IAASB Main Agenda (May 2006) Page 2006·1143 Agenda Item
9-F
Prepared by: Alta Prinsloo (April 2006) Page 1 of 10
PROPOSED INTERNATIONAL STANDARD ON AUDITING 450
(REDRAFTED)
EVALUATION OF MISSTATEMENTS IDENTIFIED DURING THE AUDIT
(Effective for audits of financial statements for periods beginning on or after [date])
CONTENTS
Paragraph
Introduction
Scope of this ISA ................................................................................................................... 1
Effective Date ........................................................................................................................ 2
Objective to be Achieved..................................................................................................... 3
Definitions............................................................................................................................. 4
Requirements
Accumulation of Identified Misstatements............................................................................ 5
Considerations as the Audit Progresses................................................................................. 6-8
Communication and Correction of Misstatements ................................................................ 9-13
Evaluating the Effect of Uncorrected Misstatements ............................................................ 14-16
Evaluating Whether the Financial Statements as a Whole are Free of
Material Misstatement ..................................................................................................... 17-18
Documentation....................................................................................................................... 19
Application Material
Accumulation of Identified Misstatements............................................................................ A1-A2
Considerations as the Audit Progresses................................................................................. A3-A4
Communication and Correction of Misstatements ................................................................ A5-
A10
Evaluating the Effect of Uncorrected Misstatements ............................................................ A11-
18
Evaluating Whether the Financial Statements as a Whole are Free of
Material Misstatement ..................................................................................................... A19-
A21
Documentation....................................................................................................................... A22
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Introduction
Scope of this ISA
1. This International Standard on Auditing (ISA) deals with the evaluation of misstatements
identified during the audit of financial statements. ISA 320, “Materiality in Planning and
Performing anAudit” deals with the determination of materiality and its application in planning
and performing an audit of financial statements. This ISAexplains how materiality is applied in
evaluating misstatements identified during the audit.
Effective Date
2. This ISAis effective for audits of financial statements for periods beginning on or after [date].
Objective to be Achieved
3. In relation to this ISA, the objective of the auditor is to evaluate the effect of uncorrected
misstatements on the financial statements and whether the financial statements as a whole are
free of material misstatement.
Definitions
4. The following terms are introduced in this ISA:
(a) Error – An unintentional misstatement in the financial statements.
(b) Factual misstatements – Misstatements about which there is no doubt.
(c) Fraud –An intentional act by one or more individuals among management, those charged
with governance, employees, or third parties, involving the use of deception to obtain an
unjust or illegal advantage. Two types of intentional misstatements are relevant to the
auditor, that is, misstatements resulting from fraudulent financial reporting and
misstatements resulting from misappropriation of assets.
(d) Judgmental misstatements – Differences arising from management’s judgments
concerning accounting estimates that the auditor considers unreasonable, or the selection
or application of accounting policies that the auditor considers inappropriate.
(e) Misstatement – A difference between the amount, 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 and
may result from:
(i) An inaccuracy in gathering or processing data from which the financial statements
are prepared;
(ii) An omission of an amount or disclosure;
(iii) An incorrect accounting estimate arising from overlooking or clear misinterpretation
of facts; and
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(iv) Management’s judgments concerning accounting estimates that the auditor
considers unreasonable or the selection and application of accounting policies that
the auditor considers inappropriate.
When the auditor expresses an opinion on whether the financial statements give a true and
fair view or are presented fairly, in all material respects, misstatements also include those
adjustments of amounts, classifications, presentation, or disclosures that, in the auditor’s
judgment, are necessary for the financial statements to give a true and fair view or present
fairly, in all material respects.
(f) Projected misstatements – 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. The determination of projected
misstatements and evaluation of the results are explained in ISA530, “Audit Sampling and
Other Means of Testing.”
(g) Uncorrected misstatements – Misstatements that the auditor has accumulated during the
audit and that management has not corrected.
