Evaluating misstatements and evidence

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Evaluating misstatements and evidence

MODULE 3 | 3.8 | STUDENT COMPANION

Throughout fieldwork the auditor accumulates every misstatement that isn't clearly trivial and classifies it

as factual, judgemental or projected. All of them go to management with a request for correction.

Corrections can change the numbers materiality was based on, so materiality may need revising; and the

nature of a misstatement can change the plan even after it is fixed. Finally the auditor asks whether the

risk assessments still hold and the evidence is sufficient and appropriate.

Accumulating misstatements

A misstatement is recorded on the schedule of misstatements unless it is clearly trivial: so small, and so

unremarkable in nature, that it clearly couldn't matter even when added to the others. If there is any doubt, an

item is not treated as clearly trivial. Clearly trivial is a much lower bar than immaterial; at Voltana it was set at 5%

of materiality, $30,000 at planning.

Three kinds of misstatement

Accumulate every misstatement found, unless it is clearly trivial (for Voltana, originally below $30,000). If there is any doubt, an item

is not treated as clearly trivial.

Factual

No doubt about it. For example, a sale

recorded in the wrong year

At Voltana

Revenue cut-off: about $1.2 million

Judgemental

Differences from management's

judgements on recognition, measurement,

presentation or disclosure, including the

choice or application of accounting policies,

that the auditor considers unreasonable or

inappropriate

At Voltana

Inventory write-down $0.3 million; warranty

provision at least $0.6 million

Projected

The auditor's best estimate of misstatement

in a population, extrapolated from a sample

At Voltana

Receivables not tested: about $18,000

All go on one schedule of misstatements: recorded, classified, totalled and evaluated

ADVANCED AUDIT AND ASSURANCE | M3 | 3.8 | STUDENT COMPANION

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Voltana's schedule of misstatements

Item Kind Amount Management

1 Revenue cut-off. June revenue for installations not done by

30 June, all through the CFO's manual journals

Factual about $1.2 million Corrects

2 Inventory. Older models carried at $2.1 million; sales after

year end support $1.8 million

Judgemental $0.3 million Corrects

3 Warranty. Auditor's range $18.6 million to $20.4 million;

management's figure $18 million

Judgemental at least $0.6 million Corrects, to $18.6

million

4 Receivables. $210,000 of cancellation credits never

processed, plus other sample errors

Factual and

projected

about $226,000 +

about $18,000

Corrects the $226,000

5 Disclosures. The lease called arm's length; the CFO's

brother's business left out

Disclosure No amount Corrects

Left uncorrected: projected receivables about $18,000 + an understated accrual of about $22,000 (kept on the schedule because it sits

close to the clearly trivial threshold) = $40,000

Reading the schedule. The warranty misstatement is measured to the nearest point of the auditor's range:

management's $18 million sits below a range of $18.6 million to $20.4 million, so the misstatement is at least

$0.6 million. The receivables item mixes kinds: $226,000 found and certain, plus about $18,000 projected onto

the balances that weren't tested. The disclosure item has no amount, but it still has to be fixed.

Communicating and correcting

The auditor must tell management about all accumulated misstatements on a timely basis and ask for them to

be corrected. Voltana's management corrects all five items, so what remains is small: the projected receivables

misstatement of about $18,000 and an understated accrual of about $22,000, which the team kept on the

schedule because it sits close to the threshold: $40,000 in total. Had management refused, the auditor would

have sought to understand why and taken those reasons into account in judging whether the statements are free

from material misstatement.

Why the evaluation isn't over

Corrections reduce profit

Profit before tax, as first measured $12.0m

Revenue cut-off - $1.2m

Inventory write-down - $0.3m

Warranty provision - $0.6m

Receivables - $0.2m

After corrections about $9.7m

So materiality is revised

Threshold At planning Revised

Overall materiality (5% of profit

before tax)

$600,000 about $480,000

Performance materiality (60%) $360,000 about $290,000

Clearly trivial (5% of materiality) $30,000 about $24,000

Then ask: is the work already done still enough?

Most of it is, because it was planned with the higher amounts in mind; the team extends testing where samples were designed around the old

thresholds

ADVANCED AUDIT AND ASSURANCE | M3 | 3.8 | STUDENT COMPANION

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Revising materiality. Materiality was 5% of a profit before tax of $12 million. The corrections total about $2.3

million ($1.2m + $0.3m + $0.6m + $0.226m), leaving about $9.7 million, and 5% of that is a little over $480,000.

Because the team would have set a lower amount had it known the true profit at the start, it revises all three

thresholds and checks whether work planned with the higher amounts is still enough.

When the nature matters more than the size

A corrected misstatement can still change the audit, because of what it reveals about people and controls. The

auditor revisits the audit strategy and plan when the nature of misstatements suggests others may exist. At

Voltana, revenue overstated through the CFO's own manual journals, together with an undisclosed business

owned by a family member and paid above-market rates, points towards possible intentional misstatement. So

the team:

extends its testing to every manual journal the CFO posted;

reconsiders how much weight to place on the CFO's representations;

considers whether legal advice is needed; and

plans to raise the matter with the audit committee.

The final questions before completion

Voltana's remaining $40,000 is well below the revised materiality of about $480,000, so on the numbers alone it

wouldn't change the opinion. Module 4 takes the story to completion.

