Audit Risk and Materiality in Conducting an Audit: Auditing Interpretations of Section 312
- (.01 - .04) The Meaning of the Term Misstatement
- (.05 - .09) Evaluating Differences in Estimates
- (.10 - .14) Quantitative Measures of Materiality in Evaluating Audit Findings
- (.15 - .17) Considering the Qualitative Characteristics of Misstatements
Question—Section 312, Audit Risk and Materiality in Conducting an Audit, paragraph .04, states that financial statements would be considered materially misstated if "they contain misstatements whose effect, individually or in the aggregate, is important enough to cause them not to be presented fairly, in all material respects, in conformity with generally accepted accounting principles." Section 312.04 also states that misstatements can result from errors or fraud. The term misstatement is used throughout generally accepted auditing standards; however, this term is not defined. What is the meaning of the term misstatement?
Interpretation—In the absence of materiality considerations, a misstatement causes the financial statements not to be in conformity with generally accepted accounting principles. fn 1 A misstatement may consist of any of the following:
- A difference between the amount, classification, or presentation of a reported financial statement element, account, or item and the amount, classification, or presentation that would have been reported under generally accepted accounting principles
- The omission of a financial statement element, account, or item
- A financial statement disclosure that is not presented in accordance with generally accepted accounting principles
- The omission of information required to be disclosed in accordance with generally accepted accounting principles.
Misstatements may be of two types: known and likely. Section 312.35 refers to known misstatements as "the amount of misstatements specifically identified." For example, the failure to accrue an unpaid invoice for goods received or services rendered prior to the end of the period presented would be a known misstatement. Section 312.35 refers to likely misstatements as "the auditor's best estimate of the total misstatements in the account balances or classes of transactions…." Likely misstatements may be identified when an auditor performs analytical or sampling procedures. For example, if an auditor applies sampling procedures to a certain class of transactions that identify a known misstatement in the items sampled, the auditor will then determine the likely misstatement by projecting the known difference identified in the sample to the total population tested. With regard to analytical procedures, section 312.35 states, in part—
When the auditor tests an account balance or class of transactions and related assertions by an analytical procedure, he or she ordinarily would not specifically identify misstatements but would only obtain an indication of whether misstatements might exist in the balance or class and possibly its approximate magnitude. If the analytical procedure indicates that a misstatement might exist, but not its approximate amount, the auditor ordinarily would have to employ other procedures to enable him or her to estimate the likely misstatement in the balance or class.
Likely misstatements also are associated with accounting estimates. Section 312.36 states, in part—
The risk of material misstatement of the financial statements is generally greater when account balances and classes of transactions include accounting estimates rather than essentially factual data because of the inherent subjectivity in estimating future events. Estimates, such as those for inventory obsolescence, uncollectible receivables, and warranty obligations, are subject not only to the unpredictability of future events but also to misstatements that may arise from using inadequate or inappropriate data or misapplying appropriate data. Since no one accounting estimate can be considered accurate with certainty, the auditor recognizes that a difference between an estimated amount best supported by the audit evidence and the estimated amount included in the financial statements may be reasonable, and such difference would not be considered to be a likely misstatement. However, if the auditor believes the estimated amount included in the financial statements is unreasonable, he or she should treat the difference between that estimate and the closest reasonable estimate as a likely misstatement and aggregate it with other likely misstatements.
[Issue Date: December, 2000.]
Question—Section 312.36 states, in part—
Since no one accounting estimate can be considered accurate with certainty, the auditor recognizes that a difference between an estimated amount best supported by the audit evidence and the estimated amount included in the financial statements may be reasonable, and such difference would not be considered to be a likely misstatement. However, if the auditor believes the estimated amount included in the financial statements is unreasonable, he or she should treat the difference between that estimate and the closest reasonable estimate as a likely misstatement and aggregate it with other likely misstatements.
With respect to an estimate, what should the auditor consider in determining the amount of the likely misstatements to be aggregated?
Interpretation—In determining the amount of the likely misstatements to be aggregated, the auditor considers the "closest reasonable estimate" which may be a range of acceptable amounts or a point estimate, if that is a better estimate than any other amount.
In some cases the auditor may use a method that produces a range of acceptable amounts to determine the reasonableness of amounts recorded. For example, the auditor's analysis of specific problem accounts receivable and recent trends in bad-debt write-offs as a percent of sales may cause the auditor to conclude that the allowance for doubtful accounts should be between $130,000 and $160,000. If management's recorded estimate falls within that range, the auditor ordinarily would conclude that the recorded amount is reasonable and no difference would be aggregated. If management's recorded estimate falls outside the auditor's range of acceptable amounts, the difference between the recorded amount and the amount at the closest end of the auditor's range would be aggregated as a misstatement. For example, if management has recorded $110,000 as the allowance, the amount by which the recorded estimate falls outside the range ($20,000) is aggregated as a misstatement.