Requirements
Accumulation of Identified Misstatements
5. The auditor shall accumulate misstatements identified during the audit, other than those that are
clearly trivial. (Ref: Para. A1-A2)
Considerations as the Audit Progresses
6. The auditor shall consider whether the overall audit strategy and audit plan need to be revised if
the nature of identified misstatements and the circumstances of their occurrence are indicative
that other misstatements may exist that, when aggregated with misstatements accumulated
during the audit, could be material. (Ref: Para. A3)
7. The auditor shall also determine whether the overall audit strategy and audit plan need to be
revised if the aggregate of misstatements accumulated during the audit approaches the
materiality level or levels. (Ref: Para. A4)
8. It may be necessary for management to examine a class of transactions, account balance or
disclosure to identify and correct misstatements therein. After management has examined a
class of transactions, account balance or disclosure and corrected misstatements that were
found, the auditor shall perform further audit procedures to reevaluate the amount of
misstatements.
Communication and Correction of Misstatements
9. The auditor shall communicate all misstatements accumulated during the audit to the
appropriate level of management on a timely basis. The auditor shall request management to
correct all such misstatements. (Ref: Para. A5-A7)
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10. If management refuses to correct some or all of the misstatements communicated to it by the
auditor, the auditor shall obtain an understanding of management’s reasons for not making the
corrections and take that into account when evaluating whether the financial statements as a
whole are free from material misstatement. (See paragraph 17.)
Management Representations
11. The auditor shall obtain written representation from management that it believes the effects of
uncorrected misstatements are immaterial, individually and in aggregate, to the financial
statements as a whole. A summary of such items shall be included in or attached to the written
representations. (Ref: Para. A8)
Communications with Those Charged with Governance
12. The auditor shall communicate uncorrected misstatements and their potential effect on the
auditor’s report with those charged with governance, and request their correction. The written
representation obtained from management in accordance with paragraph 11 shall form part of
this communication. In communicating the potential effect of the uncorrected misstatements on
the auditor’s report, the auditor shall address material uncorrected misstatements individually.
(Ref: Para. A9)
13. The auditor shall discuss with those charged with governance the reasons for, and the
implications of a failure to correct misstatements, having regard to the size and nature of the
misstatement judged in the surrounding circumstances, including possible implications in
relation to future financial statements. (Ref: Para. A10)
Evaluating the Effect of Uncorrected Misstatements
14. Prior to evaluating the effect o uncorrected misstatements, the auditor shall reassess the
materiality level or levels used in planning and performing the audit to confirm whether they
remain appropriate in the context of the entity’s actual financial results. (Ref: Para. A11-A12)
15. The auditor shall evaluate whether uncorrected misstatements are material, individually or in
aggregate. In making this evaluation, the auditor shall consider the size and nature of the
misstatements, both in relation to particular classes of transactions, account balances and
disclosures and the financial statements as a whole, and the particular circumstances of their
occurrence. (Ref: Para. A13, A15-A18)
16. The auditor shall also consider the effect of uncorrected misstatements related to prior periods
on the relevant classes of transactions, account balances or disclosures, and the financial
statements as a whole. (Ref: Para. A14)
Evaluating Whether the Financial Statements as a Whole are Free of Material
Misstatement
17. The auditor shall evaluate whether the financial statements as a whole are free of material
misstatement. In making this evaluation, the auditor shall consider both the results of the
evaluation of the uncorrected misstatements and the qualitative aspects of the entity’s
accounting practices. (Ref: Para. A19-20)
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18. If the auditor concludes that, or is unable to conclude whether, the financial statements as a
whole are materially misstated, the auditor shall consider the effect thereof on the auditor’s
report. (Ref: Para. A21)
Documentation
19. The auditor shall document:
(a) The amount below which misstatements would be regarded as clearly trivial.
