Inherent limitations are such features of audit that constrains the auditor to obtain absolute assurance. It is because of these inherent limitations of audit the practitioner cannot assure the users of financial statements that financial statements are absolutely free of (material) misstatements. As a result of these limitations auditor is expected provide reasonable assurance which is high level of assurance i.e. reasonably high but not touching the levels of absoluteness.
Inherent limitations cannot be completely eliminated but the effects of such limitations can be reduced to an appropriate level. On auditor’s part, the effects of inherent limitations are reduced by taking appropriate steps e.g. proper planning to conduct audit engagement especially the risk prone areas, adequate supervision of junior members of audit team etc. To read more about how auditor overcomes inherent limitations of audit please read this: http://pakaccountants.com/how-to-overcome-inherent-limitations-of-audit/
Inherent limitations of an audit does not arise due to any particular reason rather there are several reasons that contribute and collectively restricts auditor in many different ways to limit him only to reasonable assurance. Here is a list of some of the limitations auditor faces while conducting audit engagement:
- Persuasive evidence instead of conclusive evidence: Evidence can either be conclusive i.e. solid evidence after which no further proof or inquiry is required and the evidence in itself is complete and needs no supplemental evidence for example bank statement showing the amount in bank account is a conclusive evidence. However, there are certain evidence which auditor gathers that persuade the auditor instead of confirming completely. For example, the deteriorating condition of one debtor persuades the auditor that a specific provision is necessary.
- Inherent limitations of an accounting system:
- Use of judgement in establishing estimates for reporting purposes: In reporting many important financial quantities management takes help of estimation and this opens the door to inaccuracies as well. For example depreciation expense for the year is a perfect example which can either be more or less than the real depreciation. As there is almost no way available to quantify the devaluation of asset, accountants can only estimate it.
- Human error: In the end there is always a man behind the machine. To enter the data which is to be processed by accounting system we have to employ humans and humans can make mistakes and such mistakes can penetrate in the financial information as well. Although we can devise several checks to fight these errors but we cannot completely eliminate it. One reason for not able to do so is cost-benefit issues and after all even if we have the system that eliminates human errors, it will be too slow to be any good!
- Absence of clear instructions on accounting treatment: There are many instances where certain events and resulting transactions happened for which accounting standards do not provide clear instructions regarding accounting treatment and this may lead to confusions and puts management in a position to use their judgment to decide about best possible reporting alternative available.
- Room for more then one possible interpretations of the requirements or more than one possible treatments: This as well adds up to the confusion on part of management and auditor and both may have differing opinions. Most often standards give this option on their own to those preparing financial statement.
- Degree of uncertainty and complexity of the transactions involved: Auditors conduct audit on sampling basis. More the complexity more the risk will be and use of sampling techniques limit the auditor to reach such conclusions that provide absolute assurance as auditor has not tested each and every item in the population.
- Negative effects of subjective decisions or bias on part of the management or employee of the entity
- Existence of fraud committed by entity’s management or employees and thus concealing important financial information leading towards fraud
- Use of sampling techniques by the auditor in conducting different audit procedures. In sampling auditor applies audit procedures only to a small portion of the whole population instead of checking each and every element of the population.
- Practical and/or legal limitations to obtain sufficient appropriate audit evidence
- Limitations applied or forced by the management
- Limitations as agreed upon in engagement letter
- Auditor does not have investigative rights and cannot demand certain information or evidence from management if refused by the management
- Existence of situations at present or in future that may cause an entity to stop being a going concern
- Cost-benefit limitations i.e. conducting audit engagement requires resources which auditor might not have or in auditor’s judgment cost of gaining additional assurance will be higher than the benefit gained and thus not obtained.