Question What the auditor does

Do the risk assessments still hold? Revisits them in the light of what fieldwork found, and changes the plan if

they don't

Is the evidence sufficient and appropriate

for every material area?

Obtains more if not; if it can't be obtained, considers the effect on the

opinion

Are the uncorrected misstatements

material?

Judges them individually and in total, by size and nature; tells those

charged with governance and asks again for correction

What does management say? Obtains written confirmation that management believes the uncorrected

misstatements are immaterial, individually and in total, with a summary

of them included in the letter

ADVANCED AUDIT AND ASSURANCE | M3 | 3.8 | STUDENT COMPANION

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Practice questions

MODULE 3 | 3.8 | TRY THESE BEFORE THE WORKED ANSWERS

Question 1 - Classify the misstatements

Tolhurst Racking Ltd (imagined) makes steel storage racking for warehouses and has a 30 June year end.

Classify each misstatement found during the audit, and state its amount and its effect on profit.

Misstatement Factual, judgemental

or projected?

Amount and effect

(a) Repairs to the factory roof, $64,000, were finished on

24 June, but the invoice was recorded in July

(b) A sale of $85,000 was recorded on 29 June, but the

racking was dispatched on 3 July; it cost $55,000 to

make and was still on hand at 30 June

(c) Management's allowance for expected credit losses is

$40,000; the auditor's range, based on ageing and

receipts after year end, is $90,000 to $110,000

(d) A sample of inventory lines covering 8% of inventory

value had pricing errors of $3,100 (overstated); the

auditor's best estimate for the whole of inventory is

$38,750

(e) $48,000 spent on a new racking design was

capitalised, but the auditor considers the project still at

the research stage

(f) Timesheets covering 5% of June overtime showed

$1,200 not accrued; the auditor's best estimate for all of

June's overtime is $24,000

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Question 2 - Are the uncorrected misstatements material?

Tolhurst's schedule of misstatements is below. After management's corrections, profit before tax is $3,240,000.

The auditor set materiality at $160,000. The managing director is paid a bonus if profit before tax reaches

$3,200,000. Decide whether the uncorrected misstatements are material, considering both their size and their

nature.

Item Amount (overstates profit) Corrected?

(a) Roof repairs not accrued $64,000 Yes

(b) Sale recorded before dispatch $30,000 Yes

(c) Expected credit losses $50,000 No: 'just a difference of opinion'

(d) Inventory pricing $3,100 found; $35,650 projected Only the $3,100

(e) Research costs capitalised $48,000 Yes

(f) Overtime accrual $1,200 found; $22,800 projected Only the $1,200

Question 3 - Management refuses

Tolhurst's finance director refuses to adjust the allowance for expected credit losses, saying the $50,000

difference is immaterial and 'just a matter of opinion'. How should the auditor respond?

ADVANCED AUDIT AND ASSURANCE | M3 | 3.8 | STUDENT COMPANION

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Worked answers

MODULE 3 | 3.8 | WORKED ANSWERS - ATTEMPT THE QUESTIONS FIRST

Question 1 - Classification

Kind Amount and effect

(a) Factual $64,000: expenses and payables understated; profit overstated by $64,000

(b) Factual Revenue and receivables overstated by $85,000; the goods ($55,000) belong in

inventory, so profit is overstated by $30,000

(c) Judgemental (estimate) At least $50,000, the gap to the nearest point of the range: receivables overstated,

profit overstated

(d) Factual and projected $3,100 factual plus $35,650 projected for the untested lines: inventory and profit

overstated by $38,750 in total

(e) Judgemental (policy) $48,000: research costs must be expensed, so intangible assets and profit are

overstated

(f) Factual and projected $1,200 factual plus $22,800 projected: accrued expenses understated, profit

overstated by $24,000 in total

Question 2 - Material?

Size. Uncorrected: (c) $50,000 + (d) $35,650 + (f) $22,800 = $108,450, all overstating profit: about two-thirds

of materiality, so not material on size alone, though the projected amounts carry sampling risk and the true

figure could be higher.

Nature. Without the uncorrected items, profit before tax would be about $3,131,550, below the $3,200,000

bonus hurdle. They decide whether the managing director is paid a bonus, and the refusal to adjust the most

judgemental item, in management's favour, hints at bias.

Conclusion. Material by nature. Ask again for correction and tell those charged with governance; if they stay

uncorrected, the opinion is qualified ('except for'), not unmodified.

Question 3 - Management refuses

Understand the reasons. Is there new evidence, or only a preference for the lower figure? If the range still

holds after re-checking receipts after year end, the misstatement stands.

Reassess materiality, then evaluate the uncorrected misstatements individually and in total, with any from

prior periods, by size and nature, including the bonus hurdle and possible bias.

Communicate them to those charged with governance, asking for correction and explaining the effect on the

auditor's report.

Get a written representation that management believes the uncorrected misstatements are immaterial,

individually and in total, with a summary of them included in the letter; it doesn't replace the auditor's own

judgement.

If they are material, modify the opinion (qualified, or adverse if pervasive), consider what the refusal says

about management's integrity, and document the evaluation.

ADVANCED AUDIT AND ASSURANCE | M3 | 3.8 | WORKED ANSWERS

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