(a) All misstatements accumulated during the audit, and whether they have been corrected
by management; and
(b) The auditor’s conclusion as to whether uncorrected misstatements, individually or in
aggregate, cause the financial statements as a whole to be materially misstated, and the
basis for that conclusion. (Ref: Para. A22)
***
Application Material
Accumulation of Identified Misstatements (Ref: Para. 5)
A1. The auditor may designate an amount below which misstatements would 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. “Clearly trivial” is
not another expression for not material. Matters that are “clearly trivial” will be of a wholly
different (smaller) order of magnitude than materiality used in planning and performing the
audit, and will be matters that are clearly inconsequential, whether taken individually or in
aggregate and whether judged by any criteria of size, nature or circumstances. Whenever there
is any uncertainty about whether one or more items are “clearly trivial,” it is presumed that the
matter is not “clearly trivial.”
A2. To assist the auditor in communicating misstatements accumulated during the audit to
management and those charged with governance, it is useful to distinguish between factual
misstatements, judgmental misstatements and projected misstatements.
Considerations as the Audit Progresses (Ref: Para. 6-8)
A3. The auditor cannot simply assume that a misstatement is an isolated occurrence. Evidence that
other misstatements may exist include, 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.
A4. If the aggregate of misstatements accumulated during the audit approaches the materiality
levels or levels, there may be a greater than acceptably low level of risk that possible
undetected misstatements, when taken with the aggregate of misstatements accumulated during
the audit, could exceed the materiality level. Undetected misstatements could possibly exist
because of the presence of sampling risk (the risk that the auditor’s conclusion based on a
sample may be different from the conclusion if the entire population was subjected to the same
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audit procedure) and non-sampling risk (the risk that the auditor may misinterpret audit
evidence and thus not recognize misstatements when they occur).
Communication and Correction of Misstatements (Ref: Para. 9-10)
A5. Timely communication of misstatements to the appropriate level of management is important as
it enables management to evaluate whether the items are misstatements, inform the auditor if
they disagree, and take action as necessary. Ordinarily, the appropriate level of management is
the one that has responsibility and authority to evaluate the misstatements and to take the
necessary action.
A6. Laws or regulations may prevent the auditor from communicating certain misstatements to
management, or others, within the entity. For example, laws or regulations may specifically
prohibit a communication, or other action, that might prejudice an investigation by an
appropriate authority into an actual, or suspected, illegal act. In such circumstances it may be
appropriate to seek legal advice.
A7. The correction of all misstatements accumulated during the audit assists management in
maintaining accurate accounting books and records and reduces the risks of material
misstatement of financial statements because of the cumulative effect of immaterial uncorrected
misstatements related to prior periods.
Management Representations (Ref: Para. 11)
A8. Because management is responsible for adjusting the financial statements to correct material
misstatements, it is important that the auditor obtain written representation from management
that any uncorrected misstatements, other than those that are clearly trivial, resulting from
either fraud or error are, in management’s opinion, immaterial, both individually and in the
aggregate. In some circumstances, management may not believe that certain of the uncorrected
misstatements are misstatements. For that reason, management may want to add to their written
representation words such as: “We do not agree that items … and … constitute misstatements
because [description of reasons].”
Communications with Those Charged with Governance (Ref: Para. 12-13)
A9. Where there is a large number of small 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.
A10.To reduce the possibility of misunderstandings, the auditor may request a written representation
from those charged with governance that explains why uncorrected misstatements brought to
their attention have not been corrected. Obtaining this representation does not, however, relieve
the auditor of the need to form a conclusion on the effect of uncorrected misstatements.
Evaluating the Effect of Uncorrected Misstatements (Ref: Para. 14-16)
A11.The auditor’s initial determination of the materiality level or levels is often based on estimates
of the entity’s financial results, because the actual financial results may not yet be known.
Therefore, prior to the auditor’s evaluation of the effect of uncorrected misstatements, the
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materiality level or levels used in planning and performing the audit are reassessed based on the
actual financial results.