In other cases the auditor may determine that a point estimate is a better estimate than any other amount. In those situations, the auditor would use that amount to determine the reasonableness of the recorded amount. The auditor would compare the point estimate to the amount recorded by the client and include any difference in the aggregation of misstatements. fn 2
Section 312.36 indicates that the auditor should be alert to the possibility that management's recorded estimates are clustered at either end of the auditor's range of acceptable amounts, indicating a possible bias on the part of management. Section 312.36 states, in part—
The auditor should also consider whether the difference between estimates best supported by the audit evidence and the estimates included in the financial statements, which are individually reasonable, indicate a possible bias on the part of the entity's management. For example, if each accounting estimate included in the financial statements was individually reasonable, but the effect of the difference between each estimate and the estimate best supported by the audit evidence was to increase income, the auditor should reconsider the estimates taken as a whole.
In these circumstances, the auditor should reconsider whether other recorded estimates reflect a similar bias and should perform additional audit procedures that address those estimates. In addition, the auditor should be alert to the possibility that management's recorded estimates were clustered at one end of the range of acceptable amounts in the preceding year and clustered at the other end of the range of acceptable amounts in the current year, thus indicating the possibility that management is using swings in accounting estimates to offset higher or lower than expected earnings. If the auditor believes that such circumstances exist, the auditor should consider whether these matters should be communicated to the entity's audit committee, as described in section 380, Communication With Audit Committees, paragraphs .08 and .11.
[Issue Date: December, 2000.]
Question—Section 312, Audit Risk and Materiality in Conducting an Audit, provides guidance to the auditor on evaluating the effect of misstatements on the financial statements under audit. Section 312.10 states, in part—
The auditor's consideration of materiality is a matter of professional judgment and is influenced by his or her perception of the needs of a reasonable person who will rely on the financial statements.
Section 312.34 further describes the auditor's evaluation of the quantitative aspects of materiality. It states, in part—
In evaluating whether the financial statements are presented fairly, in all material respects, in conformity with generally accepted accounting principles, the auditor should aggregate misstatements that the entity has not corrected in a way that enables him or her to consider whether, in relation to individual amounts, subtotals, or totals in the financial statements, they materially misstate the financial statements taken as a whole.
What factors should the auditor consider in assessing the quantitative impact of identified misstatements?
Interpretation—The quantitative evaluation of identified misstatements is a matter of professional judgment and should reflect a measure of materiality that is based on the element or elements of the financial statements that, in the auditor's judgment, are expected to affect the judgment of a reasonable person who will rely on the financial statements, considering the nature of the reporting entity. For example, it is generally recognized that after-tax income from continuing operations is, in most circumstances, the measure of greatest significance to the financial statement users of entities whose debt or equity securities are publicly traded. Depending on the entity's particular circumstances, other elements of the financial statements that may be useful in making a quantitative assessment of the materiality of identified misstatements include current assets, net working capital, total assets, total revenues, gross profit, total equity, and cash flows from operations. In all instances, the element or elements selected should reflect, in the auditor's judgment, the measures most likely to be considered important by the financial statement users.
Question—An entity's after-tax income or loss from continuing operations may be nominal or may fluctuate widely from year to year due to the inclusion in the results of operations of significant, unusual, or infrequently occurring income or expense items. What other quantitative measures could be considered if after-tax income or loss from continuing operations is nominal or fluctuates widely from period to period?
Interpretation—In certain circumstances, a quantitative measure of materiality based on after-tax income from continuing operations may not be appropriate. The auditor may identify another element or elements that are appropriate in the circumstances or may compute an amount of current-year after-tax income from continuing operations adjusted to exclude unusual or infrequently occurring items of income or expense. fn 3
The selection of an alternate element or elements for use in assessing a quantitative measure of materiality is a matter of the auditor's professional judgment. In choosing an alternate element or elements, the auditor should evaluate the perceived needs of the financial statement users, the particular circumstances that caused the abnormal results for the current year, the likelihood of their recurrence, and any other matters that, in the auditor's judgment, may be relevant to a quantitative assessment of materiality.
[Issue Date: December, 2000.]
Question—Section 312, Audit Risk and Materiality in Conducting an Audit, paragraph .34, states, in part—
Qualitative considerations also influence the auditor in reaching a conclusion as to whether misstatements are material.
What qualitative factors should the auditor consider in assessing whether misstatements are material?
