[FAQs] Comprehensive Guide to Auditing Standards | Objectives | Limitations

• An audit does not provide assurance to investor in shares regarding safety of his money. Share prices of securities are affected by range of factors.
• An audit only provides reasonable assurance that financial statements are free from material misstatement whether due to fraud or error.

An Audit of Financial Statements include within its scope the following:

1. Coverage of all aspects of entity: Audit of F.S. should be organized adequately to cover all aspects of the entity relevant to the F.S.
2. Reliability and sufficiency of financial information: Auditor should be reasonably satisfied that information contained in accounting records and other source data (like bills, vouchers, documents etc.) is reliable and provide sufficient basis for preparation of F.S.
3. Proper disclosure of financial information: Auditor should decide whether relevant information is properly disclosed in F.S in compliance with applicable statutory requirements. For this purpose, auditor is required to study and assess accounting systems and internal controls.

• An Audit is independent examination of Financial Information of any entity, whether profit oriented or not, and irrespective of its size or legal form, when such an examination is conducted with a view to expressing an opinion thereon.
• Audit is not an official investigation into alleged wrong doing.
• In this case, CA was appointed for verification of books of accounts/financial records and
  circumstances surrounding the loss is for a specific objective to determine genuineness of loss and any issue affecting liability of insurance company.

• Choosing of appropriate accounting policies is responsibility of management. Role of auditor lies in evaluating selection and consistent application of accounting policies by management.
• Auditor’s duties in relation to accounting policies includes:

1. 1. to evaluate whether accounting policies selected by management are proper and
   2. whether chosen policy has been applied consistently on a period-to-period basis.

• Audited accounts provide high quality information. It gives confidence to users that information on which they are relying is qualitative and it is the outcome of an exercise carried out by following Auditing Standards recognized globally.
• In case of companies, shareholders may or may not be involved in daily affairs of the company. F.S. are prepared by management consisting of directors. As shareholders are owners of the company, they need an independent mechanism so that financial information is qualitative and reliable. Hence, their interest is safeguarded by an audit.
• Audit acts as a moral check on employees from committing frauds for the fear of being
  discovered by audit.
• Audited F.S. are helpful to government authorities for determining tax liabilities.
• Audited F.S. can be relied upon by lenders, bankers for making their credit decisions i.e., whether to lend or not to lend to a particular entity.
• Audit may also detect fraud or error or both.
• Audit reviews existence and operations of various controls operating in any entity. Hence, it is useful at pointing out deficiencies.

Meaning of Audit:

An Audit is independent examination of Financial Information of any entity, whether profit oriented or not, and irrespective of its size or legal form, when such an examination is conducted with a view to expressing an opinion thereon.

This definition has the following implications:

• Audit is independent examination of financial information.
• Requirement of audit applies in case of every entity, whether profit oriented or not (NGO or a Charitable Trust), whatever is business size of entity (Small Size entity or large size entity), whatever is the legal form of the entity (proprietor, partnership, LLP or company).
• Purpose of audit is to express an opinion on the F.S. by means of written audit report.

Points to be ensured that F.S. not misled anybody:

Auditor engaged to perform task of performing audit need to ensure the following:

• Accounts have been drawn up with reference to entries in books of account;
• Entries in books of account are adequately supported by sufficient and appropriate evidence;
• None of the entries in books of account has been omitted in the process of compilation;
• Information contained in the F.S. is clear and unambiguous.
• Amounts shown in F.S. are properly classified, described and disclosures are made in conformity with applicable ASs.
• F.S. reflect true and fair view of financial results and financial position.

• Accounting and auditing are closely related with each other as auditing reviews the financial statements which are nothing but a result of the overall accounting process.
• Auditing begins when accounting ends.
• It requires that the auditor must have a thorough and sound knowledge of generally accepted principles of accounting before he can review the financial statements.

As per SA-200 “Overall Objectives of the Independent Auditor”, in conducting an audit of financial statements, the overall objectives of the auditor are:

1. To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and
2. To report on the financial statements, and communicate as required by the SAs, in accordance with the auditor’s findings.