A12.ISA 320 explains that, as the audit progresses, the materiality level or levels are revised in the
event of becoming aware of information during the audit that would have caused the auditor to
have determined different materiality level or levels initially. Thus, any significant revision of
the materiality level or levels is likely to have been made before the auditor applies the
materiality level or levels in evaluating the effect of uncorrected misstatements. However, as
explained in ISA320, if the materiality level or levels are revised to lower amount or amounts,
the lower amount or amounts determined for purposes of assessing risks of material
misstatements and designing further audit procedures, and the appropriateness of the nature,
timing and extent of further audit procedures, are reconsidered to ensure that sufficient
appropriate audit evidence is obtained on which to base the audit opinion.
A13.Before considering the aggregate effect of uncorrected misstatements, each misstatement is
considered separately to:
(a) Evaluate its effect on the relevant classes of transactions, account balances or
disclosures, including whether the materiality level for that particular class of
transactions account balance or disclosure, if any, has been exceeded;
(b) Evaluate whether it is appropriate to offset misstatements. If an individual misstatement
is judged to be material, it is unlikely that it can be offset by other misstatements. For
example, if revenue has been materially overstated, the financial statements as a whole
will be materially misstated, even if the effect of the misstatement on earnings is
completely offset by an equivalent overstatement of expenses. It may be appropriate to
offset immaterial misstatements within an account balance or class of transactions;
however, the risk that further undetected misstatements may exist is considered before
concluding that offsetting such immaterial misstatements is appropriate.1
(c) Evaluate the financial statement effect of classification misstatements. The determination
of whether a classification misstatement is material requires the use of professional
judgment and the evaluation of qualitative considerations, such a the effect of the
classification misstatement on debt or other contractual covenants, the effect on
individual line items or sub-totals on the effect on key ratios. There may be
circumstances where the auditor concludes that a classification misstatement is not
material in the context of the financial statements as a whole, even though it may exceed
the materiality level or levels applied in evaluating other misstatements. For example, a
misclassification between balance sheet line items may not be considered material in the
context of the financial statements as a whole when the amount of the misclassification is
small in relation to the size of the related balance sheet line items and the
misclassification does not affect the income statement or any key ratios.
1
The identification of a number of immaterial misstatements within an account balance or class of transactions may
require the auditor to reassess the risk of material misstatement for that account balance or class of transactions.
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A14.The cumulative effect of immaterial uncorrected misstatements related to prior periods may
have a material effect on the current period’s financial statements. Approaches that the auditor
may follow include:
• Considering the effect of uncorrected misstatements arising in the current period
affecting the income statement together with prior period uncorrected misstatements
flowing through the current period’s income statement;
• Considering only the cumulative uncorrected misstatements remaining in the ending
balance sheet; or
• Following both approaches.
Whichever approach is followed by the auditor, it is important that it be followed consistently
from period to period.
A15.The circumstances related to some misstatements may cause the auditor to evaluate them as
material, individually or when considered together with other misstatements accumulated
during the audit, even if they are lower than the materiality level for the financial statements as
a whole (or for a particular class of transactions, account balance or disclosure, if any).
Circumstances that may affect the evaluation include the extent to which the misstatement:
• Affects compliance with regulatory requirements;
• Affects compliance with debt covenants or other contractual requirements;
• Masks a change in earnings or other trends, especially in the context of general economic
and industry conditions;
• Affects ratios used to evaluate the entity’s financial position, results of operations or cash
flows;
• Affects segment information presented in the financial statements (e.g., the significance
of the matter to a segment or other portion of the entity’s business that has been
identified as playing a significant role in the entity’s operations or profitability);
• Has the effect of increasing management compensation, for example, by ensuring that
the requirements for the award of bonuses or other incentives are satisfied;
• Is a misclassification between certain account balances affecting items disclosed
separately in the financial statements (e.g., misclassification between operating and nonoperating
income or recurring and non-recurring income items; or a misclassification
between restricted and unrestricted resources in a not-for-profit entity);
• Is significant having regard to the auditor’s understanding of known previous
communications to users, for example in relation to forecast earnings;
• Relates to items involving particular parties (e.g., whether external parties to the
transaction are related to members of the entity’s management);
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• Is an omission of information not specifically required by the applicable financial
reporting framework but which, in the judgment of the auditor, is important to the users’
understanding of the financial position, financial performance or cash flows of the entity;
• Affects other information that will be communicated in documents containing the audited
financial statements (e.g., information to be included in a “Management Discussion and
Analysis” or an “Operating and Financial Review”) that may reasonably be expected to
influence the economic decisions of the users of the financial statements. ISA 720,
“Other Information in Documents ContainingAudited Financial Statements” deals with
the auditor’s consideration of other information, on which the auditor has no obligation
to report, in documents containing audited financial statements.
