The completion stage of the audit is when the auditor reviews the work performed and considers the implications for the auditor’s report. A crucial part of this review is the evaluation of misstatements found during the audit. This article describes and discusses the requirements of ISA 450, Evaluation of Misstatements Identified during the Audit and provides some examples of the application of the ISA in the context of the Advanced Audit and Assurance exam.
ISA 450 – Objectives and definitions
According to ISA 450, the objectives of the auditor are to evaluate:
- The effect of identified misstatements on the audit, and
- The effect of uncorrected misstatements, if any, on the financial statements
A misstatement occurs when something has not been treated correctly in the financial statements, meaning that the applicable financial reporting framework, namely IFRS, has not been properly applied. Examples of misstatement, which can arise due to error or fraud, could include:
- An incorrect amount has been recognised – for example, an asset is not valued in accordance with the relevant IFRS requirement.
- An item is classified incorrectly – for example, finance cost is included within cost of sales in the statement of profit or loss.
- Presentation is not appropriate – for example, the results of discontinued operations are not separately presented.
- Disclosure is not correct or misleading disclosure has been included as a result of management bias – for example, a contingent liability disclosure is missing or inadequately described in the notes to the financial statements.
Specific requirements and application of ISA 450
ISA 450 requires that ‘the auditor shall accumulate misstatements identified during the audit, other than those that are clearly trivial’.
The auditor should set a monetary benchmark below which misstatements are considered to be clearly trivial and would not need to be accumulated because the auditor expects that the accumulation of such amounts clearly would not have a material effect on the financial statements. The application notes to ISA 450 make it clear that ‘clearly trivial’ is not another expression for ‘not material.’ The auditor will need to use judgement to decide whether matters are clearly trivial, and this may be affected by a range of issues including but not limited to the monetary size of the matter, for example, the level of audit risk being applied in the situation.
ISA 450 also requires that ‘The auditor shall communicate on a timely basis all misstatements accumulated during the audit with the appropriate level of management, unless prohibited by law or regulation. The auditor shall request management to correct those misstatements.’
Simply put, this means that the auditor keeps a note of all misstatements (other than those which are clearly trivial), raises them with management and asks for the misstatements to be corrected in the financial statements.
It is useful, when evaluating misstatements and in making requests to management for misstatements to be corrected, to consider and apply the framework as laid out in ISA 450, which categorises misstatements as follows:
- Factual misstatements are misstatements about which there is no doubt. An example would be a clear breach of an IFRS requirement meaning that the financial statements are incorrect, for instance if a necessary disclosure is missing – for example, non-disclosure of EPS for a listed company.
- Judgmental misstatements are differences arising from the judgments of management concerning accounting estimates that the auditor considers unreasonable, or the selection or application of accounting policies that the auditor considers inappropriate. There are of course many examples of using judgement in financial reporting, for instance, when determining the fair value of non-current assets, the level of disclosure necessary in relation to a contingent liability, or the recoverability of receivables.
- Projected misstatements are the auditor’s best estimate of misstatements in populations, involving the projection of misstatements identified in audit samples to the entire populations from which the samples were drawn.
For the auditor it is important to distinguish between these types of misstatements in order to properly discuss them with management, and ask for the necessary corrections, where relevant, to be made. For example, with a factual misstatement, there is little room for negotiation with management, as the item has simply been treated incorrectly in the financial statements. With judgemental misstatement there is likely to be more discussion with management. The auditor will need to present their conclusion based on robust audit evidence, in order to explain the misstatement which has been uncovered, and justify a recommended correction of the misstatement.
With projected misstatements, because these are based on extrapolations of audit evidence, it is normally not appropriate for management to be asked to correct the misstatement. Instead, a projected misstatement should be evaluated to consider whether further audit testing is appropriate.
Correction of Misstatements
Management is expected to correct the misstatements which are brought to their attention by the auditor. If management refuses to correct some or all of the misstatements, ISA 450 requires the auditor to obtain an understanding of management’s reasons for not making the corrections, and to take that understanding into account when evaluating whether the financial statements as a whole are free from material misstatement.
Evaluating the Effect of Uncorrected Misstatements
The auditor is required to determine whether uncorrected misstatements are material, individually or in aggregate. At this point the auditor should also reassess materiality to confirm whether it remains appropriate in the context of the entity’s actual financial results. This is to ensure that the materiality is based on up to date financial information, bearing in mind that when materiality is initially determined at the planning stage of the audit, it is based on projected or draft financial statements. By the time the auditor is evaluating uncorrected misstatements at the completion stage of the audit, there may have been many changes made to the financial statements, so ensuring the materiality level remains appropriate is very important.
Some misstatements may be evaluated as material, individually or when considered together with other misstatements accumulated during the audit, even if they are lower than materiality for the financial statements as a whole. Examples include, but are not restricted to the following:
- Misstatements which affect compliance with regulatory requirements
- Misstatements which impact on debt covenants or other financing or contractual arrangements
- Misstatements which obscure a change in earnings or other trends
- Misstatements which affect ratios used to evaluate the entity’s financial position, results of operations or cash flows
- Misstatements which increase management compensation
- Misstatements which relate to misapplication of an accounting policy where the impact is immaterial in the context of the current period financial statements, but may become material in future periods
Communication with those charged with governance
ISA 450 requires the auditor to communicate uncorrected misstatements to those charged with governance and the effect that they, individually or in aggregate, will have on the opinion in the auditor’s report. The auditor’s communication shall identify material uncorrected misstatements individually and the communication should request that uncorrected misstatements be corrected. The auditor may discuss with those charged with governance the reasons for, and the implications of, a failure to correct misstatements, and possible implications in relation to future financial statements. Perhaps the key issue here is that that auditor should discuss the potential implications for the auditor’s report, which is likely to contain a modified opinion, if material misstatements are not corrected as requested by the auditor.
In addition the auditor is required to request a written representation from management and, where appropriate, those charged with governance with regard to whether they believe the effects of uncorrected misstatements are immaterial, individually and in aggregate, to the financial statements as a whole.
Finally, ISA 450 requires certain documentation in relation to misstatements:
- The amount below which misstatements would be regarded as clearly trivial
- All misstatements accumulated 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, and the basis for that conclusion.
This is an important part of the audit working papers, as it shows the rationale for the auditor’s opinion in relation to material misstatements.
Candidates preparing for the Advanced Audit and Assurance exam should ensure that they are familiar with the requirements of ISA 450 as ultimately in forming an opinion on the financial statements the auditor must conclude on whether reasonable assurance has been obtained that the financial statements as a whole are free from material misstatements and this conclusion takes into account the auditor’s evaluation of uncorrected misstatements.
Written by a member of the P7 examining team