In the given case of SR Ltd., CA N expressed his opinion on the financial statements of SR Ltd. without obtaining reasonable assurance about whether the financial statements as a whole are free from material misstatement or not. Therefore, it can be concluded that CA N did not comply with the objective of audit as stated in SA 200.

• Audit is distinct from investigation. Investigation is a critical examination of the accounts with a special purpose. For example, if fraud is suspected and it is specifically called upon to check the accounts whether fraud really exists, it takes character of investigation.
• The objective of audit, on the other hand, is to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion.
• Therefore, audit is never started with a pre-conceived notion about state of affairs; about wrong doing; about some wrong having been committed. The auditor seeks to report what he finds in normal course of examination of accounts.
• However, it is quite possible that sometimes investigation results from the prima facie findings of the auditor. It may happen that auditor has given some findings of serious concern. Such findings may prompt for calling an investigation.

• The auditor should decide whether relevant information is properly disclosed in the financial statements. He should also keep in mind applicable statutory requirements in this regard.
• It is done by ensuring that financial statements properly summarize transactions and events recorded therein and by considering the judgments made by management in preparation of financial statements.
• The management responsible for preparation and presentation of financial statements makes many judgments in this process of preparing and presenting financial statements. For example, choosing of appropriate accounting policies in relation to various accounting issues like choosing method of charging depreciation on fixed assets or choosing appropriate method for valuation of inventories.
• The auditor evaluates selection and consistent application of accounting policies by  management; whether such a selection is proper and whether chosen policy has been applied consistently on a period-to-period basis

In conducting audit of financial statements, objectives of auditor in accordance with SA-200 “Overall Objectives of the Independent auditor and the conduct of an audit in accordance with Standards on Auditing” are:

• To obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework; and
• To report on the financial statements, and communicate as required by the SAs, in accordance with the auditor’s findings.

An analysis of above brings out following points clearly:

1. Auditor’s objective is to obtain a reasonable assurance whether financial statements as a whole are free from material misstatement whether due to fraud or error.
   Reasonable assurance is to be distinguished from absolute assurance. Absolute assurance is a complete assurance or a guarantee that financial statements are free from material misstatements. However, reasonable assurance is not a complete guarantee. Although it is a high-level of assurance but it is not complete assurance.
   Audit of financial statements is carried out by the auditor with professional competence and skills in accordance with Standards on Auditing. Audit procedures are applied in accordance with SAs, audit evidence is obtained and evaluated. On the basis of that, conclusions are drawn and opinion is formed. It leads to high level of assurance which is called as reasonable assurance but it is not absolute assurance.
2. Misstatements in financial statements can occur due to fraud or error or both. The auditor seeks to obtain reasonable assurance whether financial statements as a whole are free from material misstatements caused by fraud or error. He has to see effect of misstatements on financial statements as a whole, in totality.
3. Obtaining reasonable assurance that financial statements as a whole are free from material misstatements enables the auditor to express an opinion on whether the financial statements are prepared, in all material respects, in accordance with an applicable financial reporting framework.
4. The opinion is reported and communicated in accordance with audit findings through a written report as required by Standards on Auditing.

• An audit suffers from inherent limitations due to which auditor is not expected to, and cannot, reduce audit risk to zero and cannot therefore obtain absolute assurance that the F.S. are free from material misstatement due to fraud or error.
• Circumstances as given in questions is an example of failure of internal controls of the firm. The internal control has not operated due to collusion between employees which is a limitation of internal control itself. The auditor has relied upon internal controls. It is very nature of financial reporting that management is responsible for devising suitable internal controls.

Inherent Limitations of an Audit – Nature of Audit Procedures:

There are practical and legal limitations on the auditor’s ability to obtain audit evidence. For example:

1. Auditor does not test all transactions and balances. He forms his opinion only by testing samples. It is an example of practical limitation on auditor’s ability to obtain audit evidence.
2. Management may not provide complete information as requested by auditor. There is no way by which auditor can force management to provide complete information as requested. In case he is not provided with required information, he can only report. It is an example of legal limitation on auditor’s ability to obtain audit evidence.