These circumstances are only examples; not all are likely to be present in all audits nor is the
list necessarily complete. The existence of any circumstances such as these does not necessarily
lead to a conclusion that the misstatement is material.
A16.ISA240, “TheAuditor’s Responsibility to Consider Fraud in anAudit of Financial Statements”
explains how the implications of a misstatement that is, or may be, the result of fraud ought to
be considered in relation to other aspects of the audit, even if the effect of the misstatement is
not material to the financial statements.
Considerations Specific to Public Sector Entities
A17.In the case of an audit of a public sector entity, the evaluation of the materiality of a
misstatement may also be affected by legislation or regulation and additional responsibilities to
report fraud, waste or abuse.
A18.Furthermore, issues such as public interest, accountability, probity and ensuring effective
legislative oversight, in particular, are considered when assessing whether an item is material
by virtue of its nature. This is particularly so for items that relate to compliance with
regulation, legislation or other authority.
Evaluating Whether the Financial Statements as a Whole are Free of Material
Misstatement (Ref: Para. 17-18)
A19.In considering the qualitative aspects of the entity’s accounting practices, the auditor recognizes
that management makes a number of judgments about the amounts and disclosures in the
financial statements. During the audit, the auditor is alert for possible bias in management’s
judgments. The auditor may conclude that the cumulative effect of a lack of neutrality, together
with the effect of uncorrected misstatements, cause the financial statements as a whole to be
materially misstated. Indicators of a lack of neutrality that may affect the auditor’s evaluation
whether the financial statements as a whole are materially misstated include the following:
• The selective correction of misstatements brought to management’s attention during the
audit (e.g., correcting misstatements with the effect of increasing reported earnings, but
not correcting misstatements that have the effect of decreasing reported earnings).
• Possible management bias in the making of accounting estimates.
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A20.[Proposed] ISA540 (Revised), “AuditingAccounting Estimates and Related Disclosures (Other
Than Those Involving Fair Value Measurements and Disclosures)” addresses possible
management bias in making accounting estimates. Indicators of possible management bias do
not constitute misstatements for purposes of drawing conclusions on the reasonableness of
individual accounting estimates. They may, however, affect the auditor’s evaluation of whether
the financial statements as a whole are free of material misstatement.
A21.[Proposed] ISA705, “Modifications to the Opinion in the IndependentAuditor’s Report,” deals
with circumstances that may result in a modification to the auditor’s opinion on the financial
statements, the type of opinion appropriate in the circumstances, and the content of the auditor’s
report when the auditor’s opinion is modified.
Documentation (Ref: Para. 19)
A22.Misstatements are documented in a manner that allows the auditor to:
(a) Separately consider the effects of factual misstatements, judgmental misstatements and
projected misstatements;
(b) Consider the aggregate effect of uncorrected misstatements on the financial statements as
a whole ;
(c) Evaluate whether the materiality level for a particular class of transactions account
balance or disclosure, if any, has been exceeded; and
(d) Evaluate the effect of uncorrected misstatements on key ratios or trends, and compliance
with legal, regulatory and contractual requirements (e.g., debt covenants).