Scope and objectives
This auditing standard outlines the auditor’s responsibility for evaluating the impact of misstatements on the financial statements during an audit. Misstatements can arise from errors or fraud, and the SA 450 provides examples of how misstatements can occur, such as inaccurate data gathering or processing, omission of amounts or disclosures, incorrect accounting estimates, and inappropriate accounting policies.
The SA 450 defines misstatements as a difference between reported financial statement items and the amount, classification, presentation, or disclosure required by the applicable financial reporting framework. This means that if there is a discrepancy between what is reported in the financial statements and what should have been reported based on the applicable financial reporting framework, it is considered a misstatement.
The SA 450 specifies that the auditor must evaluate the effect of identified misstatements on the audit and uncorrected misstatements on the financial statements. Uncorrected misstatements are misstatements that the auditor has accumulated during the audit and that have not been corrected. The auditor must also consider the impact of uncorrected misstatements on the financial statements when forming an opinion on the financial statements’ overall accuracy.
The SA 450 is effective for audits of financial statements for periods beginning on or after April 1, 2010. The objective of the auditor is to ensure that financial statements are free from material misstatements and that reasonable assurance has been obtained that the financial statements are presented fairly, in all material respects, in accordance with the applicable financial reporting framework.
Accumulation of Identified Misstatements
The auditor’s responsibility for identifying and accumulating misstatements that are identified during an audit. Misstatements are defined as differences between the amounts, classification, presentation, or disclosure of a reported financial statement item and the amount, classification, presentation, or disclosure that is required for the item to be in accordance with the applicable financial reporting framework. Misstatements can arise from error or fraud.
The auditor is required to accumulate misstatements identified during the audit, other than those that are clearly trivial. The auditor may set an amount below which misstatements would be considered clearly trivial and would not need to be accumulated because they are not expected to have a material effect on the financial statements. However, the term “clearly trivial” does not mean “not material,” and any uncertainty about whether one or more items are clearly trivial should be considered not to be clearly trivial.
To help evaluate the effect of misstatements, the auditor may distinguish between three types of misstatements: factual, judgmental, and projected. Factual misstatements are misstatements about which there is no doubt. Judgmental misstatements arise from management’s judgments concerning accounting estimates or the selection or application of accounting policies that the auditor considers unreasonable or inappropriate. Projected misstatements are the auditor’s best estimate of misstatements in populations and involve the projection of misstatements identified in audit samples to the entire populations from which the samples were drawn.
Overall, the objective of accumulating misstatements is to evaluate their effect on the financial statements and to communicate significant misstatements to management and those charged with governance.
Consideration of Identified Misstatements as the Audit Progresses
According to the International Standards on Auditing (ISA), the auditor must consider any identified misstatements in the financial statements as the audit progresses.
Firstly, if the auditor identifies misstatements during the audit, except for those that are clearly trivial, they must be accumulated. The auditor may define an amount below which misstatements would be clearly trivial and not need to be accumulated if the auditor expects that the accumulation of such amounts would not have a material effect on the financial statements.
Secondly, the auditor must determine whether the overall audit strategy and plan need to be revised if the nature of identified misstatements and their circumstances suggest that other misstatements may exist that, when combined with those already accumulated, could be material. This may occur, for example, where the auditor identifies that a misstatement arose from a breakdown in internal control or from inappropriate assumptions or valuation methods that have been widely applied by the entity. Additionally, if the aggregate of misstatements accumulated during the audit approaches materiality determined in accordance with ISA 320, there may be a greater risk that possible undetected misstatements, when taken with the aggregate of misstatements accumulated during the audit, could exceed the materiality.
Finally, if management has examined a class of transactions, account balance or disclosure and corrected misstatements that were detected, the auditor must perform additional audit procedures to determine whether misstatements remain. The auditor may request management to examine a class of transactions, account balance, or disclosure to understand the cause of the misstatement identified by the auditor, perform procedures to determine the amount of the actual misstatement in the class of transactions, account balance, or disclosure, and make appropriate adjustments to the financial statements.
