In accordance with the framework laid out in the International Standards of Accounting (ISA), the main objective of auditors is to ensure that they are able to provide reasonable assurance regarding the financial statements not being materially misstated.
This requires the auditors to go through stringent audit processes, which ensure that they are able to plan the audit process so that they can base their opinion based on facts.
The audit process is a cumbersome process that revolves around several different audit processes. Based on these observations, auditors are then able to provide analysis regarding the authenticity of the financial statements presented.
External stakeholders (mostly shareholders and investors) then rely on the audit report in order to ascertain the internal functioning of the company, and if it is a safe investment from the perspective of the investors.
What is meant by Inherent Limitations of Auditing?
Despite the fact that the core purpose of the auditing process is to ensure that the larger interest of the external stakeholder is kept in mind, yet there are a couple of limitations that occur in the auditing process, that need to be determined, and subsequently accounted for.
There is a need to account for these limitations so that the auditors are able to get plan the audit process in a manner that contains these limitations to a reasonable threshold.
Regardless of the fact that in most cases, auditors are able to issue an unqualified report, yet there are certain inherent limitations of the audit process that should still be accounted for. These inherent limitations are given below:
1) Judgement in Financial Reporting
In most cases, auditors have no option other than to rely on their professional knowledge and skillset to extrapolate, and make assumptions. Therefore, there is significant use of estimation in the process, which paves way for inaccuracies during the audit process.
This judgment is used by accountants, during the course of the preparation of financial statements, and hence, they are often prone to error in this regard.
For example, depreciation is something that is fairly subjective, and auditors might not have a clear idea if the basis of depreciation used by the company is fine or not.
Even though there are depreciation rules that need to be complied with, yet in a lot of cases, an accountant’s judgment is required in order to make the final decisions.
The financial statements are a reflection of these judgments, and there is no way for an auditor to find out if these judgments are rationalized with proper knowledge.
2) Generalization and Estimation on the part of the auditor
Regardless of the fact that the audit process does involve rigorous research, yet across the magnitude of planning that goes in the auditing process, auditors never ‘guarantee’ the fact that there are no material misstatements.
In fact, they can only provide reasonable assurance based on the knowledge they have gained during the audit process. The audit process itself spans several days.
Given the scope of work, and the ground that needs to be covered, it is often not humanly possible for auditors to go through every single transaction in order to check for authenticity. Therefore, they always provide assurance to the best of their knowledge.
3) Human Error
The entire process of audit is carried out by humans. Therefore, the chance of error across different stages of the audit is quite considerable. These errors can range from simple data entry errors to errors in judgment on the part of the auditor.
Additionally, for human errors that are committed on the part of the accountant too, there is no way for auditors to find out what errors were actually made. More often than not, these errors might go unnoticed, resulting in the inaccuracy of the financial statements.
4) Ambiguity regarding accounting treatment of certain financial transactions
For certain accounting transactions, accountants are not always entirely sure of the accounting treatment.
This is because the accounting standards do not provide stringent requirements pertaining to that particular clause, and hence, it is left at the discretion of the accountant to treat the particular line item in any way that he pleases.
Therefore, for such instances, auditors can only rely on the decision taken by the accountants in the company.
For example, Non-Current Assets are supposed to be checked for impairment on a regular basis. In the case of a natural disaster, there is no way for an auditor to find out if the impairment loss recorded in the Income Statement is justified or not.
In the same manner, if the company has written off bad debts, it is difficult for an auditor to ascertain if these receivables are actually irrecoverable.
5) Sample-Based Auditing
Mostly, auditors need to rely on samples that they take from the general ledger or any other book of accounts. It is humanly impossible for them to go through all transactions. This also increases the room for error on the part of the auditors.
In the same manner, it also creates room for sample bias. This can result in inaccurate observations regarding the financial analysis of the company.
Sampling cannot be avoided, but auditors need to do strategize sampling in order to ensure that the correct sample size is used, which can be used as a valid basis of generalization and subsequent extrapolation.
6) Management Cooperation Dependency
The audit process cannot be solely executed by the auditors on their own. They are dependent on the support of the management in order to complete the audit process in a smooth manner. In the case where the management does not provide support, the audit process cannot be executed in a smooth manner.
It will eventually result in an Adverse Opinion being issued on the part of shareholders, yet the overall process of audit is tarnished as a result of management non-cooperation.
For example, if management refuses to answer some of the questions, or if the auditors are unable to be satisfied with the responses delivered by the management, the audit process might not go as expected. Even if the auditors issue an adverse opinion, or a qualified opinion, the overall purpose of the audit might be rendered useless.
7) Possibility of Fraud
Followed by the cases of Enron and World Com, the field of audit has seen some significant changes directed towards making the process more effective. However, despite these changes, there is still a possibility of fraud, in the case where the auditor is not reputed enough.
If investors solely rely on the audit report, and the audit report is a combination of fraud by the auditors and the company, investors might end up losing their money. This is an inherent limitation of the audit process because there is no way to know if there is fraud or not by the investors unless it actually happens.
Therefore, it can be seen that there are certain inherent limitations that need to be considered when it comes to the audit process. This does not imply that audit is a redundant feature that can be ignored. The importance of audit is manifold considering the impact it has on the security of investments from the shareholders.
Additionally, it also becomes the responsibility of the auditor to ensure that these risks are minimized to a maximum level so that the efficacy of the audit process is not compromised upon.