The management may consist of dishonest and unscrupulous people and may be, itself, involved in fraud. It may be engaged in concealing fraud by designing sophisticated and carefully organized schemes which may be hard to detect by the auditor. It may produce fabricated documents before auditor to lead him to believe that audit evidence is valid. However, in reality, such documents could be fake or non-genuine.

It is quite possible that entity may have entered into some transactions with related parties. Such transactions may be only paper transactions and may not have actually occurred. The auditor may not be aware of such related party relationships or audit procedures may not be able to detect probable wrong doings in such transactions.

As per SA 200 “Overall Objectives of the Independent Auditor and the Conduct of an Audit in accordance with Standards on Auditing” the auditor is not expected to, and cannot, reduce audit risk to zero and cannot therefore obtain absolute assurance that the financial statements are free from material misstatement due to fraud or error. This is because there are inherent limitations of an audit, which may arise from:

1. The Nature of Financial Reporting: Preparation of F.S. involves making many judgments by management. These judgments may involve subjective decisions or a degree of uncertainty. Therefore, auditor may not be able to obtain absolute assurance that F.S. are free from material misstatements due to frauds or errors.
2. Nature of Audit Procedures: There are practical and legal limitations on the auditor’s ability to obtain audit evidence. For example: Auditor does not test all transactions and balances. He forms his opinion only by testing samples. It is an example of practical limitation on auditor’s ability to obtain audit evidence. Management may not provide complete information as requested by auditor. There is no way by which auditor can force management to provide complete information as requested. In case he is not provided with required information, he can only report. It is an example of legal limitation on auditor’s ability to obtain audit evidence.
3. Not in Nature of Investigation: Audit is not an official investigation. Hence, auditor cannot obtain absolute assurance that F.S. are free from material misstatements due to frauds or errors.
4. Timeliness of Financial Reporting & the Balance between Benefit & Cost: The relevance of information decreases over time and auditor cannot verify each and every matter. Therefore, a balance has to be struck between reliability of information and cost of obtaining it.
5. Future Events: Future events or conditions may affect an entity adversely. Adverse events may seriously affect ability of an entity to continue its business. The business may cease to exist in future due to change in market conditions, emergence of new business models or products or due to onset of some adverse events.

• Audit is not an official investigation into alleged wrong doing. Auditor does not have any specific legal powers of search or recording statements of witness on oath which may be necessary for carrying out an official investigation.
• Investigation is a critical examination of accounts with a special purpose. For example, if fraud is suspected and it is specifically called upon to check the accounts whether fraud really exists, it takes character of investigation.
• Objective of audit is to obtain reasonable assurance about whether the F.S. as a whole are free from material misstatement, whether due to fraud or error, thereby enabling the auditor to express an opinion.
• Scope of audit is general and broad whereas scope of investigation is specific and narrow.

• Preparation of financial statements involves making many judgments by management. These judgments may involve subjective decisions or a degree of uncertainty. Therefore, auditor may not be able to obtain absolute assurance that financial statements are free from material misstatements due to frauds or errors.
• One of the premises for conducting an audit is that management acknowledges its responsibility of preparation of financial statements in accordance with applicable financial reporting framework and for devising suitable internal controls. However, such controls may not have operated to produce reliable financial information due to their own limitations.
• Therefore, nature of financial reporting itself is one of causes inherent limitations of audit.

Review Engagement:

Raja & Co. can provide a review report in this case. Review is a limited assurance engagement and involves fewer procedures and gathers sufficient appropriate evidence on the basis of which limited conclusions can be drawn up.

Hence Raja & Co. can provide a report as requested by management of Exotic Tours and Travels Limited. Such report would be in nature of “Review”.

Raja & Co. will be required to obtain sufficient appropriate evidence based on limited procedures performed.

