Auditor Limitations: Can They Detect All Material Misstatements?
A key element of financial reporting is an independent and objective analysis of a company’s financial statements. This assessment is carried out by auditors who are thorough and meticulous. Auditors may face limitations when conducting audits, impacting their ability to detect material misstatements.
We explore the auditors’ constraints and provide tips on identifying and overcoming these limitations. We highlight internal controls that risk the accuracy and reliability of financial statements at stake with an example of the recent audit episode involving KPMG and Hyflux.
Before further sharing, here is a quick insight into auditor limitations and material misstatements.
Auditor Limitations
Auditor limitations are restrictions auditors face when auditing a company’s financial statements. These limitations include time constraints and access to reliable information, which increase audit risk. If the limitations are stringent, auditors must report them and inform readers who can access the financial statements.
Material Misstatements
Material misstatements are errors or omissions in a company’s financial statements that significantly impact users’ decisions about those financial statements. Material misstatements include incorrect accounting, overstated or understated balances, or undisclosed liabilities.
Types of Limitations of Financial Statement Audits
Auditors are responsible for detecting and reporting material misstatements in their audit reports. Material misstatements can surface, and when this happens, the auditor must take action.
They must request supplementary information or perform additional procedures. This ensures the accuracy of the financial statements, and this is precisely when the situation gets tricky.
1. Test Nature of the Audit
Auditors use a combination of procedures and tests of controls to gather evidence to form an audit opinion on financial statements. These procedures help evaluate a company’s internal controls over financial reporting to prevent material misstatements.
Tests of controls involve several steps. Analytical approaches are used to compare current and prior financial period results. Inspecting relevant documentation related to transactions and accounts is also carried out. Scope limitation can hinder audit control.
2. Professional Judgement
Professional judgement for financial auditors or management professionals comes with experience, technical skills, and moral principles. The auditor learns from reflecting on financial processes and procedures so they can improve their quality of judgement over time.
Four fundamental factors of an auditor enhance or cause limitations to a financial audit statement.
i. Mindset: A professional auditor should have an impartial and objective mindset. This mindset can help them better understand the purpose and benefits of the audit process. As a result, they can create more effective audit reports.
ii. Triggers and Processes: Analysis, framework creation, documentation, and decision making are integral to auditing. These activities can influence the outcome of a financial audit.
iii. Consultation: Effective communication and consultation is crucial for auditors with all the relevant parties and stakeholders.
iv. Work Culture and Factors: Work culture can indirectly affect professional judgement in auditing. This includes things like the work culture, the management team, resources, and the audit team’s culture.
3. Reliance on Management Representation
Reliance on management representation is a common audit practice. An auditor is provided with written or oral representations or material for financial statements from the management. While it can support evidence during the audit, there is a high possibility of management bias. This can include being bound to limited verification or assurance of audit evidence.
Limitations can limit a proper audit. Internal controls play an important role in examining financial statements during an audit. This ensures the accuracy of the audit.
Limitations of Internal Controls
It is essential to recognize that internal controls have inherent limitations. Despite their effectiveness in detecting and preventing errors and fraud, internal controls are not fool proof.
Identifying and implementing internal controls can be challenging and reduce efficiency in achieving a clean audit report. Auditors need to be aware of the four common limitations of internal controls. They must address these limitations to ensure their audit procedures are effective.
1. Human Error
Manual Intervention can compromise internal controls best practices. Human error is common when using internal control procedures. This error may not be intentional, but it can have serious consequences. It can lead to failure and losses for both the client and the auditing firm.
2. Cost and Time Constraints
Conducting internal control procedures during an audit can incur high costs. Auditors may also face time constraints that restrict their audit process. The auditors’ abilities to thoroughly examine the financial statements are impacted. They may need to prioritize their efforts based on available resources and time constraints.
3. Management Override
A significant limitation of internal controls is management override for fraudulent reporting or other reasons like management bias etc. Thus, manual internal controls can be manipulated. This poses a risk, and material thresholds may not be detected, as management can exploit financial statements.
4. External factors
In addition to internal control procedures’ challenges, external factors also impact productivity. Monitoring and following up on internal control procedures can take time, leading to inefficiencies and affecting the work environment and productivity.
Example Case Studies
We highlight 3 cases that have garnered attention in recent years and the lessons that can be learnt.
1. 1MDB and Multiple Audit Firms
The 1MDB scandal was a major financial scandal in Malaysia, which involved the misappropriation of billions of dollars from a state investment fund called 1Malaysia Development Berhad.
Several international audit firms, including KPMG and Deloitte, were involved in auditing the financial statements of 1MDB, and their roles as auditors were heavily scrutinized.
One of the major issues in the scandal was the test nature of the audit, where the role of auditors in detecting and reporting the financial irregularities at 1MDB was called to attention. The scandal also highlighted the limitations of auditors in detecting fraud and financial irregularities, and raised several questions about the adequacy of auditing
standards and procedures. Finally, the high-profile scandal demonstrated strong regulatory oversight’s importance in improving audit processes and procedures.
2. Hyflux and KPMG
Olivia Lum, the former CEO of Hyflux, faces multiple charges in relation to the Singapore based water treatment firm. In November 2022, she was charged with two counts of failing to disclose information about Tuaspring Integrated Water and Power Project, when such disclosures were required under the Singapore Exchange Listing Rules. She was also charged with one count under the Companies Act for failing to ensure the water treatment company’s compliance with accounting standards.
More recently in May 2023, she was handed three additional charges over her alleged failure to exercise reasonable diligence as a director. The charges were in relation to Hyflux’s omission to disclose some restricted bank balances.
Hyflux and two of its units are also claiming over S$684.6 million from the group’s former external auditor, KPMG, for alleged negligence in auditing the accounts. KPMG refuted the allegations of it being negligent, and argued in its defence filed that the obligation to prepare the financial statements in compliance with the law and reporting standards lies with the plaintiffs’ management and board.
Hyflux group’s financial statements, KPMG claimed, were audited in accordance with auditing standards and there were no material misstatements. Where judgment calls were required by the auditor, they had conformed with the standards. Therefore, if any judgment was incorrect, it is not an indication of misconduct or negligence.
3. Noble Group and Ernst & Young
The Noble Group, a Singapore-based commodity trading firm, was accused of accounting irregularities, and incurred substantial losses in 2018, prompting a restructuring process.
Questions were raised over the clean audit opinions given for the company by Ernst & Young, the company’s auditors, when investigations into Noble’s financial statements found that they had reported inflated profits and net assets.
The scandal highlighted auditor limitations in detecting financial irregularities in the company’s valuation of assets on the balance sheet, which were allegedly overvalued. It also re-emphasised concerns about auditing procedures and the importance of auditors exercising professional diligence to identify and report financial irregularities. It also stresses the need for companies to be transparent and provide adequate information during audits.
Lessons Learnt
Auditors may face difficulties in obtaining facts to examine the reliability of financial statements, mainly when managerial controls and discrepancies exist within the business. It
is important to have adequate internal controls, unbiased professional auditors, and open communication between auditors and relevant stakeholders.
In summary, an effective auditor should
1. Identify and assess the risks
2. Clarify issues and objectives with whatever resources are available 3. Consider alternatives when stuck with limitations and controls
4. Gather and evaluate information without any bias or manual interventions 5. Conclude the audit effectively
6. Have the ability to articulate and document the rationale thoroughly
The complex audit process highlights the need for continuous improvement in financial reporting practices, understanding the framework, and demonstrating professional judgement and expertise.
