying the standard before the new one comes on.

Final reason is the cost beneficial issue. Most of the solution put forward by many researchers could not be implemented due to cost beneficial issues. For example, Gray and mason 2000 suggested about the introduction of the new auditing technology, this technology is not yet introduced due to cost of researching and developing it being high. Another example is Knutson 1994 suggested to the board to introduce new standard dealing with expectation gap only, this standards is not yet introduced due to time consuming and being expensive to set it.

6.     CONCLUSION

Expectation gap is an important current auditing issue which has existed for many years. This report critically discussed reasons for the expectation gap such as lack of auditor’s independence which can be caused by economic dependency on clients, inadequate competence which can be caused by level of audit fees paid by different clients, deficient standards and unreasonable expectation gap. Moreover this report critically discussed solutions such as expansion of auditor’s duties and responsibilities, Public awareness, provision of clarity auditing standards and introduction of new auditing software to verify all transactions during an audit. However expectation gap still exist even though there have been solution suggested to solve it due to cost involved in implementing those solutions, continuous changing in auditing standards, improper ways of educating the public and dishonest by some of the members of the auditing bodies/peer.

7.     RECOMMENDATIONS

In the light of these conclusions, this report is recommending the auditing bodies to run free seminars on audit functions and limitations to public and allow the public to ask or put forward their suggestions concerning an audit. However this recommendation has limitations such as not all stakeholders will attend these free seminars. Therefore, after running free seminars, audit firm should be given time during the Annual General Meeting to educate the shareholders on audit functions and limitations. Moreover, in Annual General Meeting, the company should encourage conversation between auditors and shareholder. After the general meeting, since not all shareholders will attend the meeting, audit firm should be allowed to use mass media to educate the public about audit functions, importance and limitations.

Moreover, auditing bodies should have a free yearly professional development program which will help auditors to refresh their skills and keep up to date with the most recent audit techniques and any improvement in audit standards or legislation and hence solve the problem of inadequate competence. Furthermore, this report agrees with Knutson (1994) by recommending to the auditing bodies an introduction of a new standard to deal with the expectation gap. Final recommendation is that, each company should give the current audit committee a more active role or establish an independent shareholders committee which will be choosing auditors to perform an audit instead of directors recommending to the shareholders auditors which they want to perform an audit. This report is aware that some of these recommendations are expensive and time consuming however in order for the gap to be bridged; auditing bodies should implement them accordingly.

8.     BIBLIOGRAPHY

8.1.          BOOKS

ACCA (The Chartered Association of Certified Accountants). (1992). Eliminating the expectation gap. London: The Chartered Association of Certified Accountants.

Cosserat, G (2004), Modern Auditing, 2^nd ed. London: Thomson learning.

Gray, I. and Manson, S. (2000). The audit process: Principles and practice and cases. 2^nd Ed. London: Thomson learning

Hussey, R (1999). A dictionary of Accounting. England: Oxford University Press.

Humphrey, C.G., Moizer, P. and Turley, W.S. (1992) The audit expectation gap in United kingdom. ICAEW research Board.

Sherer, M. and Turley, S. (1997). Current issues in auditing. 3^rd ed. London: Paul Chapman Publishing Ltd.

8.2.          INTERNET SOURCES

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8.3.          JOURNALS

Beattie, V., Brandt, R. and Fearnley, S. (1999) Perceptions of auditor independence: U.K. evidence. Journal of International Accounting, Auditing and Taxation, 8 (1). pp. 67-107. ISSN 1061-9518

Epstein, M.J. and Geiger, M.A. (1994), “Investor views of audit assurance: recent evidence of the expectation gap”, Journal of Accountancy, Vol. 177, January, pp. 60-66.

Humphrey, C.G., Moizer, P. and Turley, W.S. (1993),“The audit expectation gap in Britain: an empirical investigation”, Accounting and Business Research, Vol. 23, Summer, pp. 395-411

Knutson, P.H. (1994), “In the public interest – is it enough?”, CPA Journal, Vol. 64, January, pp. 32-4.

Lee, T. H., Ali, A. M and Gloeck, J. D (2009). The audit expectation gap in Malaysia: an investigation into its causes and remedies: Southern African Journal of Accountability and Auditing Research Vol 9: (57-88).

Lee, D. D., Faff, R. W and Langfield-Smith, K. (2007) Revisiting the Vexing Question: Does Superior Corporate Social Performance Lead to Improved Financial Performance? Australian Journal of Management: Vol 34: pg 21-49

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Salehi, M., Mansoury, A and Azary, Z. (2009). Audit Independence and Expectation Gap: Empirical Evidences from Iran. International Journal of Finance and Economics. Vol. 1 No. 1.