Communication and Correction of Misstatements
The auditor is required to communicate all misstatements identified during the audit to the appropriate level of management in a timely manner. This allows management to evaluate the misstatements, take corrective action if necessary, and inform the auditor if they disagree with the identification of the misstatement. In general, the appropriate level of management is the one that has the responsibility and authority to evaluate and take action on the misstatements.
However, there may be situations where laws or regulations prohibit the auditor from communicating certain misstatements to management or others within the entity. For example, regulations may prevent the communication of information that could prejudice an investigation into a suspected illegal act. In such cases, the auditor may need to seek legal advice to determine the appropriate course of action.
If management refuses to correct some or all of the misstatements identified by the auditor, the auditor must seek to understand management’s reasons for not making the corrections. This understanding should be taken into account when evaluating whether the financial statements as a whole are free from material misstatement. The auditor must also evaluate whether the financial statements are prepared and presented in accordance with the applicable financial reporting framework, including consideration of the qualitative aspects of the entity’s accounting practices and indicators of possible bias in management’s judgments.
Evaluating the Effect of Uncorrected Misstatements
The evaluation of uncorrected misstatements by auditors during the course of their audit engagements. Prior to conducting this evaluation, the auditor must reassess the materiality determined in accordance with SA 320 to ensure that it remains appropriate based on the actual financial results of the entity being audited. The auditor’s determination of materiality is often based on estimates of financial results, so it may be necessary to revise materiality based on the actual financial results.
When evaluating uncorrected misstatements, the auditor must determine whether they are material, either individually or in aggregate. The auditor must consider the size and nature of the misstatements in relation to specific classes of transactions, account balances, disclosures, and the financial statements as a whole. The circumstances surrounding the misstatement may also be taken into account when determining its materiality, such as its effect on compliance with regulatory requirements or debt covenants, or its impact on earnings or key ratios.
If an individual misstatement is judged to be material, it cannot be offset by other misstatements. However, it may be appropriate to offset misstatements within the same account balance or class of transactions, provided that the risk of further undetected misstatements is considered. The evaluation of whether a classification misstatement is material involves considering qualitative factors such as its effect on debt or contractual covenants, individual line items or subtotals, or key ratios.
Certain circumstances may cause the auditor to evaluate misstatements as material, even if they are lower than the materiality level for the financial statements as a whole. These circumstances include the misstatement’s effect on compliance with regulatory or contractual requirements, its impact on future financial statements, its impact on earnings or trends, or its effect on segment information presented in the financial statements. Other circumstances that may affect the evaluation of misstatements as material include their relation to management compensation, their significance in relation to known previous communications to users, or their impact on other information included in the entity’s annual report.
The auditor must carefully evaluate all uncorrected misstatements in the financial statements to determine their materiality and impact on the overall financial picture of the entity being audited. This evaluation must take into account a variety of factors, including the size and nature of the misstatements, their impact on specific classes of transactions or account balances, and any relevant circumstances that may affect their materiality.
Communication with Those Charged with Governance
The communication requirements of an auditor with those charged with governance. It states that the auditor must communicate any uncorrected misstatements and their potential impact on the auditor’s report to those charged with governance, unless prohibited by law or regulation. The communication must identify material uncorrected misstatements individually and request that they be corrected.
If uncorrected misstatements have already been communicated with individuals who have both management and governance responsibilities, they need not be communicated again in their governance capacity. However, the auditor must ensure that the communication with management adequately informs all parties with whom the auditor would otherwise communicate in their governance role.
When there is a large number of individual immaterial uncorrected misstatements, the auditor may communicate the number and overall monetary effect of the uncorrected misstatements, rather than the details of each individual uncorrected misstatement.
The auditor is also required to communicate the effect of uncorrected misstatements related to prior periods on relevant classes of transactions, account balances, disclosures, and the financial statements as a whole. SA 260(Revised) requires the auditor to communicate the written representations requested and discuss the reasons for, and implications of, a failure to correct misstatements, having regard to the size and nature of the misstatement judged in the surrounding circumstances and possible implications in relation to future financial statements.
