Evaluating the Effect of Uncorrected Misstatements
considers materiality concepts already outlined previously. In this context, we can infer that misstatements are considered material if they would affect decisions made by users on the basis of the financial statements. This might include a decision not to invest in the entity, to invest more, to sell an investment, or not to contest a takeover bid. This decision affects what the entity’s future course of action might be and as such the decision may have future implications on the user. Material misstatements may also affect agreements or adherence to stipulated terms and conditions on contracts and might affect legal rights or obligations. By considering materiality in this context, it becomes evident that the consequences of material misstatements may require changes to the financial statements in order to reflect what management now has to do, rather than what it would have done but for the misstatement. This might include changes in accounting policy or restatement of comparative prior period amounts.
This section evaluates the effect of misstatements, both individually and in the aggregate, on the financial statements. In making this evaluation, the auditor considers the possibility of further undetected misstatements, for example in the recognition of contingent liabilities or in the accounting for future losses under a provision. When evaluating the effect of misstatements, auditors often consider the effect of correcting the misstatement in the following year, the misstatement’s effect on key ratios and the potential effect on share price. Widespread use of financial analysts’ forecasts as a measure of corporate performance has meant that the potential effect of misstatements on earnings per share and the extent to which earnings per share drives share valuation is also relevant to the evaluation of misstatements.
- Consideration of Materiality
Utilization of materiality concept is very important when deciding whether to correct the detected misstatements. When conducting auditing process, auditors will look into the financial statements as a whole. Materiality is a relative term that has the inference to the size and importance of misstatements identified during the audit to the users of financial statements. Misstatements are considered material if they could influence the economic decisions of users that are taken on the basis of the financial statements. Therefore it is said that materiality lies in the eyes of the beholder (Arens et al., 2012). Materiality for one company could be unmatched with the materiality for another company. Materiality for the largest public entity would be contrasted with materiality for the small private entity. Materiality levels of different users would also be different. Therefore the considerations surrounding materiality should be seen within the broader context of the role of financial statements and the audit in the capital markets as the definition of materiality proposed by FASB in its statements underlines the differs type of accounting and auditing judgement. High materiality level which known as known as performance materiality has been concern by the auditors when considering the effect of uncorrected misstatements. Performance materiality is set to reduce to an acceptably low level the probability that the aggregate of uncorrected and undetected misstatements does not exceed materiality for the financial statements as a whole. The higher the materiality level, the more the auditor willing to accept that there are undetected misstatements remain in the financial statement as the level of the materiality to the financial statement. Unfixed performance materiality at the higher level could result in increase of the probability of misstatements that known as over materiality. Over materiality occurs when the aggregate of uncorrected misstatements exceed performance materiality and it could represent potential impact for the financial statements users. This undue influence poses threats to the confidence of the users if there were material misstatements undetected at the end of the audit. Therefore, the considerable factors would be the cost for the users and the potential liabilities to the auditors. This situation would force some of the companies or auditors to amend the performance materiality at the lower level.
- Impact on Financial Statements
When evaluating the effects of uncorrected misstatements, consideration should be made to the impact on the financial statements. It is clear that misstatements can have very different effects on individual elements of financial statements, and the combined effects of different misstatements are often more serious than those of the individual misstatements. If a misstatement can change a loss into income or vice versa, it is more serious than if the misstatement can change income of $100,000 to $105,000. Materiality for the whole financial statements should be considered when evaluating the effects of misstatements. Another factor to consider is the potential the misstatement has to affect future cash flows of the client. If the misstatement involves recognizing an asset or liability that exists but has not previously been recognized, it has future economic repercussions. The effects are again more serious if the misstatement changes the classification of an item or affects the client’s compliance with debt covenants. The effects of misstatements on taxation or dividend declarations also have implications on future cash flows. The more serious the effects of misstatements, the more likely that the client will need to restate the financial statements. This is a serious outcome for the client and may lead to a loss of future work for the auditor.
- Disclosure Requirements
If the auditor has knowledge of a misstatement that would require disclosure, but the client refuses to make the disclosure, the auditor must determine the effect on his or her opinion. If the item is a pervasive one in that the misstatement affects many different items on the financial statements, or the failure to disclose puts into question other areas of the financial statements, the auditor will not be able to express an unqualified opinion.
There are certain kinds of misstatements which will require disclosure no matter how immaterial they may be in relation to a particular item. For instance, misstatements regarding accounting for a change in accounting principle or following revaluation of an asset under FAS No. 35 will always require note disclosure even if the misstatements are relatively small. This is because these kinds of item would be of interest to users as they indicate a change in the fundamentals of how the company is representing certain areas of its financial position.
The auditor must determine whether a misstatement is of such a nature that it affects the comparability of the financial statements. According to SAS No. 58, a misstatement of an item considered in isolation may be so slight that it does not affect the judgment of a reasonable person. Working with this guideline in mind, the auditor must consider the nature of the misstatement, its size, and the circumstances surrounding it in order to determine whether disclosure would be necessary for the financial statements to be fairly presented. This is the case also for items that would otherwise be considered clearly trivial.