Assurance engagements:

• Assurance Engagement is an engagement in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria.
• Scope of Assurance Engagements is not restricted to audit of financial statements only; it also extends to examination of Prospective Financial Information (PFI) and examination of internal controls.
• Examples of various assurance engagements that can be rendered by a practitioner includes the following:

1. 1. Audit of F.S. – Reasonable assurance engagement
   2. Review of F.S. – Limited assurance engagement
   3. Examination of PFI – Provides assurance regarding reasonability of assumptions forming basis of projections and related matters.
   4. Report on controls operating at an organization – Provides assurance regarding design and operation of controls.

Three Party relationship of assurance engagement:

An assurance engagement involves three parties – a practitioner, a responsible party, and intended users.

1. Practitioner: Person who provides the assurance. Practitioner is broader than auditor. Audit is related to historical information whereas practitioner may provide assurance not necessarily related to historical financial information.
2. Responsible party: Party responsible for preparation of subject matter.
3. Intended users: Persons for whom an assurance report is prepared. These persons may use the report in making decisions.

Examination of Accounts for Determining Existence of Fraud:

• Assurance engagement is an engagement in which a practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users other than the responsible party about the outcome of the evaluation or measurement of a subject matter against criteria.
• Reasonable Assurance requires a high, but absolute assurance.
• In this case, a Chartered Accountant is specifically asked to check accounts whether fraud exists.

Conclusion: It is not a reasonable assurance engagement. It is in nature of investigation.

• Auditor is concerned with the reporting on financial matters of business and other institutions. Financial matters inherently are to be set with the problems of human fallibility; errors and frauds are frequent.
• The qualities required are tact, caution, firmness, good temper, integrity, discretion, industry knowledge, judgement, patience, clear-headedness and reliability. In short, all those personal qualities that go to make a good businessman contribute to the making of a good auditor.
• In addition, auditor must have the shine of culture for attaining a great height. He must have the highest degree of integrity backed by adequate independence.
• Auditor, who holds a position of trust, must have the basic human qualities apart from the
  technical requirement of professional training and education. He is called upon constantly to critically review F.S. and it is obviously useless for him to attempt that task unless his own knowledge is that of an expert.
• An exhaustive knowledge of accounting in all its branches is the sine qua non of the practice of auditing. He must know thoroughly all accounting principles and techniques.

• It is the duty of professional accountants to see that Standards are followed in engagements undertaken by them.
• However, a situation may arise when a specific procedure as required in Standards would be ineffective in a particular engagement. In such a case, professional accountant is required to ensure the following:

1. 1. Document how alternative procedures performed to achieve the purpose of required
      procedure;
   2. Reason for departure has also to be documented;
   3. Report should draw attention to such departures.

Standards on Auditing and Standards on Review Engagements:

• Standards on auditing apply in “audit” of historical financial information which is a reasonable assurance engagement whereas Standards on Review Engagements apply in “review” of historical financial information which is a limited assurance engagement only.
• “Historical financial information” means information expressed in financial terms in relation to a particular entity, derived primarily from that entity’s accounting system, about economic events occurring in past time periods or about economic conditions or circumstances at points in time in the past.
• “Audit” and “Review” are two different terms. Audit is a reasonable assurance engagement and its objective is reduction in assurance engagement risk to an acceptably low level in the circumstances of the engagement. However, “review” is a limited assurance engagement and its objective is a reduction in assurance engagement risk to a level that is acceptable in the circumstances of the engagement.
• Standards on Auditing have been issued on wide spectrum of issues in the field of auditing
  including (but not limited to) overall objectives of independent auditor, audit documentation, planning an audit of financial statements, identifying and assessing risk of material misstatement, audit evidence, audit sampling, going concern and forming an opinion and reporting on financial statements. Some examples of Standards on Auditing are:

1. 1. SA 200: Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Standards on Auditing.
   2. SA 230: Audit Documentation.
   3. SA 315: Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and its Environment.
   4. SA 500: Audit Evidence.
   5. SA 700: Forming an Opinion and Reporting on Financial Statements.

• Examples of Standards on Review engagements are:

1. 1. SRE 2400: Engagements to Review Historical Financial Statements.
   2. SRE 2410: Review of Interim Financial Information Performed by the Independent Auditor of the Entity.