Interpretation—Section 312.10 states that the auditor's consideration of materiality is a matter of professional judgment and is influenced by his or her perception of the needs of a reasonable person. Section 312.11 states—
As a result of the interaction of quantitative and qualitative considerations in materiality judgments, misstatements of relatively small amounts that come to the auditor's attention could have a material effect on the financial statements. For example, an illegal payment of an otherwise immaterial amount could be material if there is a reasonable possibility that it could lead to a material contingent liability or a material loss of revenue.
Section 508, Reports on Audited Financial Statements, paragraph .36, states that the significance of an item to a particular entity (for example, inventories to a manufacturing company), the pervasiveness of the misstatement (such as whether it affects the amounts and presentation of numerous financial statement items), and the effect of the misstatement on the financial statements taken as a whole are all factors to be considered in making a judgment regarding materiality. Section 312.10 also makes reference to the discussion of materiality in Financial Accounting Standards Board Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information. FASB Concepts Statement No. 2, paragraphs 123 through 132, includes a discussion about matters that might affect a materiality judgment.
The auditor considers relevant qualitative factors in his or her qualitative considerations. Qualitative factors the auditor may consider relevant to his or her consideration include the following:
- The potential effect of the misstatement on trends, especially trends in profitability.
- A misstatement that changes a loss into income or vice versa.
- The effect of the misstatement on segment information, for example, the significance of the matter to a particular segment important to the future profitability of the entity, the pervasiveness of the matter on the segment information, and the impact of the matter on trends in segment information, all in relation to the financial statements taken as a whole. (See Interpretation No. 4 of section 326, Evidential Matter, "Applying Auditing Procedures to Segment Disclosures in Financial Statements" [section 9326.39]).
- The potential effect of the misstatement on the entity's compliance with loan covenants, other contractual agreements, and regulatory provisions.
- The existence of statutory or regulatory reporting requirements that affect materiality thresholds.
- A misstatement that has the effect of increasing management's compensation, for example, by satisfying the requirements for the award of bonuses or other forms of incentive compensation.
- The sensitivity of the circumstances surrounding the misstatement, for example, the implications of misstatements involving fraud and possible illegal acts, violations of contractual provisions, and conflicts of interest.
- The significance of the financial statement element affected by the misstatement, for example, a misstatement affecting recurring earnings as contrasted to one involving a non-recurring charge or credit, such as an extraordinary item.
- The effects of misclassifications, for example, misclassification between operating and non-operating income or recurring and non-recurring income items or a misclassification between fundraising costs and program activity costs in a not-for-profit organization.
- The significance of the misstatement or disclosures relative to known user needs, for example—
- The significance of earnings and earnings per share to public-company investors and the significance of equity amounts to private-company creditors.
- The magnifying effects of a misstatement on the calculation of purchase price in a transfer of interests (buy/sell agreement).
- The effect of misstatements of earnings when contrasted with expectations.
Obtaining the views and expectations of the entity's audit committee and management may be helpful in gaining or corroborating an understanding of user needs, such as those illustrated above.
- The definitive character of the misstatement, for example, the precision of an error that is objectively determinable as contrasted with a misstatement that unavoidably involves a degree of subjectivity through estimation, allocation, or uncertainty.
- The motivation of management with respect to the misstatement, for example, (i) an indication of a possible pattern of bias by management when developing and accumulating accounting estimates or (ii) a misstatement precipitated by management's continued unwillingness to correct weaknesses in the financial reporting process.
- The existence of offsetting effects of individually significant but different misstatements.
- The likelihood that a misstatement that is currently immaterial may have a material effect in future periods because of a cumulative effect, for example, that builds over several periods.
- The cost of making the correction—it may not be cost-beneficial for the client to develop a system to calculate a basis to record the effect of an immaterial misstatement. On the other hand, if management appears to have developed a system to calculate an amount that represents an immaterial misstatement, it may reflect a motivation of management as noted in paragraph .17(l) above.
- The risk that possible additional undetected misstatements would affect the auditor's evaluation.
[Issue Date: December, 2000.]
Footnotes (AU Section 9312 — Audit Risk and Materiality in Conducting an Audit: Auditing Interpretations of Section 312):
fn 1 Reference to generally accepted accounting principles includes, where applicable, a comprehensive basis of accounting other than generally accepted accounting principles as defined in section 623, Special Reports, paragraph .04.
fn 2 See Interpretation No. 14, "Reasonable Estimation of the Amount of a Loss" of FASB Statement No. 5, Accounting for Contingencies.
fn 3 Paragraph 26 of APB Opinion No. 30, Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, discusses unusual or infrequently occurring items.