Written Representation
The auditors are required to request from management and, where appropriate, those charged with governance, about uncorrected misstatements in financial statements. The auditor is required to ask management and governance if they believe that the effects of uncorrected misstatements are immaterial, both individually and in aggregate, to the financial statements as a whole.
If management and governance do not believe that certain uncorrected misstatements are misstatements, they can provide written reasons why they believe so. However, obtaining this representation does not relieve the auditor of the need to form a conclusion on the effect of uncorrected misstatements. The auditor is still required to form an opinion on whether the financial statements are free from material misstatement.
Documentation
The requirements for audit documentation, which is the written record of the auditor’s work during an audit. Specifically, it is focusing on the auditor’s documentation of uncorrected misstatements, which are errors or inaccuracies found during the audit that have not been corrected by management.
The auditor’s documentation of uncorrected misstatements must take into account several factors. Firstly, the auditor must consider the aggregate effect of all uncorrected misstatements found during the audit. This means that even if individual misstatements may not be material on their own, the auditor must assess whether their cumulative effect could be material.
Secondly, the auditor must evaluate whether any particular materiality levels have been exceeded for specific classes of transactions, account balances, or disclosures. Materiality levels are set by the auditor and represent the threshold above which errors or inaccuracies are considered to be material and therefore require correction.
Thirdly, the auditor must evaluate the impact of uncorrected misstatements on key ratios or trends. This means that the auditor must consider whether uncorrected misstatements could materially affect important financial metrics or trends, such as profitability, liquidity, or solvency.
Finally, the auditor must also consider compliance with legal, regulatory, and contractual requirements. For example, if a company has debt covenants, the auditor must assess whether uncorrected misstatements could result in a breach of these covenants.
The auditor’s documentation of uncorrected misstatements must include several key pieces of information. This includes the amount below which misstatements are considered to be trivial, all misstatements identified during the audit and whether they have been corrected, and the auditor’s conclusion as to whether uncorrected misstatements are material, individually or in aggregate. The documentation must also include the basis for that conclusion, which could include information such as the impact on key ratios or trends or compliance with legal, regulatory, and contractual requirements.
Evaluation of Misstatements Identified during the Audit
The ISA 45, which provides guidance on the evaluation of misstatements identified during an audit. The previous version of the standard included specific guidance related to the audit of public sector entities. This was because the evaluation of misstatements in the public sector may be affected by legislation or regulation, and there may be additional responsibilities for the auditor to report on matters such as fraud.
However, the Auditing and Assurance Standards Board has decided that their standards should apply equally to all entities, regardless of their form, nature, and size. As a result, the specific reference to public sector entities has been deleted from ISA 45. This means that the guidance provided in the standard now applies to all entities, including those in the public sector.
SA 420 also notes that a similar situation may exist in the case of Central/State governments or related government entities, where the evaluation of misstatements may be affected by the specific statute or regulation under which they operate. This means that auditors should remain aware of any specific requirements or regulations that may affect the evaluation of misstatements in different types of entities, including those in the public sector or related to government operations.
Quiz: Evaluation of Misstatements Identified during the Audit
1. According to SA 450, what is considered a misstatement?
a. Differences between reported financial statement items and the applicable financial reporting framework.
b. Differences between the auditor’s judgment and management’s judgment.
c. Differences between audited financial statements and previous year’s financial statements.
d. Differences between projected misstatements and factual misstatements.
Answer: a.
2. Which of the following is not a type of misstatement mentioned in the text?
a. Factual misstatement.
b. Judgmental misstatement.
c. Projected misstatement.
d. Qualitative misstatement.
Answer: d.
3. When should the auditor accumulate misstatements identified during the audit?
a. Only if they are clearly trivial.
b. Only if they exceed a certain monetary threshold.
c. Only if they affect the overall accuracy of the financial statements.
d. Except for those that are clearly trivial.
Answer: d.
4. When evaluating uncorrected misstatements, the auditor should consider:
a. Only the size of the misstatements.
b. Only the nature of the misstatements.
c. Only the impact on specific classes of transactions.
d. Both the size and nature of the misstatements.
Answer: d.
