Downsides and Limitations of External Audit – All you need to know!

The Audit of Financial Statements is one of the most critical factors during the ordinary course of business. This is primarily because it helps the financial statement users get reasonable assurance that financial statements have been prepared accurately. The main objective of a financial audit is to ensure that all the respective checks have been duly made in the financial statements to be relied upon by the decision-makers.

Therefore, companies are under the compulsion to get their financial statements audited by external auditors to issue their unbiased opinion regarding the accuracy and presentation of the financial statements. However, there are certain limitations involved in external audits. These limitations also need to be accounted for by both organizations and users of the financial statements.

This is not meant to undermine the importance of financial audits. However, it increases the emphasis that reports issued by external auditors are not final, and they are only opinionated to the extent to which the audit has been conducted. This is why auditors mention in the report that financial statements are not materially misstated as per their knowledge. However, they do not guarantee that it is a safe investment or absolutely nothing wrong with the company.

In this regard, the limitations of the external audit are given below:

  • External audit relies on estimation and judgment: External Audit takes place across a month or two. During this window, auditors have to gather reasonable evidence that can help them formulate an opinion. Therefore, it is not always easier for them to go through every transaction during this shorter period to ensure no material misstatements. They are supposed to formulate their judgment based on estimation and judgment. In this regard, they have to rely on numerous different things that the management tells them. These judgments cannot be double-checked, and hence, external auditors have to rely on the management’s decision on these factors. Examples include provision for doubtful debts and a salvage value of a given asset.
  • Historical Reporting: Annual Audits are supposed to give an opinion regarding the financial statements (both presentation and accuracy) depending on the financial data made available to them over the past 12 months in the fiscal calendar. In this regard, they can only give their opinion regarding the time frame that they have audited. They cannot comment on the present or the future of the company. Although they will comment on the extent to which they believe that the company is a going concern. Yet, the audit report itself about the past fiscal year might not always be reliable as a decision-making tool.
  • Sampling Bias: As mentioned earlier, it can be seen that it is not possible for auditors to manually check and verify all the transactions to make sure that they have been adequately recorded. Therefore, they need to employ sampling and subsequent extrapolation to gather the required evidence. On the one hand, this might be an effective strategy in limiting the workload, yet it can be seen that it also comes at an added cost in the form of the risk involved. Sampling might not always be 100% accurate, and a smaller sample size might result in an overgeneralization that might hamper the authenticity of the audit results.
  • Nature of Evidence: Audit itself is a cumbersome process that requires the auditors to gather evidence based on which they can give an opinion. However, if the evidence itself is fabricated or has issues, the efficacy of the audit is compromised. All the evidence that the auditors put forth can be described as persuasive rather than conclusive. Therefore, with lacking conclusive evidence in place, it might be a long shot to give opinions based on the compelling evidence gathered.
  • Management Cooperation: Even though engagement partners are supposed to be changed after every five years, yet it can be seen that there is still a change of auditors cooperating with the management and issuing an unqualified report. Even though the possibility of this happening is very minute, but there is no way to find out if this is the case unless it happens. Hence, the reliability of the audit process tends to be questionable in this regard, especially in the case where a possible collaboration between the auditors and the management might be possible.
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Similar to this, external audits also have certain limitations relevant to the organizations conducting the audit itself. These limitations are as follows:

  • Costs Involved: External Audit needs to be conducted by third parties, as required by the law. However, the fees that are associated with the audit process cannot be ignored. External Audits need to be costly, and this is something that the organization needs to pay themselves. This is a significant downside of external audits simply because it tends to leave a dent in its financials. Additionally, accountants also need to play a part in the auditing process because they need to offer their support and cooperation to auditors to be executed smoothly.
  • Risk of a Qualified Report: This is also a very major risk associated with an eternal audit. Audit opinion, if unfavorable for the company, can harness its reputation in the market. It leads to shareholders losing trust and eventually withdrawing their shares of investment from the company. Although the probability of this happening, in the case of a clean practice by the company, is negligible, but still, there is a risk involved. If the auditor is not satisfied, he has the right to mention it in the audit report, which can be detrimental for the company.
  • Disruption in normal routine operations of the company: Since the audit is considered to be a cumbersome process, it can be seen that numerous processes are involved in making sure that the auditing process is carried out with relative ease. However, when auditors are working, the normal course of operations might be disrupted as a result, essentially because audit requires complete cooperation from the management.
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Therefore, it can be seen that during the ordinary course of the audit, there are a few challenges and limitations that are concurred by the organization undergoing the audit. However, this does not, in any way, mean that audit is not necessary and can be looked upon by the company. Organizations should strive harder to make sure that they can make the audit process as easy as possible. The auditors can gather all the necessary evidence with relative ease so that the integrity of the audit will not be compromised in any way.

On the other hand, as far as limitations of the auditors are concerned, it can be seen that the limitations of audit can be covered too by ensuring that the audit is planned properly. This might help prove that evidence gathering and sampling are conducted appropriately to minimize the underlying risk associated.

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