According to International Standards on Auditing ISAs, auditor is required to obtain reasonable assurance whether financial statements give true and fair view or in others words he must be reasonably sure that financial statements are free from material misstatements.
Again, I must emphasize he needs to be reasonably sure and NOT absolutely sure. There is a big difference if you are absolutely sure about something or reasonably sure.
Making the two level of assurances easy to understand in context of financial statements and audit engagements or other assurance engagements, absolute assurance means that there is absolutely no misstatement in the financial statement and thus financial statements are absolutely reliable and relevant for the user of financial statements. On the other hand reasonable assurance is also a high level of assurance but it means that auditor has conducted the engagement in a way that he is reasonably i.e. to the best possible extent provided the situation circumstances he is reasonable sure that financial statements are free from material misstatement but there might be some misstatements that go undetected.
The reason why auditor is unable to obtain absolute assurance is not because auditor’s do not conduct audit engagements with enough care rather there are limitations and these limitations restricts the auditor to obtain only reasonable assurance and even with such limitations and restrictions auditor tries his best to provide some level of assurance to the users to reinforce their confidence in the financial statements.
Such limitations that restricts the auditor to gain absolute assurance are known as Inherent limitations of an Audit.
Inherent Limitations of an audit
Inherent limitations of an audit arise due to the following reasons:
- Persuasive evidence instead of conclusive evidence
- Inherent limitations of an accounting system:
- Use of judgement in establishing estimates for reporting purposes
- Human error
- Absence of clear instructions on accounting treatment
- Room for more then one possible interpretations of the requirements
- Degree of uncertainty and complexity of the transactions involved
- 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.