5. If management refuses to correct identified misstatements, the auditor should:
a. Ignore the misstatements and proceed with the audit.
b. Seek legal advice before taking any action.
c. Report the misstatements directly to the board of directors.
d. Consider management’s reasons and evaluate the impact on the financial statements.
Answer: d.
6. When should the auditor communicate uncorrected misstatements to those charged with governance?
a. Only if the misstatements are material.
b. Only if the misstatements are immaterial.
c. Only if the misstatements are judgmental in nature.
d. Unless prohibited by law or regulation.
Answer: d.
7. In the case of a large number of immaterial uncorrected misstatements, the auditor may communicate:
a. The details of each individual uncorrected misstatement.
b. The number and overall monetary effect of the uncorrected misstatements.
c. Only the misstatements that affect key ratios or trends.
d. Only the misstatements that affect compliance with regulatory requirements.
Answer: b.
8. What is the purpose of obtaining written representation from management and governance?
a. To shift the responsibility for misstatements to management and governance.
b. To obtain permission to disclose misstatements to the public.
c. To assess the materiality of identified misstatements.
d. To understand management’s and governance’s beliefs regarding the effects of uncorrected misstatements.
Answer: d.
9. When documenting uncorrected misstatements, the auditor should consider:
a. Only the aggregate effect of all misstatements.
b. Only the impact on compliance with contractual requirements.
c. Only the impact on key ratios and trends.
d. The aggregate effect, materiality levels, impact on key ratios or trends, and compliance with legal, regulatory, and contractual requirements.
Answer: d.
10. According to ISA 45, which entities do the standards apply to?
a. Only private sector entities.
b. Only public sector entities.
c. Both public and private sector entities.
d. Only entities related to government operations.
Answer: c.
Additional question:
11. The accumulation of misstatements identified during an audit is the responsibility of:
a. Management
b. External stakeholders
c. The auditor
d. The board of directors
Answer: c.
12. What are the three types of misstatements that the auditor may distinguish between?
a. Factual, qualitative, and projected misstatements
b. Trivial, judgmental, and projected misstatements
c. Factual, judgmental, and projected misstatements
d. Material, immaterial, and projected misstatements
Answer: c.
13. If a misstatement is considered material, it means that it:
a. Has a significant impact on a specific account balance
b. Cannot be corrected by management
c. Has a significant impact on the financial statements as a whole
d. Is the result of fraud committed by management
Answer: c.
14. When evaluating uncorrected misstatements, the auditor should consider their impact on:
a. Compliance with internal control procedures
b. Management’s compensation
c. The auditor’s reputation
d. The financial statements as a whole
Answer: d.
15. What should the auditor do if uncorrected misstatements are judged to be material?
a. Notify the regulatory authorities
b. Adjust the financial statements without management’s approval
c. Request additional information from management
d. Issue a modified audit opinion
Answer: d.
16. The communication of uncorrected misstatements to those charged with governance should include:
a. Only material misstatements individually
b. Both material and immaterial misstatements individually
c. Only material misstatements in aggregate
d. Only immaterial misstatements in aggregate
Answer: b.
17. In the context of evaluating misstatements, what is the purpose of reassessing materiality?
a. To determine the auditor’s fees for the audit
b. To align materiality with management’s expectations
c. To ensure the accuracy of financial reporting framework
d. To consider the actual financial results of the entity being audited
Answer: d.
18. If management and governance do not believe certain uncorrected misstatements are misstatements, the auditor should:
a. Accept management’s and governance’s judgment without further evaluation
b. Revise the financial statements to reflect management’s and governance’s judgment
c. Document management’s and governance’s reasons but form an independent conclusion
d. Report the misstatements to the regulatory authorities for further investigation
Answer: c.
19. The documentation of uncorrected misstatements should include:
a. The auditor’s personal opinion on their materiality
b. The estimated financial impact of each individual misstatement
c. An explanation of why management failed to correct the misstatements
d. The basis for the auditor’s conclusion on materiality and impact
Answer: d.
20. According to SA 450, the evaluation of misstatements applies to audits of financial statements for periods beginning on or after:
a. January 1, 2000
b. April 1, 2010
c. January 1, 2015
d. April 1, 2025
Answer: b.
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